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CHAPTER- III
Evolution of Fiscal Federalism in India and Canada
The chapter reviews the historical factors in which Indian and Canadian federal
system has grown. It attempts to probe ancient Indian thoughts as a guide for resource
transfer .Criteria for tax, social benefit theory, and non economic aims of taxation
classification of revenue, in the ancient time has been discussed in this chapter. This
chapter has taken care of the colonial past of some federation. After the first armed
struggle for independence the power to rule over the country was shifted from the
hands of East India Company to the British Crown and with this transfer came a sense
of stability in the British Rule. In 1870 Lord Mayo took steps to organise the
administration and finance in the country. Till now, all financial power was
centralized. Lord Mayo initiated powers to facilitate administration. Lord Lytton
(1877), Lord Ripon (1882), Lord Curzon (1904) and Lord Harding (1912) all
contributed in expanding this trend of de –centralization of finance in the country. The
reforms of 1919 were described as a half way house to federalism. But the evolution
of federal financial system could get a sum what concrete shape only with the
Government India Act, 1935. It analyses the evolution of the Constitutional
provisions relating to fiscal federalism during drafting of the constitution and Finance
Commission, commencing with the Government of India Act of 1935, the
deliberations of the Constituent Assembly and their influence on the evolution of the
Finance Commission and its role. Principles for sharing of receipts are also being
discussed in this chapter. Financial emergencies and constitutional amendments in the
direction of fiscal federalism are also elaborated.
As far as Canada is concerned, Federal and provincial roles and responsibilities have
evolved throughout Canadian history in response to sometimes dramatic changes in
circumstances. Many of the major events of the 20th century—the Great Depression
of the 1930s, the two World Wars, the emergence of the post-war welfare state—all
involved dramatic shifts in "fiscal balance" either vertical (between the federal and
provincial governments) or horizontal (e.g. changing fiscal disparities among the
different provinces). Fiscal relations have had to evolve alongside these shifts in roles
and responsibilities—and corresponding shifts in fiscal balance. Throughout Canada’s
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history, federal and provincial-territorial governments have found a variety of ways of
meeting these challenges.
Ancient Indian Thoughts and System of Resource Transfer
The ancient Indian literature provides instances, which can be seen as the basis to
analyse the evolution of the transfer system and fiscal relations between centre and
sub units of the empire. Arthshastra, Indica, Pali literature and regional scripts such as
rajtarangini written by kalhan, and records of some foreigner travellers are the sources
to know about the economic condition, tax system, etc.
The first principle of modern taxation is that it is compulsory in nature. In ancient
Indian texts, there are abundant evidences to show that taxes as compulsory payments
were well. Next is that, taxes should be moderate and not burdensome on its subjects.
Manu opines that the king should "always fix in his realm the duties and taxes in such
a manner that he, himself and the man who does the work receive their due reward" 1
He continues that "as the leach, the calf and the bee take their food little by little, even
so must the king draw from his realm moderate annual taxes"19. Kulluka, in his
commentary on Manu states that taxes should be realised from "what is in excess of
the capital. The next principle of taxation as prescribed in ancient Indian scriptures is
that if at all an increase in taxation is inevitable; it has to be gradual and not sudden
and steep. The Mahabharata opines that little by little money should be extracted from
prosperous subjects. The king should increase the burden of his subjects by and by
like a person gradually increasing the load of a young bullock.2
In the Magadha Empire, the large long service army had to be fed by the state
exchequer. Axe were assessed and collected by royal agents with the help of village
head. The aim of individual and community life in the ancient period was the
realization of dharma (Dharma pradhana) and not a purely material objective
(Arthapradhana). In our theories of State finance the basic assumptions in addition to
the hypothesis, that all human effort should be directed towards the goal set by
Dharma, were the existence of government, and the maintenance of harmonious
relation between the people and the government. In every one of our financial
theories, the stress laid upon the necessity for the State involves a corresponding
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emphasis on the obligation of the people to support the sovereign authority, whatever,
its form.3
Based on religious sanction, the ruler’s right to levy taxes and contributions, and the
obligation of the people to pay them on an implied contract between the State and the
subjects, had important corollaries. Imposition of taxes is not a matter of caprice. The
duty to pay them is voluntary. The right to tax rests solely on the states discharging its
appointed duties. In the medieval period, Akbar the Great4 and his minister Todarmal
evolve a system of economic regulations and taxation.5
Basis for Taxation
In India, the system of direct taxation as it is known today has been in force in one
form or another even from ancient times. There are references both in Manu Smriti
and Arthasastra to a variety of tax measures. Manu, the ancient sage and law-giver
stated that the king could levy taxes, according to Sastras. The wise sage advised that
taxes should be related to the income and expenditure of the subject. He, however,
cautioned the king against excessive taxation and stated that both extremes should be
avoided namely either complete absence of taxes or exorbitant taxation. According to
him, the king should arrange the collection of taxes in such a manner that the subjects
did not feel the pinch of paying taxes. He laid down that traders and artisans should
pay 1/5th of their profits in silver and gold, while the agriculturists were to pay 1/6 th,
1/8th and 1/10th of their produce depending upon their circumstances. The detailed
analysis given by Manu on the subject clearly shows the existence of a well-planned
taxation system, even in ancient times. Not only this, taxes were also levied on
various classes of people like actors, dancers, singers and even dancing girls. Taxes
were paid in the shape of gold-coins, cattle, grains, raw-materials and also by
rendering personal service.6
The modern criterion of a tax is that it is a compulsory levy by the states. The old
Indian ideas of taxation are implied in the very conception of a tax. It is due to the
king, because its payment is divinely ordained, because it flows from an original
contract, and also because it is the price for the security afforded to the subject by the
existence of settled government. The states may not only levy its share from the
owner’s own property, but it can compel even the property less person to contribute
by his labour.7
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Further , to our ancestors it seemed a reasonable deduction from their premises that
the contributions made by a subject to the states should be deemed to be taxes only
when they were collected for use in beneficial ways, and not for being squandered
away by a tyrannical government . This attitude is reflected in the many exhortations
to kings, in our political and economic literature, for the expenditures of the revenue
of the state only in ways beneficial to the people8.
Society is Prime
A further support to this view is found in the statements that the tax is simply the
wage (vetanam) of the king, his reward for protecting his subjects, his remunerations
for being the servant of the people, and his salary as a public functionary. These ideas
are developed by extending the meaning of ‘protection, so as to make it comprehend
internal security, including the maintenance of law and order, and the relief of
indigence and unemployment. In a word many sections of the community were
admitted to be contributing by its endeavour to the common welfare. Someone
contributes by the work of his hands and someone by that of his brain.
It has already been pointed out that the right of the states to tax solely from the
protection it gives the right ceasing when the capacity to protect disappears. ‘The
social benefit theory’, which seeks to establish a relation between taxes and the
benefits conferred to the tax- payers , may appear to be implied in this postulate , but
it is not. For, if the principle of protection is applied to individuals , so as to make the
contribution in taxes proportionate to the benefit derived by each tax-payer , the
absurd position, that the members of society who receive most benefit from the state,
should contribute most, is reached . This fallacy is escaped in the Indian proverb,
‘The right of the road is to be blind, the deaf, and the cripple’. This is the welfare
state. Activities of the states are not to make money or to run the government, but it is
for the wellbeing of the weakest person in the society, even if he has not contributed
anything to the state in terms of economy. Social benefit is estimated by reference to
the benefit to the community as a whole, and not to the individuals composing the
community. The numerous customs, tolls and transit duties seem to have been
imposed for revenue only.9
Aims of Taxation is non economic
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Tax systems are often used to secure specific social and political objects. This
possibility is not lost of sight by our authorities. The concentration in state workshops
of the manufacture of spirituous liquors, poisons and drugs, whose unrestricted use
would under-mine the health and morale of the people, is apparently dictated by this
conviction. Consumption is controlled more by regulating the quantity produced than
by raising prices to the consumer. Unrestricted production of liquor, side by side with
its sale at high prices, invites evasion, illicit production and even excessive
consumption, for as Adam Smith saw, the attraction of deleterious articles is often
their high price as their intrinsic qualities. It was only for the good of the people that
the king collected taxes from them, just as the sun drew moisture from the earth only
to give it back a thousand fold.10
Kautilya’s work Arthshastras is the first mile stone on the subject. Although this work
is directly not related with the economics, it has described statesmanship as a whole
and maintenance of the treasury and collection of the taxes in specific terms. It is an
authenticated work and adopted by the successors, in ancient, medieval and modern
period also. In our old economic theory the recognition of the moral, political, and
economic necessity for taxation goes side by side with the perception of the
importance of fiscal part of it. The Treasury (Kosha) is one of the seventh elements
(saptanga) of the State. A king with an empty treasury preys on his people; keep the
treasury therefore full. All enterprises find their root in treasure; let kings and
ministers, therefore, endeavour to keep the treasury full. Wastage, faulty collection,
defalcation and inefficient management, reduce treasure; let them by therefore sternly
repressed. Their detailed character suggests that they reflect practice. The
uninterrupted vigilance, with which the interests of the exchequer were safeguarded,
is also testified to by the available epigraphic records of both North and south India.
The latter relate mainly to the period of the Great Chola Empire11. They show that
even small exemptions from taxation were invariable brought on record, and that the
rule requiring the countersignature of the chief financial authority of the kingdom
(Cholainayakam) to grants was always out, in all their detail, in our old treatises, is
itself proof of acute sensitiveness of an old Indian kingdom to the interests of the
fiscal side.12
Kautilya has also described in great detail the system of tax administration in the
Mauryan Empire. It is remarkable that the present day tax system is in many ways
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similar to the system of taxation in vogue about 2300 years ago. According to the
Arthasastra, each tax was specific and there was no scope for arbitrariness. Precision
determined the schedule of each payment, and its time, manner and quantity being all
pre-determined. The land revenue was fixed at 1/6 share of the produce and import
and export duties were determined on advalorem basis. The import duties on foreign
goods were roughly 20 per cent of their value. Similarly, tolls, road cess, ferry charges
and other levies were all fixed. Kautilya’s concept of taxation is more or less akin to
the modern system of taxation. His overall emphasis was on equity and justice in
taxation. The affluent had to pay higher taxes as compared to the not so fortunate.
People who were suffering from diseases or were minor and students were exempted
from tax or given suitable remissions. The revenue collectors maintained up-to-date
records of collection and exemptions. The total revenue of the State was collected
from a large number of sources as enumerated above. There were also other sources
like profits from Stand land (Sita) religious taxes (Bali) and taxes paid in cash (Kara).
Vanikpath was the income from roads and traffic paid as tolls.13
A consideration of the heads of income, in a well-developed ancient idea, and the
principles of the assessments may now be attempted. For such a study, there is huge
material in literature and in inscriptions. It will show that the tax system of ancient
India was quite complex as it is now exit. The classification of taxes was deemed to
be important. The Arthashastras differentiate between forms of revenue, not according
to their incidence but according to their source. Revenue is either derived from land
(prthivi), or derived from sources other than land (aprthivi). Under the former, come
the contribution of the crown lands (bali), the land revenue paid by private owners
(bhaga), the cesses collected on the supply of water from state sources, the tree-tax of
one-sixth of the fruits of trees, medicinal herbs, etc, the profits of state mine and
quarries, the sale produce of forests produce and the income from the royal herds, as
well as the tax collected from owners of private cattle farms. All other revenues come
under the head of aprthivi. In this rough classification, no attempt is made to
distinguish direct and indirect taxes and fees and royalties, and tax and non-tax
receipts. The last of the distinctions may have appeared unimportant to our ancient
economists, as from their standpoint the only test of a tax was that it was due to the
state. It does not, however, follow that the relative merits of direct and indirect
taxation was not understood. In our ancient rules of taxation, we find that much store
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is set on the tax being directly levied from the tax-payer on account of its certainty,
e.g. of the land tax, the toll tax, etc. We also find that the advantages which indirect
taxation affords for quietly adding to the burdens of the community, while enabling
the revenue to be collected conveniently and economically were also appreciated.
Miscellaneous Revenue
Kautilya divided revenue in seven classes, according to source. These are the
following: Sita-The revenue from crown land, Bhaga-The revenue from private lands,
Bali-The special tax demanded from land for religious purposes, Kara- Sundry
collections in money, Tara- The dues on boats, ferries and ships, Vartam-Road cess
and toll. The revenue derived from cities included items such as fines, license fees on
weights and measures, fees for the issue of passports, income from the jail, mint,
gambling houses and slaughter-house, the proceeds of salt monopoly, gate dues,
Octroi and the Profession tax. Even the tax was imposed on leisure time activity. The
revenues from monopolies and from the state mines, forests and cattle ranches come
under another head. The main sources of revenue are the land tax (including forests),
customs and excise, the proceeds of salt monopoly, property taxes, judicial and other
fines, the profits from state factories, the revenue from the crown monopolies in
gambling, the sale on intoxicants, the manufactures and sale of salt and saffron, the
trade in horses and fine wool, the sale of elephants and miscellaneous items like
Octroi and port dues.14
Principles of Taxation
The learned author K.B.Sarkar commends the system of taxation in ancient India in
his book "Public Finance in Ancient India", (1978 Edition) as follows:-
"Most of the taxes of Ancient India were highly productive. The admixture of direct
taxes with indirect Taxes secured elasticity in the tax system, although more emphasis
was laid on direct tax. The tax-structure was a broad based one and covered most
people within its fold. The taxes were varied and the large variety of taxes reflected
the life of a large and composite population".
The analysis of our old schemes of taxation reveals their underlying principles.
Maxims of taxation are sometimes given, but they are more rules of taxes than of
taxation. The principles can be collected under the familiar heads of modern cannons
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of taxation. The advice of Kautilya that the state should imitate the wise gardener,
who collects only the ripe fruit, involves the ‘canon of convenience’. The taxing king
is; for example, to be a wise cow-herd, behave like the bee, the leech, the tiger, and
the mouse, the owner of a young bull, the garland-maker and the market-gardener.
The commentators explain these similes as rules of finance.
The state was enjoined to permit the resources of the subjects to grow before
imposing taxes on them. A tax should be collected after a careful consideration of
place (desa) and time (kala). This implies the ‘canon of convenience. The
specification of the percentages to be collected under the several tax-heads denotes
that the proportional to be paid is to be definite and its amount, as well as the time and
manner of its payment, are to be as clear to the payer as to the tax collector. This is a
‘canon of certainty’. The ‘canon of economy’ is involved in the exhortation to keep
down expenses, and avoid waste and the multiplication of agencies for collection.
The aim is obviously to do what Adam Smith has said “to take out and to keep out of
the pocket of the tax –payer as little possible over and above what goes to the coffers
of the state”. The ‘canon of equality’ in the sense of sacrifice is admittedly hard to
put into practice, because sacrifice is measurable only by reference to psychical states.
This is perhaps why our old economists do not trouble themselves to lay down any
rule to secure parity of sacrifice. Even If the social assumptions of their times are
considered, it was not to be expected from them. Some of the good sayings in the
ancient slokas, which reflects the principle of taxation, are as under-
“The girl covets beauty, the mother riches, the father knowledge, the relation a good
family, and other people a sumptuous marriage feast”
“Pluck the goose with the least squealing.”
Manu says in Manu Smriti that “the king is counselled tax little by little, as the leech,
the calf and bee takes their food.”
This was the philosophy behind the taxation.15
State Expenditure
From the meticulous attention of our authorities to sources of revenue, however small,
we should expect a corresponding minuteness in specifying the forms of obligatory
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State expenditures. But, the references to State expenditures in our authorities are not
as full or systematized as those relating to the collections. A budget in the modern
sense does not appear to have existed. Our writers are generally agreed that, in
abnormal as in normal times, the expenditures of a State should not outrun its
revenue. To ensure this, they strain ingenuity to discover new forms of revenue for
meeting the progressive needs of the State .They advocate large and recurring annual
surplus. If through unforeseen causes such as seasonal vicissitudes, epidemics or war,
the income of the Sate shrinks or its expenditures grows abnormally, the emergency is
to be met by special expedients from raising the necessary funds. The elaborate
provisions, which we find in the works of Kautilya for meeting such emergencies,
would show that they were neither few nor infrequent.
In strong languages, the failure of the state to spend its revenue, in such a way as to
develop the resources of the subjects, is censured. In equally strong terms is the type
of taxation condemned, which trenches on the accumulations of the people and
cripples their productive capacity. Our financial experts have many devices for
relieving the subject, considered as a consumer as well as a producer. The old Indian
State relied very largely on what would now be called ‘non-tax receipts”. This is
probably due to the anxiety of Indian statesman to discover forms of income, which
would be free conspicuousness, would not press hard on the poorer section of the
population and would be un-obnoxious.
Central and Local Expenditures
The low percentage of expenditure apparently suggested for items of social service
like Relief Programmes for the poorer section of the population, the construction of
protective irrigation works, and industrial and commercial development, might also be
explained. Our old theories separate central from local finance. We learn from
Megasthenes16 and Kautilya that municipalities had their own resources and fiscal
obligations, and that they had to look after such matters as sanitation, the
establishment and management of markets, the erection of fortifications, the city
police and poor relief programmes. The village is similarly responsible for its own
administration, sanitation, poor relief, communications and irrigation. The central
government like to take only those duties, which could not safely be assigned to
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village and towns, or which could be more conveniently undertaken by the central
government than by local bodies.
The budget proportions, in the Arthasastra of Kautilya, relate only to the expenditure
from the central fiscal. Such expenditures would naturally be small on those items for
which provision is made by voluntary organizations, or in local bodies. In regard to
poor relief a definite responsibility was admitted to, lie upon the State. The State had
to provide work for the unemployed , and asylums for those who by age, disease , or
accident , were unable to earn their livelihood , and no relations on whom they
might be legally charged. Nevertheless , the burden of poor relief lay more heavily
upon the people than on the state, in ancient as in modern India; but , it was willingly
borne , owing to the belief in the spiritual benefits , which would accrue from the
practice of charity.
The responsibility of the State for the advancement of education was believed to lie
only in making stray gifts to eminent teachers, or in occasional endowments to big
universities (Parisad). Such universities as those of, Takshshila in North West,
Nalanda and Vikramsila” Bihar, were in no sense State foundations. They were
established and maintained out of pious gifts, made by private persons and kings.
To sum up, the principles of taxation mentioned in the ancient Hindu texts do not
necessarily deal with the tax policy of the governments of the time nor did the state
treat them as must considerations in evolving its fiscal policy. The canons of taxation,
variously expressed and advocated in the sacred texts are indeed one and the same.
They are simply a modification of one and other and move round the only theme i.e.
the king should not resort to arbitrary and oppressive taxes. Most of the canons are
applicable only in the work of collection and not in the decision of making a policy.
General Review
The above survey of ancient Indian finance reveals certain features. It shows the
completeness of theories and their remarkable soundness, even if judged by modern
canons. It discloses also the powerful hold which the theories had upon the Indian
rulers. Our inscriptions and literature delight to say that particular kings levied taxes
only in accordance with the precepts of sages like Manu. This can only mean a
widespread desire to pay homage to an ideal. A third feature consists in the ingenuity
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shown in devising Tax schemes which ,while filling the treasury , put little ,
additional burden on the people. Such lurid picture, we find in the Rajatarangini of
Kalhana17 He wrote about an extortionate king Sankaravarman (A.D .883-902), who
had to fill the depleted treasury but before he studied methods suggested by even
public spirited and high-minded writers like Kautilya and Sukra, for making
additions to the income of the state, in periods of grave emergency. It shows that the
administration of our old Indian Sates, normally in accordance with the maxims of
Indian economists, was in no way oppressive.18 It may even be claimed for the old
Indian state that it anticipated and avoided some of the difficulties with which a
modern State is often faced, because of the differences in their outlook. Our old
economists openly base, on certain fundamental ethical-social assumptions, the right
to tax and the liability to pay. It became thereby possible for them to use the tax
system to prevent such social stratification as might lead to class hatred, anarchic
agitation and a proletariat. The survey of economic policies and conditions of a great
Empire, like that of the Mauryas or the Guptas or the imperial Cholas at their best,
will show that, however, heavy the burden of taxation might sometimes have proved,
it was borne by the different classes of the population because, among other things,
they had the satisfaction that they obtained adequate protection against dangers,
internal and external, the service of an efficient administration presided by sovereigns,
who shared their belief in the direction of all human activity to the goal to a high
moral purpose.19
Evolution of the System of Resource Transfer
The situation starts getting difficult and centre-state relationship starts getting tense
when a politically conscious state feels frustrated on the point of inadequacy of fiscal
transfer from the centre. But things do not happen overnight. The process of evolution
always takes time. Therefore the present centre-state relationship in India can only be
analysed after taking into account the evolution of the system of resource transfers in
the Indian federal governance.
After the first armed struggle for independence the power to rule over the country was
shifted from the hands of East India Company to the British Crown and with this
transfer came a sense of stability in the British Rule. In 1870 Lord Mayo took steps to
organise the administration and finance in the country. Till now, all financial power
142
was centralized. Lord Mayo initiated powers to facilitate administration. Lord Lytton
(1877), Lord Ripon (1882), Lord Curzon (1904) and Lord Harding (1912) all
contributed in expanding this trend of de –centralization of finance in the country. The
reforms of 1919 were described as a half-way house to federalism. But the evolution
of federal financial system could get a sum what concrete shape only with the
Government India Act, 1935.
The roots of fiscal federalism in India go back to the Government of India Acts of
1919 and 1935. By the reforms of 1919 the provincial executive were made
responsible for the fundamental functions of government, the enforcement of law and
order, and the maintenance of an upright administration .The 1919 Act and the
devolution rules made there under gave the provinces considerable latitude in
financial matters. They now had freedom to adjust the levies on transferred head of
revenue; they similarly had the right to spend whatever they lacked on the transferred
subject. Expenditure on reserved subjects alone continued to be subject to regulations
and control by the central government. The provinces were also given the power to
float loans both in India and abroad on the security of their revenues, but there were
no separations of cash balances of the centre and the provinces. The provinces could
withdraw from the same public account; and any amount overdraw was to be
reimbursed before the close of the financial years. So 1919 Act was a half-way house
between control and autonomy.20
While 1919 Act provided for a separation of revenue heads between the Centre and
the Provinces, the 1935 Act allowed for the sharing of the Centre’s revenues and for
the provision of grants-in-aid to the Provinces. The Indian Constitution carried these
provisions a step forward by providing for a finance commission to determine the
distribution, between the Union and the states, of the net proceeds of taxes and the
grants-in-aid to be provided to the states which are in need of assistance. While the
Constitutional provisions relating to the functions of the finance commissions have
remained unchanged, one notable change in the framework of federal fiscal
arrangements was brought out by the 80th Amendment which broadened the ambit of
the sharable Central taxes. The enlargement of the sharable pool to cover all Central
taxes, except those listed in Articles 268 and 269 and earmarked cesses and
surcharges, has enabled states to share in the overall buoyancy of taxes. It has also
provided greater stability to resource transfers as fluctuations in individual taxes are
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evened out. With the 73rd and 74th Amendments to the Constitution, which have
provided constitutional support to the process of decentralisation, the finance
commissions are also required to suggest measures to augment the resources for the
panchayats and municipalities
In the economic sphere, liberalization have necessitated greater fiscal
decentralisation .on the political front , factors such as the end of single party rule,
emergence of coalition Government at the centre and increasing importance of
regional parties in the political affairs of the country have forced greater
decentralization. Finally the amendment of the constitution in 1992 to empower local
government is yet another enabling factor in the evolution of a more decentralized
federalism in India.
Government of India Act 1935
The government of India Act, 1935 had not only embodied the basic principles of
federal finance but had also endowed the provinces with financial power and authority
which enables the constituent within a federation to proceed , further on the way of all
round development . The Act 1935 gave full control over provincial administration to
elected legislatures and popular ministers, subject however, to control and regulation
in vital matter by the British using the agency of the governor-General and Governors
who were invested with special responsibilities.
The provisions for fiscal federalism including the fiscal transfers provided under the
Constitution of 1950 drew heavily from the Government of India Act, 1935. That Act
was the first attempt of the British Government to bring in an arrangement of
federalism in the Indian sub-continent, which was till then categorised into British
ruled areas and the fiscally independent princely states. Through the Act of 1935, a
scheme of fiscal integration of the princely states into the proposed Indian Federation
was mooted. To achieve such ends, the Act had provided that the federating States
shall surrender their right to levy certain taxes such as the income tax, the excise
duties, export duties and duties on salt. In turn, the States were to receive a share in
the federal revenues by way of tax sharing and grants. These arrangements were
applicable to both, the federating Indian States and the Provinces under the direct
administrative control of His Majesty in Council, i.e. the British Government. The
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classification of the functional domain was made into three parts, the Federal List, the
State/Provincial List and the Concurrent List, similar to the Seventh Schedule of the
Constitution.21 The financial arrangements provided in the GOI Act of 1935 insofar as
these related to the princely states, did not come into operation, as the states did not
join the federation. However, these provisions were implemented in relation to the
Centre (the federation) and the provinces.
The provincial governments no longer derived their authority political and fiscal, by
devolutions made by the centre but obtained it as a direct grant from the crown. In the
Central field also, the Act provided for a partial transfer of responsibility to a
ministry, but only when the federal provisions of the Act became operative and it had
retained the supervisory control of the secretary of state over India’s administration.
Regarding the federal provisions becoming operative, the act 1935 provided that the
federations comprising Governors provinces. The states which has accused or would
accede later to the federation and the chief commissioner’s provinces would come
into existence only when a proclamation of inauguration was issued by the Majesty.
The sharing of revenue authority between the federation and the provinces provided
that the major sources of revenue for the Centre were to be the duties of customs
including the export duties, duties of excise except on alcoholic and narcotic
substances and on medicinal and toilet preparations that contained such substances,
corporation tax, taxes on income other than agricultural income. For the provinces,
the major revenue sources were the land revenue, sales tax, forest and irrigation
receipts, mining receipts, etc. On the expenditure side, the major responsibilities
assigned exclusively to the Centre included the defence, armed forces, external
affairs, a few Central universities and institutions of research, census, foreign trade,
shipping and ports, airways, petroleum and other inflammable products, federal
pensions, labour safely in mines, banking etc. The major responsibilities assigned
exclusively to the provinces included law & order, courts, police, prisons, public
works, roads, inland waterways, irrigation, agriculture, land rights and records,
forests, fisheries, unemployment, provincial pensions, public health and sanitation,
etc. The concurrent list had few significant expenditure items such as welfare of
labour, invalidity and old age pensions, electricity, and unemployment insurance. The
net fiscal position of the Centre vis-à-vis the provinces was expected to be a surplus
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for the Centre and a deficit for the provinces, both of a small order, as the data for the
preceding few years given in Table 1 would indicate.
Land revenue, which used to contribute more than half of the total tax revenues and
was thus the major resource base for the provinces, had lost much of its buoyancy
consequent upon introduction of permanent settlement or similar long-term
settlements in most parts of the British India. By 1930-31, land revenue was
contributing less than a quarter of the total tax revenues. The relative share of various
major sources of taxes and duties in the overall tax revenues of the government during
the last half-century of British rule is given in Table 2
The plan for fiscal transfers under the GOI Act, 1935 had provided for a structure
wherein some of the federal taxes and duties were assigned to the provinces, some
were made sharable either unconditionally or under certain conditions, while some
others were prohibited from sharing. Besides the devolution of taxes and duties, the
Act had provided for extension of grants-in-aid of the revenue of such of the
provinces and states that were in need of assistance by the federal government. Such
need was to be decided at the discretion of the His Majesty in Council. These
arrangements can be explained in terms of the following groups:
(a) Taxes and duties levied and collected by the Federation but assigned the
Provinces and to the Federated States:
Section 137 of the Act provided that succession and estate duties in respect of non-
agricultural properties, terminal taxes on goods or passengers carried by railway, sea
or air, and taxes on railway fares and freights, shall not form part of the federal
revenues but shall be assigned to the Provinces and to the Federated States, if any,
within which that tax is levy able in that year, and shall be distributed among the
Provinces and those States in accordance with such principles as may be prescribed
the Federal Legislation.
(b) Federal taxes that were to be shared with the Provinces mandatorily:
This group includes the income tax on non-agricultural incomes, which 67 was a
shared tax and the export duty on jute and jute products, which was an assigned tax.
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For these purposes, the relevant provisions were contained in sections 138 and 140(2),
respectively, of the Act which read, inter alia, as follows:
“138(1) Taxes on income other than agricultural income shall be levied and collected
by the Federation, but a prescribed percentage of the net proceeds in any financial
year of any such tax, except in so far as those proceeds represent proceeds attributable
to Chief Commissioner’s Provinces or to taxes payable in respect of Federal
emoluments, shall not form part of the revenues of the Federation, but shall be
assigned to the Provinces and to the Federated States, if any, within which that tax is
proper to be levied in that year, and shall be distributed among the Provinces and
those States in such manner and from such time as may be prescribed.
“140(2) one half or such greater proportion as His Majesty in Council may determine,
of the net proceeds in each year of any export duty on jute or jute products shall not
form part of the revenues of the Federation, but shall be assigned to the Provinces or
Federated States in which jute is grown in proportion to the respective amounts of jute
grown therein.”
(c) Federal taxes that could be shared with the Provinces if the federal legislature
chose to do so:
Section 140 of the GOI Act, 1935 provided for sharing of certain taxes with the
Provinces and the Federated States only if the Federal Legislature provided for such
sharing by enacting a legislation for the purpose. Such legislation was, however,
never enacted and during the entire period of British Rule, these duties were not
shared with the Provinces. The relevant part of this section is quoted below:
140(1) Duties on salt, Federal duties of excise and export duties shall be levied and
collected by the Federation, but, if an Act of the Federal Legislature so provides, there
shall be paid out of the revenues of the Federation to the Provinces and the Federated
States, if any, to which the Act imposing the duty extends, sums equivalent to the
whole or any part of the net proceeds of that duty, and those sums shall be distributed
among the Provinces and those States in accordance with such principles of
distribution as may be formulated by the Act.’
(d) Non-sharable Union levies:
The GOI Act, 1935 had retained the custom duties and the corporation taxes a non-
sharable. However, with regard 68 to the latter tax, a special provision was made
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under section 139 to say that corporation taxes shall not be levied in any Federated
State until ten years and thereafter, if the ruler of a Federated State chooses so, that
tax would not be levied in such State but the ruler shall have to compensate the
federation suitably for the same.
(e) Grants-in-aid:
The Act provided for grants-in-aid (GIA) to the needy provinces. Section 142 stated
that such sums as may be prescribed by His Majesty in Council should be charged on
the revenues of the Federation as GIA of the revenues of such provinces as His
Majesty may determine to be in need of assistance, and different sums may be
prescribed for different provinces. This was to be “charged” expenditure for the
Centre (Section 142).
The Government of India Act, 1935 had not prescribed the exact ratios for vertical
and horizontal sharing of the sharable taxes and duties, leaving it to be decided by the
His Majesty in Council, i.e. the Federal Government in its absolute discretion. The
Act did not provide for the intermediation or recommendation of any advisory
institution such as the Finance Commission in respect of discretionary aspects of the
transfers. Still, the British Government decided to appoint a one-man committee
comprising Sir Otto Niemeyer to make recommendations in regard to the
discretionary parts of the fiscal transfers. The Niemeyer Committee (1936-47) was
responsible to make recommendations to the Government on the matters which come
under sections 138(1) & (2), 140(2) and 142 of the GOI Act, 1935,22, subject to
approval of both Houses of the British Parliament, and on any ancillary matters
arising out of the financial adjustments between the Government of India and the
Provincial Governments regarding which the Government might desire a report.
Effectively, the Committee was asked to make recommendations only on limited
items, namely, vertical and horizontal sharing of the net proceeds of income tax and
of the export duties on jute or jute products and grants-in-aid of revenues of the needy
provinces. The issue of devolution of the revenues from the export and excise duties
including the salt duties, mentioned for optional sharing in terms of section 140(1) of
the Act, was not referred to the Committee.
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Negotiations initiated with the provinces to secure their assistance were protected and
had not made much progress when the war intervened in 1939 to interrupt their
continuance. The federal provisions of Act, therefore was put into hold. The
provisions relating to them however came into force in 1937. The relations of
provinces with the centre were regulated thereafter in accordance with provisions. In
this way, although the act executed the facade of federations is retained in reality the
essentials of a unitary form of government. The reservation of usual powers to the
government answerable to the Governor–General and his overriding authority over
the entire field of India’s administration including the demarcated sphere of provincial
jurisdiction did little to change basically the centralized feature of administration. The
purpose of the provisions which served this position was to retain British Control over
the Indian government even after a responsible ministry had been installed at the
centre, so this act 1935 was a half-way house of federations. At best, it may be said,
because of its comprehensiveness the government of India Act, 1935 was admirably
suited for adoption as the interim constitution.
The federal provisions of the GOI Act, 1935 were to come into force only when the
Rulers of the native States aggregate population whereof amounted to at least one-half
of the total population had acceded to the Federation. This condition could not be met
as the rulers of the states kept dithering. Thus, the Federation of India could not come
into being as envisaged in the Act. However, the other parts of the Act impacting the
fiscal, legislative and administrative relationship between the Centre and the
Provinces were brought into operation in 1937. Implementation of even those
provisions was subject to considerable stress from time to time owing to the outbreak
of the Second World War and the engagement of the British authorities as well as the
native political leaders with the freedom movement.
Despite its halting and partial implementation, the provisions in the GOI Act, 1935
proved to be a significant step in defining the boundaries of the legislative and
executive domain for the Centre and the provinces. These arrangements were
conducive for fiscal stability of the Centre and the provinces and laid the legal
foundation for fiscal federalism in the country. These provisions indeed influenced the
drafting of the Constitution of 1950 to a good extent. The deliberations of the
Constitution Drafting Committee and the Constituent Assembly Debates indicate that
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particularly for defining the fiscal contours of federalism for the united India, the
framers of the Constitution found merit in several of the features of the GOI Act of
1935. Also, the TOR for the Niemeyer Committee, though brief, found their imprint
on the TORs of the Finance Commissions of the post-independence India.
Niemeyer Award (1936-47)
The report of Sir Otto Niemeyer, officially titled as The Indian Financial Enquiry
Report, and popularly called the Niemeyer Award (April, 1936)23, made 69 specific
recommendations in regard to the vertical and horizontal sharing of the sharable taxes
and duties as well as for grants-in-aid of the revenue of such of the provinces that it
determined to be in need of assistance owing to their financial weakness. It also made
recommendations for debt relief, in relation to the outstanding debts of the provinces
to the Centre. The Niemeyer Award included the vertical and horizontal sharing of the
net proceeds of income tax, assignment of the net proceeds to the jute growing
provinces, and grants-in-aid and debt relief to the financially weaker provinces.
Vertical Sharing of the Proceeds of Income Tax
The Niemeyer Committee turned out to be rather conservative in making
recommendation on the transfer of the proceeds of income tax to the provinces. On
the face of it, it recommended sharing of 50 per cent of the net proceeds of income tax
with the provinces. However, it also put a rider to the effect that for the first five year
after the award was put into operation, the share for the provinces shall be reduced by
such amounts as would make the Central government’s share in the divisible pool Rs.
13 crore. For the next five year period, the sum retained in the last year of the first
period would be reduced by a factor of 1/6 every year24. The result of Niemeyer
formulation was that the provinces got far less than the figure of 50 per cent
recommended by Niemeyer in the first instance, as the figures in Table 3 would show.
No doubt, the gross collections were to be reduced by the proceeds attributable to the
Chief Commissioner’s provinces, taxes on federal emoluments and the cost of
collection. Exact figures for these three factors for the aforesaid years are not
available, but these generally amount to about 10 per cent of the gross collections25.
Therefore, the actual transfers to the provinces remained far less than 50 per cent.
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Niemeyer justified this on the grounds of financial stability and credit of India as a
whole being of paramount consideration, for which it was essential to maintain the
solvency of the Central government26.
Sharing of the Sharable Proceeds of Income Tax-
For the sharing of the sharable proceeds of income tax among the provinces, Sir
Niemeyer indicated that he had adopted two factors, namely, population and the
source of collection for some reference year and determined a fixed percentage share
for each province. He did not indicate the relative weights assigned to the two factors
citing uncertainty of some of the statistical data. Obviously, Niemeyer used his
discretion in the matter27.
Assignment in Respect of Jute Export Duties
In respect of the jute export duties, the GOI Act, 1935 had provided for assignment of
at least 50 per cent of the net proceeds to the jute growing provinces in proportion to
the respective amounts of jute grown therein28. It had also provided that such
assignment could be more than 50 per cent, if the federal government so decided. The
federal government, in turn, referred this matter to Sir Niemeyer, who recommended
that 62.50 per cent of the net proceeds be assigned to the provinces. The GOI Act,
1935 had also provided that the inter se sharing of the sharable proceeds of the jute
export duties should be distributed among the jute growing provinces/states in
proportion to the respective amounts of jute grown therein. Niemeyer was not happy
about this provision and stated in his report that: “In my opinion, it is doubtful
whether the argument that the incidence of this particular duty falls wholly on the
producer can be maintained and even if such proof can be produced, it may be
doubted whether it would be valid in a changing market’29. Having noted such
opinion, Niemeyer did not pursue the matter further.
Grants-in-aid to Provinces
The terms of reference for Sir Otto Niemeyer included the issue of grants-in- aid for
the provinces, in line with section 142 of which the substantive provision stated that,
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“Such sums as may be prescribed by His Majesty in Council shall be charged on the
revenues of the Federation in each year as grants in aid of revenues of such Provinces
as His Majesty may determine to be in need of assistance, and different sums may be
prescribed for different Provinces”30. A similar provision exists in the Constitution of
India and all the Finance Commissions have examined this issue and made
recommendations. Comparing the approaches of the Finance Commissions with that
of Niemeyer, it appears that Niemeyer took a very limited view of the matter, in
defining the “needs” of the respective provinces. He took the estimates of the revenue
receipts and expenditure as was presented to him for the year 1936- 37 as the primary
basis for determining the “needs”. On that, he imposed certain specific requirements
of the individual provinces.
For instance, for Sindh, he examined only the cost and returns from the Lloyd Barrage
and the need for another sum of Rs. 5 lakh for providing a jail at Shikarpur. For the
newly created province of Orissa, the Central Government had, in the preceding year,
provided a grant of Rs. 50 lakh which included Rs. 40.50 lakh towards revenue
expenditure, Rs. 7.50 lakh for non-recurrent expenses relating to famine etc. and Rs. 2
lakh as untied funds. Niemeyer made an ad hoc increase in this sum to Rs. 57 lakh for
the first year, Rs. 53 lakh annually for the next four years and Rs. 50 lakh per annum
thereafter. For Assam, Niemeyer recommended assistance of Rs. 45 lakh towards
revenue deficit and Rs. 7 lakh towards maintenance of Assam Rifles, For the North
West Frontier Province (NWFP), and the GOI had already been extending annual
subvention of Rs.100 lakh. Niemeyer enhanced it by Rs. 10 lakh annually for period
of 5 years, subject to a review at the end of that period. For the provinces of Bengal,
Bihar, Central Provinces and the United Provinces, Niemeyer recommended annual
grants of Rs. 75 lakh, 25 lakh, 15 lakh and 25 lakh, respectively, without explaining
the reasons for arriving at the individual figures. Having assessed the needs of the
provinces for revenue assistance, Niemeyer first considered meeting part of that need
by way of debt cancellation and consequent reduction in debt servicing expenditure.
For the remaining sums, he recommended Grant in Aid under section 142 of the GOI
Act, 1935 amounting to sums ranging from Rs. 25 lakh to Rs. 110 lakh per year to
each of the provinces31. It needs to be appreciated that the initial Finance
Commissions in India did not depart drastically from the approach of Niemeyer,
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though they made certain improvements by way of broad basing and refining the
methodology.
The Period 1947-1950
During the period commencing with the Independence and till the promulgation of the
Constitution in 1950, the principles being followed till 1947 in respect of devolution
of central revenues, based upon the Niemeyer Award, were broadly continued by the
executive decisions of the Government of India. Thus 50 per cent of the net proceeds
of income tax were transferred to the States. It may be noted that the GOI Act was
continued to be in operation till the 26th January 1950, i.e. till it was repealed by
article 395 of the Constitution. Further, under the GOI Act, 1935, it was permissible
to share the proceeds of the Union excise duties too. However, the GOI chose not to
extend any such share to the provinces/states, as was the practice prior to 1947. For
the inter se sharing of the divisible share of income tax, the Government of India took
an executive decision in regard to the shares attributable to the divided parts of the
provinces of Punjab and Bengal as well as the North-West Frontier Province (NWFP)
that had gone to the newly created Pakistan. The provincial shares were revised after
distributing the quota of such transferred territories among the provinces of the Indian
Union according to population with some adjustments in favour of West Bengal and
Assam. Integration of the Princely States into the Indian Union, some way of
attachment with the Part A States (erstwhile British Provinces) and some others as
group of States in Part B of the First Schedule had revenue implications on the receipt
as well as expenditure side, as the Centre took over some of the sources of revenue
receipts, such as the income tax, as also the expenditure responsibilities of the
subjects falling in the Union List of the Seventh Schedule.
To examine such issues, the Indian States Finances Enquiry Committee was set up in
October 1948 with Shri V.T. Krishnamachari as chairman, with primary focus for the
Part B States and of Baroda’s merger with Bombay32. The report of the Committee
was discussed by the Union Government with the States concerned and with certain
agreed modifications, incorporated in the agreements entered into by the Union
Government with the States. The main feature of the agreements between the
Government of India and the Part B States was that the Centre would make good
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difference between the loss of revenue and savings on expenditure responsibilities, for
a transitional period, as ‘revenue gap grants’. For this purpose, the revenue receipts
and expenditure figures were determined based upon an agreed period immediately
preceding the integration. The revenue gap grants were guaranteed in full for the first
five years and on a gradually diminishing scale for a further period of five years at the
end of which the grants would reach the level of approximately sixty per cent of the
original figure. It was also agreed that the Part B States would get either a share in
divisible sources of revenue like the income tax, or the ‘revenue gap grant’,
whichever would be higher.
It was also agreed that the share of each Part B State should be 50 per cent of the net
proceeds of the taxes on income other than agricultural income levied and collected
by the Government of India in that State in each year. Four Part B States, namely,
Hyderabad, Mysore, Travancore-Cochin and Saurashtra, qualified for the ‘revenue
gap grants’ whereas the others did not as the expenditure saved to them by integration
was more than the revenue lost to them. The issue of financial burden caused to some
of the Part A States by merger of the former Princely States with them was also
addressed. It was provided that all Part A States affected by the merger would receive
50 per cent of the net proceeds of the taxes on income other than agricultural income
levied and collected in the merged territories within the State each year or the
‘revenue gap grant’, whichever was higher. Accordingly, four Part A States received
such grant, namely, Bombay, Bihar, Madhya Pradesh and West Bengal.
The issue of financial provisions to be incorporated in the Constitution was entrusted
to an expert committee headed by Shri Nalini Ranjan Sarkar.33 The Committee made
various suggestions relating to fiscal transfers and sharing, including the setting up of
a Finance Commission. The suggestions of the Committee were discussed in the
Constituent Assembly and were incorporated in the Constitution after some
amendments.
Deshmukh Award (1950-52)
While the Constitutional provisions relating to federal fiscal transfers were brought
into force with effect from 26th January, 1950, an interim arrangement was followed
by the Government of India till 31st March, 1952 when the decision in pursuance to
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the Award of the First Finance Commission came into force. During this period, i.e.,
till 31st March, 1952, the arrangements followed till then, which were in turn broadly
on the lines of the Niemeyer Scheme, were continued. Accordingly, fifty per cent of
the net proceeds of income tax, exclusive of the proceeds attributable to Part C States
and the proceeds of the taxes payable in respect of Union emoluments were assigned
to the States. As for the horizontal transfers, a need was felt to make certain interim
arrangements, to take care of the situation arising out of the partition of India that had
led to transfer of some of provinces (or parts) to Pakistan and the share of such
provinces (or parts) was to be redistributed among the Indian States.
To address these issues, a committee under the chairmanship of Shri C.D.
Deshmukh34 was constituted towards end of 1949 to examine the matter and make
suitable recommendations. Shri Deshmukh, in his report, recommended for
redistribution of the aggregate quota available for redistribution largely on the basis of
population, with two adjustments, one for the purposes of rounding off and the other
for giving a small weight in favour of the weaker States.35 The inter se share of the
Provinces in the sharable proceeds of income tax under the Deshmukh Award vis-à-
vis the extant GOI scheme was as presented in Table 4.
The Deshmukh Award was not expected to deal with the matter of sharing of Union
duties of excise, nor did it make any reference to that matter. The Award also made
recommendations regarding grants-in-aid to the jute growing provinces in terms of
article 273. The Award was accepted by the Government of India and remained the
basis for fiscal transfers from 1st April, 1950 till 31st March, 1952, where after the
scheme pursuant to the recommendations of the Finance Commission came into force.
Drafting of the Constitution
The principles based upon the Niemeyer Award for distribution of income tax
receipts, were in the practice during the period 1936- 1947, were adopted for the
initial years after the independence i.e. till the promulgation of the Constitution in
1950, but with some amendments in the inter se sharing of the divisible share of
income tax to take into account the territories transferred to Pakistan. The President of
the Constituent Assembly had, in the meanwhile, referred the issue of financial
provisions to be incorporated in the Constitution to an Expert Committee headed by
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Nalini Ranjan Sarkar, a former member of the Viceroy’s Executive Council and with
two other members, V.S. Sundaram and M.V. Rangachari (Member Secretary), who
were senior officers of the Indian Audit & Accounts Service. The Committee
consulted various opinions including the draft prepared by B.N. Rau, the
Constitutional Adviser, memoranda of the Provinces and the Union Finance Ministry,
and made various suggestions including the setting up of a Finance Commission for
making recommendations relating to fiscal transfers and sharing. The financial
arrangements recommended by the Expert Committee mooted significant departure
from the provisions of the GOI Act, 1935. For instance, the Expert Committee had
recommended that 60 per cent of the net proceeds of the income tax collections,
except the proceeds attributable to the Chief Commissioner’s Provinces and to the
federal emoluments, should be transferred to the provinces, and of that 60, 20 should
be on the basis of population, 35 on the basis of collection and 5, as a balancing factor
to mitigate any hardship that might arise for some provinces in implementing the
other two factors.
The Expert Committee had further recommended that the net proceeds of the
corporation tax should also be included in the divisible pool and that 50 per cent of
the net proceeds of the excise duty on tobacco be assigned to the provinces and
distributed among them on the basis of estimated consumption. The Committee
recommended for continuation of the arrangements in regard to the assigned taxes
(federal stamp duties, terminal taxes on goods and passengers, etc.) but made a
limited departure by recommending that the Centre should retain 40 per cent of the
net proceeds of the estate and succession duties.
The suggestions of the Expert Committee were discussed by the Drafting Committee
for the Constitution and later in the Constituent Assembly and were incorporated in
the Constitution after some amendments. In certain respects, the Drafting Committee
did not accept the recommendations of the Expert Committee. For instance, the
Drafting Committee did not accept the recommendations of the Expert Committee
relating to devolution and chose to retain the provisions on the lines of the GOI Act,
1935. Thus, in the draft placed before the Constituent Assembly, the provisions for
devolution included a mandatory sharing of income tax without indicating any
specific number, optional sharing of excise duties and no sharing of the remaining
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central taxes including the corporation tax, and that was adopted by the Constituent
Assembly.
In most other respects, the Drafting Committee favoured and accepted the
recommendations of the Expert Committee, with some modifications in some cases.
Among the most significant provisions so accepted was the one relating to the
Finance Commission36. The Expert Committee had recommended the aforesaid
principles for devolution etc. only for a limited period. For the long term, it had
recommended setting up of an expert body, Finance Commission, to make periodic
recommendations on three broad issues namely,
(a) Allocation between provinces of the centrally administered taxes assigned to
them,
(b) Considering applications for grants-in-aid for provinces and recommending
thereon, and
(c) Considering and reporting on other matters referred to it by the President.
The basis for allocation of revenues between the provinces was to be reviewed by the
Finance Commission every five years, or, in special circumstances, earlier. In this
respect, the Drafting Committee concurred with the recommendations of the Expert
Committee and the provisions relating to constitution and functions of the Finance
Commission were, with some drafting changes, incorporated in the Constitution.
The Constituent Assembly had adopted the Constitution of India on the 26th
November, 1949. A few of articles, namely, articles 5 to 9, 60, 324, 366,367,379, 380,
388,391 to 393, were brought into force on that day itself, whereas the majority of the
provisions, including those relating to the financial matters, were brought into effect
from 26th January, 1950. The Constitution of India, as it was adopted by the
Constituent Assembly on the 26th November 1949, had recognised the necessity and
the significance of specifying the powers and functions of the Union and the States
and their mutual relationship at the interface. The main features of the federal
structure envisaged in the Constitution are as follows:
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(a) The distribution of functional domain, which includes the powers to make laws,
between the Union and the States by virtue of the lists contained in the Seventh
Schedule. List I contains the list of functions in the exclusive domain of the
Union, List II, of the States and List III, concurrent.37
(b) The power given to the Parliament to legislate on exclusively State subjects in two
situations, first was with respect to the matters in the State list in national
interest, but for a limited period (article 249), second was in respect of any matter
in the State list if the proclamation of emergency is in operation (articles 250 and
353) and the third was for two or more States by consent of those States (article
252). Fourth was the executive power given to the Union to give directions to the
States in the normal circumstances (article 257) and during the operation of a
proclamation of emergency (article 353).Fifth was superiority of Union laws over
State laws in cases of overlap or conflict (article 254). Sixth was a residuary
power of legislation vest with the Centre (article 248).
While the Constitution has indicated the broad framework for the terms of reference
of the Finance Commission, it allows the Finance Commission to determine its own
principles for making recommendations in relation to the tasks assigned to it. The
Constitution also permits the Finance Commission to follow its own procedure in the
matter. In addition to the Constitutional provisions, Parliament has enacted the
Finance Commission (Miscellaneous Provisions) Act, 1951, which prescribes the
qualifications for the chairman and members of the Finance Commission and also the
procedure that the Finance Commission should follow to perform its duties. The
ensuing paragraphs review the principles adopted by the Finance Commissions for
assessment of the finances of the Centre and the States and for the tax devolution,
grants-in-aid and other items of the Transfer of Resources.
Commission and Committees on Centre-State Relations
Discussions about the centre –state relation have been marked by recommendations of
committees and commissions. More prominent among them are the Administrative
Reforms Commissions (1969); the Rajamannar Committee (1971) and the Sarkaria
Commission (1983) all of which made many important recommendations for
reconstructing the centre state relations.
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Administrative Reforms Commission (1969)
The administrative reforms commission held firmly that the Indian constitution is a
federation with a strong Centre. It started that the constitution is so well balanced that
while providing maximum possible autonomy to the states, it places in the hands of
the centre adequate powers to ensure the unity and integrity of the country. The
following are the key recommendations of the administrative Reforms Commission.:
(a) The Finance Commission may be asked to make recommendations on the
principles which should govern the distribution of plan grants to states.
(b) The appointments of the finance commission may be so timed, that when
making its recommendation it will have before it an outline of the forthcoming
Five year Plan.
(c) In order to secure effective coordination of the finance commission’s
recommendations, a member of the planning commission may be appointed to
the finance Commission.
(d) The finance Commission should include two persons, one having experience
of financial administration at the centre and the other having such experience
in state; and
(e) The unit of the plan finance Division of the ministry of finance at the centre
may be strengthened.
Rajamannnar Committee (1971)38
The government of Tamil Nadu constituted this committee to examine the entire
question regarding the relationship that should subsist between the centre and the
states in India’s federal setup, with reference to the provisions of the constitution so as
to secure to the states the utmost autonomy. The based devolution of revenues on the
states should be widened by including Corporation tax Custom and export duties; and
Tax on the Capital value of assets in the divisible pool to be shared by the centre and
the states.
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All excise duties and cesses which are shareable at the option of the union, should all
be made compulsory divisible between the union and the states. Grants by the centre
to the states both for plan expenditure and non –plan expenditure should be made only
on the recommendation of finance commission or a similar statutory body.
Recommendations of the finance commission shall be binding on all the parties-
Centre as well as the states. Planning commission should be placed on a statutory
Basis and the existing Planning Commission should be abolished. This committee had
observed that the assistance to be given by the centre for plan projects is practically
dependent on the recommendations of the Planning Commission and, therefore a body
like the Finance Commission cannot operate in the same field.
Sarkaria Commission (1983)
The Sarkaria Commission was constituted in June 1983 to examine and review the
working of the existing arrangements between the union and the states in regard to
powers, functions and responsibilities in all spheres and recommend such changes and
other measures as may be appropriate. The Commission has made a large number of
recommendations. The more important of these recommendations relate to Finance.
(a) Corporation tax should be made shareable with states
(b) Certain other levies, loan procedures and foreign exchange entitlements
should be liberalized in favour of the states;
(c) Municipal bonds should be tax exempt
(d) Centrally sponsored schemes should be strictly limited.
The Sarkaria Commission had discussed setting up an expert committee also to
recommend restructuring taxation and resource distribution from the centre to the
states. It was proposed that an advisory Sub Committee of Finance be set up in the
National Development Council (NDC), and that the Finance Commission itself work
under the member –in- charge of financial resources in the Planning Commission. The
recommendations of the Sarkaria commission have been widely acclaimed across the
political spectrum. But most of the crucial recommendations which constitute the
sentinel of a federal re-structuring are yet to be implemented. The Clamour by the
state government for more powers vis-à-vis the centre, is sought to be modified by
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appointments of such commission without any pragmatic intention of really
implementing their recommendations. Meanwhile, the old theory persist a strong
Centre to preserve the unity and integrity of the country. Now, the moot question is
whether the old theory is capable of tackling all the federal problems or a radical
federalism that aims at securing more powers to the states in to be put on the agenda.
And the choice for a new federalist balance has to trace the problems right from the
constitutional provisions to the present practices.
Evolution of the Finance Commission
The Finance Commission is a constitutional body, constituted under the provisions of
article 280 of the Constitution, and the Finance Commission (Miscellaneous
Provisions) Act, 1951. Under these provisions, the President constitutes the Finance
Commission and appoints for it the chairman and members, at the interval of no more
than five years. The finance Commission make recommendations relating to the
distribution of the net proceeds of taxes between the Union and the States, the
principles which should govern the grants-in-aid of the revenues of the States out of
the Consolidated Fund of India and the measures needed to augment the Consolidate
Fund of a State to supplement the resources of the Panchayats and the Municipalities.
In addition, any other matter may be referred to the Commission by the President in
the interests of sound finance.
Guided by the recommendations of the Sarkaria Committee, the Constitution Drafting
Committee had proposed setting up of Finance Commission at a maximum interval
five years for the purposes of making recommendations in respect of the following:
(a) Devolution of Central taxes and duties to the States and distribution of the same
among the States;
(b) Extension of grants-in-aid to the revenues of the needy States
(c) Extension of grants-in-aid to the states for the development and welfare of the
scheduled tribes and scheduled areas; and
(d) Any other matter in the interest of sound finance.
The Constituent Assembly had found these proposals generally acceptable39 and
adopted the proposed clauses with minor changes. The provisions of the Constitution
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relating to Finance Commission were brought into effect on 26th January, 1950. The
First Finance Commission was set up in November 1951 and was required to give its
report covering five fiscal years commencing 1st April, 1952.So far twelve Finance
Commissions have been set up as per the details given in table given below.
The Finance Commission are contained in clause (3) of article 280. In the original
form of the Constitution (1950), this clause prescribes five broad themes for the
Finance Commission to make recommendations about,
(a) The distribution between the Union and the States of the net proceeds of taxes
which are to be, or may be, divided between them under Chapter I of Part XII
of the Constitution (i.e., the vertical transfers, or devolution);
(b) The allocation between the States of the respective shares of such proceeds
(i.e., the inter se or horizontal distribution);
(c) The principles for making grants-in-aid of the revenues of the States from the
Consolidated Fund of India;
(d) The continuation or modification of the terms of any agreement entered into
by the GOI with the Government of any State specified in Part B of the First
Schedule under clause (1) of article 278 or under article 306;
(e) Any other mater considered by the President to be in the interest of sound
finance.
Of the above five themes, the one at (d) was deleted by the 7th Amendment (1956)
which had also omitted article 27817. Subsequently, a set of new terms was added in
article 280 (3) by the 73rd and 74th Amendments (1973)1, requiring the Finance
Commission to make recommendation also in respect of the measures needed to
enable the States extend financial help to the local bodies, the Panchayats and the
Municipalities. While the Constitutional provisions for the Finance Commissions
have been fairly cryptic, the Terms of Reference assigned for the successive Finance
Commissions have been far more elaborate and extensive. The various tasks/ issues
referred to the FCs by way of the TOR can be broadly classified as the mandatory
considerations and the non-mandatory one. The evolution of the mandatory and the
non-mandatory considerations in the TORs for the successive Finance Commissions
is analysed in the subsequent Chapters.
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Trends in Constitutional Developments in India
Initially the governmental levels recognised in the Constitution were two, the Union
and the states. But the two constitutional amendments carried out in 1992, have
accorded constitutional status to the panchayats and municipalities, although the exact
demarcation of their powers and functions is left to the state governments to specify
through their respective legislatures. Indian Constitution has been characterised as
“quasi-federal”. In several respects, the unitary elements have clearly over-shadowed
the federal attributes with the centre assuming more dominating role than what even
the constitution-makers had visualised.40
Although the powers of the Union and the states are enumerated in separate lists in a
schedule appended to the Constitution, the “ownership” of powers cannot be said to
be clear-cut. There is concurrent list covering fairly wide areas wherein the Union
Government is vested with powers to dismiss an elected state government and
promulgate central control, through the President rule, on the grounds of break-down
of normal constitutional arrangement. The adoption of planning in the country in 1951
and the establishment of the Planning Commission through an administrative order of
the Government of India gave further powers of control over the states by the centre
through its strategy of development and planning. The institution of All-India services
provides another mechanism for exercising control over the states. The centres, sway
over the economy was widened further by public ownership of large industries and
nationalisation of major banks in the country. The ambit of central control over state
subjects was further extended through a number of centrally sponsored schemes to be
implemented by the state and local governments.
As in other federations, the Constitution of India mandates that, subject to the
provisions made in the constitution, 'trade, commerce and intercourse throughout the
territory of India shall be free' (Article 301). Comparable to the 'commerce clause' of
the US constitution, these provisions should have helped to secure the free
functioning of a common market in India. The Indian constitution however stipulates
that Parliament may impose restrictions on freedom in 'public interest'. Invoking
public interest, both the centre and the states imposed controls on the movement of
commodities that play a vital role in the life of the common people like food grains,
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edible oils, and cotton, severely impeding the emergence of an integrated market in
the country. The states on their part used 'public interest' to create barriers segmenting
the country's market, Maharashtra's Cotton Monopoly Procurement Scheme of 1971
being a glaring example. The centre is clearly a party to this segmentation which
continues even now as the continuation of the scheme requires centre's approval
periodically. There was often a multiplicity of control orders imposed on the same
commodity and notifications were issued for the same item by both centre and the
states.
Financial Emergencies
The Indian Constitution contains a unique provision to deal with a financial
emergency. Article 360(1) provides that if the president is satisfied that a situation has
arisen whereby the financial stability or credit of India or any part of the territory
there of is threatens he may by proclamation make a declaration to that effect. The
proclamation ceases to operate at the expiration of two months (and can be revoked or
varied earlier by the President). If it is approved by both Houses of Parliament, it can
be continues longer.
The effect of issue of Proclamation under Article 360(1) known as the Proclamation
of Financial Emergency is that during its subsistence the executive authority of the
Union shall extend under Article 360(3)
(a) To the giving of directions to any State to observe such canons of financial
propriety as may be
(b) To the giving of such other directions as the President may deem necessary
and adequate for the purpose.
Directions of the nature mentioned in (b) above notwithstanding the apparent width of
language must be connected with the financial propriety (not the words “for the
purpose”). Subject to this requirement it would appear that the Union can give
directions even of an administrative nature that is directions to reduce or modify
certain types of administrative action by the State Government, in order to avert the
threat to financial stability or credit. It is further provided in Article 260(4) which
begins with a non-obstinate clause, that the directions issued under Article 360 may
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include a requirement to reduce salaries and allowances of “all or any clad of persons
serving in connection with the affairs of a State” as provided in Article 360(4)(i).
It is further provided in Article 360(4) (ii) that the directions may include a provision
requiring all Money. Bills or other bills to which the provisions of Article 207 apply
to be reserved for the consideration of the President after they are passed by the
Legislature of the State. It is finally provided in Article 360(4)(b) that the President
may (while the Proclamation of Financial Emergency is in operation) directions for he
reduction of salaries and allowances of all or the Union including the Judges of the
Supreme Court and the High Courts.
A little analysis will show that the most important effect of a Proclamation of
Financial Emergency is that it empowers the President to modify the constitutional
scheme of division of financial powers inasmuch as the Union can give directions
vitally affecting the manner in which the executive power of the State may be
exercised. The provision regarding Money bills has a similar consequence. Another
notable feature of Article 360 is that it empowers the issue of directions for reducing
the salaries and allowances not only of persons employed in connection with the
affairs of a State, but of persons serving in connection with the affairs of the Union
including the Judges of the Supreme Court and the High Courts.
Here is an example of power to modify rights conferred by the Constitution. It is also
worth pointing out that the scope of the power to issue directions under Article 360
regarding salaries etc, of employees is wide enough to affect contractual rights also.
To sum up a Proclamation under Article 360 of the Indian Constitution has at least
three important consequences temporarily modifying.
(a) The federal scheme of distribution of power.
(b) Constitutional rights of individuals (particularly judges) and
(c) Contractual rights.
Modification of the federal scheme- (a) above touches no merely the exercise of the
executive authority but also as regards money bills the legislative authority as well.
These important consequences of a Proclamation of Financial Emergency did not go
unnoticed in the Constituent Assembly. When in mid-October 1949, Dr. Ambedkar
introduced into the Constituent Assembly the last of the Emergency provisions-new
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Article 280(A) (now Article 360)-Pandit Kunzru disliked this provision. Dr.
Ambedkar contended that the proposed provision was similar to the National
Recovery Act of 1935 (U.S.A.). But this did not satisfy Pandit Kunzru who said that
the National Recovery Act was a temporary measure. Pandit Kunzru pointed out that
only three days earlier (13 October 1949) Jawaharlal Nehru had said that the Indian
Constitution was federal and was based on the American Constitution. In Pandit
Kunzru’s view the proposed Article 280A was not consistent with that statement of
Nehru. Dr. Ambedkar’s explanation was that the provision was necessary in view of
the present economic and financial situation in the country.
It needs to be pointed out there must be satisfaction on the part of the President of
India that there is a threat to the financial stability or credit of India or any part
thereof. The part may of course extend over more than one State. The Proclamation
will be issued, varied or revoked only on the bona fide. Their foes not appear to be
any scope for legal valence to the issue of the Proclamation. As regards the measures
taken by Government in pursuance of the Proclamation they must have some nexus
with the threat to financial stability of credit. No doubt the courts will make a
presumption of the constitutionality of such action.
While the Constitution clearly recognised the needs for coordination among different
levels of government in the matters of governance, and made provision for the
creation of a forum for consultation among governments in the shape of Inter-State
Council (Article 263), the Council was constituted as late as 1990, despite strong
recommendations by high powered commissions - the Administrative Reforms
Commission and the Sarkaria Commission. The entire gamut of centre-state relations
was considered in depth by the Sarkaria Commission, but its recommendations are yet
to be fully acted upon.
The initiation of economic reforms in 1991 has reduced centre’s role in controlling
the economy and recent changes in the political configuration in the country, have
broken the monopoly of the political party that had ruled at the centre and the states in
the initial 40 years after independence, and has replaced it by the coalition
government at the centre. There has been the emergence of governments in several
states run by regional parties, leading to the demand for greater regional autonomy to
the states and vesting of constitutional status to local bodies, consequent upon the
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enactment of constitutional amendments. All these developments led to the demand
for “cooperative federalism” in the country, to guard against the emergence of
monopoly at the centre. Cooperative federalism accords primacy to lower tiers of the
government in providing public services, and contemplates the most decentralised
form of governance. But a change from quasi-federalism to cooperative federalism
needs lot of changes - political, legal and constitutional. A Constitution Review
Commission has been set up recently by the Govt. of India, to consider different
aspects of changes demanded in the Constitution.
The above presentation shows that federation is not just a structure but a process and,
therefore, it is more important to activate the forum for interaction than going in only
for formal arrangements that divide the powers between the Union and the states and
the state and the local bodies. Federalism is poised for acquiring new dimensions,
with world economy getting globalised and integrated and the paradigm of desirable
arrangements of functions and finances at the sub national levels undergoing changes,
old ideas of sovereignty are fast facing obsolescence, as nations agree on their own to
abide by internationally accepted conventions and standards.41
Relevant Constitutional Amendments
The constitutional amendment Act, 1992, by making a provision for the constitution
of State Finance Commission, under Article 243(i) and 243(y) after the expiry of
every five years, for recommending devolution of resources from state government to
local bodies, has altered the erstwhile fiscal arrangement between the state
government and local bodies and has tried to rectify the imbalance. The Constitutional
Amendment Act gives local bodies a constitutional status, assigns them a number of
functions, ensures them stability, provides a suitable framework to function with
greater freedom and also makes institutional arrangements for devolution of finances
from the state government to local bodies.
It is for the first time that unlike its predecessors, the XI Finance Commission was
assigned certain terms of reference relating to local bodies and their finances. The
inclusion of certain issues relating to local finances in the TOR of the Commission
has added a new dimension to the character of fiscal federalism in India and also
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demonstrates the fact that the nation as a whole should feel interested in the financial
health of local bodies and have a stake in the task of restructuring and strengthening
local bodies as units of self-government.
The 80th and 88th Constitutional Amendments brought in major changes in the
scheme of fiscal relations between the Centre and the States. The 80th Amendment
brought in June 2000 made all the Central taxes and duties sharable with the States as
per the recommendations of the Tenth Finance Commission. However, it excluded the
cess and surcharges from sharing even though the Tenth FC had not recommended so.
The 88th Amendment, brought in January 2004, gave a formal place to the service tax
in the Union List, which was all along a residuary taxation. The Amendment also took
the service tax outside the purview of the Finance Commission but empowered the
Parliament to make laws for bringing about the share ability of this tax.
The 80th Amendment substituted the entire wording of article 269 and retained only
two items under this article, namely, taxes on inter-State sales/purchases of goods and
taxes on inter-State consignment of goods. Despite this amendment, Parliament still
has the power to levy these taxes as the Seventh Schedule remains unchanged by this
Amendment. However, the effect of the Amendment is that the taxes that are not
mentioned in article 269 remain mandatorily sharable with the States42 along with all
other taxes, in terms of article 270.
A Brief History of Fiscal Relations in Canada
Federal and provincial roles and responsibilities have evolved throughout Canadian
history in response to sometimes dramatic changes in circumstances. Many of the
major events of the 20th century—the Great Depression of the 1930s, the two World
Wars, the emergence of the post-war welfare state—all involved dramatic shifts in
"fiscal balance" either vertical (between the federal and provincial governments) or
horizontal (e.g. changing fiscal disparities among the different provinces). Fiscal
relations have had to evolve alongside these shifts in roles and responsibilities—and
corresponding shifts in fiscal balance. Throughout Canada’s history, federal and
provincial-territorial governments have found a variety of ways of meeting these
challenges.
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In many cases, adjustments to shifts in fiscal balance were achieved through
incremental spending and taxation choices by individual governments. In other cases,
they involved coordinated action by federal and provincial-territorial governments to
realign revenues or expenditure responsibilities. In only a few cases were
constitutional changes involved. The variety of fiscal rebalancing mechanisms used
over the years reflects a high degree of flexibility in Canadian fiscal federalism.
Unlike many other federal countries, both the federal and provincial-territorial orders
of government are able to exercise significant autonomy across a broad range of
expenditure and taxation areas. As a result, all governments in Canada are able to
raise revenues from all major tax fields, enabling them to shift relative emphasis on
different tax fields over time in response to changes in roles and responsibilities.43
Early in Canada’s history, the largest part of expenditure responsibilities and most of
the revenues from the major tax fields then in use (primarily customs, excise and
indirect taxes) lay with the federal government. However, by the 1920s, the role of
provinces in delivering programs and services (including the predecessors of many
social programs today) had already grown significantly. Their own-source revenues
had also increased substantially, as provincial sales taxes, personal income taxes and
corporate taxes came to be widely used. The uncoordinated presence of both federal
and provincial governments in these tax fields came to be known as the era of the "tax
jungle" in Canada and resulted in a vigorous debate over the need for greater clarity in
the allocation of taxing powers and the need to harmonize federal and provincial
taxes.44
The Great Depression of the 1930s had a dramatic impact on the revenues and
expenditure requirements of both orders of government—but especially the provinces,
given their role in providing income support to persons in need. The resulting
financial strain led to calls for a major restructuring of federal and provincial roles and
responsibilities in relation to both taxing powers and expenditure responsibilities and
for new federal transfers to the provinces.
The Second World War resulted in an equally dramatic change to the pattern of
government expenditures and revenues: provincial expenditures declined as
employment increased while federal defence expenditures rose markedly. The fiscal
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rebalancing required as a result of these developments was achieved through
temporary "tax rental agreements," under which provinces "leased" a number of tax
fields to the federal government, including personal and corporate income taxes. In
the years following the war, provinces re-entered these tax fields as the federal
government reduced its own taxes as a result of demobilization. Provinces also
resumed their pre-war expenditure responsibilities and began to take on new roles.
To avoid a return to the "tax jungle" of earlier decades, federal and provincial
governments agreed to harmonize their personal and corporate income taxes to a
substantial degree. From the 1950s to the 1970s, the development of most of the
major social programs familiar to Canadians today (in the fields of health, education
and social services) led to significant new pressures on provincial and territorial
expenditures, corresponding increases in provincial-territorial taxes and significant
increases in federal transfers, including both cash transfers and formal transfers of tax
room from the federal government to provinces and territories. The period starting in
the 1980s was marked by consolidation of Canada’s system of intergovernmental
fiscal relations. By the mid-1990s, increasingly large deficits and debt burdens,
especially those of the federal government, led to fiscal restraint that culminated in
significant reductions across a wide range of federal expenditures, including transfers
to provinces and territories.45
Expenditure Responsibility
The federal government has constitutional responsibilities for foreign affairs trade and
commerce , copyright, currency , banking , national defence , the post office , census
taking and statistics , navigation , fisheries , criminal law, penitentiaries (for long term
offenders ), old age pensions and unemployment insurance. The federal government
has what is known as spending power under the constitution, whereby it may spend
money on functions that are under provincial jurisdiction46. In addition, the
constitution contains some specific provision, added in 1982, which commits the
federal government to the principle of making equalization payments. The federal
government is responsible for enacting criminal law but the provinces are responsible
for its enforcement.
The constitution assigns major expenditure responsibilities to the provinces-including
health, education, and most elements of welfare, but not unemployment insurance or
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old-age pensions – both of which were transferred to the federal government some
time ago by constitutional amendment. The provinces are also responsible for
property and civil rights , highway transportation , policing , the judicial system ,
prisons (for short term of offenders ) , environmental protection and local works such
as fire protection , sewage and garbage collection. Many of these expenditures are
made by municipal and school authorities
There are joint responsibilities by both federal government and provinces for
agriculture and immigration. The federal government has authority to legislate in
areas not explicitly allocated to provinces47. The federal government has also made
considerable use of its concurrent spending power under the constitution, and has
done this in the form of large transfer payments to province for health, welfare and
education.
Revenue Raising Responsibilities
The Constitution assigns responsibilities for taxation to the different levels of
government. These provisions appear to strongly favour the deferral government but,
in fact, have very little by way of practical significance in effect, there are overlapping
tax assignments, except that provinces may not levy customs duties on imports into
Canada or export charges on export from Canada or tax inter provincial trade so that a
provincial tax may not be levied on goods being shipped to or coming from another
province. Both levels of government may borrow to finance budgetary deficits as well
as capital expenditures. There are no constitutionally mandated tax-sharing
arrangements which exist in some federal courtiers such as Germany. Both levels of
government have access to the major tax bases. Both levels of government levy
general sales taxes. The federal government levies a value added tax. Nine of the ten
provinces levy a sales tax. Eight of these levy in on the value of goods and services at
the retail level (with varying exemptions) while one province (Quebec) has largely
harmonized its tax with the federal one, but tax collection is done by that province
rather than the federal government.The federal government also has important
revenues from special excise taxes on tobacco, alcohol and gasoline, unemployment
insurance levies and customs duties but has not utilized has voluntarily agreed to yield
the base to the province.
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The province levy a somewhat broader range of taxes on consumption than the federal
government, including on tobacco, alcohol and gasoline, in addition, revenue from the
rapidly growing field of lotteries and other forms of gambling goes entirely to the
province. In addition, provinces and local governments, mainly the latter, levy all of
the real property taxes in Canada, and derive very large revenues from this source.
Indeed in relation to gross domestic product (GDP), Canada has had the highest
property taxes in the world in recent years. The provinces also derive large revenues
from levies on natural resources, to capture their economic rents. Such revenues are
very unevenly distributed, going largely to the three western provinces. Nearly all of
the oil and gas reserves in the provinces are actually owned by the provincial
governments as sub-surface rights to land and the province also have a very special
position here, although the federal government can be pre-emptive in the field as in
the 1970s and 1980s when world oil prices were very high.48
Vertical Fiscal Balance
The foregoing background would suggest that the Canadian Constitution itself should
not inherently lead to a vertical fiscal imbalance of a structural or long term nature,
because the taxing powers of both levels of government should be strong enough to
prevent this from happening. However a significant imbalance has existed for many
years, in part because the federal government achieved a dominant position in the
fast-growing income tax fields at the time of World War II accompanied by a new
post-depression view of the important economic role of national governments. In
addition there was relatively rapid growth of expenditures for major function assigned
to the provinces, such as health welfare and education. However the latter stemmed in
part from the introduction of large federal-provincial transfers which, at the same
time, dealt with much of the imbalance.
On a national accounts basis, as of 1993, federal government own-source revenues
were almost equal to own-account expenditures (just 1.1 present lower) while the
provincial-local governments had own- source revenues 23.2 percent below own-
account expenditure. The vertical imbalance does, however provide a rationale for
transfers from the federal government to the provincial/ local levels. Of the 1993
provincial- local gap of 23.2 percent of expenditures, equal to $47,904 million, 65
percent was financed by federal-provincial/ local transfers totalling $31,191 million,
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and the remainder was met by borrowing. However, the federal government’s own
account expenditures exclude its large cash transfers to provincial- local government
and since the own account expenditures are almost equal to federal own source
revenues there is also a close parallel between the extent of the federal deficit and the
amount of federal cash transfers to provincial local governments, which is not to say,
however, that the transfers are the main cause of this deficit.
Vertical imbalances can also be discerned with respect to the provincial local
desegregation of the total government sector. When this is done for 1993 the vertical
imbalance relates exclusively to local governments that are to municipalities, school
authorities and hospital authorities. For provincial governments alone, own source
revenues exceed their own account expenditures by almost 3 percent, but province
make very large transfers to local government. Thus the own source revenues of
municipalities and school authorities, as of 1993 equalled only about 57 percent of
their own account expenditures and for hospital authorities the corresponding figure
was only about 6 per cent.
Finally the degree of vertical imbalance cannot be expected to remain stable over
time. The relatively large deferral deficits and debt which have existed in recent years
indicate that the extent of vertical imbalance in favour of the federal government has
been decreasing significantly. This will have important implications for the federal
provincial transfer system.
Horizontal Fiscal Balance
Regional fiscal disparities in Canada appear to be relatively large compared with other
federations, partly because of the large and highly taxable, economic rents from
natural resources in Canada and their uneven geographic incidence. Another factor
generating regional disparities is the location of big cities. Canada has three large
cities population. Their main characteristics are shown in Table 3.2 There is a
demographic trend in provinces which one would expect, with population growth
significantly stronger in the rich provinces than the poorer ones. This factor would
tend to reduce provincial disparities over time. There is also some historical evidence
in Canada of gradual fiscal capacity ‘convergence on a per capita basis. The factors
used in the country’s equalization program make it feasible to quantify the overall
fiscal disparities among provinces quite accurately through ‘indices of fiscal
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capacity’. These are estimated each year for all provinces , based upon assessments
of the amount of revenue per-capita each province could derive from all of the
various taxes and quasi-taxes levied by provinces and local governments in Canada ,
if each province together with its local government, imposed each tax at the average
provincial rate for that tax. These indices, which go back to 1972, indicate a
considerable differential in fiscal capacity from the richest province to the poorest.
The richest province (oil-rich Alberta) has consistently had a per-capita revenue –
raising capacity that has been at least double that of the poorest province (either
Newfoundland or Prince Edward Island). During the periods of historically high
world prices for oil, from 1974to1985, Alberta’s index was roughly three to four
times as high as that of the poorest province. If the comparison made between the
average index of federal capacity for all ten provinces (referred to as the ‘national
average’) and the average index for those provinces that receive equalization
transfers, then for the period from 1974 to 1985 the provinces receiving such
transfers collectively averaged between 73 and 81 percent of the national average
per-capita fiscal capacity , depending upon the year and, for all other years from 1972
onwards , the equalization – receiving provinces have collectively averaged between
81 and 85 percent of the national average per-capita revenue –raising capacity.49 The
above indices indicate that horizontal fiscal imbalance in Canada is significant and
needs to be addressed. This is done through the Equalization Program and, if indices
of fiscal capacity are calculated on a post-equalization basis, the range shown above is
greatly reduced.
The ‘Representative Tax System
The most notable reform came in 1967 when the ‘Representative Tax System’ (a
concept developed in the United States by the Advisory commission on
Intergovernmental Relation) was introduced. This concept embodies the notion that
the fiscal capacities of provincial governments should be assessed with reference to a
comprehensive range of all other actual taxes. In applying this concept, a relatively
broad definition of taxes has been used in Canada to include natural resources levies
in full, and such revenues as license fees and permits, and revenues from the sales
goods and services by provincial governments .governments revenues from any
business enterprises owned by them have also been taken into account. The final steps
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occurred in 1973 and 1982 respectively, when revenue coverage was successively
broadened to bring in the large revenues from property taxes levied by local
governments, for school and municipal purposes, respectively.
The representative tax system now has 30 separate revenue sources, and the
assessment of revenue-raising capacity is done separately for each source. This is
done by defining a tax base for each tax that will be typical of the actual tax bases
used by those provinces levying the tax, and then estimating the revenue yield in each
province, by applying the average rate of provincial tax to that typical base. The
assessments for all 30 revenues sources are than added for each province to arrive at
its total fiscal capacity. The assessments of fiscal capacity among provinces therefore
reflects the real world of what provinces and their local governments collectively
choose to tax , rather than some top-down notion of what they ought to be taxing. The
total assessments of each province’s fiscal capacity is then put on a per-capita basis
and compared with a per-capita standard, with any province that is below that
standard having an equalization entitlement equal to its per-capita short fall multiplied
by its population. This calculation is done for each fiscal year and the payments are
made free of any conditions as to how the money is to be spent50. The standard is a
key element of the equalization Program, because it determines the level of
equalization and the extent to which measured disparities among provinces in fiscal
capacity will be narrowed , It is inherently a very subjective elements of the
equalization ‘formula’, but on which must be established with reference to the
constitutional mandate for equalization . The original equalization standard was based
upon the per capita revenue-raising capacity of the two richest provinces. As revenue
coverage was expanded , the standard was lowered – first to the average for all ten
provinces (known as the ‘national average’) in 1967 and then to five ‘middle –rich’
provinces in 1982 , excluding extremes consisting of rich , but volatile , Alberta and
the four relatively poor Atlantic provinces . Each excluded group has about 9 percent
of total provincial population.
Another key element of equalization in Canada is the provincial population, because
the equalization standard is always expressed in terms of per-capita fiscal capacity, so
that provinces of different size may be compared on a reasonable basis. Accurate
population estimates are therefore of great importance. They are determined by means
of a census conducted by statistics Canada every five years, and are estimated with
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reference to census benchmarks adjusted for annual data on births, deaths and both
interprovincial and international migration .Census counts are now adjusted for
estimates of coverage error. A program ceiling was added in 1982, which places an
upper limit on total annual entitlements as a percentage share of gross national
product in the year for which entitlements are being calculated. This, together with
the change in the program standard made in the same year , was added in response
to federal government concerns over sudden and large year-to-year increases in
program entitlements, which at the time were largely attributable to natural resources
and , in particular , to highly volatile and unpredictable oil and natural gas revenues.
Some (relatively minor) ‘floor provisions’ were added at the same time to protect
individual provinces ([particularly the very poorest) in respect of any significant year-
over-year reductions in their total entitlements.
The most important, and also the most difficult, element of the equalization
calculation is to define the typical tax base for each revenue source. The basis reason
for the difficulty is that for most taxes the definition of what is taxed varies across
provinces and that some provinces may not levy a particular tax at all, In addition,
even if the definition of what is taxed is uniform, there may be a problem of allocating
the tax among provinces for business firms that operate in more than one jurisdiction.
The Canadian treatment of these problems is described below. In the important cases
of the income taxes, there are essentially uniform tax base across all provinces, and
the allocation of the corporation income tax base for corporations operating in more
than one provinces is done on formulae basis which taken account of relevant data
required on the tax return of each corporation, usually relating to the corporations
salary and wage payments by province and to its sales by province. For a tax where
there is not uniformity of base across provinces, a proxy base is used, based on data of
good quality with reference to its provincial breakdown and whose percentage
distribution among provinces may be expected to be a reasonably comparable to the
distribution of the typical base used by provinces for that tax if relevant data on that
base were available. These proxy bases include, for example, data on the value or
volume of sales of a given good by province in the case of consumption tax, and on
the value or volume of production by province of particular natural resources in
respect of levies intended to capture the economic rent from that resource.
176
The representative tax system (RTS) is generally considered to work well because of
the high quality of Canada’s statistical data base. Relatively few changes have been
made to the structure of the equalization Program since 1982, except that the ceiling
limit , expressed as a share of Canada’s GNP, derived from total program pay-out as
a percentage of GNP in some base year, has been changed each time that the program
has been legislative renewed. However, numerous and important techniques changes
have been made, relating mainly to the measurement of fiscal capacity. these reflect
on-going changes in provincial tax bases for existing taxes, the introduction to new
taxes by provinces, and conceptual and measurements problems with some taxes ,
notably including real property taxes and natural resource revenues.
Trends in Canadian Fiscal Federalism
Much of the literature in fiscal federalism is about whether the tide is flowing of the
federal government or the provinces and the factors that lie behind those trends.
Casual reporting of this issue often focuses on the power struggle between orders of
government. But there is more at stake. In this regard, perhaps the main issue is
whether the 'sharing community' within Canada is the country as a whole or its
constituent units.
Centralization or Decentralization
Expenditures required huge sums of money. The result was tax "rental" agreements
negotiated between the federal and provincial government under which Ottawa alone
would levy and collect personal and corporate income taxes and death duties in return
for rent payments to the provinces.51 From the viewpoint of the way power is
distributed within the Canadian federation, the way years were ones of very strong
centralization.
Even before the war was over, political leaders and intellectuals in Canada and many
other countries had begun to consider what kind of transformation might be necessary
in order to make the post-war years safe and prosperous. For the liberal democracies
of the Western world, there was enthusiasm for the creation of multilateral institution
to promote peace and security and economic growth, leading to the creation of the
United Nations, the North Atlantic Treaty Organization, the International Monetary
Fund [IMF], the General Agreement on Tariffs and Trade [GATT] and the World
177
Bank. The idea that fiscal and monetary policy could be used counter-cyclically to
stabilize the economy and ensure high employment took root and the seeds of the
modern welfare state were also planted.
As the Cold War dominated much of the post-war era internationally, defence
spending remained a high priority for Canada and for the federal government. The
IMF and GATT became the vehicles through which and international system of
payments and trade were liberalized and it was the federal government that
represented Canadian interests in those bodies. As for domestic policy, Keynesian
counter-cyclical stabilization policy emerged as a central role for the federal
government. Ottawa also began to implement its vision of a modern welfare state.
This had begun with unemployment insurance in 1940 and was followed by family
allowances in 1945 and old age security52, for liberalizing, and for early development
in the post-war welfare state, the federal government remained the dominant actor in
the Canadian federation even after they end of the war.
Since the provinces had most of the legislative authority for social programs, the
federal government could not act on its own in fashioning the welfare state. It could
use its constitutional powers to design unemployment insurance programs and its
'spending power ‘to individuals.53 But it lacked the constitutional power to design and
deliver most social services. Accordingly for key components Ottawa could only act
by working with and through the provinces. The result included a series of federal-
provincial shared-cost programs that included hospital care, medical services, post-
secondary education, social assistance, and social services54. The arrangements also
included federal equalization transfers to the less wealthy provinces to enable them to
provide reasonably comparable levels of services at reasonably comparable levels of
taxation. On the whole, power remained cantered in Ottawa during the early post-war
decades. But during these same decades, events were also sowing the seeds of change.
For one thing, as the scope and size of the Canadian welfare state grew to encompass
more and more of these activities, the role and size of provincial government began
also to expand rapidly. The late 1850s and mid-1960s saw the introduction of public
hospital insurance and medical insurance by the provinces under cost-sharing
arrangements with the federal government.55 At the same time, helped by fiscal
incentives from Ottawa, provinces undertook a massive expansion of Canada's post-
secondary education and social service systems, Provincial government thus came to
178
play a progressively larger direct role in the lives of Canadians. With these changes,
they had a consequential requirement for additional sources of revenue sector, but
rather a provincial expansion in collaboration with the federal government as cost-
sharing partner. Motivated by economic efficiency and equity concerns, on the one
hand, and nation-building, on the other, the federal government transferred large sums
to the provinces to facilitate the construction of national programs for social purposes
and post-secondary education.
The federal government's direct role in social policy also increased during these years.
Through negotiation with the provinces, Ottawa secured their support for a
constitutional amendment that allowed for the introduction of the Canada Pension
Plan. The coverage of the unemployment insurance system was also broadened and
made much more generous .By the 1970s, all of the basic building blocks of Canada's
current welfare state were in place. While the role of both orders of government had
grown, the provincial role had grown more because the largest expenditure
components, health care and education, were provincial responsibilities. And even as
these provincial responsibilities were growing, three parallel development. The first
was that the tension surrounding the Cold War had begun to ease. Well before the
collapse of the Soviet Union, defence and security had shrunk dramatically as
political and spending priorities. Second, counter-cyclical macroeconomic
stabilization policy had come to be seen as ineffective. The 'stagflation' of the 1970s
and the serious recession of the early 1980s led to the emergence of a new
macroeconomic orthodoxy-one that placed much less weight on counter-cyclical
macroeconomic policy and much more on getting the economic fundamentals right.
The result was that the case for Ottawa continuing to control a large enough share of
the tax system to effect stabilization came to be diminished. The third development
was an accumulation of federal government deficits and rising debt-service costs.
Over time, this reduced the ability of the federal government to undertake new
spending initiatives and hence to shape and influence provincial spending patterns
through the use of federal-provincial matching grants or other cost-sharing devices.
The federal government even found it difficult to maintain its financial commitments
for existing joint programs.
179
Centralization in the post-war Canadian federation may have peaked sometime in the
1970s or possibly the early 1980s with the Constitution Act, 1982. But from the
perspective of spending and taxing only, and related policy initiatives, the peak in
federal government power occurred in the second half of the 1960s.Subsequently, the
provincial tide began to rise. In the year 2000, it was unclear whether this phase of
decentralization had run its full course or whether another leg of decentralization lay
ahead. Whatever the answer to this question, however the federal government is likely
to remain a large fiscal actor.
In 1945, of course the distribution of spending reflects the federal government's role
in financing the war effort. By the 1960s the implementation of the post-war welfare
state was well under way. From 1961 to 1999 the overall size of the state was growing
sharply (form around 30 to 45 percent of the gross domestic product). Provincial
government, by far, experienced the strongest growth. In relative terms, provincial
program spending almost doubled from 1961 to the early 1990s while the federal
share was dropping.
The growth of the provincial state was financed in part through the huge increase in
its own-source provincial revenues. But it also reflected a growth in transfers from the
federal government payments Ottawa could afford to make in good measure because
it had retained through negotiation much of the tax room it had occupied during the
war. In the early years of the post-war welfare state, federal transfer were thus a major
source of revenue to the provinces and these transfers were all cash transfers.56
By the end of the century, however, transfers had become relatively less important as
a source of provincial revenues. Moreover, almost one-third of federal transfers were
in the form of "tax transfer". They notion of "tax transfer" may be a uniquely
Canadian phenomenon and refers to the federal government relinquishing "tax room"
to the provinces as partial compensation for cash transfers it has promised. The main
point to note here is that federal cash transfers to the provinces are now a relatively
small share of provincial revenues, just over half of what they were in 1961, although
they remain very important in Atlantic Canada. This reflects more the huge growth in
provincial "own-source" revenues that it does relative reductions in those federal
transfers.
180
In summary, from the perspective of the broad trends in revenues and expenditures,
and especially the role of federal transfers in provincial finances, the peak in federal
government power was reached during the 1960s. Since then, the provincial role has
been increasing in relative importance, whether one is examining spending or
revenues or the declining role of federal transfer to the provinces.
In other respects as well, federal government influence over provincial programs has
declined. For example, the level of conditionality associated with federal transfer’s
payments to the provinces has been lightened significantly since the 1960s. Today, the
two largest transfers by far are the Canada Health and Social Transfer (CHST) and
Equalization. The latter program has no conditions and the former, a bloc fund
intended for provincial health, higher education, and social welfare programs, has
only two sets of conditions. The first is that provinces impose no restrictions on
eligibility for welfare for residents arriving from other provinces. The second is that
provinces meet the five broad principles of the Canada Health Act in the design and
delivery of their health services.57 The area of personal and corporate income taxes is
another example of decentralization. For reasons of economic efficiency,
administrative efficiency and to avoid tax competition almost all provinces agreed to
sign tax sharing and then tax-collection agreements with Ottawa in the years after
World War II. One result was a cost-effective personal and corporate income tax-
collection system for the provinces. Another was that compliance costs of businesses
that operated in more than one province were minimized.
These agreements did entail costs for the provinces, however. In the case of personal
income tax, one cost was that the federal government required provinces to
"piggyback: their income taxes on top of federal taxes, which narrowed the freedom
of the provinces to design and incentive structure to meet local needs and political
preferences. Provinces could raise and lower their tax rates but were not free to adjust
the basic structure of the system. This has now changed. Under new flexibility that the
provinces negotiated with Ottawa, provincial government are able to continue to
secure the economies and efficiencies of a single tax-collection agency while
181
obtaining much more room to design the incentive structure of their systems. This is
an important growth of effective provincial power.
It was noted earlier that fiscal federalism today is much more decentralized that it was
in the 1940s, 50s and 60s. But whether that decentralization trend will continue into
the first decade of the 21st century is less certain. When one looks at the 1960s, for
example, there is evidence of both decentralization and centralization. On the
decentralization side, both federal and provincial expenditures as a share of total
government spending dropped slightly with the share of municipalities rising.
Pointing in the same direction, some of the reductions on federal transfers that were
discussed above also occurred in the 1996s. And much of the new flexibility in
effective provincial power in respect of personal income tax has come about in the
last year. On top of this, there is perhaps the beginning of a trend toward more fiscal
autonomy for First Nations.
But in other respects decentralization stalled or was even reversed. Federal and
provincial shares of own-source revenues were more or less flat in the 1990s. And it
was around ten years ago that Ottawa moved into to area of value-added tax, revenue
base that had, by convention, been largely the domain of the provinces. Moreover,
beginning in the late 1990s, as its fiscal position improved the federal government
started exercising its direct spending power again in such diverse areas as child
benefits, Millennium Scholarships and Canada Research Chairs.58 Thus, the 1990s
appear to have been a period of cross-currents rather that clear directions. The
movement toward of relatively greater role for the provinces from a fiscal federalism
perspective may thus have slowed or stalled over the last decade. But it has not been
reversed. From a fiscal viewpoint, the Canadian federation remains much more
decentralized that it was 30 years ago.
The early post-war decades were ones in which many of the advanced capitalist
democracies built their modern welfare states. In Canada as discussed above, although
much of the constitutional power for promoting equity goals rested with the
provinces, the federal government heavily influenced the construction of the systems
of social security and last resort. Two main constitutional powers enabled Ottawa to
182
play this role. One was the power to levy both direct and indirect taxes and thus to
construct a progressive tax system. The second was the "spending power" which
enabled the federal government to transfer money to provinces and to persons to
achieve desired social goals. The two powers were connected, in the sense that the
revenues raised through the federal tax system provided the federal government with
the financial wherewithal to exercise its spending power.
The transfer system, both direct indirect, was used by Ottawa to promote equity and
efficiency. The late 1950s and 1960s saw the establishment of a pan-Canadian system
of universal publicly insured systems of hospital and medical services. Post-secondary
education was expanded hugely. A last resort safety net ensured that the most
disadvantaged would be able to survive with at least a modicum of dignity.5920 In all
of these cases, federal-provincial cost-sharing was key instrument. In addition, as
noted above, countrywide systems of old age security, child benefits, and
unemployment insurance were also introduced, in these instances through direct
spending by Ottawa. At the same time, federal government leadership avoided a
return to the tax jungles of the interwar years with all of the inefficiencies they
entailed.
The importance of equity goals was also given concrete expression in the constitution
of 1982. Among other things, Section 36 of the Charter of Rights and Freedoms
committed both orders of government to "promoting equal opportunities for the well-
being of Canadians"60and "furthering economic development to reduce disparity in
opportunities." It further committed the Government of Canada to the "principle of
making equalization payment to ensure that provincial government have sufficient
revenues to provide reasonably comparable levels of public services at reasonably
comparable levels of taxation"61A basic instrument of fiscal federalism, the
intergovernmental transfer, was thus given a form of constitutional recognition to do
its takes.
By several criteria, regional differences in economic conditions were narrowed over
the post-war decades, as reflected, for example, in provincial trends in GDP per
capita. Part of this may have been attributed to the important role of
intergovernmental transfers in the economy of the less wealthy provinces, including
not only Equalizations but also the transfers for health and especially higher
183
education.62 In those parts of the country, and most especially Atlantic Canada,
transfers from Ottawa have been major components in provincial budgets, helping to
promote the goals of reasonably comparable levels of services at reasonable
comparable tax rates. One result, in particular, has been to improve education and
skill levels relative to other regions of the country.
The economics literature generally supports the idea that decentralizations of public
services is a good idea for efficiency reasons.63 The general trend to decentralize
spending, as outlined above, is therefore consistent with this element of theory.
However, there is a divide in the literature about the merits of decentralized revenue
collection. For much of the post-war period, there may have been a consensus that
there were advantages in centralized revenue collection. There were thought to be
administrative efficiencies in collection. Efficiencies in compliance and in the
avoidance of spill over associated with the differing fiscal capacities of the provinces.
In this view, a vertical fiscal imbalance simultaneously supported efficiency and
Canada-wide equity goals.
This relatively good picture of the policy impacts of fiscal federalism became more
blurred over the 1990s, however, as Ottawa reduced its commitment to social
programs and equity goals. Moreover, the economics literature is more divided now
than it once was about the merits of a central government collecting more revenue
than it requires for financing its own programs while other orders of government are
collecting less.64 There is an increased concern that such transfers obscure
accountability relationship. In this view, the government that spends should also be
the government that levies the tax.
This recent questioning of the efficiency aspects of federal transfers to the provinces
overlaps two much broader concerns about the role that the Canadian state came to
play during its post-war expansion. The first was the growth in public sector deficits
and debt, especially at the federal level. Starting in 1975, federal government
spending exceeded federal revenues every year for more than 20 years. As the deficit
problem grew, all government programs were subject to more scrutiny and question,
including, the major federal transfers to the provinces. The second development was
the huge growth in economic linkages between Canada and the United States relative
to the east-west links within Canada,65 a process that has been accelerated by the
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Canada-United States Free Trade Agreement and the North America Free Trade
Agreement. One result has been to reduce the economic self-interest of the wealthier
provinces in seeing the federal government redistribute income to the less prosperous
regions.66
Under the twin pressures of deficit reduction and competitiveness, as noted above,
Canada's system of fiscal federalism did not serve Canada-wide social goals as well in
the 1990s as it did in earlier decades .Public health insurance was under stress.
Income-support programs deteriorated. Tuition fees in post-secondary institutions
rose dramatically. These are all programs that were once heavily supported through
federal transfers.
It might be thought that many economists would applaud the shift from cost-shared to
bloc-funding and reduced transfers, at least from an efficiency perspective. But as
noted above the very idea of intergovernmental transfers has itself come under
challenge by some analysts.67And therefore there may be fewer consensuses today
about the efficiency benefits of fiscal federalism that there was when the system was
less flexible. This does not deny the value of programs like Equalization in reducing
differences in fiscal capacity and thus reducing the probability for economically
inefficient migration of households or firms and in reducing horizontal externalities
(as when province with low investments in education can poach from others that
invest more), But in an era where the value of fiscal restraint has risen, the political
weight attached to these particular efficiency arguments has weakened.
On the favourable sided Canadian fiscal federalism has been an important instrument
for giving concrete expression to the idea which is accrues to Canadian citizens no
matter where in Canada they may live. If federations are polities that seek to bridge
shared rule and self-rule, fiscal federalism has been an important tool for building the
areas of commonality and for promoting the idea of Canada as a sharing society. The
evidence for the success of these programs in building same of common purpose if
reflected in the apparent determination of the citizenry today to preserve and repair
the deterioration in the public health insurance system. Polling data confirm this
statement.68
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The federal government has played an essential leadership role in this process,
providing much of the vision and important amounts of money. Provincial
government have also been vital to what has been achieved. In some cases, they have
provided the ideas. And in most cased provincial governments are the governments
"on the ground," the jurisdictions responsible for designing and delivering the benefits
and services. Working together, the two orders of government have accomplished
much. This does not mean, however, that these achievements came easily. Form the
viewpoint of provincial government, each step along the way has involved serious
concerns. In the 1950s and 1960s, the lack of clear rules around and limits on the use
of the federal spending power in respect of intergovernmental transfers created
tension. In subsequent decades, provinces continued to demand that be fully involved
in federal spending power decisions before they were taken. They also wanted
transfer to be made less conditional and more stable. As discussed above, the transfers
system is much less conditional today that it was 25 years age. The 1999 Social Union
Framework Agreement also included some new limits on unilateral federal use of its
spending power. It provided as well for advance consultation provisions prior to
renewal of or significant changes in social transfers to make federal funding more
predictable for the provinces.
A tug of war around revenue-sharing has been a second source of conflict, with the
provinces periodically arguing that the sharing or revenues between the federal and
provincial government. Thus, in a report to premiers in 1998, provincial and territorial
ministers of finance asserted that "there is fiscal imbalance between the federal
government and the provinces. Even after the federal transfers system in taken into
account" and that this imbalance "is likely to widen"
The third tension has related to the tax-collection agreements, the provincial argument
being two-fold. First, the federal government was not administering the agreements in
a flexible enough way to accommodate provincial priorities. Second, provincial
revenues were too vulnerable to changes in federal tax law. Whenever in the case of
personal income tax, Ottawa changed either the tax base or the federal tax rate,
provincial revenues were automatically affected. Beginning in the 1970s the federal
government agreed, within the framework of the federal-provincial tax-collection
agreements, to allow some kinds of provincial tax-collection agreements, to allow
some kinds of provincial credits to be included in provincial personal income tax
186
systems. Over the following quarter century, Ottawa became progressively more
flexible, to the point where it agreed over the last few years that provinces would have
autonomy within the tax-collection agreements, to impose their tax on taxable income
rather than on federal tax payable. The result has been to provide provinces with wide
discretion in the design of their systems and somewhat more stability in forecasting
revenues. Provinces have since begun acting on this freedom. Whether this new
arrangement fully meets provincial needs, however, remains to be seen.
In the current context, the amount that Ottawa is transferring to the provinces under
CHST, and more generally the reliability of Ottawa as a founding partner, are hot
spots. For almost three decades, the federal government reduced the amounts it had
committed to the provinces in support of jointly financed programs. As one
Parliament cannot bind another, there is no constitutional impropriety in the federal
government changing its mind about how much money it transfers to the provinces
for joint programs. It is also the case that the federal government requires flexibility to
deal with the finances of the country as they shift. Thus, federal-provincial relations
reached a building point in the mid-1990s, after Ottawa announced its planned cuts in
transfer payments in conjunction with the introduction of the CHST. This led to a
united negotiating position among all provinces (Quebec included) and the signing of
the Social Union Framework Agreement (Quebec excluded), as an effort to secure
agreed rules around the uses of the federal spending power and stability in funding. In
September 2000, in an agreement that was consistent with the Social Union
Framework Agreement, the federal and provincial government undertook to preserve
and strengthen the health system in Canada and in conjunction with that initiative,
Ottawa committed to increase very substantially the amounts it would transfer to the
provinces for health-related purposes.69
Two main points are being made here. The first is the simple one that the growth of
Canada-wide programs has helped to build civic nationalism in Canada and that the
tools of fiscal federalism were prominent in their accomplishment. This achievement
has become a defining feature of the Canadian polity. The second is that while
intergovernmental cooperation played an important role in the construction of this
pan-Canadian nationalism, the process has also entailed periodic political conflict.
The 1990s were particularly acrimonious in this regard and one of the legacies of that
decade is too much mistrust between the two orders of government.
187
In looking broadly at the impacts on the federation, Canadian fiscal federalism has
been instrumental in building a sense of political nationhood within Canada outside
Quebec. The effects on bridge building between Quebec and the rest of Canada are
harder to evaluate. While fiscal federalism may not have played a decisive role in
contributing to secessionist pressures from Quebec, as a minimum it has periodically
served as a substantial irritant in Quebec-federal relations.
The System Of Transfers
Canada has an extensive system of federal transfers to other levels of government.
These go mainly to the provincial governments, but also to the northern territories,
and to limited degree to municipal and school authorities.There are also transfers from
the provinces to local governments, and these are even larger than those which the
provinces receive from the federal government. They vary from province to province
and are not described in this chapter. Suffice it to note that they have a major focus on
payments to education and hospital authorities.
In fact, both orders of government should seek to reduce the number and size of the
surprises having for each other. One way of doing this is to take seriously the joint
planning provisions of SUFA.70 Joint planning should not, and will not, mean joint
design and delivery of social programs. But it can and should mean jointly analysing
the challenges of the sectors, exchanging information that is relevant to those
challenges, systematically documenting successes and failures and, where possible,
setting objectives together. Individual government would then be responsible for
designing and delivering programs to meet those challenges and objectives. Among
other things, this leaves lots of scope for asymmetry in the federation.
Further, the federal government should not attempt to deal with the big structural
issues of fiscal federalism in the context of its annual budget cycle. If it does so, there
is no real chance that provinces will be equal partners in the decision-making process.
The experience of the last decade has included examples of such decisions being
taken inside and outside the federal budgetary process ant the latter certainly makes
for a more humorous federation. It is also the case, however, that it is easier to secure
harmony when federal transfer to the provinces are being increased than decreased
and it might be easier for Ottawa to accept this suggestion if provinces were willing to
negotiate with Ottawa during bad economic and fiscal times as well as good. If
188
decisions relating to the basic structure of fiscal federalism are taken outside the
federal budgetary process, there is also more scope for transparency in what goes on
and it is easier to include other political actors in the dialogue. In an age where all
government point to the growing importance of partnerships with the private and
voluntary sectors, these are increasingly relevant considerations71.
Again there is a need to imbed the idea of mutual respect between the two orders of
government. Not only is this necessary for functional reasons, it is also what the
public wants, as evidenced in polling data. Finally, the mission statement should
confirm the importance of both-equity and efficiency goals. Each is essential for a
balanced public policy. It is important; however to articulate what these commitments
may mean in the year 2000. For example, the post-war federal-provincial tax rental
and tax-collection agreements were linked to particular public purposes. These
included a big role for federal fiscal policy in macroeconomic stabilization, achieving
tax harmonization for purpose of economic efficiency, and Ottawa's perceived need to
maintain a strong revenue position to help fund a more equitable post-war society.
The first of these purposes is no longer present today. As for the second, it may
remain but with growing north-south economic integration, it needs to be spelled out
in a way that reflects current circumstances. In this regard, the recently reformed tax-
collection agreements may be adequate for this purpose but this remains to be seen.
Even the third goad merits re-exanimation to capture contemporary thinking about the
shifting roles of security and opportunity in the Canadian social security-system.72
These four elements fall far short of a full statement of principles. And they in no way
speak to the substance of policy content. If governments committed effectively to
them, however, this would help to build the trust relations that are required to fashion
a modern system of fiscal federalism which advances policy goals, supports
democratic values, and respects the very idea of a federal state.
Notice that the statement does not imply that the current balance between orders of
government is appropriate. Rather, what happens to centralization/decentralization
will be an outcome of implementing a set of principles and agreed processes and not
and end in itself. And sorting out the size of vertical fiscal imbalances will be at least
in part a result of careful analysis about the efficiency and equity impacts of
sustaining current imbalances relative to reducing them. Such a new mission
189
statement would be constructed on top of the one element of fiscal federalism that is
apparently not controversial, namely, the commitment to equalization. This
commitment is not only imbedded in the constitution, the wealthier provinces often
question whether and equalization component should be included in programs other
than the formal Equalization program, but they are consistent in support of some
substantial program to meet the equalization objectives set out in the constitution. The
Social Union Framework Agreement provides that the governments involved will
undertake a full review of the agreement and its implementation by 2002. This is an
important opportunity for beginning the task or renewing not only the governance
structures and rules around the safety net but also the closely related system of fiscal
federalism. This should be a priority item in the public policy agenda of the next few
years.
Canadian fiscal federalism adapts to changing times and priorities. The demands of a
more integrated world suggest that the next transition for the system could well be
toward a more collaborative set of arrangements for fiscal federalism that has been the
case in recent decades. The past flexibility of the system suggests that such an
adjustment is not beyond our reach. History also suggests, however, that such a result
will not come easily. Nor is it likely to manifest itself in a formal change to the
constitution. Rather, it will slowly emerge through new administrative arrangements
and as a result of the sheer necessity of Canadian governments-federal and provincial-
coping with ever-greater interdependence among economies and polities around the
world and especially in North America.
NOTES
190
1 S.V.Karandikar, Hindu Exogamy,Bombay University Publicatio: Kitab Mahal, 1929, Manu Smriti (Manu). VII.137-1382 T.V. Mahalingam, South Indian Polity; History of Tamil Literature. (V.R.P. Dikshitar).available on wikipedia
3 R.C.Majumdar, Ancient India, New Delhi: MotiLal Benarsidas Publishers, available on wikipedia
4 Abul Fazal, Aine Akbari, available at books.google.co.in/books?isbn=8174828885
5 Abul Fazal, Akbarnama, available on books.google.co.in/books?isbn=8120710150
6Retrieved from http://www.incometaxindia.gov.in, The official website of income tax department, Government of India
7 Rigveda (Rv).III.43.5; V54; Atharvaveda (Av) IV.22.3. 8; VIII 7.16,Extract from article Dr. B. Prasad, Principle of Taxation in Ancient India, avilable at www.articlebase .com
8 Chanakya, Arthshastra, available at books.google.co.in/books?isbn=0140446036
9 Chanakya, Arthshastra, for link see above
10Kalidas,AbhigyanShakuntalam,available at books.google.co.in/books?isbn=1856495167
11 Ptolemy, Circa, available at books.google.co.in/books?isbn=0802043135
12Unknown,Periplus of the Erytherian Sea, books.google.co.in/books?id=POcNAAAAYAAJ
13 Retrieved from http://www.incometaxindia.gov.in
14 Chanakya, Arthshastra, available at books.google.co.in/books?isbn=0140446036
15 P.K.Gautam, One Hundred Years of Kautilya’s Arthasastra, New Delhi: Fellow Seminar at IDSA, 12 Sep 2012
16Megasthenes in his work Indica on ancient India, Mauryan Period, Retrieved from books.google.co.in/books?isbn=8131729052
17Rajtarangini is written by Kalhan,a Brahmin in Kashmir about Varman Empire’s State craft, Retrieved from books.google.co.in/books?isbn=8120817893
18 The Jatakas (Buddhist texts)., Rajatarangini and some other historical rcords are full of such references which mention the oppressive taxes and plight of the people.
19 Reference has been taken from the various books on ancient, medieval Indian History.
20 NBT book on Indian National Movement
21 D.D.Basu, Constitution of India, www.flipkart.com/Constitution+Of+India
22Sections 138 (1) & (2) related to the income taxes, section 140(2) to the assignment of the net proceeds of the jute export duty and section 142 to the grants-in-aid to the revenues of the Provinces.
23Sir Niemeyer , The Indian Financial Enquiry Report, presented by the secretary of State for India to the Parliament of the United Kingdom in April 1936
24The rider was permissible under clause (2) of section 138 of the GOI Act, 1935
25Niemeyer report (Para 26) has given an indication in this respect, as follows. The estimated net proceeds of income tax for 1936-37, net of the cost of collection and proceeds attributable to Burma, would be Rs.13.4 crore. In that figure, the estimated amount pertaining to corporation tax , Chief Commissioner’s provinces and federal emoluments, would be about Rs.1.4 crore, leaving a residuum of about Rs.12 crore divisible between the centre and the federating units.
26 Niemeyer Report, Para 3,1936.
27 ibid. Para 34,139
28Section 140(2) of the GOI Act, 1935
29 Niemeyer, Para 22,op cit. 140
30Niemeyer report
31Ibid, Para 13, 14 and 19-24.
32Report of the First Finance Commission, Government of India, Chapter II, 1952
33Former member of Viceroy’s Executive Council
34Chintaman Dwarakanath Deshmukh (1896-1982) of the Indian Civil Service was the first Indian Governor of the Reserve Bank of India (from August 11, 1943 to June 30, 1949). In 1950, he joined the Union Cabinet as the Finance Minister and held that office with distinction till he resigned in July1956. He was Vice-Chancellor the University of Delhi from March 1962 to February 1967, Chairman of the University Grants Commission from 1956 to 1960, President of the Indian Statistical Institute(ISI) from 1945 to 1964, President of the Institute of Economic Growth, New Delhi, from 1965 to 1974etc. It was during the period when he was both the President of the ISI and the Union Finance Ministe rthat the National Sample Survey, to be conducted by the ISI, was instituted (1951-52), and the Central Statistics Office was established.
35Report of the First Finance Commission, GOI, 1952, Chapter II
36The Framing of India’s Constitution, a study commissioned by the Indian Institute of Public Administration, New Delhi, with B. Shiva Rao as chairman (1968). And, the Report of the First Finance Commission, GOI,1952, Chapter II.
37 Constitution of India, Seventh Schedule
38P.V.Rajamannar, was the Chairman of the Fourth Finance Commission (1964)
39Proceedings of the Constituent Assembly dated 9th and 10th August, 1949.
40Dandekar V.M., Unitary elements in a Federal Constitution, Economic and Political Weekly, 7th October 1987, reprinted in journal of Indian School of Political economy - Volume 3, July September 1999.
41Bagchi Ameresh ,Rethinking Federalism: Overview of current debate with some reflections in Indian Context , Economic and Political Weekly, August 19, 2000
42In India currently there are twenty-eight State governments and seven Union territory governments. The finances of Union territories are the direct responsibility of the Central government. The twenty eight State governments are classified in two categories, viz., special category States and Non-special category States. There are eleven special category States and rest are non-special category States. Thespecial category States are given special central assistance in the form of 90:10 plan grants and loan. The same ratio for the non-special category States is 30:70.
43 Boadway, Robin W., and Paul A. R. Hobson, Intergovernmental Fiscal Relations in Canada, Toronto: Canadian Tax Foundation, 1993
44 Bird, R. M., Fiscal Dimensions of Canadian Federalism. Toronto: Canadian Tax Foundation, 1980, ISBN : 0-88808-005-0
45Taylor, Charles , Shared and Divergent Values, in Ronald Watts and Douglas M. Brown (ed.), Options for a New Canada, Toronto: University of Toronto Press, 1991, p. 53-76.
46 Boadway, R. and H. Kitchen , Canadian Tax Policy, Toronto: Canadian Tax Foundation, 1999, Third Edition, Canadian Tax Paper no. 103
47Robin W. Boadway and Paul A.R.Hobson, Intergovernmental Relation in Canada, Toronto: Canadian Tax Foundation, Canadian Tax Papers Series, vol viii, p.23
48 Boadway, R. and R. Watts, Fiscal Federalism in Canada, the USA, and Germany, Canada: MQAP, Queen’s University, Institute of Intergovernmental Relations, Working Paper 2004(6),
49Kymlicka, Will (2007), Ethnocultural Diversity in a Liberal State: Making Sense of the Canadian Model(s), in Keith Banting, Thomas J. Courchene and F. Leslie Seidle (eds.) 2007, Belonging?: Diversity, Recognition and Shared Citizenship in Canada. The Art of the State, Vol. 3, Institute for Research on Public Policy, pp. 39-86.
50Gagnon, Alain G. and Rafaele Iacovino, Federalism, Citizenship and Quebec: Debating Multinationalism, Toronto: University of Toronto Press, 2007
51The expression "tax rental" is probably unique to Canada. During World War Two, there was an agreement between federal and provincial governments that Ottawa needed the lion's share of government revenues to finance the fighting of the war. As a result of the emergency, provincial governments agreed to temporarily give up their constitutional right to tax certain tax bases. In effect, they rented their right to Ottawa for the duration of the war. Ottawa then remitted a portion of what it collected to the provinces.
52Prior to the enactment of the Old Age Security Act, there was an income tested state pension available under the 1927 Old Age Pensions Act. This provided for provincial administration of pensions but with the then Dominion (i.e.,federal) government paying one-half.
53Section 94 A of the Constitution Act was amended in 1964. The amendment allowed the Parliament of Canada to "make laws in relation to old age pensions and supplementary benefits" but with the qualification that no such federal law "shall affect the operation of any law present or future of a provincial legislature in relation to any such matter."
54Cairns, Alain C., Constitutional Change and the Three Equalities, in Ronald L. Watts and Douglas M. Brown, Options for a New Canada, Toronto: University of Toronto Press, pp. 77-100 55Alain G. Gagnon and James Tully, Multinational Democracies, Oxford: Cambridge University Press, 2001, pp. 1-33
56Carens, Joseph, Immigration, Political Community and the Transformation of Identity: Quebec’s Immigration Politics in Critical Perspective, in Joseph Carens (ed.), Is Quebec Nationalism Just? Perspective from Anglophone Canada, Montréal: McGill- Queen’s University Press, 1995, pp. 20-81 57If provinces fail to meet the principles, the federal government may penalize the province by reducing its cash transfer. The principles include: universality, accessibility, comprehensiveness, portability, and public administration
58 Breton, Albert and Anthony Scott, The Economic Constitution of Federal States, Toranto: Toranto University Press, 1978
59James Rice and Michael Prince, Changing Politics of Canadian Social Policy Toronto: University of Toronto Press, 1999, pp 54-8060The Constitution Act, Constitution of Canada, sub-section 36 (1) and 36 (2), retrieved from en.wikipedia.org/wiki/Constitution of Canada
61Ibid., sub-section 36 (2)
62Serge Coulombs, Economic Growth and Provincial Disparity , Toronto: C.D. Howe Institute, 1999
63Robin Broadway, Recent Development in the Economics of Federalism in Harvey Lazar, ed., Towards a New Mission Statement for Canadian Fiscal Federalism Kingston : Institute of Intergovernmental Relations, 2000, pp. 41-7864Richard Bird and jack Mintz, Tax Assignment in Canada: A Modest Proposal in Harvey Lazar, ed. Towards a New Mission Statement for Canadian Fiscal Federalism, Kingston : Institute of Intergovernmental Relations, 2000, pp. 263-293
65Thomas J. Couching with Colin R. Telnet, From Hartland to North American Region State: The Social Fiscal and Federal Evolution of Ontario , Toronto: Centre for Public Management, Faculty of Management, University of Toronto, 1998
66http"//socialunion.gc.ca/news
67John Richards, Reducing the Middle in the Middle: Three Propositions for Running the Welfare State, in Canada: The State of the Federation 1997: Non-Constitutional Renewal, ed., Harvey Lazar, Kingston: Institute of Intergovernmental Relations, 1998, pp 71-104
68Frank Graves, Identity and National Attachments in Contemporary Canada, in Harvey Lazar and Tom Mc Intec, eds., Canada: The State of the Federation 1998/99 How Canadians Connect, Kingston: Institute of Intergovernmental Relations, 1999, pp 307-54
69 Boadway, R. and H. Kitchen , Canadian Tax Policy, Toronto: Canadian Tax Foundation, Canadian Tax Paper no. 103, Third Edition, 1999
70 Social Union Framework Agreement
71 Boadway, R. and R. Watts , Fiscal Federalism in Canada, the USA, and Germany, Toronto: Queen’s University, Institute of Intergovernmental Relations, Working Paper 2004
72 Kymlicka, Will , Multicultural Citizenship: A Liberal Theory of Minority Rights, Oxford: Oxford University Press, IFF Summer University 2008 – Paper for week 2, 1995
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