Federal Finance: Concept, Principles and Problems

After reading this article you will learn about:- 1. The Concept of Federal Finance 2. Principles of Federal Finance 3. Problems.

The Concept of Federal Finance:

In usual parlance federation is defined as an association of two or more states. The federal setup is characterized by the existence of a union government (Central government) on the one hand and state government for different constituent units.


It is a form of political association in which two or more states constitute a political unity with a common government, but in which the member states retain a measures of internal autonomy. Encyclopedia Britannica defines fed­eration “as a form of government in which the essential principle is that there is a union of two or more States under the central body for certain permanent objectives.”

Sir Robert Garran defined federation as a foam of government in which Sovereignty or political power is divided between the central and the local governments, so that each of them within its own sphere is independent of the other.

As far as functions and resources are concerned the two sets of government are independent. Actual federations are however of different forms. For example India is more a unitary than federal type, where there is large concentration of power in the hands of central government.

Whereas USA is more of a federal than unitary type Country, Where there is lesser concentration of power with centre and larger exer­cise of power by provincial and local governments.

Thus depending on the type of federation fiscal responsibilities is shared between central, state and local governments. Therefore federal finance means divisions and coordination of different items of income and expenditure between central, state and local govern­ments. This multilevel decentralized fiscal system is known as fiscal federalism.

In this context Dr. R. N. Bhargava opines “federal finance refers to the finance of the federal as well as of the state governments and the relationship between the two.” However the concept and definition of federal principles is still a controversial issue.


Prof. K. C. Wheare states:

“by the federal principle I mean the method of divid­ing power so that the general and regional governments are each, within a sphere, Co- ordinate and independent.”

Therefore federation is characterized by certain basic principles like:

(a) Division of power and functions,


(b) Supremacy of the constitutions,

(c) Constitutional independence of the constituent units, and 

(d) Federal predominance.

Principles of Federal Finance:

In a federation functions are distributed among different layers of government. Since each government is responsible for its own sphere of activity there should be adequate provision for source of revenue and its efficient administration for discharging the assigned func­tions independently and satisfactory.


Therefore the pool of total rev­enue source should be divided between the centre, state and local governments scientifically and reasonably. This warrants some mu­tually beneficial and sound principles, for the division of revenue source.

What should be the guiding principle regarding the division of functions and resources among different layers of government.

A host of economist provided an array of guiding principles in determining the resource allocation. Prof. Seligman prescribed three principles on the basis of which revenue sources i.e., taxes should be divided between the different layers of government.

These fundamental principles governing resource allocation are:

(a) Efficiency,

(b) Suitability, and

(c) Adequacy.

Efficiency norms insist that tax allocation among different layers of government should be decided by the capacity of feasibility to administer the tax effectively. There will be taxes, which can be best administered by the centre. Such taxes should be assigned to the central government. For example income tax in India.

Likewise there are some taxes which can be administered by the state government. Such taxes should be assigned to the state government. Best example is agricultural income tax. Suitability criterion insists that the nature of tax is an important aspect determining allocation.

Taxes will possess wider or narrow jurisdiction. Taxes with narrow jurisdiction should be allocated to regional or local governments rather than central government. The adequacy norms insist that revenue assigned to a particular layer of government should be sufficient to carry out the functions and responsibilities assigned to them.

The non-coordination between functions of government and revenue allocated to discharge the functions generate crucial problem in federal finance. Prof. Seligman in his Essays in Taxation observes” no matter how well intentioned a scheme may be or how completely it may harmonies with the abstract principles of Justice, if the tax does not work administratively, it is doomed to failure”.

Therefore as a matter of fact there are no uniform principles which determine the resource allocation in federal finance.

Prof. B.P Adarkar in his master piece “Principles and Problems of Federal Finance.” laid down three principles governing the working of Federal Finance. Later economists added a few more principles based on certain practical situations.

These principles are briefly explained below:

1. Independence and Responsibilities:

The success of fiscal federalism is conditioned by the two funda­mental requisites- Financial independence and financial responsibil­ity. It means that the central and state government must be finan­cially independent within their own spheres.

Each government should possess separate and independent sources of revenue. Government at different layers should have full power to tax, to incur expenditure and to borrow to perform the assigned functions effectively.

Prof. Adarkar observes, “Taxing autonomy and spending autonomy should go hand in hand. In the broader interest of the nation the centraliza­tion of revenue in the hands of the central government seems to be good. However too much dependence of state government on cen­tral government for resources is not a healthy practice in federal finance.”

Prof. Adaekar Says, “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 achievements of their legitimate aspirations for the promotion of social and economic advancement.”

Therefore the centre and state government should be financially in­dependent and autonomous in respect of taxing with in their own spheres.

2. Adequacy and Elasticity:

Adequacy implies that allocation of resources should be based on distribution of functions. The sources of revenue assigned to each layer of government, should be sufficient enough to discharge the functions efficiently and effectively.

For achieving this financial structure should be elastic, flexible and adaptable to the changing conditions of economy. The resources should be capable of expres­sion in response to the rapidly growing needs and responsibilities of government otherwise the federal finance system will create rigidi­ties during times of economic stress and strain.

As John Athan Says “if a federal system with real independence in the states is to continue, the state must have financial resources under their own control reasonably adequate to meet their responsibilities.” Justify­ing the principle of adequacy and elasticity.

Dr. R. N. Bhargawa observes “the scheme of resources must be set up on elastic sys­tem because no scheme, howsoever good, can be final for all times to come; under changing conditions, any argument is bound to be­come out of date in course of time. The scheme of division must, therefore, incorporate provisions for such changes when they be­come necessary in the national interest.”

3. Administrative Efficiency and Economy:

Tax resources should be assigned to different layers of government considering efficiency and economy in administration. The adminis­trative Cost should be minimized. There should be no scope for fraud and evasion.

While allocating resources the administrative efficiency should be adhered. For example it is better and economical to allo­cate land tax to local bodies, excise tax on alcohol to state govern­ment and income tax to central government.

Here each layer of gov­ernment is assigned such sources of revenue which it can adminis­ter efficiently. As point out by prof. Seligman, the nature of tax and character of administration determine the effectiveness of different taxes. This will ensure optimum utilization of revenue potential and help to prevent corruption and evasion in revenue mobilization and realization.

4. Other Important Principles:

1. Principle of Uniformity and Equity:

In a federation there may be regional variation in the level of eco­nomic development, owing to a number of economic and non-economic factors. Therefore contribution of each state in federal resources structure should be based according to its ability or economic con­dition.

Hence the principles of equality in the distribution of tax bur­den are another guiding principle of federal finance. Principles of uni­formity insist that there should be no discrimination between citi­zens of different states in a federation.

Adequate provision should be there to protect the interest of backward regions and states and even weaker sections of the community, under conditions of differ­ence in resource endowments, tax burden should be distributed on the basis of marginal sacrifice principle.

For the success of fiscal federalism there should be proper integra­tion and co-ordinations of the financial system of different layers of government. Judicious uses of scarce resources are affected by well co-ordinated and integrated intergovernmental fiscal policy.

3. Principles of Accountability:

In a federal form of political set up federation and democracy are considered as sister institutions. So in a federation each layer of government should be accountable to its own legislature for its tax­ing and spending decisions.

Utmost transparency should be retained in all financial and administrative matters. Each government spend­ing and taxing decisions should be done with regard to their effect on other governments.

4. Principle of Financial Access:

This principle implies that there should be no bar on centre and state governments in exploring new source of resources, to meet the grow­ing financial requirements. In a sense resource should grow along with growth in responsibilities.

Moreover in order to develop healthy financial relation between different units in a federation each government unit will have to work under certain self-imposed discipline. Moreover division of resources should be subject to flexibility.

It is a reality that a number of problems arises and exist in federal finance. We should not try to overshadow these problems by putting certain rigid norms and principles.

A pragmatic approach towards finding solutions to problem is needed. Since socio-eco­nomic conditions differ from time to time and from state to state the division of resources should be subjected to flexibility and adaptabil­ity. In a federal fiscal system, there is only scope for adjustment in the light of changing circumstances

Problems of Federal Finance:

Federalism whereby two or more sovereign units of government Co­exist within the same political environment, provides the primary basis for the intergovernmental fiscal problems. It is very difficult to decide which level of government will perform the specific functions as per community preference.

In addition the revenue sources nec­essary to finance these expenditure functions must be allocated among the various levels of government in a specified manner. A considerable divergence exist between the sources of revenue and functional expenditure obligations among the government of a fed­eration.

Therefore some government may find it easier to than others to meet their expenditure responsibilities from their own revenue source. This situation is a form of imbalance between revenue and expenditure, that too between different levels of government.

The problems of a decentralized fiscal system in fiscal federal­ism, as it is called, have received much attention, in public finance literatures during the past 3 decades. This is partly due to the fact that there are different sovereign levels in the political system and because of the extension of the theory of public goods, at the na­tional, state and local levels.

It has also been partly due to certain development in federal fiscal structure including the imbalance in the distribution of resources and needs among different levels of govern­ment. This has called forth a reconsideration of the fiscal rules to be performed by various levels of government and there relations to one another. In this context it is worth to analyses some of the important problems in federal fiscal system.

For the smooth functioning of a federation division of functions and resources is imperative. However for the last several years, there is a growing conflict between centre and state in matters regarding the distribution of financial resources, between the units in a federa­tion, owing to political and ideological grounds.

There is multiplicity of taxing and spending activities in a federation. The allocation of functions between the centre and the state government differ from country to country. Generally the functions which are of national im­portance like defence, foreign affairs interstate activities etc. is usu­ally shouldered by the central government.

Whereas matters which are of regional interest remain in the hands of regional government. Performance efficiency is the basis criteria for allocating functions among different constituent units in a federation.

As such functions like defence, foreign trade foreign affairs, post and telegraph etc. are put under the jurisdiction of central government. Subjects of regional interest like education, health service, public works, internal law and order etc. are assigned to the local government. This necessitates a proper co-ordination of the policies and activities of the centre and state governments.

Vertical Fiscal Imbalance:

In many democratic countries a large divergence exists between the revenue source and expenditure obligations among the governments of a federation. Some constituent governments in a federation many find it easier than others to manage their expenditure responsibilities from their own revenue source.

Whereas some others find it difficult to manage the revenue-expenditure programme in a balanced manner. Nowadays there is a continuous and persistent increase in the expenditure programmes of the state and local governments due to increasing welfare oriented programmes.

Expenditures on activities like education public health, social welfare, urban management, welfare schemes for weaker sections rural development activities etc. are on a continuous increase.

Whereas majority of revenue source under the control of state and local governments is inelastic in nature. This creates a situation of imbalance between growing expenditure requirements and poor yield of revenue source for state and local governments.

Contrary to this, the central government always possesses surplus revenue owing to control over more elastic sources of revenue. There occurs a situation of greater expansion of financial resources of central government, and shrinking of resources bases of state and local governments, coupled with increasing responsibilities of state and local governments due to growth of welfare activities.

This type of resource gap between the centre states is called vertical fiscal imbalance. The situation of imbalance of revenue and expenditures vertically between levels of government is referred to as the problem of non-correspondence or vertical fiscal imbalance.

Fiscal federalism tries to bridge this gap and attain a balance through vertical co-ordinations between the centre, state and local level public expenditure and resources needed to finance them.

The important methods adopted to achieve vertical fiscal equality be­tween the centre and regional governments in a federation are:

1. Tax sharing,

2. Tax credit,

3. Tax deductibility,

4. Tax denial,

5. General grants-in-add, and

6. Selective grants-in-aid.

Under tax sharing arrangement a tax is levied and collected by single administration. But the proceeds are shared either wholly or partly with two or more units.

The allocation of the share to constitu­ent units require some criteria which may be either within in the constitution or left to be determined by the national government or it may be determined by periodical agreement between the centre gov­ernment and constituent units.

Under the tax credit, a superior government unit allows a credit against its tax to anyone who pays the same kind of tax to subor­dinate units. This method eliminates tax competition problem and thereby increases the capacity of the subordinate units.

Tax deductibility is another method to correct vertical imbalance. Under the method permission is granted by one government to de­duct tax paid from the tax payers upon which another government levies taxes.

Under the tax denial the government may put restrictions on state and local government taxing powers. It includes denial of power to subordinate jurisdictions to levy certain taxes, putting a ceiling on the tax rule used by the lower level governmental units; Any upward change in the tax rate requires the approval of the central legislature. These methods of tax co-ordination are known as tax denial or tax restrictions.

In order to avoid overlapping of taxes and duplication of adminis­tration and to ensure uniformity of the base of taxation, the method of tax supplement must be used. The higher level government collects the tax with an additional duty imposed by the lower level gov­ernments.

Another method of collecting vertical imbalance in fiscal re­sources transfer is grants-in-aid. Three types of grants are used to transfer revenue to lower level of government viz. General (Block or unconditional) grant, or selective grant (restrictive or conditional grant and matching or non-matching grants.

Horizontal Fiscal Imbalance:

Horizontal imbalance exists between units at the same level of sover­eignty. When fiscal imbalance occurs between different units of gov­ernment at the same level of government in a federation, it is known as problem of equalization or horizontal fiscal imbalance.

In a federation differences exist in the per capita distribution of income and wealth and the volume of trade among different states. Regional difference in resource endowment among different commu­nities leads to variation in per capita revenue potential among com­munities.

Horizontal fiscal imbalance is corrected and the principle of fiscal equity is achieved through equalization of fiscal residue. Prof. J. M. Buchanan defines fiscal residue as “net benefits from tax-expenditure programme i.e., benefit from expenditures minus disutility from tax payment.”

Due to difference in resource endowment, level of development and variation in the implementation of tax expenditure programmes among different states in a federation, the central and state taxes generate unequal fiscal residue for their citizens. Thus a gap in fiscal residue arises and the some must be equalized to achieve, what is called horizontal fiscal balance.

This gap in fiscal residue can be filled by interstate transfer of resources. That is there should be a federal arrangement for transferring resources from richer states to poor states.

This will help to reduce interpersonal fiscal inequality. Musgrave put it as realization of horizontal equality however it is unlikely that rich states within a country will voluntarily agree to transfer adequate resources to the resource deficient poor states. Foe affecting such a transfer a strong political set up at the centre is needed.

Another problem in federal set up is the tax competition, In order to attract more capital and trade from other parts of the country, one state government may reduce or abolish certain type of taxes, this policy may sometimes benefit backward states. However this type of competitive tax reduction may hinder the smooth flow of interstate trade.

It may again generate regional disparities in development, and income endowments among communities. This is a practical prob­lem in federal fiscal system in modern period.

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