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Mumbai: Since it came into power in 2014, the Bharatiya Janata Party (BJP) has repeatedly stressed the importance of cooperative federalism. But at least in terms of finances, cooperative federalism has yet to benefit states. And the 15th Finance Commission (FC), which had to balance the fiscal needs of the Centre and state governments, has done little so far to address shrinking transfers from the Centre to the states. Consequently, like the Centre, state finances are becoming increasingly vulnerable.

One measure of this vulnerability is state government debt. In a recent report, the Reserve Bank of India warned that rising public debt at state-level is becoming unsustainable. Public debt as a share of states’ own revenue, which captures the ability of a state government to repay debt, has increased since 2014. Few states’ debts are increasingly precarious. West Bengal, Punjab and states in the North-East have the highest debt to own revenue ratio in India. In contrast, southern states are better off but they’re also more likely to lose out from the new 15th FC’s recommendations.

(Graphic: Santosh Sharma/Mint)
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(Graphic: Santosh Sharma/Mint)

Though the 15th FC, in its recommendations for 2020-21, has left the overall devolution from Union government tax revenues to state governments largely unchanged (from 42% to 41% in 2020-21), it has tweaked the way funds are allocated between states The weight assigned for population has been lowered to 15% (compared to 17.5% earlier) while the weight for demographic performance increased to 12.5% (from 10%). Despite this, southern states, which have consistently performed better on population control, will lose out because the rewards will now be based on 2011 population rather than 1971 population.

Since the 14th FC, which increased the devolution of Union government tax revenues to states significantly, the role of transfers from the Centre has grown in importance for states. The share of funds from the Centre in the overall revenue receipts of states has increased while the contribution of states’ revenue receipts has fallen.

But despite the increase in mandated devolution, actual transfers to states have plateaued and actually shrunk in 2019-20. One reason for this has been the sharp growth in cesses and surcharges. While cesses and surcharges add to the Union government’s tax kitty, they are not part of the divisible pool shared with states. So, as the mandated share of states in the divisible pool grew, their share in overall tax revenues stagnated because the non-divisible pool of cesses and surcharges grew faster. The 15th FC has yet to address this shrinking divisible pool. And if it decides to carve out funds for defence in its full report for 2021-26, the pool will shrink further.

(Graphic: Santosh Sharma/Mint)
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(Graphic: Santosh Sharma/Mint)

Another constraint for states has been the Union government’s shortfall in tax collections. Data from budget documents show that the revised estimates of gross tax collections for 2019-20 are short of the budget estimates by 1.5% of gross domestic product (GDP). Within this, states are hit harder with the shortfall in tax revenues for states accounting for 0.8% of GDP.

The increased shortfall in actual figures compared to budget and revised estimates have also meant that states are facing increased uncertainty regarding their inflows. If tax revenues fall short in reality, this would mean that states have been overpaid with the adjustment coming in the subsequent year’s devolution. In 2018-19, an analysis of budget documents shows that because of the major shortfall in tax revenues, the difference between the actual devolution to states and the revised estimate was 58,843 crore (or around 8%). As a result of this deduction, the 2019-20 devolution is estimated to be substantially lower than what was paid out last year - the first time in over a decade that the actual outgo from Centre to states fell compared between two years. Major deviations like this can hurt a state’s ability to budget and make plans.

Another source of financial uncertainty for states has been the shortfall in GST compensation. Projected state GST (SGST) collections are based on annual growth rate of 14% from the net collection of taxes subsumed under GST in 2015-16. Any shortfall in actual collections below this ‘protected revenue’ is to be compensated by the Union government till the transition period gets over in 2022. But as the economic slowdown has hit GST collections, this compensation has not come.

“This mechanism (of GST compensation) was itself faulty. It depends on the underlying nominal growth rate. If the nominal growth rate tanked, as it has, to compensate states as per the 14% growth rate as through the nominal growth would sustain was an unreasonable commitment to make," said Indira Rajaraman, economist and a former finance committee member.

All these constraints to state finances could exacerbate the ongoing slowdown and investment slump. Over the last decade, state government spending has emerged as the major engine for investment in India. In 2010-11, state governments and the Union government contributed equally to capital spending in India but since then the states’ share has grown significantly. This spending has been channelled into critical sectors such as transport and rural development. Consequently, any fall in state spending will have outsized effects on India’s development.

Given this, the 15th FC may have to be more sensitive to the concerns of the states when it comes out with its full report for 2021-26 in October this year.

Sneha Alexander from Mumbai contributed to this story.

This is the first of a 10-part series on the 2020 Budget.

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