Fiscal Federalism is a term coined by American economist Richard Musgrave in 1959.
Fiscal federalism is an economic framework for understanding the relationship among federal, state, and local governments that focuses on the division of spending and taxing powers among these governments.
First of all, what do we mean by the term federal. Federation is defined as the form of government in which there is a division of powers between the governing bodies. One body holds the reins of the central government and the other is responsible for the state or local government. Each of them is independent to perform in their own sphere without any interference. So, both of these government have to collect revenues so that they will be able to dispense their duties effectively. For this the resources should be divided effectively between the two governments. Some countries also have local governments in addition to state and central government so the division should be done accordingly.
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Among the different criteria of division, one is the division of responsibilities. It is argued that the central government should be responsible for macroeconomic policies but state governments should be primarily responsible for fire protection services. Another cornerstone of division is that of revenue-raising powers among various governments, often referred to as “tax assignment.” Taxes on highly mobile entities should be assigned to the central government, and taxes on less mobile entities to state or local governments. Last but not the least is the division through grants-in-aid because of the potential mismatch between a government’s expenditure responsibilities and its tax capacity.
Fiscal Federalism comes under the domain of public finance. Public finance is the branch of economics that assesses the government revenue and government expenditure of the public authorities and the adjustment of one or the other to achieve desirable effects and avoid undesirable ones. The policy of fiscal federalism applies to both the unitary and federal type of government. Although more power is concentrated in the hands of the central government, state government also has a beneficial role to play. The success of fiscal federalism is conditioned by the two fundamental requisites- Financial independence and financial responsibility. Therefore, even if the states are dependent on the centre for some of their needs, they have the power to be financially independent within their own spheres. Each government should possess separate and independent sources of revenue. Government at different levels should have full power to tax, to incur expenditure and to borrow to perform the assigned functions effectively. The financial structure also has to change with the changing times and changing economy. So, the structure is required to be elastic to cater to the needs of the population of the country.
There are many principles which govern this policy like the principle of uniformity and equity which states that equality should be observed in the distribution of tax revenue. The backward regions should not be harassed with undue tax demands. Another is the principle of accountability in which each layer of government should be accountable to its own legislature for its taxing and spending decisions. Their plan of action should not become a hindrance in the other government’s work. Last is the principle of financial access implies that there should be no bar on centre and state governments in exploring new source of resources, to meet the growing financial requirements.
But this perfect looking model has its own shortcomings. The first one is Vertical fiscal imbalance in which the amount of revenue held by one government exceeds superfluously than the other. With the growing demand of welfare activities to be done by the government state government is running short of revenue as majority of revenue source under the control of state and local governments is inelastic in nature. This creates a situation of imbalance between growing expenditure requirements and poor yield of revenue source for state and local governments while the central government as sitting on the reserves of elastic revenue never run short of money. This creates a huge gap between the two termed as vertical imbalance. Fiscal federalism with its approach tries to balance the situation. This problem is overcome by the methods of Tax sharing, Tax credit, Tax deductibility Tax denial, General grants-in-aid and, Selective grants-in-aid. Grants in aid is the way in which the central government transfers some of its revenue to the state government. Next is the horizontal imbalance in which units at the same level of sovereignty come in conflict due to fiscal imbalance. Due to difference in resource endowment, level of development and variation in the implementation of tax expenditure programmes among different states in a federation, the central and state taxes generate unequal fiscal residue for their citizens. This gap in fiscal residue can be filled by interstate transfer of resources. That is there should be a federal arrangement for transferring resources from richer states to poor states.
India has a Federal form of Government (rather quasi-federal). Article 246 of the Constitution sets out the rundown of subjects on which various levels of government can make laws. There are three records referenced under Article 246. The Union can make laws identifying with the topic given under Union List. The Sates has the position to make laws identifying with subjects given under State List, and the Concurrent List, permits both the Union and the States to make laws, identifying with subjects provided by the list.
These three records additionally incorporate tax collection as a topic. The Union List incorporates taxes like Customs and Excise obligations, Corporation Tax and so forth. The State List incorporates taxes like charges on vehicles, taxes on alcohols, land revenue, taxes on stamp obligations and so forth. Both the subject can make laws on Concurrent List.
So, fiscal federalism is in huge demand right now. By adopting this policy, both the governments will be able to comprehend how much is the requirement for the betterment of the economy. Also, both the levels of government be it unitary or federal will be able to lend each other a helping hand in the times of need.