State Finances in a Fiat Currency System
For States, taxes are indeed revenue: they are required to finance budgets, pay salaries, and deliver public services. But for a federal government with sovereign authority to issue a non-convertible fiat currency, the logic is different. Federal spending is not constrained by prior tax collection. Spending creates money; taxation merely withdraws it from circulation.
This distinction matters. Under the gold standard, currency issuance was limited by reserves, and spending depended on collected taxes. That world no longer exists. In today’s system of floating exchange rates and fiat money, the federal government finances itself by issuing currency, constrained not by revenue but by real resources—labour, materials, technology, and productive capacity.
Seen through this lens, siphoning taxes from States and then rationing their fiscal space is not prudence; it is a monetary misunderstanding. Taxes raised within a State should primarily remain available for use within that State to support local development, employment, and infrastructure. Denying States their own revenue—or withholding additional support when shocks strike—is an avoidable injustice rooted in obsolete fiscal thinking.
The federal government can and should fund lagging States directly, using its currency-issuing capacity to lift development where private investment and local revenues fall short. Why extract State taxes only to redistribute them inefficiently later? A simpler and more effective approach is to allow States to retain their revenues while the Centre steps in to address regional gaps, national priorities, and systemic shocks such as floods, pandemics, or global downturns.
A fiat monetary system frees policy from artificial financial limits. Rules inherited from a different era—balanced budgets, rigid borrowing caps, and deficit fixation—no longer define what is possible. The true constraints are full employment and the availability of real goods and services. When public spending is insufficient or taxation drains too much currency from the economy, activity slows, capacity is underutilised, and livelihoods suffer. India’s own experience with demonetisation offers a stark reminder of how monetary contraction can paralyse economic life.
In this system, the federal government bears responsibility for ensuring that enough currency circulates to keep the economy functioning at full capacity. States, like households and firms, are currency users. They require reliable revenue flows to operate. Returning their full tax share is the first step toward restoring balance.
A common counter-argument is that high-performing States benefit from nationwide sales and therefore cannot claim exclusive rights over their tax revenues. This argument misses a critical economic reality. Exports—whether across borders or across States—are a real cost. They represent goods and services that could have been used locally but were instead sent elsewhere.
In a fiat currency system unconstrained by gold or foreign exchange reserves, real wealth lies in managing these trade-offs wisely. Exporting in order to import what is genuinely needed makes sense. Beyond that point, excessive outward flows can drain resources that would otherwise raise local living standards, especially in societies where consumption is uneven. Development strategy should prioritise meeting State-level needs, not merely maximising notional sales credited at the national level.
We now operate in a monetary system where spending limits are defined by real resources, not deficits or inherited dogmas. Policymakers must adapt accordingly. States constrained by centralised tax extraction could dramatically expand social and economic outcomes if allowed to deploy their revenues freely, with federal spending filling gaps rather than policing ceilings.
The priorities are clear: full employment, rising real wages, resilient public services, and the capacity to respond to climate shocks and recessions—starting with the most vulnerable regions. Persisting with outdated fiscal rules does not protect stability; it suppresses potential.
A fiat currency system offers powerful tools. Refusing to use them is not caution.
It is a choice.
Rajendra Rasu,
The author writes on monetary systems and political economy.