India needs a robust and institutionalised system of resource federalism as an intrinsic part of fiscal federalism

Over the last three decades, the nature of the economic regime in India has undergone an unrecognisable transformation. Business Today, an offspring of liberalisation, launched as it was a year after the economic reforms of 1991, has been a witness to India moving from state socialism to business liberalism, closed economy to an open one, and a controlled economy to a regulated one. The fragmented and protected markets across 14 states and six Union territories in 1956 are now a unified common economic space across 28 states and eight Union Territories.

The Indian economy was just about $30 billion in 1951, which is roughly the size of the Jammu & Kashmir economy today. The bigger states like Maharashtra, Tamil Nadu, Karnataka, and Uttar Pradesh have their sights set on becoming $1-trillion economies. Collectively, the states now raise more revenues and undertake more public expenditure than the Centre.

Despite this, the states continue to be tied to the apron strings of the Union in a federal system, whose foundational framework is infirm, and the design as laid out in the Constitution of India, simply outdated. The needs, requirements and policy instrumentalities of an open regulated economy are very different from those of a closed economy for which the current framework has been designed.

 

To ensure growth, federalism must move beyond government finances. A new federal compact must be defined in the context of the contemporary relationship between the state and markets. The new framework of federalism should be based on the needs of the economy and not on the requirements of the government.

Given the growing size and significance of the states, the overwhelming dominant “vertical federalism” inbuilt in the Indian model needs to be revisited. It might well be the time to introduce “lateral federalism” in the fiscal-federal policy regime in India. If individual states can coordinate with each other then they could internalise externalities and achieve the social optimum for the federation.

In this rejigged federated structure, the Centre will exercise leadership instead of control, and economic support instead of dominance and that will form the foundation of the new federal compact between the Union with states and between states. The design of the lateral federal structure should be such that it will align with the market-led growth paradigm by focusing on the natural resources – minerals, oil, natural gas, and hydropower–which are the key revenue drivers for, and major constraints to macroeconomic growth and its spread across the sub-national economies. This is important going forward, as India is a resource deficit economy and there is a premium on raw materials.

As such, what is needed is a robust and institutionalised system of resource federalism as an intrinsic part of fiscal federalism, which is now restricted to “transactional revenue” sharing.

Further, as the sub-national economies develop, there is a strong case for looking at a monetary federalism. For one, in an open economy, monetary policy is the main tool of policy intervention and it is exclusively the domain of the Centre. Also, the case for a monetary federalism rests on the fact that there is a differential impact of monetary policy on states depending on the level of their economic development, the financial deepening of the state, the extent of industrialisation, distribution of large and small corporates. Based on these factors, there is a prima facie case on economic grounds to give the Reserve Bank of India the character of a Federal Reserve Bank.

The final aspect of redesigning the fiscal federal set-up should be to give states a role in the regulatory framework of the country. At present, most of the regulatory powers are vested with or subservient to the Union government. They have replaced direct ministerial and bureaucratic control with indirect regulatory regimes. The Indian regulatory state is nothing but an extended arm of the central government. In this context, it is important to federalise the regulatory set-up if only to break the new congruence of powers—executive, legislative and judicial—within the regulatory system.

To conclude, the extant federal framework that functions more as a decentralised model of governance than a fiscal federal model, has rid itself of its colonial mooring and closed economic rigidities. It must be reformulated in the context of an open regulated economy through the widening of its ambit by dividing the regulatory powers between the two tiers of government, sharing not just the tax revenues but the revenues accruing form usage of natural resources and include states in the formulation of monetary policy.

This could be the beginning of a new sub-national fiscal and financial architecture. A new federal compact that will unshackle the state economies, provide diverse sectoral sources that will engender broad-based national macroeconomic growth in an inclusive and equitable manner. 

The author is Haseeb A. Drabu, Former Finance, Minister, Jammu & Kashmir. Views are personal.