A Plain Facts column published on Monday argued that it would be difficult for the Central government to balance its objectives of fiscal consolidation and providing a fiscal stimulus to growth to compensate demonetisation’s adverse effects on growth. But can we expect state governments to raise spending and boost growth, now that they are entitled to a greater share of the revenue pie?

The answer is not a straightforward one. This is because the Fourteenth Finance Commission (FFC) compensated the Centre’s loss to some extent by reducing its commitment to funding of centrally-sponsored schemes (CSS). The effects of this rejig however have been different for different states, because CSS funding was not similar across the board. So states which were relatively more dependent on CSS funds have lost out.

What has been the overall effect of FFC on state finances?

A World Bank report published in July last year estimated that overall effect of FFC on state finances in 2015-16 has been positive, as the reduction in grants was smaller than expected while devolution to states proceeded largely as budgeted.

A recent paper by Mita Choudhury, Ranjan Kumar Mohanty and Jay Dev Dubey of the National Institute of Public Finance and Policy (NIPFP) provides figures to show that such studies could have overestimated the positive impact of FFC recommendations on state finances.

First of all, 2014-15; the year before FFC recommendations were implemented was an unusually low year for central transfers to states. Aggregate transfer to states as percentage of gross tax revenues of centre increased from 55% to 57% between 2014-15 and 2015-16. However, as the chart shows these levels were much higher in previous years, the share being more than 60% in 2010-11 and 2011-12.

Even the above 2 percentage point year on year increase in aggregate transfers to states in 2015-16 could be an over-estimate because it compares provisional numbers for 2015-16 over actual values for the previous year. As has been the trend over many years, government expenditure and receipt numbers are often revised downwards. Therefore it is possible that the available ‘revised estimates’ for 2015-16 might be adjusted even lower subsequently.

Another indicator supports the claim that all states have not gained unambiguously from FFC arrangements. Aggregate transfers from the Centre as a proportion of the respective gross state domestic product (GSDP) fell for a number of states in 2015-16, with Bihar and Madhya Pradesh faring the worst.

In addition to a 10 percentage point increase in tax devolution to states, the FFC also made these funds untied in nature. This is different from the pre-FFC arrangement, as earlier funds could only be spent under designated CSS schemes. Has a shift from tied to untied grants changed the expenditure priorities of the states?

As was expected, there has been an increase in devolution of untied funds from the centre to states, unlike the pre-FFC period when a lot of funding for CSS was tied in nature. While, the move might have given greater fiscal freedom to state governments, social sector spending seems to have become a casualty in most states.

To be sure, the paper notes that these could be transitory effects and things could change with time, as states are still trying to adjust to the post-FFC arrangements. However, given this backdrop to expect states to significantly up the ante vis-à-vis fiscal stimulus to counter the effects of demonetisation might be too optimistic.

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