Theories of Market Preserving Federalism emphasize the positive role of a common internal market. In the United States, this idea was incorporated in the Interstate Commerce Clause, which eventually received strong support from the Supreme Court.
The framers of the Indian Constitution, although aware of the need to ensure a common market in the federation, were not averse to the idea of placing restrictions if the situation so demanded article 301 of the Constitution states, “subject to the other provisions of this part, trade, commerce and intercourse throughout the territory of India shall be free”.
At the same time, Article 302 empowers Parliament to impose restrictions on this in “public interest”. An important fiscal impediment to free inter-state trade is the levy of inter-state sales tax. The tax is levied by the exporting state on inter-state sale of goods. The framers of the Constitution intended that the sales tax system in India should be destination based.
According to Article 286 of the Constitution, “No law of a state shall impose, or authorise the imposition of the tax on the sale or purchase of goods where such sale or purchase takes place (a) outside the state, or (b) in the course of import of goods into, or export of goods out of, the territory of India.” However, based on the recommendations of the Taxation Enquiry Commission of 1953, the Sixth amendment added clauses to enable the central government to levy taxes on inter-state transactions.
Under these provisions, the central government authorized the states to levy a tax on inter-state sale subject to a specified ceiling rate. Besides creating impediment to free movement of goods (through check-posts), this tax on export of goods from one state to another has converted the sales tax into an origin-based tax. The tax has also has caused significant inter-state exportation of the tax burden from the richer producing states to the residents of poorer consuming states.
Also, entry 52 in the State list empowers the States to levy tax on the entry of goods into a local area for consumption, use or sale. In many states, the tax has been assigned to the urban local bodies and the tax is variously Thus, taxes are levied not only on exports from one state to another but also on all imports into local areas including imports from other states.
These taxes have complicated the tax system, created severe distortions, and caused severe impediments to inter-regional movement of goods.
Evolving a coordinated consumption-tax system remains a major challenge Rao provides detailed recommendations with respect to issues such as rates, interstate sales taxes, and tax administration for a dual VAT coordinated between the Center and the states, and notes the problem created by the failure of the Constitution to explicitly include services within the scope of states’ sales tax authority.
Moving taxation of services from the Union list, where it implicitly lies through the Center’s residual powers over taxes not explicitly specified in the Constitution, to the Concurrent list will require a constitutional amendment. Such an amendment must be proposed by the central government, but would benefit the states. One can incorporate political economy considerations by tying such an amendment to persuading the states to reduce and eventually eliminate taxation of interstate sales.
This would remove some of the internal barriers that have plagued the development of a true national market within India. It would also smooth the implementation of a destination-based VAT for the states, which in turn could also reduce tax exporting by the richer states, complementing the role of transfers in keeping interstate divergence from becoming politically unacceptable.
Conclusion: Lessons and Challenges
An understanding of historical forces and ideologies can be important in explaining the evolution of IGFR systems, as well as current structures. In particular, a historical perspective can help in realizing that the context has changed enough to require some institutional reform.
In India, many features of its IGFR system were a product of colonial rule and the immediate post-independence environment. It can be argued that, over fifty years later, it is time for a major overhaul of India’s system of IGFR.
A case can be made that greater simplicity, through reducing channels of intergovernmental transfers, as well as consolidating and simplifying formulae, will aid in achieving objectives of horizontal equity, as well as managing political challenges arising from increased regional inequality within the federation.
Incentives for sub national fiscal discipline can also be built into the transfer system more effectively (“hard budget constraints”). While there will always be a role for political discretion, even its exercise can be made more efficient through more effective design of the transfer system.
Furthermore, decentralization is not anti-thetical to fiscal discipline, as long as the transfer system has appropriate incentives built into it for local governments as well, and there is no reason this cannot be done. Effective decentralization seems critical to improving the efficiency of government delivery of local public goods and services, particularly those that improve human capabilities. Thus, improvements in India’s IGFR system must include reforming the system of tax and expenditure assignments, as well as the inter-governmental transfer system.
Tax reforms go well beyond decentralizing tax authority more effectively in areas such as local property taxes, to a major overhaul of the system of indirect taxes to reduce economic distortions and increase tax efficiency.
Implementing systemic reforms in government is always a major challenge. Each of the areas viz. taxation, intergovernmental transfers, fiscal deficits and decentralization, requires detailed policy formulation and implementation that must overcome inertia, resource constraints, and active opposition from vested interests.
What is encouraging is that a considerable amount has been accomplished in the past decade, partly spurred by the acceleration of India’s economic growth. It will be interesting to see how recent political changes at the center and several important states shape the debate about reforming India’s governance in general, and its IGFR system in particular.