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

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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