How financial resources are distributed between the Centre and states—or, fiscal federalism—is a concept as old as independent India. But what’s emerged as critical factor in the last three years is uncertainty from new revenue sources, which has ratcheted up the tension between the Centre and states.

One source of that uncertainty is a big tax reform: the goods and services tax (GST). Introduced in July 2017, this nationwide tax subsumed a host of taxes. It was a Centre-led reform that required states to buy in. States were assured they would be better off. Except they aren’t.

Tax collections—which are then distributed to states in a given formula—have not grown as expected after the GST switchover. Meanwhile, economic growth has slumped. Are collections low because of the new GST system or because of a slowing economy?

Such is the fog that the finance commission (FC)—the national body that decides this distribution—has broken from precedent, and given recommendations for only the first year (FY21) of its five-year term. For the remaining four years, it added, it needs more time for the data to stabilize and to understand the landscape so as to answer the central question: will tax collections pick up and by how much?

Meanwhile, the Centre and most states are struggling to balance their books and raise new revenues. And they are all battling an economy that is not encouraging companies to invest more, or create enough new jobs. All this is creating conflict lines in the delicate fiscal framework between the Centre and states, the contours of which are outlined below.

Why do we have a Central-state fiscal framework?

The Centre collects a bulk of the taxes. However, states do most of the expenditure including on education, health, law and order, etc. Thus, there is an imbalance between revenue input and work output. This imbalance is sought to be addressed by transferring a part of the taxes collected by the Centre to the 28 states and 8 Union territories (UTs).

A sum of ₹11.87 trillion is projected to be transferred in FY20. From the Centre’s perspective, this is 55% of taxes collected by it, and thus that much less for its own spending. From the states’ perspective, this amounts to 38% of the combined revenues of states (Chart 1). The Centre and states jockey for a larger slice of this pool. As do states among themselves.

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Development in India is lopsided, with some states better off (Maharashtra, Karnataka and Tamil Nadu) than others (Bihar, Jharkhand, Uttar Pradesh). Also, the ability of states to collect taxes varies. Nearly 85% of Delhi’s revenues comprise the taxes collected by it, which gives it a high degree of self-sufficiency. But for north-eastern states like Mizoram, Nagaland, Arunachal Pradesh and Manipur, taxes don’t even make up 10% of their overall revenues (Chart 2).

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In a federal polity like India, revenue collected by governments at various levels have to be redistributed in a way that ensures states have adequate funds to spend; and, within them, backward states are receiving enough to improve.

Who sets the Central-state fiscal framework?

FC decides how these tax revenues are to be distributed between the Centre and states, as well as within states.

It determines the distribution of three things:

i. Centre’s taxes to states: these are “untied" funds, which means a state can use them as it wants.

ii. Grants-in-aid to needy states: these are mostly “tied" funds, which means they can be used only for the purpose they are given for.

iii. Funds to urban and rural local bodies: these can be tied or untied.

In theory, FC is an impartial referee between the Centre and states. In reality, the Centre can influence through the terms of reference set by it, a charge that is levelled on every FC, including the current one .

The current FC is the 15th one, and it is headed by N.K. Singh, a former bureaucrat and a member of the ruling Bharatiya Janata Party. Maintaining continuity with 14th FC, 15th FC has recommended a transfer of 42% of the taxes collected by the Centre to states.

But if the less-than-expected tax buoyancy continues, states will feel more anxious, especially with GST having the unintended effect of creating a new Centre-state fault line. Pre-GST, there was a separation between the Centre and states on taxing goods and services. Barring some exceptions like alcohol and petroleum products, the Centre taxed goods on production (excise duty), while states taxed them on sale (sales tax or state value-added tax).

GST removed most production-oriented taxes. Now, tax is imposed primarily at the point of consumption, and both states and Centre can levy. Chart 3 gives details of taxes levied at different levels of governments. Income tax (from both companies and individuals) and customs duties are the sole purview of the Centre. Thus, the Centre ends up with a lion’s share of taxes, and its sharing becomes a thing that many have varied views on.

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Overall, how much does the Centre give to states?

Besides what FC decides on devolution of taxes, as outlined above, the Centre also gives money to states to implement central schemes like Swachh Bharat Abhiyan. But this money is tied: states can use Swachh Bharat funds for the scheme only. With most FC transfers (about 60% of the total central transfer), states have that freedom. With about 40%, they don’t.

For FY21, the Centre is projecting a transfer of ₹13.9 trillion to states, or 58% of the tax revenue collected by it. Since FY91, the year before India opened up its economy, transfers to states have ranged between 50% and 64%, with the highest being 63% in FY17. In FY19, this declined to 55% (Chart 4).

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This number is important as these are untied funds. States have been seeking a higher share of Central taxes, accompanied by a drop in other forms of transfers, after the 14th FC report. But this hasn’t happened. Even among grants from the Centre, the share of centrally sponsored schemes—designed by the Centre but executed by the states—account for a majority of transfers. These are tied funds, and have replaced transfers to state plans. If the report for FY21 submitted by this FC is an indicator, the trend is unlikely to reverse.

How has this fiscal framework evolved?

14th FC, headed by former Reserve Bank of India chairman Y.V. Reddy, concluded that “tax devolution should be the primary route of transfer of resources to states", and raised it to 42%. This, it hoped, would reduce the share of tied funds in transfers to states. But this hasn’t happened.

Sluggish tax collections impact the shareable pool, as compared to the previous system where grants are relatively insulated from vagaries of tax buoyancy. The Centre says it is transferring more. States argue a slowdown is making it tough to grow tax revenues.

GST is the additional factor currently in play. In order to incentivize states to sign up for GST, the Centre assured them a revenue growth of 14% in the first five years. With nominal GDP itself expected to grow only 10% this year, a 14% increase in tax revenues is considered optimistic.

Shortfalls were to be met via the “compensation cess", which is an additional tax levied on five “sin" products: sport utility vehicles, tobacco, aerated water, coal and cigarettes. Punjab and Kerala have complained about delays in transferring this compensation. Even as the Centre blames poor tax collections for the delay, data shows it disbursed ₹27,000 crore less than what it collected in FY18 and FY19.

How is the overall kitty distributed across states?

How much the Centre shares with states is one debate. How this money is distributed among the 28 states and 8 UTs is another. Richer states argue they contribute more to the exchequer, but don’t receive a commensurate amount. Poorer states argue they need more to improve.

11th FC onwards have used 10 parameters to decide which state gets how much. Each FC has changed the methodology. 15th FC has used six parameters: population, area, forest and ecology, income distance (difference between a particular state’s per capita income and that of the richest state), demographic performance, and tax effort (Chart 5).

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It reduced the weightage of population from 27.5% to 15%. Previously, the population was considered at two points: 1971 and 2011. Now, it is considered only for 2011. To counter the argument that it is penalizing states that have performed well in population control, 15th FC added a new criteria, “demographic performance", as measured by the total fertility rate (TFR).

The use of 2011 data has not disadvantaged states that reduced TFR. We considered the states’ share of central taxes for FY21. We combined population and TFR criteria, which together has a weight of 27.5% in 15th FC, same as under 14th FC. We applied the new and old formulas on the divisible pool of central taxes.

Contrary to what is claimed, poor states are losing out due to the introduction of the TFR criteria. Uttar Pradesh and Bihar will lose ₹2,645 crore and ₹1,868 crore, respectively, under the population plus TFR criteria.

So then, overall, which states are benefitting from the new formula of 15th FC? We applied all the criteria defined by 15th FC. Maharashtra, one of the most industrialized states, is the biggest gainer. Uttar Pradesh will lose marginally. Karnataka and Kerala stand to lose the most (Chart 6).

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How is the Centre protecting its own interests?

About 18% of taxes collected by the Centre are in the form of cess and surcharge. These are essentially a tax on a tax, and these collections don’t go into the divisible pool. This has peeved states, who complain they effectively get 42% of ₹82 and not ₹100.

Post-GST, even as the number of cess items have reduced from 42 to six, their total collections have increased over the years. Each cess is collected for a specific purpose (for example, education), and can’t be used for other purposes.

But the government auditor has pointed out that the Centre is not maintaining a separate fund for the secondary and higher education cess. Instead, ₹94,036 crore collected is maintained under the Consolidated Fund of India. Seen another way, even as the Centre distributes money to states, it is using the cess route to safeguard its own financial interests.

Meanwhile, the dependency of states on central funds has increased over time. In FY91, of every ₹100 combined revenues of states, ₹40 came from the Centre. This is now ₹50. A higher reliance on the Centre’s transfers in recent years could be because of the economic slowdown impacting the states’ own tax collections.

Ultimately, be it Centre or states, economic growth is essential for more fiscal latitude. GST alone accounts for 44% of states’ own tax revenues, and 29% of Centre’s total tax revenues. Five items alone account for about 75% of states’ own tax revenues: state GST, state excise, taxes on vehicles, taxes on property and capital transactions, and taxes and duties on electricity.

Buoyancy in each of these is contingent on improvement in the overall economy. At the moment, the economy is not firing; GST is not firing. And states are firing at the Centre for not giving a whole lot more, and the fiscal tension is building.

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