Fiscal Policy:

Fiscal policy or management of government finances in a federal structure is linked with devolution of functional responsibility to different levels of government and fiscal instruments (sources of finances) to carry out the functions. The devolution of functions demarcates the spheres of responsibility of different governmental units; for instance provision of national defence by central government, irrigation by state governments, and street lighting by municipalities. The demarcations of sources of finances endow the ability and flexibility to different governmental units to undertake the functions assigned to them. The functional responsibility and revenue powers to different levels of government many a time are enshrined in the Constitution of the country.

Efficient assignment provides sufficient flexibility to all governmental units in designing levels of public services to be provided and levying reasonable tax keeping the preference of citizens in mind. The functional demarcation also helps in minimising the inter-jurisdictional tax and expenditure benefit spillovers and provides adequate resources in the hand of central government to  undertake regional equalisation.

On the revenue side, governments in different levels have access to taxation powers and non-tax revenue sources.  In addition to these revenue sources, there are others ways allocating funds which is called intergovernmental transfers. Local governments almost invariably depend in part, and some times heavily, upon transfers from upper- level governments to finance the services for which they are responsible.

Intergovernmental transfer of resources play significant role financing the budget of the lower level of governments. The appropriate level and design of such transfers has been an important concern in the fiscal policy of governments in federal system. Depending upon how the taxation powers are assigned and taxes collected, some of the taxes having wide base are distributed between the governments. In this context borrowing from market and abroad are significant as the debt instruments and power to borrow have been delineated in the assignment of financial powers. Both the central government and state governments present their budgets annually that give accounts of detailed expenditures under various heads and revenue sources that finance the expenditures. In the case of central government budget the revenues mentioned are net of the transfers to the state governments and in the case of state governments, budgets include the revenue transfers from the central governments. Let us take an example of a state government to know about the fiscal management in the context of fiscal federalism. The revenues of a state government constitutes tax and non-taxes collected from its own sources (assigned revenue power) and transfers from the central government in the form of share in central taxes and grants. The expenditures incurred are categorised into two types- revenue/current expenditures and capital expenditures.  Revenue/current expenditures consists of salaries, pensions, interests, operation and maintenance, subsides and any other transfer payment. The capital expenditure are incurred basically to create durable assets like infrastructure spanning over social and economic sectors that can be helpful in creating further income in future. The capital expenditures are generally financed from borrowed funds. The state can borrow from market meaning development and commercial banks, from central government and use the funds under small savings. The loans from central government are part of overall central assistance to state plans. The states to borrow from market require the permission of central government if they have outstanding loans to the Central government.

However, a prudent management of government finances emphasizes creating surpluses in the revenue account, i.e., generating surpluses after meeting the current expenditures, to be invested in capital assets. The borrowings are to be repaid over a period of time with interest payments. The overall management of the finances of the government is expected to create income and employment in the economy and thus more revenues for the government that would enable it to repay the loans. In this context the transfers from the central government play crucial role in the finances of state government.