UNIT IV: FEDERALISM AND ECONOMIC GROWTH

5
Chapter
INFLUENCE OF FEDERALISM IN
INDIAN ECONOMY

Objectives
This Chapter is focused on the following objectives:
z Federalism and Economic Growth: Theory of federalism, division of sources of
revenue between the Central and State governments with special reference to Indian
adjusting mechanism, problems of resources mobilization at the regional level
z Federalism
z Theory of federalism
z Division of sources of revenue between the Central and State governments with
special reference to Indian adjusting mechanism
z Problems of resources mobilization at the regional level

Structure:
5.1 Federalism
5.2 Economic Growth
5.3 Theory of Federalism
5.4 Division of Sources of Revenue between the Central and State Governments with
Special Reference to Indian Adjusting Mechanism
5.5 Problems of Resources Mobilization at the Regional Level
5.6 Summary
5.7 Self Assessment Questions
5.8 Key Terms
5.9 Key to Check your Answer

5.1 FEDERALISM

Federalism is a political concept in which a group of members are bound together by

covenant Latin: foedus, covenant) with a governing representative head. The term
“federalism” is also used to describe a system of government in which
sovereignty is constitutionally divided between a central governing authority and constituent
political units (such as states or provinces). Federalism is a system based
upon democratic rules and institutions in which the power to govern is shared between
national and provincial/state governments, creating what is often called a federation. The
term federalist describes several political beliefs around the world. Also, it may refer to the
concept of parties; its members or supporters called themselves Federalists.
Influence of Federalism in Indian Economy 175

European vs. American Federalism NOTES

In Europe, “Federalist” is sometimes used to describe those who favour a common
federal government, with distributed power at regional, national and supranational levels.
Most European federalists want this development to continue within the European Union.
European federalism originated in post-war Europe; one of the more important initiatives
was Winston Churchill’s speech in Zurich in 1946.
In the United States, federalism originally referred to belief in a stronger central
government. When the US Constitution was being drafted, the Federalist Party supported a
stronger central government, while “Anti-federalists” wanted a weaker central government.
This is very different from the modern usage of “federalism” in Europe and the United States.
The distinction stems from the fact that “federalism” is situated in the middle of the political
spectrum between a confederacy and a unitary state. The US Constitution was written as a
reaction to the Articles of Confederation, under which the United States was a loose
confederation with a weak central government. Further, during the American Civil War,
members of the Confederate States of America, which seceded in favor of a weaker central
government, referred to pro-Union soldiers of the United States government as “Federals.”
Thus, in the United States, “federalism” argued for a stronger central government, relative to
a confederacy.
In contrast, Europe has a greater history of unitary states than North America, thus,
European “federalism” argues for a weaker central government, relative to a unitary state.
The modern American usage of the word is much closer to the European sense. As the power
of the Federal government has increased, some people have perceived a much more unitary
state than they believe the Founding Fathers intended. Most people politically advocating
“federalism” in the United States argue in favour of limiting the powers of the federal
government, especially the judiciary.
In Canada, federalism typically implies opposition to sovereigntist movements (most
commonly Quebec separatism).
The governments of Argentina, Australia, Brazil, India, and Mexico, among others, are
also organized along federalist principles.
Federalism may encompass as few as two or three internal divisions, as is the case
in Belgium or Bosnia and Herzegovina. In general, two extremes of federalism can be
distinguished: at one extreme, the strong federal state is almost completely unitary, with few
powers reserved for local governments; while at the other extreme, the national government
may be a federal state in name only, being a confederation in actuality.
In 1999, the Government of Canada established the Forum of Federations as an
international network for exchange of best practices among federal and federalizing countries.
Headquartered in Ottawa, the Forum of Federations partner governments include Australia,
Brazil, Canada, Ethiopia, Germany, India, Mexico, Nigeria and Switzerland.
Some Christian denominations are organized on federalist principles; in these churches
this is known as ecclesiastic or theological federalism.
Indian Federalism: The Government of India (referred to as the Union Government)
was established by the Constitution of India and is the governing authority of a federal
union of 29 states and 7 union territories. Though, Andhra Pradesh was divided into two
states, Telangana and a residual Andhra Pradesh on 2 June 2014. Hyderabad, located entirely
within the borders of Telangana, is to serve as joint capital for both states for a period of time
not exceeding ten years.
176 Regional Economics

NOTES In August 2014, the Government of Andhra Pradesh announced that Vijayawada will
serve as the de facto administrative capital for Andhra Pradesh.
The government of India is based on a tiered system, in which the Constitution of
India delineates the subjects on which each tier of government has executive powers. The
Constitution originally provided for a two-tier system of government, the Union Government
(also known as the Central Government), representing the Union of India, and the State
Governments. Later, a third tier was added in the form of Panchayats and Municipalities. In
the current arrangement, The Seventh Schedule of the Indian Constitution delimits the
subjects of each level of governmental jurisdiction, dividing them into three lists:
1. Union List includes subjects of national importance such as defence of the country,
foreign affairs, banking, communications and currency. The Union Government alone can
make laws relating to the subjects mentioned in the Union List.
2. State List contains subjects of State and local importance such as police, trade,
commerce, agriculture and irrigation. The State Governments alone can make laws relating to
the subjects mentioned in the State List.
3. Concurrent List includes subjects of common interest to both the Union Government
as well as the State Governments, such as education, forest, trade unions, marriage, adoption
and succession. Both the Union as well as the State Governments can make laws on the
subjects mentioned in this list. If their laws conflict with each other, the law made by the
Union Government will prevail.
Asymmetric Federalism: A distinguishing aspect of Indian federalism is that unlike
many other forms of federalism, it is asymmetric. Article 370 makes special provisions for
the state of Jammu and Kashmir as per its Instrument of Accession. Article 371 makes special
provisions for the states of Andhra Pradesh, Arunachal Pradesh, Assam, Goa, Mizoram,
Manipur, Nagaland and Sikkim as per their accession or state-hood deals. Also one more
aspect of Indian federalism is system of President’s Rule in which the central government
(through its appointed Governor) takes control of state’s administration for certain months
when no party can form a government in the state or there is violent disturbance in the state.
Coalition Politics: Although the Constitution does not say so, India is now a
multilingual federation. India has a multi-party system,with political allegiances frequently
based on linguistic, regional and caste identities, necessitating coalition politics, especially at
the Union Level.
Federalism as the Anarchist and Libertarian Socialist Mode of Political
Organization: Anarchists are against the State but are not against political organization or
“governance” — so long as it is self-governance utilizing direct democracy. The mode of
political organization preferred by anarchists, in general, is federalism
or confederalism. However, the anarchist definition of federalism tends to differ from the
definition of federalism assumed by pro-state political scientists. The following is a brief
description of federalism from Section I.5 of An Anarchist.
The social and political structure of anarchy is similar to that of the economic structure,
i.e., it is based on a voluntary federation of decentralized, directly democratic policy-making
bodies. These are the neighbourhood and community assemblies and their confederations. In
these grassroots political units, the concept of “self-management” becomes that of
“self-government”, a form of municipal organization in which people take back control of
their living places from the bureaucratic state and the capitalist class whose interests it serves.
Influence of Federalism in Indian Economy 177

The key to that change, from the anarchist standpoint, is the creation of a network of NOTES
participatory communities based on self-government through direct, face-to-face democracy
in grassroots neighbourhood and community assemblies [meetings for discussion, debate, and
decision-making].
Since not all issues are local, the neighbourhood and community assemblies will also
elect mandated and recallable delegates to the larger-scale units of self-government in order
to address issues affecting larger areas, such as urban districts, the city or town as a whole,
the county, the bio-region, and ultimately the entire planet. Thus, the assemblies will
confederate at several levels in order to develop and co-ordinate common policies to deal
with common problems.
This need for co-operation does not imply a centralized body. To exercise your
autonomy by joining self-managing organizations and, therefore, agreeing to abide by the
decisions you help make is not a denial of that autonomy (unlike joining a hierarchical
structure, where you forsake autonomy within the organization). In a centralized system, we
must stress, power rests at the top and the role of those below is simply to obey (it matters not
if those with the power are elected or not, the principle is the same). In a federal system,
power is not delegated into the hands of a few (obviously a “federal” government or state is a
centralized system). Decisions in a federal system are made at the base of the organization
and flow upwards so ensuring that power remains decentralized in the hands of all. Working
together to solve common problems and organize common efforts to reach common goals is
not centralization and those who confuse the two make a serious error – they fail to understand
the different relations of authority each generates and confuse obedience with co-operation.
Christian Church: Federalism also finds expression in ecclesiology (the doctrine of the
church). For example, Presbyterian church governance resembles parliamentary
republicanism (a form of political federalism) to a large extent. In Presbyterian
denominations, the local church is ruled by elected elders, some of which are ministerial.
Each church then sends representatives or commissioners to presbyteries and further to
a general assembly. Each greater level of assembly has ruling authority over its constituent
members. In this governmental structure, each component has some level of sovereignty over
itself. As in political federalism, in presbyterian ecclesiology there is shared sovereignty.
Other ecclesiologies also have significant representational and federalistic components,
including the more anarchic congregational ecclesiology, and even in more hierarchic
alepiscopal ecclesiology.
Some Christians argue that the earliest source of political federalism (or federalism in
human institutions; in contrast to theological federalism) is the ecclesiastical federalism found
in the Binle. They point to the structure of the early Christian Church as described (and to
many, prescribed) in the New Testament. This is particularly demonstrated in the Council of
Jerusalem, described in Acts Chapter 15, where the Apostles and elders gathered together to
govern the Church; the Apostles being representatives of the universal Church, and elders
being such for the local church. To this day, elements of federalism can be found in almost
every Christian denomination, some more than others.

Constitutional Structure
Division of Powers: In a federation, the division of power between federal and regional
governments is usually outlined in the constitution. It is in this way that the right to self-
government of the component states is usually constitutionally entrenched. Component states
178 Regional Economics

NOTES often also possess their own constitutions which they may amend as they see fit, although in
the event of conflict the federal constitution usually takes precedence.
In almost all federations, the central government enjoys the powers of foreign policy
and national defense. Were this not the case a federation would not be a single sovereign state,
per the UN definition. Notably, the states of Germany retain the right to act on their own
behalf at an international level, a condition originally granted in exchange for the Kingdom of
Bavaria’s agreement to join the German Empire in 1871. Beyond this the precise division of
power varies from one nation to another. The constitutions of Germany and the United
States provide that all powers not specifically granted to the federal government are retained
by the states. The Constitution of some countries like Canada and India, on the other hand,
state that powers not explicitly granted to the provincial governments are retained by the
federal government. Much like the US system, the Australian Constitution allocates to the
Federal government (the Commonwealth of Australia) the power to make laws about certain
specified matters which were considered too difficult for the States to manage, so that the
States retain all other areas of responsibility. Under the division of powers of the European
Union in the Lisbon Treaty, powers which are not either exclusively of European competence
or shared between EU and state are retained by the constituent states.
Where every component state of a federation possesses the same powers, we are said to
find ‘symmetric federalism’. Asymmetric federalism exists where states are granted different
powers, or some possess greater autonomy than others do. This is often done in recognition of
the existence of a distinct culture in a particular region or regions. In Spain,
the Basques and Catalans, as well as the Galicians, spearheaded a historic movement to have
their national specificity recognized, crystallizing in the “historical communities” such
as Navarre, Galicia, Catalonia and the Basque Country. They have more powers than the later
expanded arrangement for other Spanish regions, or the Spain of the autonomous
communities (called also the “coffee for everyone” arrangement), partly to deal with their
separate identity and to appease peripheral nationalist leanings, partly out of respect
to specific rights they had held earlier in history. However, strictly speaking, Spain is not a
federalism, but a decentralized administrative organization of the state.
It is common that during the historical evolution of a federation there is a gradual
movement of power from the component states to the centre, as the federal government
acquires additional powers, sometimes to deal with unforeseen circumstances. The
acquisition of new powers by a federal government may occur through formal constitutional
amendment or simply through a broadening of the interpretation of a government’s existing
constitutional powers given by the courts.
Usually, a federation is formed at two levels: the central government and the regions
(states, provinces, territories), and little to nothing is said about second or third level
administrative political entities. Brazil is an exception, because the 1988 Constitution
included the municipalities as autonomous political entities making the federation tripartite,
encompassing the Union, the States, and the municipalities. Each state is divided into
municipalities (municípios) with their own legislative council (camara de vereadores) and a
mayor (prefeito), which are partly autonomous from both Federal and State Government.
Each municipality has a “little constitution”, called “organic law” (lei organica). Mexico is an
intermediate case, in that municipalities are granted full autonomy by the federal constitution
and their existence as autonomous entities (municipio libre, “free municipality”) is
established by the federal government and cannot be revoked by the states’ constitutions.
Moreover, the federal constitution determines which powers and competencies belong
Influence of Federalism in Indian Economy 179

exclusively to the municipalities and not to the consultant states. However, municipalities do NOTES
not have an elected legislative assembly.
Federations often employ the paradox of being a union of states, while still being states
(or having aspects of statehood) in themselves. For example, James Madison (author of
the US Constitution) wrote in Federalist Paper No. 39 that the US Constitution is in strictness
neither a national nor a federal constitution; but a composition of both. In its foundation, it is
federal, not national; in the sources from which the ordinary powers of the Government are
drawn, it is partly federal, and partly national. This stems from the fact that states in the US
maintain all sovereignty that they do not yield to the federation by their own consent. This
was reaffirmed by the Tenth Amendment to the United States Constitution, which reserves all
powers and rights that are not delegated to the Federal Government as left to the States and to
the people.
Organs of Government: The structures of most federal governments incorporate
mechanisms to protect the rights of component states. One method, known as intrastate
federalism, is to directly represent the governments of component states in federal political
institutions. Where a federation has a bicameral legislature, the upper house is often used to
represent the component states while the lower house represents the people of the nation as a
whole. A federal upper house may be based on a special scheme of apportionment, as is the
case in the senates of the United States and Australia, where each state is represented by an
equal number of senators irrespective of the size of its population.
Alternatively, or in addition to this practice, the members of an upper house may be
indirectly elected by the government or legislature of the component states, as occurred in the
United States prior to 1913, or be actual members or delegates of the state governments, as,
for example, is the case in the German Bundesrat and in the Council of the European Union.
The lower house of a federal legislature is usually directly elected, with apportionment in
proportion to population, although states may sometimes still be guaranteed a certain
minimum number of seats.
In Canada, the provincial governments represent regional interests and negotiate
directly with the central government. A First Ministers conference of the prime minister and
the provincial premiers is the de facto highest political forum in the land, although it is not
mentioned in the constitution.
Federations often have special procedures for amendment of the federal constitution. As
well as reflecting the federal structure of the state, this may guarantee that the self-governing
status of the component states cannot be abolished without their consent. An amendment to
the constitution of the United States must be ratified by three-quarters of either the state
legislatures, or of constitutional conventions specially elected in each of the states, before it
can come into effect. In referendums to amend the constitutions of Australia and Switzerland,
it is required that a proposal be endorsed not just by an overall majority of the electorate in
the nation as a whole, but also by separate majorities in each of a majority of the states or
cantons. In Australia, this latter requirement is known as a double majority.
Some federal constitutions also provide that certain constitutional amendments cannot
occur without the unanimous consent of all states or of a particular state. The US constitution
provides that no state may be deprived of equal representation in the senate without its
consent. In Australia, if a proposed amendment will specifically impact one or more states,
then it must be endorsed in the referendum held in each of those states. Any amendment to
the Canadian constitution that would modify the role of the monarchy would require
180 Regional Economics

NOTES unanimous consent of the provinces. The German Basic Law provides that no amendment is
admissible at all that would abolish the federal system.
Other Technical Terms: Fiscal federalism – federalism involving the transfer of funds
between different levels of government.
Formal federalism (or ‘constitutional federalism’) – the delineation of powers is
specified in a written constitution.
Executive federalism (also known as ‘administrative federalism’).
Federalism as a Political Philosophy: The meaning of federalism, as a political
movement, and of what constitutes a ‘federalist’, varies with country and historical
context. Movements associated with the establishment or development of federations can
exhibit either centralizing or decentralizing trends.

5.2 ECONOMIC GROWTH

Economic Growth: Economic growth is a long-term process involving a period of

many decades. Economic growth is accompanied by substantial rise both in the total
population as well as real national income. In other words, Economic Growth implies
transformation of an economy from a state of underdevelopment to a state of development,
from an agrarian to a highly industrialized society, from a low saver to a high saver and from
a predominantly rural to a highly urbanized society. This transformation is mainly reflected in
a sustained and steady rise in national and per capita incomes. In the words of Peterson,
Economic Growth involves an increase over time in the actual output of goods and services
as well as an increase in the economy’s capability to produce goods and services. Therefore,
Economic Growth implies increase in per capita income of the country at constant prices. A
higher per capita income would mean that people are better off and enjoy a higher standard of
living. The increase in national or per capita income must be maintained for a long time is
implicit in the theory of economic growth. Literally, economic growth means an increase in
the countries Net National Product (NNP).
Economic Development: The term economic development is a process whereby an
economy’s real national income increases over a long period of time. Alternatively, the term
economic development may be defined with reference to a set of criteria or values or desired
conditions in society. So, economic development is a normative concept. It means more than
what economic growth connotes. According to Streeten, development implies modernization
and modernization implies transformation of human beings. Development as an objective and
development as a process both embrace a change in fundamental attitudes to life, work in
social, cultural and political institutions. Streeten views about development as an interrelated
process of several dimensions which include output and incomes, conditions of production,
levels of living (i.e., nutrition, housing,health and education), attitudes to work, institutions
and policies. The well-known ‘Basic Needs Approach’ to development is derived from his
concept. According to this approach, development is to be measured with reference to the
extent to which the basic needs of the people are satisfied.

Differences between Economic Growth and Economic Development

Growth and development are often used synonymously in economic discussion. But
question is – What is economic growth? What is economic development? Thus, before
explaining in detail about economic growth in this chapter, let us first of all clear the basic
concept of this two important terms here.
Influence of Federalism in Indian Economy 181

Factors Affecting Economic Growth: The primary driving force of economic growth NOTES
is the growth of productivity, which is the ratio of economic output to inputs such as capital,
labour, energy, materials and business services. Increase in productivity lowers the cost of
goods, which is called a shift in supply. According to John W. Kendrick’s estimate, three-
quarters of increase in US per capita GDP from 1889 to 1957 was due to increased
productivity. Over the 20th century, the real price of many goods declined by over 90 percent.
Lower prices create an increase in aggregate demand, but demand for individual goods and
services is subject to diminishing marginal utility. Additional demand is created by new or
improved products.
Demographic factors influence growth by changing the employment to population ratio
and the labour force participation rate. Because of their spending patterns the working age
population is an important source of aggregate demand. Other factors affecting economic
growth include the quantity and quality of available natural resources, including land.
Measuring Economic Growth: Measures of National Income and Output: Variety
of measures of national income and output are used in economics to estimate total economic
activity in a country or region, including gross domestic product (GDP), gross national
product (GNP), net national income (NNI), and adjusted national income (NNI adjusted for
natural resource depletion). All are specially concerned with counting the total amount of
goods as well as services produced within some ‘boundary’. The boundary is usually defined
by geography or citizenship and may also restrict the goods and services that are counted. For
example, some measures count only goods and services that are exchanged for money,
excluding bartered goods, while other measures may attempt to include bartered goods
by imputing monetary values to them.
National Accounts: National accounts or national account systems (NAS) are
implementation of complete and consistent accounting techniques for measuring economic
activity of a nation, which include detailed underlying measures that rely on double-entry
accounting. Such accounting makes the totals on both sides of an account equal even though
they each measure different characteristics, for instance production and income from it. As
a technique, the subject is termed as national accounting or social accounting. Alternatively,
national accounts as systems may be distinguished from the economic data associated with
those systems. While sharing several common principles with business accounting, national
accounts are based upon economic concepts. One conceptual construct for representing flows
of all economic transactions that takes place in an economy is a social accounting matrix with
accounts in every respective row-column entry.
National accounting has developed in tandem with macroeconomics from 1930s, with
its relation of aggregate demand to total output through interaction of such broad expenditure
categories as consumption and investment. Economic data from national accounts are also
used for empirical analysis of economic growth and development.
Economic Growth versus the Business Cycle: Economists differentiate between
short-run economic changes in production and long-run economic growth. Short-run variation
in economic growth is known as business cycle. Business cycle is made up of booms and
drops in production that takes place over a period of months or even years. Usually,
economists attribute the ups and downs in the business cycle to fluctuations in aggregate
demand.
In contrast, the topic of economic growth is concerned with the long-run trend in
production due to structural causes like technological growth and factor accumulation.
Business cycle moves up and down, creates fluctuations around the long-run trend in
economic growth.
182 Regional Economics

NOTES
5.3 THEORY OF FEDERALISM

Indian Federalism: A Critical Appraisal

With remarkable prescience, the framers of the Indian constitution have equipped the
Indian state to respond to the demands for autonomy through the double mechanism of
individual and group rights, as well as the federal construction of political power.
During the first phase of India’s constitutional development, some of these instruments
were useful in empowering political majorities below the level of the national state through
the effective enactment of provincial administrations.
The second phase of constitutional development through the states reorganization of
1956-57, which created linguistically homogeneous states and counter-balanced the likely
chauvinism through the promotion of the tree language formula, requiring the use of Hindi,
English, and the regional language, made it possible to institutionalize the multicultural
nature of the Indian state, albeit with regional divergences of successes and failures in its
implementation.
In its third phase, the same process of constitutional development of federalism in the
1990s, India has witnessed the deepening of the principle of power sharing by the
constitutional and statutory powers accorded to village councils after 1993. One extreme
point of view is that India is definitely unifederal. As Prof. K.P. Mukherjee contends that
Indian constitution is definitely unifederal or a unitary constitution. Likewise, K. Santhanam
has remarked that by means of this provision the fundamental principal that a federation
depends upon the territorial integrity of states seems to have been forgotten. K.V. Rao
observes that the Units are very weak compared with the Centre. According to him, while
Articles 1 and 2 guarantee the existence of the States and this granted by the Constitution
itself, the continued existence of the Units, and especially their inclusion in a particular part
in the First Schedule, is at the mercy of the Centre, nay, at the mercy of a bare majority of the
Parliament (Article 4). The other extreme view is of designating India as extremely federal.
Likewise, C.H. Alexandrowicz opines — It is undoubtedly a federation in which the
attributes of sovereignty are shared between the Centre and the States. In between these two
interpretations, we have a plethora of moderate interpreters. Granville Austin advocates the
thesis of co-operative federalism. He believes that the very concept of co-operative
federalism implies a strong Centre; provincial governments are largely administrative
agencies for central policies. Secondly, Prof. Morris Jones talks of Indian federalism as
bargaining federalism. He says — whereas the emphasis in the Constitution is on
demarcation, that of political relations is on co-operative bargaining. He points out that the
Finance Commission declined in relative importance as compared with the rise of a system of
matching grants which are made under Article 282 of the Constitution. Hard competitive
bargaining keeps on going between the Centre and States of getting these matching grants.
The new group of regional leaders of India, drawing on their power bases in the states,
often consisting of people from India’s periphery (in terms of religion, elite caste status, or
geographic distance from the Centre), are able to generate a different and new construction of
the Indian nation state. In terms of the actual policies of the state, the regionalists are much
more willing and (in view of their social base) able to listen to the minorities, to regions with
historical grievances, to sections of society that entered post-Independence politics with
unsolved, pre-Independence grievances.
Influence of Federalism in Indian Economy 183

The horizontal and vertical expansion of the federal process has brought greater NOTES
legitimacy to the Indian state and cohesion to the India nation. Rather than grand design, the
process has been based on a series of ad hoc decision, based on the perceived benefits of the
respective political actors of the day, sometimes against the advice if specialists who have
made the conventional arguments based on the imperatives of modernization and the logic of
economic viability.
One important weakness of institutional design and the federal process is clearly the
lack of effective mechanisms for a coordinated interest aggregation of states versus the
Central government. Co-ordination mechanisms, such as the informal conference of Chief
Ministers and to some extent, also the Interstate Council, have largely proven to be limited in
their effectiveness. Nevertheless, coordination among Chief Ministers belonging to parties
not included in the Central government coalition has taken place, as have collusion and
coordination between the Central government and many of those Chief Ministers belonging
to parties which support the Central government in the Lok Sabha. In its own way, therefore,
the Indian experience with the unprecedented and unconventional expansion of the federal
principle serves to enrich the theory of federalism in confirming or disconfirming received
knowledge about the strengths and weaknesses of federal systems the world over.

5.4 DIVISION OF SOURCES OF REVENUE BETWEEN THE CENTRAL

AND STATE GOVERNMENTS WITH SPECIAL REFERENCE TO
INDIAN ADJUSTING MECHANISM

In all federations of the world, the centre is financially stronger than the states.
Allocation of resources has been done in a manner as to give the centre a proportionately
much larger share of revenues than that of states. Further, sources of revenue at the disposal
of the federal authority are more elastic than those with the states. This has been so in older
federations and almost all the new federations have copied this arrangement. The central
government has responsibility for economic development and stability. Financial stability and
strength at centre is necessary for discharge of these functions. Centre has, therefore, been
given fiscal powers appropriate for this purpose.
Under such circumstances, transfer of resources from centre to states are essential part
of the financial arrangements in a federation. There are three problems which give rise to the
need for such transfers. Firstly, there is an imbalance of revenue between the centre and the
states. Allocation of the sources of revenue is such that those with the centre are more paying,
e.g., customs and excises. Secondly, all states in a federation have not reached the same stage
of development. There is not enough base for taxation in some states. Thirdly, welfare and
development activities have to be undertaken by states, for which means available to them are
not adequate and transfer of resources from Centre become, indispensable. Transfers usually
take three forms: (1) Division of proceeds of certain taxes, (2) Grants by the Centre to States
and (3) Loans given by the Centre to the States.
1. Division of the Proceeds of Certain Taxes: Proceeds of certain taxes are shared
between centre and states. In India, this is done in respect of income tax and excise. In many
cases, there are certain taxes levied and collected by centre but proceeds of those are wholly
distributed to states. These taxes could as well be levied and collected by states but central
management is for uniformity in rates and coverage. Estate duty in India is a standing
example. There are certain other taxes which are levied by centre but which are collected and
appropriated by states.
184 Regional Economics

NOTES The sharing is so done that the centre has a larger share sufficient for its requirements
and rest is distributed among states. There are three principles which are suggested for
distribution:
(i) States’ share may be on the principle of compensation for loss of revenue on
account of federalization and federal policies. This is difficult to determine,
particularly in the case of federations that have come into being as a consequence
of devolution of powers by a unitary centre.
(ii) Another principle is requirement needs of the states. These may be measured in
terms of population or policies and schemes adopted by states.
(iii) Backwardness of a state may also be a criterion for which some kind of an index of
backwardness has to be worked out.
Complete justice and satisfaction to all states is impossible under any system of
distribution. There are always pulls and pushes from states for the adoption and rejection of
specific criteria. It is difficult to estimate requirements of states by any objective criterion.
Perhaps, best scheme is for a commission to go into the state budgets, examine their plans for
development and welfare and only thereafter suggest a suitable basis for distribution.
Distribution of tax revenues has certain disadvantages. Sometimes, rates of federal taxes
have to be kept unduly high to meet financial requirements of states. Other effects of these
taxes are ignored. Further, while collecting, government incurs all unpopularity while states
that receive shares get benefits. There is also no inducement for states to effect economies in
their expenditure.
2. Grants by the Centre to the States: Sometimes transfers take the form of grants.
These are given primarily on the basis necessity of the states. Requirements have to be
carefully estimated in relation to the resources of the states and grants are given to them.
Requirements are measured in terms of population, percentage of collection, plans for welfare
and development, and backwardness of states. These grants bring about a certain measure of
uniformity in resources available to states.
Grants are given to enable centre to exercise a certain measure of influence upon
policies and schemes adopted by states. Centre can persuade units to adopt measures which
serve certain national purposes. Centre may also encourage grant receiving states to adopt
schemes for their own benefit but which fit into general national plan.
Grants are based on two principles. One is authority transferring resources may retain
responsibility for their proper use. These are called ‘Conditional Grants’ and are given for
specific purposes. Other, ‘Unconditional Grants’ are given unconditionally but are to be spent
in conformity with general principles of sound finance. Actual arrangements may be between,
these two extremes. Centre gives both these grants. There are some grants to which no
specific conditions are attached. There are others which have to be spent by states for specific
purposes such as education, public health, housing, improvements of certain industries, etc. In
developing countries, some grants are given to implement specific programmes of
development.
3. Loans Given by the Centre to the States: States raise loans in the capital market,
but they also get short-term and long-term loans from the central government. Loans may be
for specific schemes or for general purposes. Like other kinds of transfer of resources, this
form also necessitates a central watch over the purpose and use for which states borrow.
Influence of Federalism in Indian Economy 185

5.5 PROBLEMS OF RESOURCES MOBILIZATION AT THE NOTES

REGIONAL LEVEL
Regarding demarcation of sources of revenue between centre and state, yet, financial
arrangement between two are utmost important. As governments have their own allocated
functions, thus, they must possess sufficient or adequate resource to fulfill those needs.
Alternatively, division of function pre-supposes division of resources. Constitutions of each
federal state has distinct provision in this regard.
So far as basis of such division of resources are concerned, taxes and other sources
provides as base extending over entire nation, which mark its impact upon economic life of a
country included in the federal list. But, on contrary, other taxes those are based in individual
states and impacts of that seldom crosses beyond boundaries of a state are allocated in that
respective state only. For instance, suppose customs duties which is related to trade of entire
country are generally a central head of revenue. But taxes on land and other immovable
property which is concerned to states only are usually sources of revenue in the hands of
respective states only.
Distribution of resources in all federations aims at providing fiscal independence to all
governments. Central and state authorities are given sources of income to fulfill their needs.
Government should manage its resources efficiently to make its optimum utilization. Along
with this, it should also maintain expenditure at a specific level so that it remains within the
mean available to it. It shows a sense of responsibility at the hand of units which is inevitable
for effective operations of federal system.
Financial arrangement in most federation in fact desirable from both economic as well
as political point of view. It makes units dependent upon centre and reduces fiscal autonomy
to a mere ideal, which is difficult to achieve. Therefore, various adjustments are required
besides a mere distribution of revenue resources have to be in financial relations between
centre and state units.
India has a federal form of Government, and hence federal finance system. Essence of a
federal form of Government is that Central and State Governments should be independent of
each in their respective, constitutionally demarcated spheres of action. Once the functions of
the Governments are spelt out, it becomes equally important that each Governments should
be provided with sources of raising adequate revenue to discharge functions entrusted to them.
For successful operation of federal form of Government financial independence and adequacy
form the backbone.
Evolution of the finance system in India can be traced to the Government of India Act,
1935. This Act was based upon general principle of financial independence for provinces.
The constitution of India accepted this basic principle of federal finance and apart from that
tried to achieve a few more principles among them first and the foremost is achievement of a
financially strong Centre. This is done by adopting the following measures: (a) Powers of
concurrent taxation has been avoided; (b) Centre has been assigned more elastic and high
yielding sources of revenues; (c) Centre has been given the subjects of money ana banks,
currency and coinage; and powers to resort to deficit financing; (d) Centre has been provided
with certain exclusive sources of revenue; and (e) Residuary powers lies with the centre.
Secondly, the constitution has divided the various functions into three lists, viz.,
(a) Union List, (b) States’ List and (c) Concurrent List. Financial powers have likewise been
divided between the Centre and the States.
186 Regional Economics

NOTES Thirdly, the constitution has made provision for transfer of resources. This is to be
achieved by three means, viz., (a) tax sharing, (b) grants and (c) loans. These are sometimes
referred as “balancing factors” to correct inter-regional inequalities of income. One basic
principle of federal finance is functions and resources should go together. However, in most
federation, there is always a gap between functions to be discharged and financial resources
needed to discharge them. Hence, regional imbalances constitute a source of conflict and this
conflict is solved by the use of the balancing factors.
Fourthly, there exists a flexibility in transfer of resources. The reason is, resource are
transferred from the Centre to the States according to recommendations of the finance
commission constituted by the President under the provisions of Article 280 of the
constitution. The Commission does not have any set procedure to go by. It has to make its
own choice. It lends flexibility to the system. Appointment of the Finance Commission is of
great importance for it enables the financial relation between the Centre and the States to be
altered in accordance with changes in need and circumstances.
Constitutional provisions relating to federal finance are segregated into three broad
heads: i.e., (A) distribution of financial powers, (B) mechanism of resource transfers and
(C) finance commissions.
A. Distribution of Financial Powers: The constitution makes a clear division of
financial resources between Centre and States. Sources of revenue can be grouped under two
heads, viz., (a) Sources of revenue for Centre and (b) Sources of revenue for States.
Sources of revenue to Centre are: (1) sources of tax revenue; and (2) sources of non-tax
revenue. Sources of tax revenue include 12 items like taxes on income other than agricultural
income, corporation tax etc. The non-tax resources are: (1) borrowings; (2) income from
Government undertakings and monopolies; (3) income from Government property and
income arising out of the exercise of various Governmental functions and rights; (4) interest
earnings on loans as well as advances to State Governments’ commercial and non-commercial
undertakings; (5) gifts, donations etc; (6) fees in respect of any of the matters in the Union
List but not including fees taken in any court; and (7) fees taken in the Supreme court.
Similarly, the sources of revenue to the State Governments can be divided into:
(a) sources of tax revenue; and (b) sources of non-tax revenue. Under constitution, States
have been given independent tax powers and the State list contains 19 items like land revenue,
taxes on agricultural income, sales tax etc. The non-tax revenue includes: (a) fees taken in all
courts except the Supreme court; (b) income from undertakings owned partly or fully by
respective State Governments; (c) income earned from property owned by State Governments;
(d) borrowings from within the country; (e) royalty from mines, forests, etc.; (f) grants-in-aid
from centre; and (g) other grants from the Central Government.
Various taxes imposed by the Central Government are divided as follows:
1. Taxes and duties which accrue wholly to the Union Government, e.g., customs
duties including export duties, corporation taxes etc.
2. Taxes levied and collected by the Union but which may be shared with States
(Article 272 of the constitution).
3. Taxes and duties levied and collected by centre but the proceeds of which are
assigned to States (Article 269 of the constitution), e.g., succession duty in respect
of property other than agricultural land, terminal tax etc.
4. Taxes and duties levied by Centre but collected and appropriated by State
concerned (Article 268 of the constitution), e.g., stamp duties and excise duties,
duties on medicinal and toilet preparations etc.
Influence of Federalism in Indian Economy 187

This sort of the division of tax powers reflects on operational distinction made between NOTES
levying, collection and appropriation of tax proceeds. Each part has been decided on the basis
of maximum efficiency expected under the constitution.
B. Mechanism of Resource Transfer: Important means of resource transfer are:
(a) assignments; (b) tax-sharing; (c) grants-in-aid and (d) loans.
C. Finance Commissions: Specific provision has been made in the constitution for the
appointment of a finance commission every five years or earlier. Under Section 280 of the
constitution, the President is empowered to appoint a finance commission at the expiry of
every fifth year or earlier which shall consist of a chairman and four other members.
The finance commission makes recommendations to the President in regarding:
(1) distribution of net proceeds of taxes to be shared between Union and States and allocation
of shares of such proceeds among States; (2) principles which should govern the grants-in-aid
to the revenues of States out of consolidated Fund of India; and (3) any other matter the
finance commission may deem fit. Important recommendations of all the ten commissions so
far reported have been accepted and acted upon by the Central Government, in the spirit of
the constitution.
Centre-State Conflict on Finances: Financial relations between Centre and States are
of vital importance for smooth functioning of a federation. Since last few years, there has
been growing conflict and tension between Indian Union and States. This conflict has been
aggravated by political and ideological differences among different parties governing the
Centre and States. In the first place, the financial provisions of the constitution gave very
extensive financial resources to the Union and on the other hand, State Governments were
given important responsibilities but inelastic and unproductive resources. This has been a
major reason of conflict between the Centre and States.
Secondly, under the weight of successive plans of economic and social development,
there is a growing divergence between responsibilities arising from original distribution of
powers and fiscal capacities between the Union and States.
Thirdly, there have been serious regional imbalances in economic development so much
so that some States have been left behind while others have made considerable economic
progress.
However, it must be stated that the amount of imbalance between regions is inevitable
in a large country like ours. But Central Government did not use its financial resources or its
policy of economic planning to bring about balanced development of all regions. Naturally,
the backward and neglected States clamour for more powers and more financial resources.
Finally, the Indian Constitution provided for inter-governmental grants and loans, so
that the Centre might come to the help of those States which were in difficulties and also to
bring about balanced development among different regions. Use of grants and loans in the
last 40 years or so, however, has resulted in complete domination and control of the States by
the Centre and utter dependence, and to a certain extent even financial irresponsibility and
indiscipline on the part of the States. A stage has now been reached that while Centre-States
financial relations will have to be reviewed thoroughly. The Thavaraj Committee (Report of
the Taxation Enquiry Committee, Kerala government), the Rajamannar Committee on
Centre-State relations appointed by the DMK Government of Tamil Nadu and the document
on Centre-State relations adopted by the West Bengal cabinet led by the CPI(M) United
Front — all these have the same theme, i.e., political and financial autonomy for States and
drastic restriction upon power as well as financial resources of the Centre.
188 Regional Economics

NOTES 5.6 SUMMARY

1. Federalism is a political concept in which a group of members are bound together
by covenant Latin: foedus, covenant) with a governing representative head.
2. Federalist is sometimes used to describe those who favour a common federal
government, with distributed power at regional, national and supranational levels.
3. In Canada, federalism typically implies opposition to sovereigntist movements
(most commonly Quebec separatism).
4. The term economic development is a process whereby an economy’s real national
income increases over a long period of time.
5. The primary driving force of economic growth is the growth of productivity, which
is the ratio of economic output to inputs such as capital, labour, energy, materials
and business services.

5.7 SELF ASSESSMENT QUESTIONS

I. Fill in the Blanks

1. A distinguishing aspect of Indian federalism is that unlike many other forms of
federalism, it is __________.
2. In a federation, the division of power between __________ and __________ is
usually outlined in the constitution.

II. True and False

1. In almost all federations, the central government enjoys the powers of foreign
policy and national defense.
2. Usually, a federation is formed at two levels: the central government and the
regions (states, provinces, territories), and little to nothing is said about second or
third level administrative political entities.

III. Multiple Choice Questions

1. In economics, a production-possibility frontier (PPF), sometimes called __________.
(a) Production-possibility curve
(b) Production-possibility boundary curve
(c) Product transformation curve
(d) All of the above
2. Economic growth is __________.
(a) A long-term process involving a period of many decades
(b) A short-term process
(c) A periodic study
(d) None of the above

Short Answer Questions

1. Explain in brief the term ‘Economic Growth’.
2. What are the measures of the economic growth?
Influence of Federalism in Indian Economy 189

Long Answer Questions NOTES

1. Critically analyze the term ‘Federalism’. What are its constitutional structure?
2. Explain the neo-classical growth model.

5.8 KEY TERMS

z Ecclesiologies
z Federalism
z Federalist
z Production-possibility frontier

5.9 KEY TO CHECK YOUR ANSWER

I. 1. asymmetric, 2. federal, regional governments.
II. 1. True, 2. True.
III. 1. (d), 2. (a)