Impact of Vertical Fiscal Imbalance on the GDP

Impact of Vertical Fiscal Imbalance on the GDP

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When we define vertical fiscal imbalance (VFI), it usually highlights a condition in which the expenditure and revenues do not match for different tiers of a government. The institutional mechanism to correct the imbalance between expenditure and resources lay with the Finance Commission as it suggests ways and means to achieve the right balance. The central government usually has a lot more ways of raising taxes while provincial governments have more responsibilities to fulfill and this is where VFI starts to occur. However, the Constitution has provisions for financial institutions and ways of intergovernmental transfers to address VFI.

India has a quasi-federal system so that the central government is concentrated with more powers as compared to the states. For resources, more state governments depend on the center because the power of resource mobilisation assigned to them is not enough to meet the expenditure responsibilities. Thus, thevertical fiscal imbalance meaning assumes significance in this regard because, to a large extent, the fiscal management of federal governments depends on resource devolution from the center as well as the expenditure commitments that crop up from time to time. Successive Finance Commissions have highlighted the requirement to minimize the imbalances by increasing the share of states in the central taxes.

As a result, the share of the revenue receipts of states in overall revenue receipts of the center and federal governments was to be increased. Plotting a vertical fiscal imbalance graph will help in fully understanding the same but even then the share of states' revenue receipts did not increase significantly. It may also not be useful to calculate VFI with figures from own-source revenues when federal governments do not control their own-source taxation and central regulations determine the level and scope of user charges. Therefore, when the central government lays standards for federal expenditures, VFI will not be measured with data on own-purpose expenditures.

To reduce VFI, fiscal adjustment is highly desired by the central government and they are mostly in the form of fiscal transfers. They are also used as instruments to minimize the regional inequalities of wealth and income. Other measures can also be taken to tackle VFI but if nothing is done, the gross domestic product (GDP) will suffer in the long run so a vertical fiscal imbalanceGDP mismatch occurs that can have detrimental effects.