Former RBI governor calls for greater Centre-State cooperation in fiscal federalism

Special Chief Secretary (Finance) Government of Telangana, K. Ramakrishna Rao welcoming former Governor of Reserve Bank of India Duvvuri Subbarao in Hyderabad on Thursday. | Photo Credit: NAGARA GOPAL

Former Reserve Bank of India (RBI) Governor Duvvuri Subbarao underscored the need for a cooperative approach to India’s fiscal federalism in his BPR Vithal Memorial Lecture at the Centre for Economics and Social Studies (CESS) in Hyderabad on Thursday.

Speaking on ‘India’s Fiscal Federalism – Quo Vadis?’ Subbarao traced the evolution of Centre-State financial relations and highlighted the need for a more consultative and transparent framework to address current frictions.

Subbarao classified India’s fiscal federalism into three phases. The first, ‘Docile Federalism’ (1947-early 1970s), saw the Centre dominating political and economic decision-making, with a single-party rule and centralised resource allocation. The second phase, ‘Cooperative Federalism’ (early 1970s-mid-1990s), coincided with the rise of regional parties and greater state involvement in economic decision-making, though political friction often arose over Article 356. The third phase, ‘Combative Federalism’ (mid-1990s-present), has been marked by increasing contention between the Centre and states, particularly in economic matters, with regional parties playing a significant role in national governance, he said.

Are the terms of fiscal federalism unfair to states?

A common narrative among states is that India’s fiscal arrangements favour the Centre. States argue that they bear larger expenditure responsibilities but lack sufficient resources, have limited autonomy over central funds, and face restrictions on borrowing. However, Subbarao contested this claim, pointing out that states today enjoy greater spending power than their counterparts in many federal nations.

He said, “Indian states account for nearly 60% of total government expenditure, higher than in countries like Brazil (40.2%) and Indonesia (37.9%). Additionally, tax devolution has expanded, particularly after a 2000 constitutional amendment that entitled states to a share in the Centre’s total tax pool.”

Challenges in Centre-State relations

Despite these shifts, Subbarao acknowledged areas where the Centre’s actions create friction. One such issue is the growing use of cesses and surcharges, which do not form part of the divisible tax pool and thus reduce states’ overall share. “According to RBI data, the share of divisible taxes in the Centre’s revenue has fallen from 88.6% in 2011-12 to 78.8% in 2021-22 due to increasing reliance on cesses and surcharges. States also express concerns over Centrally Sponsored Schemes (CSS), arguing that they impose rigid conditions on spending. Subbarao defended CSS as necessary for national priorities but recommended greater consultation in their design,” he said.

Another point of contention is borrowing limits imposed on states under Article 293 of the Constitution. While Kerala has challenged this restriction in the Supreme Court, Subbarao argued that fiscal discipline is necessary to maintain national creditworthiness. He noted that Indian states have more borrowing flexibility than subnational entities in many other countries, where borrowing is often restricted to capital projects.

Freebies debate

Subbarao also touched upon the issue of freebies, warning against competitive populism in fiscal policy. While acknowledging the need for targeted welfare, he cautioned that indiscriminate handouts could undermine long-term economic growth. He called for a national consensus on restraining fiscal populism, urging the Centre to take the lead in framing responsible policies.

With the abolition of the Planning Commission, Subbarao noted the absence of a robust platform for Centre-State consultation. The NITI Aayog, he said, is yet to fill this void effectively. He suggested structured, agenda-driven discussions to replace the current format of Chief Ministers’ meetings, which often turn into political battlegrounds rather than constructive policy discussions.

Towards Viksit Bharat

Concluding his lecture, Subbarao underscored the need for Centre-State cooperation in achieving Viksit Bharat by 2047. While first generation economic reforms of the 1990s could be implemented unilaterally by the Centre, second generation reforms focused on land, labour, and taxation that require active state participation. Without a shared economic vision and collaborative policy-making, he warned, India’s goal of becoming a developed nation could be jeopardised.