The state-versus-centre battle for resources, in six charts

As India’s economic momentum has slowed over the past couple of years, and public resources have shrunk in tandem, the battle for scarce public funds has only intensified. The central government and state governments have been at loggerheads on a range of issues: the increased use of cesses by the centre, the compensation for shortfall in GST (goods and services tax) revenues, and the extraordinary demands on the 15th finance commission to carve out funds for central subjects such as defence and internal security.

Throughout India’s history, the centre had an oversized share in the use of public funds. But the constitutional division of subjects put more onerous welfare obligations on state governments. Since the turn of the century, successive finance commissions have tried to allot more funds for state governments to correct the imbalance. From the 11th finance commission to the 14th, the share of net proceeds recommended to be devolved to states increased each time: from 29.5% to 30.5% to 32% to 42%. Net proceeds are defined in Article 279 of the Constitution as gross tax revenue of the centre less surcharges and cesses, and cost of collection.

India’s coalition era, in which regional parties held sway over Delhi ensured that there was broad-based political support for such a shift. As a result, in several critical areas of spending, such as capital expenditure, state governments came to assume the leading role.

About two-thirds of India’s public capex comes from states, the highest decentralization of capital spending globally, according to the Reserve Bank of India’s latest report on state finances published last month.

The tide may now be turning, with the centre regaining dominance. In response to its shrinking share in the total revenue pool, the centre has over the years resorted to raising additional revenues through cesses and surcharges. Constitutionally, these are outside the remit of the finance commission’s devolution formula, and hence need not be shared with states. 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 decline in states’ share has been particularly sharp in the past couple of years.

Even the mandated devolution figure may have been lowered slightly by the 15th finance commission, according to some news agencies. The commission submitted its report to the President on Monday but it has not been made public yet. The change may not make a big difference to fortunes of all states but it signals a break with the past trend of raising allocations for states.

The nature of transfers to states has also changed with the recommendations of the 14th finance commission. A larger share of transfers has been in the form of unconditional devolution to states. The share of statutory grants paid to the states has correspondingly declined.

While this has allowed greater discretion to states, it has also made them more vulnerable to fluctuations in the centre’s tax revenues, said Indira Rajaraman, public finance expert and member of the 13th finance commission. “When states get transfers as a tax share, they are sharing in both the downside risk as well as the upside buoyancy,” said Rajaraman. “This is why they have been so heavily impacted by the decline in tax collections during the lockdowns.”

The pandemic-induced lockdown has had a crippling effect on state finances. But they were already in a weakened state. The centre contributed to some of this fiscal stress: by delaying GST compensation cess, and by lowering the amount available for the divisible pool through cesses and surcharges. But states are not blameless. Populist programs such as farm loan waivers launched by a number of state governments have also contributed to the current fiscal stress, without doing much to raise farm incomes. The rather tepid performance of the power debt restructuring scheme, UDAY, also strained state finances.

The last blow came from covid-19, and the lockdown that followed. The initial ban on liquor, the sharp fall in mobility, which hit fuel stations hard, and the slump in the property market during the lockdown --- hit state governments hard as they are heavily dependent on liquor, fuel, and real estate for revenues.

As of August, tax revenues of state governments were 3-38% lower than last year. The sharp contraction in revenues has led states to cut back expenses, wherever possible. Several states have taken desperate measures ranging from deferment of salaries, suspension of leave encashment, to cuts in vehicle and establishment expenditures. In a historic economic contraction, states have been forced to pursue austerity. The biggest casualty will be state-funded capex, which had declined even before the pandemic reached our shores.

To tide over the shortfall in revenues, market borrowings by state governments have gone up. Unsurprisingly, the yield gaps between State Development Loans (SDLs) and the benchmark rate have widened compared to last year, meaning that states have to bear additional costs of servicing these loans.

“The spreads would have been much higher had RBI not intervened with Open Market Operations (OMOs) in SDLs,” said Abhishek Upadhyay of ICICI Securities

Primary Dealership. RBI seems willing to manage states’ borrowing costs this year but this facility may not be available next year, he said.

Higher borrowing costs will add further strain on the budgets of indebted states. The ratio of state-level debt to gross domestic product (GDP) has steadily increased from 22.6% of the GDP at the end of Mar 2013 to 26.3% at the end of Mar 2020. West Bengal, Punjab and states in the North-East have the highest debt-to-GSDP ratio in India currently. These states may have to cut expenses sharply to pay for the rising interest costs.

With state finances under such strain, we’re likely to see centre-state relations become more fractious – with more attempts to shift blame to each other, said Louise Tillin, a political scientist at the India Institute, King’s College London, who studies federal relations.

“This is the time for the centre to be a lot more generous with states to help them meet their revenue needs and respond to the still-raging pandemic,” said Yamini Aiyar, president of the Delhi-based think tank, Centre for Policy Research.

The fault-lines between the centre and states are going to become only more complex over time, said Aiyar, adding that it calls for new institutional structures --- beyond what the finance commission provides --- for better negotiation and trust building between centre and states.