Demonetization – Building Allies vs Forcing into Action

Ever since the demonetization decision was made public by the Union Government of India, on the 8th of November 2016, lot has been discussed about the pros and cons of the measure. However, not much has been discussed about the measure from the federalism angle. In this article, we try to look at the whole demonetization exercise from the federalism point of view.

Taxation Powers in a Federal Polity
In many mature democracies, the taxation powers are distributed between the states and the union (also called as ‘federal’) governments. Not just the indirect taxes, even the direct taxes like Income tax and Corporate tax powers are with the state governments too. In federal polities like USA, Canada or Australia, this is the norm.

In India however, the powers to levy direct taxes rest solely with the Union Government. This in itself is, over-centralization of powers. When nations like Canada and Australia with population of 20-30 million take fiscal federalism seriously, what stops the highly diverse nation with a population of 1.25 billion from taking fiscal federalism seriously?

The Black Money
In the previous paragraphs, we discussed about direct taxation powers. Because by definition, black money is the amount for which direct tax has not been paid. By retaining the power to levy direct taxes, the union government has kept to itself all the incentives to fight tax evasion. Had the state governments been provided with direct taxation powers, as is the case in mature democracies, the union would have found natural allies in all the state governments in the fight against tax evasion.

Building Allies vs Forcing into Action
The current approach, taken by the Union Government to catch tax evaders, is more like ‘Forcing’ the state governments into action. Quite naturally, when something is forced upon someone, the reluctance levels will be high and enthusiasm levels will be low. Needless to add, that in a federal setup, such moves are against the fundamental principles of federalism. The frequently heard term of “co-operative federalism” appears to be lacking any substance, considering the current approach.

For co-operation between any two elected governments, there must be an incentive at play. Had the direct taxation powers been in concurrent list, the resulting bounty from the fight against tax evasion would have been an incentive, for both the union and the state governments. To tackle tax evasion, whether it is the USA working with Switzerland, or Germany working with Panama, the approach one can see is that of ‘carrot & stick’. That is how co-operation is achieved, and is made effective. “Stick alone” approach, doesn’t build a strong and effective co-operation.

The demonetization exercise by the union government is akin to “stick-only” approach, and is evident that there was no effort to build consensus among the state governments and the union. This one exercise has strained the federalism-fabric so much, that we might start hearing the benefits of common currency across the union of India being questioned.


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