Misconceptions in Indian fiscal federalism

India has a federal structure. It is one country of many diverse States; not a union of many countries. Most notable among the institutions that keep it together are the Finance Commissions (FCs), independent constitutional bodies appointed every five years, with the mandate to achieve uniform public services through the country.

As the 16th FC starts its work, we discuss three emotive issues that come up often in this area. Careful benchmarking with other countries and examination of data, however, suggest they are misconceptions.

The first is that States should have more freedom to tax and borrow; the second that States get less than their fair share of Central taxes; the third that richer States lose out since transfers are towards poorer States.

Rights of States

Tax and borrowing rights: The outcomes, however, suggest that restraints on States’ fiscal freedoms are among least severe in the Indian federal structure. In 2022 Indian subnational debt at 28 per cent of GDP was the fourth highest in the world. The OECD average is 20 per cent.

Borrowing is helped because the yield spread across States is the least in India. All SDLs (State development loans) have the same rate near G-secs. More indebted States can borrow at the same rate as others because the RBI has an automatic debit mechanism supporting State borrowing. In Mexico, the spread was 4.5 per cent and in South Africa it was 1.5 per cent in 2022.

Theoretical principles of federalism support giving more elastic taxes, such as on incomes, to the Centre. Otherwise there would be migration away from States with higher taxes. FCs compensate by transferring resources to the States.

In addition, no limits on State borrowing result in macroeconomic instability. For example, Brazil and Argentina had hyperinflation in periods of unconditional central bailouts, as regions competed to borrow more, raising deficits sharply. So the constitutional right of the Centre to impose borrowing limits on States with high debt is required. Yet half a dozen States habitually exceed Fiscal Responsibility and Budget Management Act debt limits of 30 per cent.

Moreover, research finds States’ own tax effort is less than potential, after controlling for all the elements that affect their tax potential. Effort is found to reduce with transfers from the Centre while the application of FRBM increased it.

Now State GST is elastic so a large rise in revenues is possible with data-based collection at the point of sale. It has increased from ₹2.6 trillion in FY18 to ₹8.4 trillion in FY24BE with double-digit growth last year.

Transfer of resources from Centre: Again, the facts show Indian States’ spending share is higher than in most other federal structures. Over 2015-20, States’ average share of general government expenditure was 63.9 per cent while in other large federal countries such as Brazil, Indonesia, the US and Australia it was about 40 per cent, with the Centre spending about 60 per cent.

But the share of States’ own taxes was only 36.7 per cent. They spend more than they tax due to large transfer of resources from the Centre. Shareable taxes and tax share rose steadily. From the 1st to the 10th FC, only Central income and excise taxes were shareable. In 2000, Article 270 of the Constitution was amended to make all Central taxes, except cess and surcharge, shareable. The States’ share of 29.5 per cent with the 11th FC had risen to 41 per cent by the 15th FC.

The actual share in Central taxes, however, stayed at about 32 per cent in the early 2020s. But there were additional transfers. In 2022-23, tax devolution was 3.5 per cent of GDP but Central grants were 3.2 per cent. Even the 14th FC, which increased the tax share by 10 per cent, did not expect the already high aggregate share to rise. It wanted a fall in centrally sponsored schemes (CSSs) and a rise in untied, predictable tax devolution. This was the time CSSs were being rationalised.

CSSs were restructured but still rose. The reason was delivery of public goods, such as health, education and environment, in the Concurrent List of the Constitution remained neglected. This hurts the poor more, since the rich can find private substitutes. This delivery requires activation of the 3rd Tier, but decentralisation of funds and functionaries to the 3rd Tier mandated by the 1990s’ 73rd and 74th Amendment remained patchy across States.

Tax devolution is a right, although the formula changes slightly with successive FCs after extensive consultations. Conditionalities can be imposed only on grants and these remain important for public service delivery. CSSs and other grants to local bodies, 60 per cent of which are for water and sanitation, are substituting for lack of devolution to 3rd Tier. Although States prefer a free hand their citizens have a right to uniform public services. Building human capacity is very important in India’s current growth juncture.

A rise in non-shareable cesses and surcharges is also regarded as unfair. But these partly finance grants. In 2022-23, 21 per cent of State revenue receipts were from grants and 26 per cent from tax sharing. Some of the rise was due to the fall in international oil prices in 2014. States raised their own oil taxes.

Imposition of Central schemes is disliked. But States can make their own add-ons, customise and own them. In Odisha, where local political cadres are more active, the schemes are known as State schemes. Bihar has used this to achieve the largest fall in multi-dimensional poverty. The Central Ayushman Bharat has been renamed Mukhyamantri Jan Arogya Yojana.

North-South divide: States in the South and West are told they are subsidising a poorer North and East. But net resource flows have differed in the past and will change again in the future. States gain much more than just resources participating in a vibrant growing common market. We see Britain suffering the consequences of Brexit. There is also protection in a fragile nuclear neighbourhood.

Moreover, facts again belie common perceptions. Data from four populous northern States — Bihar, MP, Rajasthan, UP — and four Opposition southern States — Andhra Pradesh, Karnataka, Kerala, Tamil Nadu — shows that since 2000, while the formula-based share of taxes fell for the southern States, the share of grants from the Centre rose for them and fell for the northern States. As a result, the share of total transfers to the southern States was constant.

Since northern States are more populous, and southern States more prosperous, on equity grounds, which dominates FC transfers, the North should get more. Yet, although share in total transfers was constant, since 2013 grants per capita are higher for the South. This is the effect of rising conditional transfers since more efficient States get more of these. For example, the four southern States have more than 50 per cent of Ayushman Bharat patients. Better medical facilities increase the use of this scheme. So they should not be complaining about conditionality.

Responsibilities and outcomes

The States with debt exceeding the FRBM 30 per cent also tend to be the ones with high revenue deficits and low capital expenditure. This is not fair to other States or to themselves. Conditionalities deliver more to better performing States and induce better performance, helping States escape low level traps and distorting choices such as in the electricity sector or water supply. So these should be priorities for the 16th FC. Citizens should avoid divisive agendas and ask for delivery.

The writer is Emeritus professor, IGIDR

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