FEDERAL FINANCE

INTRODUCTION In 1945, the federal principle

was defined
Kenneth C. Wheare as, "The method of by
Federalism as a concept, has evolved over a
time and it has shaped according to the powers SO that the general and
governments are each within its Own
dividing
regional
circumstances. During the 2Oth century federalism sphere. co-
was popularly employed as a safety valve against ordinateand independent. To a political scientist
nations' linguistic. racial and cultural bickerings a polity is federal| when its territorial division of power
endangering their unity by organising regional is secured formally by a written
constitution or Sorme
groups which were given sufficient autonomy in a such exceptional legal protection. Federalism is not
federation. just any decentralised polity as the case is with the
Today, the world has been divided into unitary unitary system. Federalism is a special kind of
and federal type of governments. Most of the decentralisation where the division of powers
countries have adopted federal constitution. A ensuring safeguards of the units of federations is
federation could be brought about as a result of a constitutionally protected. Thus, the decision-making
voluntary agreement on the part of the member states at a particular level of government is based on
which were sovereign and independent, as in the delegation or constitutionally guaranteed authority
case of U.S.A. or a Unitary State might convert itself
into a federation bygiving the provinces autonomy, Economists, on the other hand, take a broader
as it happened in Canada. Thus, federalism has view by not exclusively relying on formally or
evolved over the years in two ways : () by constitutionally defined governmental authority at
aggregation, and (ii) by devolution. different layers of government. All government
The federal states have been in operation in systems in economicterms are more or less foderal.
various forms in different parts of the world for quite Even in formally uniform systems (Spain, United
sometime. As a result, it has been defined differently Kingdom), there exists a considerable extent of de
by different experts in their respective areas of facto fiscal discretion at decentralised levels. Thus.
specialisation. The definitions given by political economists look at the decentralisation of fiscal
scientists and economists are widely used in this decision-making in a multi-level government for the
context. They are closely related particularly in the purpose of federalism.
matter of policy requirements, deriving end results
and also seeking different interpretations of federal From the economic point of view, the greatest
objectives and instruments. advantage lies in the creation of a unified and
While defining political federalism, Sir Robert enlarged market which makes the reaping of
Garran has said that, "Federation is a form of economies of scale possible. As a result, regional
government in which sovereignty or political power specialisation can be carried further without
is divided between the Central and Local hindrance from trade barriers. There are also benefits
Governments so that each of them within its own to be derived from the free mobility of capital nd
sphere is independent of the other." labour, through the federation.
1. Kenncth C. Wheare, Federal Government, Oxford University Press, London, 1953, P. 10.
2. Wallace E. Oates. Fiscal Federalism, Harcourt Brace Jovanovich, New York, 1972, P. 17.
3. AnilKumar Thakur, Fiscal Federalism in India, Deep &Deep Publications. New Delhi, 1984, P. 12.
410
FEDERAL FINANCE
Essential Features of a Federal System
There has been a consensus of opinion that a
involves the following essential
federal system
characteristics :
1. DualGovernment. In aunitary Statc, there
the National
is only one govermment, namely state,
there are
Governmcnt. However, in a federal
government
wo layers of govenment : the Union
A component State has
and the State governments. federation.
the
no right to secede from
This distinguishes a federation from isa
confederation.By connotations, a confederation
similar in structure to a federation but
with a weaker
Central government. In a confederation, the States
secession.
retain the right of
2. Distribution of Powers. A federal State
the federal
involves a division of authority betweendistribution
government and States. The method of
constitutions.
may difer in different federal
federal
3. Supremacy of the Constitution. A
State derives its existence from the constitution.
Every power (executive, legislative or judicial)
whether it belongs to the Union or to the State is
subordinate to and controlled by the constitution.
4. Authority of Courts. The legal supremacy
of a
of the constitution is essential to the existence
federal system. There should be no violation of the
provisions of the constitution by any tier of
government. This is secured by vesting powers of
interpretations of constitution by the judiciary.
5. Doctrine of Harmonious Construction.
Harmonious construction means that different entries
in different lists are so interpreted that a conflict
between them is avoided. It must be accepted that
constitution does not want to create a conflict and
make any entry nugatory. Hence, whenever there is
a conflict in the two lists, the two entries should be
interpreted in such a way that the scope and meaning
of one entry should not affect the meaning of the
other entry.
6. Doctrine of Pith and Substance. In a federal
set-up the Central and the State governments should
keep themselves within their respective domain
assigned to them. If there is overlapping, it is asked
what in "pith and substance" is the effect of the
411
enactment in question and in which list is the true
character to be found.
7. Rule of Repugnancy. It means that
conflicting results are produced when two laws are
applied to the same facts. In this case. if there is
any inconsistency betwecn two laws or two statutes
covering the same ficld. The Parliament should enact
its own complete code and covering the whole
ficld.
Advantages of Federalism
It is universally acknowledged, that federalism
has many advantages. Federal governance promotes
efficiency, both economic and political. Economic
efficiency is advanced by the division of
governmental functions among different levels
depending on their comparative advantage.
Assignment of matters that concern the nation as a
whole, or where there are externalities or large
economies of scale, to the government at the Centre
combined with decentralisation of responsibility to
provide services that benefit smaller segments of
lower level
the country or the community to allocation
governments, promotes efficiency in the
of resources in the economy. What is
more, in a
federal polity the economy benefits from the
operation of a common market facilitated by free
flow of goods, services and factors of production
within the country.
Federalism is considered efficient from the
political angle as well because it facilitates a
heterogeneous population to come together under
the banner of one nation and acquires strength
from unity while allowing the constituents to retain
their identity and autonomy over a wide area of
public life. Federalism also fosters democratic values
and civic virtues of people's participation inpolitical
processes. In recentyears, it is the economic benefits
of federalism that have come to the fore drawing
sovereign nations to join together in economic union
even while not surrendering their independence.
The European Union is an example of this type of
formation.
A well designed, and more important, well
functioning system of federal governance, by virtue
of various advantages, plays a key role in promoting
the stability and prosperity of nations as the heights
attained in the leading federations of the world,

416
federal finance depends
The success of the
of the above mentioned
upon the eficicnt solution with the changing
problems and adjusting it
Circumstances.
Principles of Federal Finance
division of legislative.
Ina federation there is a betwecn thenational
Crecutive and financial powers Both the federal
governments.
and sub-national of
and federating units have independent sources
of their respective
revenue for the functioning principles Prof.
govemments. But to preserve federal on Principles
book
B.P. Adarkar, in his celebrated
lays down three
and Problems of Federal Finance working of
principles which should govern the
federal finance. These principles of determining the
discussed
financial policy in a federal set up are
below.
1. Independence and Responsibility : In the
first place Prof. B.P. Adarkar said that, "full freedom
of financial operations must be extended to both
federal as well as State governments in order that
they may not suffer from a feeling of cramp in the
discharge of their normal activities and in the
achievement of their legitimate aspirations for the
promotion of social and economic advancement. It
means that both the federal government and
federating units must each have under its own
independent control financial resources sufficient
to perform its exclusive functions. In other words,
national and sub-national governments should be
financially independent within their own sphere.
Besides, each government should take the
responsibilities of taxing, borrowing and raising
resources in their spheres for performing their
functions. The authority which has the pleasing
job of spending money should also do the unpleasant
job of taxing it. Thus, "taxing autonomy and spending
autonomy should go hand to hand,"9
However, practical considerations make it
difficult to follow the principle of financial
independence. This is because of the problems like
uniformity in tax rates throughout the federation,
promotion of economic growth, maintenance of
internal and external stability, balancing social and
economic development in all regions etc. cannot be
ignored. 1Inother words, the advocates of this view
9. BN. Gupta, /ndian Federal Financing and Policy. P. 24:
-THEORY AND PRACTICE
PUBLIC ECONOMICS-7
should lie with the federal
want that taxing autonomy
government while spending autonomy with the
federating units. Thus, there may be financial
adjustment between the two governments Sharing
of taxes, grants-in-aid and loans from the federal
Thera
government are common in many federations.
is a need for such balancing factors but independence
cannot be given up. As Prof. B.P. Adarkar points
out. "The cardinal principle to be followed in financial
settlement is that, as far as practicable, the federal
government and the States should be endowed
with independent sources of revenue free from
mutual interference and that the balancing factors
should come in only marginally, so as to fill the
gaps.
2. Adequacy and Elasticity : Besides
independence, next comes the consideration of
adequacy and elasticity in federal finance. Roth
adequacy and elasticity are of paramount importance
for a federal country in view of the responsibilities
of both the layers of the government. The principle
of adequacy means that the resources of the national
and sub-nationalgovernments should be adequate
so that each layer of government can discharge its
obligations laid upon it. It stands for sufficiency of
resources for the discharge of functions andduties
assigned. Besides adequacy, it must possess the
quality of elasticity in financial resources. It means
that there must be feasibility to expand its resources
in response to its requirements especially during
the period of internal and external crisis. Basically
a systemn of federal finance which consists of the
principles of independence, adequacy and elasticity
has not yet been evolved in any federation. One
has to look to financial adjustments for resolving
these conflicts.
3. Administrative Economy and Efficiency :
An other important principle of federal finance is
that of administrative economy. In this context
operational efficiency is of great importance. Both
the Centre and the Unit is required to optimise
national welfare by co-ordinating their activities. In
other words, administrative cost should be minimum
and there should be no fraud and evasion in the
matter of finances. The administrative delay should
also be the minimum. There must be avoidance of
corruption and inter-regional smuggling and full
exploitation of sources of revenue.
FEDERAL FINANCE
other Principles
Besides the abovescholars discussed principles of
finance. some have added a few
federal of the
in view needs to the present
more principles of
conditions, cspecially developing countries.
A Principles of Uniformity and Equity : This
principles implies that the contribution by different
federating unitstowards the common burden should
cquitable
be on an basis. Thus, the contribution of
cach State in federal taxes should be according to
ability or economic consideration. Different States
af afederation may have disparity in the level of
economic development and, therefore, according
in this principle the burden of taxation will be
anegually distributed as the marginal sacrifice will
diferent in different States. The marginal sacrifice
of richer States will be less as compared to backward
States. The combined marginal sacrifice to taxation
of both the federal and State governments should
be equal or nearly equal to every person, no matter
in which State he/she resides. The creation of
uniformity also implies that there should be no
discrimination betwveen different citizens of different
States in a federation. However, some concessions
given to weaker sections and backward States for
the sake of equity and justice are quite compatible
with the principle of uniformity. Further, in order to
achieve equity in taxation, a proper balance between
direct and indirect taxes should be maintained.
Therefore, there should be a proper adjustment
between federal and State taxation to make the tax
burden on all the citizens equitable as far as possible.
5. Principle of Accountability : Freedom and
democracy are interwoven in a federal system.
Therefore, the government in a federation should
be accountable to its own legislature for its spending
and collecting revenue decisions.
6. Principle of Fiscal Access : This
implies that there should be no bar on the principle
national
and sub-national
governments
SOurces of revenue within their own
in tapping new
areas to meet the growing financial needs.prescribed
lt means
that
resources should grow with the expansion of
responsibilities.
Ihe problem of federal finance should not be
a
shadowed by rigid principles but should be solved
in apragmatic way for the healthy financial relations
federal set up. There can be adjustment and
reallocation of
Circumstances. Theresourcesin the light of changing
dynamis1m should replace rigidiy
417
according to the requirements of different layers of
government. The system of federal finance should
be designed to meet the needs of changes in the
interest of harmony and efficiency. Finally, it may
be stated that both the federal
government and
federating units co-ordinate their activity in such a
way that it leads to maximum utilisation of national
resources, accelerated economic development.
reduction. in disparities of income and wealth and
augmentation in production and productivity.
7. Principle of Integration and Co-ordination:
Integration and co-ordination are necessary in the
distribution of resources between two layers of
government. This is essential for the promotion of
economic development in afederal set-up. The co
ordination is required not only in the matter of
taxation but in all the spheres of financial activities.
For example, co-ordination is required with regard
to current budgets, capital outlay programmes and
credit operation programmes etc. formulated and
implemented by different departments and agencies
of the government at different levels in a federation.
In practice, however, the allocation of
in most federations is based upon historicalresources
reasons.
Thus, the main consideration has been expediency,
rather than adherence to scientific principles.
Social Principles of Federal Finance
They key social principle underlying an effective
system of fiscal federalism is fiscal equity. Fiscal
equity requires that individuals in similar economic
circumstances should receive similar net fiscal
benefits where they reside in the nation. In practical
terms the differences between the value of taxes
paid and the public goods and services provided
should be reasonably comparable. There are in
general, two ways in which fiscal equity, is sought
in federal systems : first, through introduction of
equalizing transfers that provide additional revenue
to areas that provide additional revenue to areas
with relatively low revenue capacities and /or
relatively high expenditure needs, and second
through the imposition of basic or minimum national
standards with respect to certain public goods.
Vertical Fiscal Imbalance
One of the major characteristics of federalism
is the có-existence of two main levels of govermment
in one system, both having the capacity to raise
revenues and responsibility to carry out various
functions. Ideally, a federation should be in a state