‘Fiscal Federalism’ in India since 1991 (Unit 3 , Reading 2)

Widening Regional Disparities

o The gap between rich and poor regions in India has been growing since the 1960s.

o The 1991 economic reforms (liberalization, privatization, globalization) made these

disparities worse.

o This inequality is seen both between states (rich states vs. poor states) and within
states (rich vs. poor people in the same state).

o The gap is not just economic but also social (education, healthcare, employment).

o The gap has widened between agriculture and non-agriculture (manufacturing,

services).

o Some regions developed more industrially, while others remained agricultural and
poor.

o The divide between rural and urban areas has also increased.

Unchanging Income Ranks of States

o The ranking of states based on per capita income (average income per person) has
remained the same for 30 years.

o Only minor changes happened for middle-income and high-income states.

o The rich states stay rich and the poor states stay poor, regardless of government
policies.

o The wealth of a state is not dependent on natural resources.

o Some resource-rich states remain poor, while some resource-poor states become
wealthy.

Growth in Low-Income States

o From 2005 to 2010, four poorer states grew faster than the national economy.

o This was unusual because poor states generally lagged behind.

o This growth was unexpected and not well-researched.

o The media praised Bihar’s economic growth, calling it a "miracle".

o However, Bihar’s economy had already started improving before the NDA
government took office in 2005.
Bihar’s Economic Growth

o Bihar depended heavily on central government funds for development.

o However, per person development spending in Bihar was lower than the national
average by 2010–11.

o The tax collection in Bihar, compared to its total income (GSDP), did not increase
despite economic growth.

o This means the state’s economy grew, but the government did not collect much tax
from it.

Impact of Growth on Social Disparities

o Economic growth in poor states did not significantly improve social issues
(education, healthcare, poverty reduction).

o This is a common issue in India—growth does not always lead to better living
conditions.

The Sound Finance Paradigm

o After 25 years of economic reforms, discussions on federalism (state vs. central

power-sharing) have decreased.

o After independence, states and the central government fought over many issues
like:

 How much power each state should have

 Land reforms

 Unequal distribution of industries and development funds

 Industrial policies

o The 1991 reforms ended many of these political conflicts.

o After that, federalism was divided into political federalism (governance issues) and
fiscal federalism (financial relations between states and the center).

o Political federalism (governance issues) became less important.

o Fiscal federalism (how money is shared between states and the center) became the
main topic of discussion.

Shift to Fiscal Federalism

  After 1991, the focus shifted away from political disputes between the states and the central
government.

 Instead, the government started handling financial issues in a technical and managerial way,
treating states like business units rather than political entities.

 The neo-liberal policies (free-market reforms) made the government less involved in directly
running the economy.

 Instead, the government’s new role was to encourage private investment (help businesses
grow rather than directly controlling industries).

 Earlier, financial problems were understood in a broad way (historical and structural issues).

 After 1991, the solution became fiscal compression (cutting government spending).

 The government believed the biggest problem was excessive spending ("fiscal profligacy"),
so they focused on reducing debt and deficits.

 The government started focusing on financial discipline rather than welfare or

redistribution.

 "Sound finance" means the government should avoid deficits, reduce spending, and not
borrow excessively.

 This rhetorical question asks: Do states really waste money?

 The assumption that state governments overspend and need strict financial control is
questioned.

 The "sound finance" approach treats states like individual businesses in a free market.

 "Bounded rationality" means states make financial decisions with limited information and
are expected to act efficiently, like a company minimizing costs.

 This approach ignored the deeper role of the state in development.

 Instead of analyzing why states behave in certain ways, it only focused on what they do
financially.

Neo-liberalism and Fiscal Federalism

 Over time, neo-liberal policies became more rigid, increasing inequalities.

 Fiscal federalism was now seen as a way to efficiently deliver public services rather than
redistribute wealth among states.

 The government confused two ideas:

o Decentralization: Giving local governments more decision-making power.

o Devolution: Transferring financial resources to states and local governments.

  The government claimed to give states more power, but in reality, it only gave them
financial responsibility without enough resources.

 The idea was that states should compete with each other to attract businesses and manage
resources better.

 This was expected to improve efficiency in delivering education, healthcare, and

infrastructure.

 Policymakers debated how large or small states should be to function effectively.

Criticism of the Sound Finance Paradigm

 The sound finance approach assumed that government borrowing (fiscal deficit) would
automatically cause inflation.

 This is not always true because borrowing can also increase production, creating more
goods.

 The belief was that if the government prints more money (monetizes the deficit), it would
lead to inflation.

 Another fear was that government borrowing would reduce private sector investment
("crowding out").

 The statement challenges the sound finance argument:

o If the economy is already at full capacity, increasing money supply might cause
inflation.

o But in India, where unemployment is high, deficit spending can actually boost
production and jobs.

 If government spending increases production, there will be more goods in the market.

 This means prices won’t necessarily rise because supply is also increasing.

 Inflation does not only depend on government spending—many other factors (demand,
wages, global economy) affect it.

 If government spending creates investments in industries, the effect on inflation takes time
and isn’t immediate.

 Just because the government prints money or borrows, it does not automatically mean
inflation will happen.

 If the government borrows instead of printing money, some economists argue that interest
rates might rise, making it harder for businesses to borrow.

 This challenges the idea that government borrowing is bad for private investment.

 In reality, India has high unemployment, so increasing government spending can help rather
than harm the economy.
 o The sound finance paradigm (which focuses on reducing government deficits and
spending) is not based on strong economic logic.

o This is because cutting spending is not always the best solution, especially in
developing economies.

o Since 1991, policymakers have pushed for fiscal austerity, meaning reducing
government spending and controlling deficits.

o These austerity policies led to the introduction of the Fiscal Responsibility and
Budget Management (FRBM) Act in 2004, which legally mandated governments to
limit borrowing and spending.

o The 12th (2005-10) and 13th (2010-15) Finance Commissions played a crucial role in
shaping these policies.

o They recommended rules for how much states and the central government could
borrow and spend.

o Fiscal policy was treated as a technical, management-driven issue rather than a

political or social one.

o Policymakers claimed that economic policies should be "neutral" and not

influenced by ideology, but in reality, the policies followed a neo-liberal, market-
driven ideology.

o The government forced states to adopt fiscal discipline laws (like FRBM) through
various financial policies.

o States were given incentives ("carrot") such as debt relief if they followed fiscal
discipline rules.

o However, there were also penalties ("stick"), where states had to meet strict
financial performance targets to receive central funds.

 The financial evaluation of states was based on a corporate-style performance review

system.

 Just like employees in a company are given performance targets and judged based on their
results, states were evaluated based on their fiscal discipline (low borrowing, controlled
spending).

o Even economists who support the idea of fiscal discipline (like Rao 2007) criticized
some aspects of the policy.
 o The fixed fiscal deficit and debt limits imposed on states and the center were not
based on India's economic reality.

o These limits were arbitrarily chosen rather than being based on actual economic
conditions.

o India's fiscal rules copied the Maastricht Treaty of the European Union (EU) without
considering India's unique economic situation.

o The Maastricht Treaty had set strict fiscal rules for EU countries (like maintaining a
fiscal deficit below 3% of GDP).

o India adopted similar targets without questioning whether they were appropriate
for a developing economy.

 The FRBM Act and similar laws were not standalone policies.

 They were part of a broader economic reform agenda aimed at reducing government
intervention in the economy.

 Officially, these reforms were supposed to increase government spending in a structured

way.

 The goal was to:

1. Increase planned expenditure (spending based on a well-defined budget).

2. Prioritize capital expenditure (investing in long-term infrastructure like roads, power

plants, and schools).

3. Allocate funds for operation and maintenance (ensuring existing infrastructure and
services function properly).

 The government wanted to fund projects using its own revenue (like taxes) rather than
borrowing.

 At the same time, it wanted to ensure that both the central and state governments
followed strict financial discipline (by reducing deficits and controlling debt).

 This approach was based on the sound finance model, which emphasized low deficits and
limited borrowing.

 "Fiscal federalism" (the financial relationship between the center and states) was shaped by
austerity policies.

 The central government forced states to cut spending as a condition for receiving financial
aid.
  The 12th, 13th, and 14th Finance Commissions promoted this expenditure compression
(reducing government spending).

 This one-size-fits-all approach did not consider the unique economic needs of different
states.

 The strict fiscal rules undermined India's federal structure.

 In true federalism, states should have financial autonomy (control over their own budgets).

 However, by forcing states to follow strict financial rules, the central government weakened
their independence.

 Even by the most limited definition of federalism, these policies reduced state-level
decision-making power in financial matters.

Line-by-Line Explanation of Expenditure Compression

 The sound finance paradigm (which emphasizes balanced budgets and low government
spending) became dominant in India after economic liberalization in 1991.

 This meant that the government faced pressure to keep taxes low while also keeping the
fiscal deficit under control (i.e., not spending more than it earned).

 Since the government could not increase taxes much and also had to limit borrowing, it
reduced spending (expenditure compression).

 This deepened economic inequality—as the government spent less on welfare, agriculture,
and social sectors, only the wealthy and corporate sectors benefited.

 After liberalization in 1991, the private corporate sector grew rapidly, meaning big
businesses became more powerful.

 However, this growth was concentrated among a small number of large business groups
(big industrial houses, conglomerates, and multinational companies).

 The corporate sector grew faster than the rest of the economy, but the benefits of this
growth were not equally shared.

 A large portion of the income was concentrated at the top (owners and investors), rather
than being distributed fairly among workers.

 In the early 1990s, 55% of corporate sector earnings went to employees as salaries.

 By 2007–08, this had fallen to around 33% or less, meaning workers were getting a smaller
share of the total income.

 Even though some high-ranking employees (white-collar workers) received salary hikes, the
overall share of wages declined.
 Wages stopped growing (wage stagnation) in the organized factory sector (large, formal
companies).

 The share of wages in total production value (value added) decreased sharply, meaning
companies kept more profits instead of paying workers more.

 This helped increase inequality, as corporate profits rose while workers' earnings remained
stagnant.

 The wage stagnation was connected to a larger labor market crisis.

 One of the biggest causes was India’s agrarian crisis (a long-term decline in rural farming
incomes, which started in the mid-1990s).

 Due to the agrarian crisis, many farmers and rural workers were forced to leave agriculture
and look for jobs in cities and other industries.

 This led to a huge surplus of workers in the job market.

 Since there were too many job seekers, wages in non-agricultural jobs also remained low,
as companies did not need to increase salaries when there were so many workers available.

 Economic growth became highly unequal (polarizing growth).

 The corporate sector benefited greatly, while workers and rural communities struggled.

 The corporate sector’s share of total income increased dramatically, meaning big
businesses took a larger slice of India’s economic pie.

 Even though the economy grew and inequality increased, tax revenue did not increase
significantly.

 This means that the government failed to collect enough taxes to support welfare programs
and public services.

 India’s tax revenue (as a percentage of GDP) had steadily increased over the decades:

o 6% in 1950-51

o 10-11% in the 1970s

o 15-15.5% in the late 1980s

 However, after 1991, this tax growth trend stopped.

 The tax-to-GDP ratio stagnated or even declined in the 1990s.

 The central government’s tax collection performed worse than the combined tax
collections of all Indian states.
  State governments were better at collecting taxes than the central government, especially
after 2007-08.

 The type of taxes collected also changed after 1991.

 Direct taxes (income tax, corporate tax) became a bigger part of total revenue compared to
before 1991.

 The policy of reducing government spending (expenditure compression) was a key reason
behind:

1. The agrarian crisis (lack of government support for agriculture).

2. Underfunding of social services (healthcare, education, welfare).

3. Limited investment in infrastructure and industry (capital expenditure).

 This deepened economic inequality, making India’s growth highly polarized, benefiting
corporations while harming workers and rural communities.

“Trends in Taxation” :

 Expenditure compression (reducing government spending) has become a central feature

("raison d’être") of fiscal federalism (how financial powers and responsibilities are shared
between central and state governments) in India post-1991.

 This has helped India integrate into the global economy, but the strategy was based on
making labour cheaper — essentially reducing wages and benefits for workers to stay
competitive internationally.

 Alongside spending cuts, there's been a noticeable lack of discussion or transparency

around how much people (especially the rich or corporates) are actually paying in effective
direct taxes (like income or corporate tax).

 The current economic system heavily favors capitalists (owners of production) over labour,
meaning workers don’t get a fair share of the economic pie.

 Classical capitalism solves this imbalance through progressive direct taxes—taxing the rich
more—to fund essential services and ensure some redistribution.

 Progressive taxation helps fund basic social welfare (health, education, housing etc.) and
also compensates for the unpaid labour that is often exploited, especially in informal
sectors, domestic work, etc.

 India’s tax policies were not focused on redistribution or welfare, but were instead designed
to support private businesses and investment.

 The Chelliah Committee argued that India’s tax system was inefficient due to:
 o High tax rates,

o Complex tax administration,

o Too many overlapping taxes.

 Hence, they pushed for reforms focused on simplification and lowering tax rates, not
necessarily on equity.

 Instead of taxing more progressively, reforms focused on making the system simpler and
reducing rates — this is called “rationalisation”.

 In addition to lower rates, the government gave out numerous tax breaks and subsidies to
corporations as a way to encourage private investment.

 While many have debated these policies, there’s been little consistent data to show how
these tax breaks have actually affected how much tax is being paid in reality.

 A key reason for this lack of evidence is that the government stopped publishing detailed
direct tax data, making analysis difficult.

 Since 1989–90, the CBDT no longer provides tax data by state and category, cutting off
important information for analysis.

 After 1999–2000, they also stopped publishing national-level data about how much income
was assessed and how much tax was collected by category (individuals, firms, etc.).

 After 10+ years, a small amount of new data was released for 2012–2014 — but it’s still far
from comprehensive.

 Ironically, when debates about fair taxation were intensifying, and direct taxes slightly
increased relative to indirect taxes, the lack of data meant that these trends couldn’t be
fully understood or evaluated.

 Despite these limitations, the authors have manually compiled data from older government
documents to estimate effective income tax rates for different categories (like individuals,
firms, etc.).

 The way tax data is reported doesn’t match the way corporate power is actually structured,
revealing a major disconnect.

 The tax system treats five different taxpayer categories (like individuals, firms, companies,
trusts, etc.) as if they are completely separate, without any connection.
 In reality, especially in family-run businesses, ownership is interlinked across all these tax
categories. So, while they appear separate on paper, they are actually parts of the same
corporate empire, making tax transparency and enforcement more difficult.

 Tax reform reports over the past 20 years assume that each corporate entity operates
independently and that simply lowering tax rates will rationalise the system.

 However, this ignores how real-world businesses—especially family-run groups—

interconnect and manage their taxes across multiple entities, which creates opportunities
for tax avoidance.

 Data from sources like the PROWESS database (which tracks company financials) show that
most firms making a profit pay less than 25% in effective taxes.

 Ironically, bigger firms often pay even lower tax rates than smaller ones, despite making
more money.

 While PROWESS helps paint the big picture, it has major limitations:

o It doesn’t show what kind of firm (e.g., HUF, trust, partnership).

o It misses the interconnections (ownership/control overlaps) between firms or with

HUFs.

o It ignores how tax policy changes affect different types of entities in different ways.

On historical ETR trends (Table 1)

 The authors identify three major patterns in effective tax rates (actual taxes paid as a % of
profits) based on historical data.

 During India’s planned economy phase under Nehru and the Mahalanobis model (which
focused on public sector growth and heavy industry), tax rates were stable.

 Exception: Registered firms (like partnerships and sole proprietorships) saw their effective
tax rates gradually rise in the late 1950s to early 60s.

 From 1972–75, all categories experienced an increase in tax rates.

 This happened at the same time as the MRTP Act, which aimed to control economic
concentration and monopolies—so it makes sense that taxes went up to enforce regulation.

 After 1975, different types of tax entities started showing very different trends in their ETRs,
rather than moving together.

 Specifically, Hindu Undivided Families (HUFs) paid more and more in taxes over this period.

 Two major changes explain this:

1. HUFs were taxed at the same rates as individuals, removing earlier benefits.

2. States like Kerala and Andhra Pradesh scrapped special tax privileges for HUFs,
increasing their burden.
 Post-liberalisation (after 1991 reforms), individuals and HUFs paid less and less in effective
taxes, reflecting policy shifts toward lower direct taxes.

On Limited Liability Companies and other categories

 Since the mid-70s, companies with limited liability (i.e., most corporations) and other non-
individual entities (like trusts and societies) have experienced a dramatic fall in their tax
burden.

 By 2000, limited liability companies were paying less than 10% of their profits as tax,
despite the nominal rates being higher.

 Back in 1947, partnerships (unlimited liability) paid the least tax, while corporations
(limited liability) paid the most.

 This trend has completely reversed over time, especially after liberalisation.

Shift in effective tax rates after 1991

 After 1991, the earlier pattern flips:

o Registered firms (like partnerships) started paying more taxes steadily.

o Limited liability companies (most big corporates) saw a sharp drop in actual taxes
paid, even though policies were supposedly pro-growth for all.

 This trend grew stronger post-liberalisation:

o By 2000, smaller entities were paying higher effective tax rates than big
corporations, which is ironic given their relative capacity.

 The tax paid by Hindu Undivided Families (HUFs) became nearly equal to what individuals
paid, reflecting policy changes that removed special treatment.

Two key methodological insights

 Based on this data, the author makes two important points about how we analyze tax policy.

 ETR trends had already started diverging well before 1991, suggesting that the so-called
'reforms' didn't cause the changes, but continued and reinforced existing trends.

 The prevailing policy logic (that liberalisation and tax reforms drive growth) cannot explain
these taxation trends.

 So, trying to find cause-effect links within that paradigm is methodologically flawed—it
misses the bigger picture.

 The real tax unit in India isn’t just a company, HUF, or individual—it’s the entire web of
interlinked entities owned/controlled by family-run business groups.

 This combined structure should be the actual focus of taxation to ensure fairness and
accountability.
 The MRTP Act (Monopolies and Restrictive Trade Practices Act) was the only law that
acknowledged these interlinked structures, treating them as a single economic entity.

 Sadly, it was dismantled during liberalisation, removing a critical tool for checking the
power of big business.

 Even today, no proper database exists on how families control multiple firms and assets.

 This data vacuum helps wealthy entities hide ownership and avoid taxation.

Regressive tax system and income inequality

 Despite 25+ years of "reforms", India’s tax system is still regressive:

o The richer a corporate entity is, the less tax it pays proportionally.

o This is backwards from what a progressive tax system is supposed to be.

Need for data transparency and monopoly tracking

 If India’s economy is going to run on free-market competition, we must build data systems
to:

o Track monopolies/oligopolies.

o Measure their real tax burdens (ETRs).

 Otherwise, claims of a fair and open market are meaningless.

Link to resource crunch and labour exploitation

 It’s not just income taxes—wealth and property taxes have also become less burdensome
for the rich, further deepening inequality.

 India’s "resource crunch"—lack of funds for public services—is directly tied to decades of
declining taxation on the wealthy, despite economic growth.

 The state has:

o Reduced public spending (education, healthcare, etc.), pushing this burden onto
households (unpaid labour).

o Also cut support for industries that generate real jobs, worsening the employment
crisis.

 Since 1991, India has followed a clear fiscal strategy:

o Lower taxes on big business, expecting this to boost investment and growth.

o But this has harmed revenue collection, increased inequality, and undermined
welfare.
From VAT to GST :

GST and erosion of state powers

 After 1991, fiscal federalism in India shifted further by reducing state governments' power
to levy taxes, all in the name of "efficiency" and simplifying the tax structure through one
unified rate.

 GST, introduced through the 122nd Amendment in 2014, merged most central and state
indirect taxes into one tax.

 This change is now being re-examined because it appears to centralize more power with the
Union government, raising questions about true federalism.

GST and the "common market" concept

 GST was promoted as a way to unify the Indian market by making tax rates uniform and
eliminating barriers between states.

 However, even the U.S., despite being a giant economy, doesn't use VAT or GST—each state
has its own sales tax, showing that decentralized tax systems can work.

 If a common market is so essential, why hasn't the U.S. adopted it? The question challenges
the necessity and universality of India’s GST move.

Imported economic models without context

 India’s push for a common market under GST mimics the European Union model
(Maastricht Treaty), where several sovereign nations agreed to form a joint market.

 The European common market aimed to unify separate countries, but it's now facing serious
challenges, showing that this model may not be perfect or stable.

 India is blindly copying a Western model (like EU's common market) without properly
understanding its own unique state structure, proving there's no coherent theory behind
India’s fiscal decisions.

India vs. Europe – fundamental differences

 In Europe, the need for a common market made sense—they were different countries but
had similar consumption habits.

 Indian leaders claim that GST is a "home-grown reform", but it clearly borrows ideas from
Europe, ignoring the fact that India’s states are very diverse, unlike European nations'
similar consumer profiles.

In European countries that didn't have similar consumption (like Eastern European nations),
VAT/GST was forced upon them as a pre-condition to join the EU, not something they freely
adopted.
Efficiency narrative questioned

 Only in developing countries like India or African nations has the push for VAT/GST been
justified using “efficiency”—not in developed countries like the U.S. or original EU members.

 So, the idea that efficiency is the global reason for GST is false—many parts of the world
didn’t adopt it for this reason.

 GST assumes full employment and economic uniformity (which India lacks). In reality,
efficiency was rebranded as “ease of doing business”, just to appeal to investors.

 The real reason for GST isn’t economic theory—it’s class politics. The state is now serving
business elites, not the public.

GST ignored lessons from VAT

 India rushed into GST without learning from its own experience with VAT, which was the
first step in tax reform.

 The justification was that the older tax system was inefficient, full of tax-on-tax (cascading)
effects, and didn’t improve revenues (tax buoyancy).

 VAT was introduced with great expectations: it would streamline taxes, allow input tax
credits, and boost tax revenue relative to GDP.

 For VAT to work efficiently, the economy needed to have a single tax rate and uniform
goods—but India’s economy is far too diverse for this to hold true.

 Despite over 10 years of VAT, there’s no evidence that it boosted revenue—tax buoyancy
did not improve, debunking its promises.

 In Bihar, almost every tax office saw a drop in revenue performance after VAT was
introduced. Only 3 out of many showed slight improvement, highlighting the failure of VAT
on the ground.

 The main policy discussions about GST centered around finding the right RNR — a rate that
ensures states do not lose revenue after moving to GST.

 States were promised compensation for any revenue losses post-GST implementation, based
on this RNR calculation.

 The data used to calculate RNRs often comes from databases like PROWESS, which estimate
figures rather than using actual data — especially regarding "sin goods" (like alcohol or
tobacco).

 These assumptions make the RNR estimations unreliable and lacking scientific precision.

 Accurate GST design would require detailed data from every tax circle (local administrative
division) within each state, showing commodity-wise sales and taxes.
 Experts advising on GST never used this readily available data, even though tax officials
already had detailed and digitized information.

 In Bihar, nearly half the VAT revenue growth came from commodities like petrol, coal, liquor,
and electricity — which are not included under GST.

 This means half of Bihar’s taxable goods were left out of GST, making GST’s impact limited in
such states.

 Most RNR studies assumed only 30–35% of goods would be exempt from GST.

 These assumptions severely underestimate the real situation in low-income states like Bihar,
where the exempted share is much higher.

 Policymakers ignored the fact that within a state, different areas contribute very unequally to
tax revenues.

 Most taxable activity happens in a few commercial cities, not evenly across the state.

 In Bihar, Patna alone contributes 86% of the VAT revenue, showing extreme concentration.

 This problem isn’t just in poor states — it affects wealthier states too.

 For example, Hyderabad and Mumbai dominate tax revenue collection in their respective
states.

 Developed countries have similar consumption patterns across regions, making GST easier
and more justified there.

 In India, where consumption is highly unequal, moving to GST is poorly thought out and
overly optimistic.

 GST was wrongly presented as a trade-off between production and consumption states,
ignoring deeper economic realities.

 Richer states tend to both produce and consume more, making them winners under GST.

 Poorer states like Bihar have weak production and consumption due to their agriculture-
heavy economies — they lose out under GST.

 To truly understand state-wise impact, we must examine current data on commodity-level

taxes in each state.
 Reforms since 1991 ignored India’s deep structural problems — like informal transactions
and domination by a few big players — which distort tax collection.

 India’s fiscal federalism has become contradictory: it follows a flawed “sound finance”
ideology and simultaneously weakens state powers.

 Technocratic justifications hide the real agenda: reducing state autonomy and shifting power
and profits toward capital, away from labor and local governments.