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Construction of an infrastructure project in Bengaluru. Karnataka is among the biggest losers in devolved tax revenue as its per capita income growth has been much faster than most other states.
Construction of an infrastructure project in Bengaluru. Karnataka is among the biggest losers in devolved tax revenue as its per capita income growth has been much faster than most other states.

Why the Centre-state battle has a new front

  • Karnataka  and  Kerala  are  likely  to  lose  out  in  interim  15th Finance  Commission  awards. Other fault lines are forming
  • The action now shifts to the full report, which will determine how the Centre shares revenues with states between 2021 and 2026. A proposal for a separate fund for defence will be keenly watched

BENGALURU : Finance minister Nirmala Sitharaman recently tabled the first report of the Fifteenth Finance Commission (15th FC) in Parliament on 1 February 2020, before the presentation of the Union budget.

It has already created a flurry of interest since the reports of FC have important implications for the finances of both the Union and state governments, as well as local bodies.

The state governments are particularly keen to see the extent of gains and losses in their shares from central taxes and the grants receivable by them. These are assured sources of revenues to the states and helps them to have stability and predictability in their budget preparations.

The basic terms of reference is specified in Article 280 of the Constitution itself. Although the terms of reference cover a wide area under “any other matter in the interest of sound finance", the focus of attention is often on the recommendations relating to tax devolution, grants in aid and local body grants.

And lists of winners and losers are already being made. Among the states, Karnataka, Uttar Pradesh and Kerala seem to be in for the largest reduction in devolved tax revenue. Secondly, the fight over the use of 2011 population figures to determine the degree of transfer to states (which could potentially benefit more populous northern states) is here to stay and 15th FC’s use of a counter-balance in the form of “demographic performance" raises questions about whether tax devolution should be the arena for population control. And lastly, a series of specific Centre-to-state grants have also been laid out (some which the Union government has already refused to accept).

But this list of fallouts could change based on what is in the final, comprehensive report. The current one is an interim report, applicable only for the fiscal year beginning on 1 April 2020. A subsequent report will make further recommendations for the following five years, and that in itself tells a story.

Making projections for five years in the prevailing economic environment posed serious risks and, therefore, the extension of the term of 15th FC is quite appropriate. The abolition of statehood to Jammu and Kashmir (J&K) required it to make estimation excluding the Union territory. Furthermore, the sharp decline in the gross domestic product growth rate—particularly the nominal growth rate (estimated at 7.5%), which is the main determinant of tax revenues and expenditures—makes it difficult to make projections for a full five-year period.

In addition, the goods and services tax (GST) continues to evolve. It has ceased to be a “money machine", and making projections from the prevailing situation poses serious risks. Moreover, there is no clarity on what would happen during the last three years of the period for which 15th FC’s recommendation will be valid, as the GST compensation agreement between the Centre and the states for any shortfall in revenues terminates in 2022-23 (states have been assured an annual 14% rise, until 2023).

Finally, the sharp downward revision in Union tax revenues and expenditure, including tax devolution, in the current year (compared to last year’s budget estimates) have rendered firming up the base year for projections an extremely difficult task.

The big takeaways

Over the course of 2019, there were apprehensions that 15th FC may deviate substantially from the past, particularly as the terms of reference stated: “The Commission may also examine whether revenue deficit grants (should) be provided at all." (Revenue spending includes expenses on routine items such as salary and this particular mandate worried many states that they may not continue to get these transfers which allowed them to meet routine expenditure).

15th FC did well to allay the apprehensions on this account in the first report by continuing with the approach and methodology laid down by the previous commissions. It has made projections of revenues and revenue expenditures of the Centre and individual states, applied selective norms to the latter, recommended devolution of taxes to the states from the divisible pool, and suggested revenue deficit grants for the states that had post-devolution gaps.

It stated “…stability and predictability of resources is an essential component of good long-term budgeting for both Union and States", and continued with the recommendation of the previous commission on tax devolution by adjusting the states’ share to 41% (from 42% earlier) to exclude the share of J&K.

Speculation was rife in the press that 15th FC may reduce the share of the states, and by maintaining the states’ share, at least this particular controversy has been avoided. However, there is no guarantee that the share will not be altered in the final report as the current report states, “Our recommendation in the final report would undergo changes and adjustments as appropriate, in the light of subsequent data and analysis." If indeed it goes about giving various sectoral and performance-based grants, there is a possibility that it may reduce the share of the states to keep the overall transfers constant.

But irrespective of how the Centre and states—taken collectively—share the tax pie, the revenue transfers that individual states receive could undergo substantial changes for two reasons: 15th FC has changed the formula for determining the share individual states are eligible for in order to consider what it calls “fiscal needs, equity and efficiency"; the weights assigned to the variables used in the distribution formula have also been changed.

For the first time, in addition to income distance (difference between a particular state’s per capita income and that of the richest state), population and area, and forest cover, 15th FC has used two additional factors—demographic performance and tax effort.

There was considerable controversy regarding the commission’s terms of reference mandating the use of 2011 population figures in its formula. By keeping the weight of 2011 population at 15% and giving additional 12.5% to demographic performance (which is the inverse of fertility rate), it has shown sensitivity to the concerns of several southern states. However, some uncomfortable questions still remain.

If the objective of the transfer system is to enable the states to provide comparable levels of public services at comparable tax effort, the services have to be provided to the current population and not the population of any past year. And the objective of tax devolution is not population control. Also, the demographic incentive structure—forward looking as it may seem—does not reward reduction in fertility rate in the future. Even in the case of the new tax effort criteria, the states have very little say in determining what the commission considers states’ own tax revenue under the prevailing GST.

Winners and losers

A comparison of the relative shares in tax devolution shows that among the country’s major states, the reduction in the share is the largest for Karnataka, followed by Uttar Pradesh, Kerala, Telangana and Andhra Pradesh. Kerala and Andhra Pradesh have post-devolution gaps, and hence qualify for revenue gap grants.

The major reason for Karnataka and Kerala losing out is that their per capita income growth has been much faster than most other states, thereby reducing the income distance from the highest per capita income state (Haryana). The difference from the highest per capita income in both Karnataka and Kerala is just about 10% now, as compared to 34% and 23%, respectively, for the two states when the Fourteenth Finance Commission (14th FC) made the recommendation.

In the case of Karnataka and Telangana, as the projected transfer (devolution and revenue-gap grants) in 2020-21 is lower than 2019-20, 15th FC recommended a special grant of 5,495 crore and 723 crore, respectively. However, the Centre has not accepted this recommendation and has asked the commission to reconsider it, stating that it introduces a new principle. This is a bit unusual as there is a tradition of automatically accepting FC’s recommendations on tax devolution and grants.

The grants for local bodies amount to 90,000 crore. Rural local bodies are to receive 60,750 crore. 15th FC has tied 50% of the grants to improving sanitation and supply of drinking water, and the remaining is untied. In the case of urban local bodies, of the total allocation of 29,250 crore, 9,229 crore is for cities with million-plus population and the remaining 20,021 crore is allocated to other towns.

One area where resources can be augmented for local bodies is by enhancing the ceiling of professional tax, which has been kept unchanged at 2,500 (fixed in 1988). 14th FC had recommended raising the ceiling to 12,000 but no action has been taken on that.

Framework for grants

The commission has worked out a framework for giving some sectoral grants as well. For 2020-21, it has recommended 7,735 crore for improving nutrition based on the number of children in the 0-6 age group and the number of lactating mothers. For the next five years, it has proposed to give sectoral grants for police training, modernization and housing, railways (to meet additional funding of projects taken on cost-sharing basis with states), maintenance of roads under the Pradhan Mantri Gram Sadak Yojana, strengthening the judicial system, and improving the statistical system.

The states are required to prepare the necessary ground. A broad framework for monitorable performance-based grants is also presented for agricultural reform, development of aspirational districts and blocks, power sector reform, incentives to enhance trade including exports, and pre-primary education.

The logic for giving specific purpose transfers is to ensure minimum standards of services that are considered meritorious (socially valuable goods). This would require defining the minimum standards of the services to be equalized, costing them, and determining the shares of the Centre and states.

There are 28 centrally sponsored umbrella schemes and several central schemes, causing a thin spread of resources. It is important to select a few and substantially fund them to equalize the standards of services. Some of the central schemes already cover the sectors chosen for performance-based grants by 15th FC.

While the commission intends to provide specific focus to some neglected and yet important aspects critical to development in these sectors, there may be more value in redesigning centrally sponsored schemes rather than duplicating them. In any case, the commission will not be there to implement these grants, and this could result in the Centre imposing additional conditions. Even though 15th FC has stated that the grants should result in additionality and not substitution, there are ways in which both the Union and state governments can substitute their contributions.

15th FC itself has made comments on the proliferation of central schemes in the report. If it decides to make these grants a permanent fixture, the important challenge will be to design and dovetail all these sectoral grants and performance grants with the existing central sector and centrally sponsored schemes.

The stage is now set for what happens in the following five years, beyond this year. One of the issues that will have to be addressed in the forthcoming full report is the demand to operationalize a non-lapsable fund for defence and internal security. The relevant ministries have suggested the creation of such a fund from a variety of sources including levying a cess, monetizing assets including surplus land, and disinvestment in defence public sector units. 15th FC proposes to constitute an expert committee to consider the modalities of implementing this.

In the coming days, there will be considerable discussion on 15th FC’s recommendations and since it continues to exist and function, it will have the onerous task of dealing with representations from the states that have lost out in the first report. Now, the focus will be on the final report to see to what extent the avowed objectives of fiscal need, equity and efficiency will be pursued to create a stable, sustainable, and predictable fiscal environment for the country.

M. Govinda Rao was a member of the Fourteenth Finance Commission and is former director of the National Institute of Public Finance and Policy.

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