Home >Opinion >Columns >Opinion | The fiscal health of states and the limits of federalism

On 8 March, I had the privilege and honour of being a panellist at an event organized at the Madras School of Economics for the release of the book Indian Fiscal Federalism authored by Y.V. Reddy, former governor of the Reserve Bank of India (RBI), and G.R. Reddy, adviser to the government of Telangana. The book was released by C. Rangarajan, another former RBI governor and chairman of the 12th Finance Commission.

Y.V. Reddy, with his self-deprecating humour, used to begin his speeches (during his tenure as chairperson of the 14th Finance Commission) by saying that he did not need an introduction but only a conclusion. He would be alluding to his tendency to couch his views and opinions as self-evident questions, leaving the audience and readers to draw their own inferences.


He has been speaking his mind on many issues of late, and in his co-authored book Indian Fiscal Federalism, he continues that practice. For example, he pulls no punches while talking of the functioning of Niti Aayog and about the Terms of Reference (ToR) of the 15th Finance Commission. Take this bit for instance: “Just a day after the presentation of the report of the Sub-group of Chief Ministers on rationalization of Centrally Sponsored Schemes, the Ministry of Finance issued a notification without taking on board most of the recommendations." In another instance, he writes that the scope and remit of the Niti Aayog had been expanded and its stature reduced, with the result that there was little evidence of focus in its working.

The authors are quite critical of some of the “Terms of Reference" of the 15th Finance Commission. While they have sympathy for the use of the population figures of 2011, they feel that the union government directing the Commission to take “expenditure on populist welfare measures" into account while devising performance-based incentives is as problematic as many of the other criteria spelt out for determining performance-based incentives. For example, achievements in the implementation of the flagship schemes of the government of India cannot be a criterion. Some of the schemes may not be necessary or relevant for some states.

With the union government announcing income support for farmers, it, too, has forayed into incurring expenditure on a populist welfare scheme.

Thus, the authors point out that these criteria should probably be applied to the Union government as well.

Finally, the union government asking the 15th Finance Commission to look into the fiscal situation of the union government due to the substantially enhanced tax devolution to states (following the recommendations of the 14th Finance Commission) is inconsistent with its claims that it has championed true federalism by implementing them.

Further, cesses and surcharges are not shared with states because they do not form part of the divisible pool as per constitutional provisions. In the spirit of true federalism, the Constitution should be amended to make sure that the cesses and surcharges are shared with the states. Otherwise, the amendment should bar the union government from levying them in the first place.

Above arguments notwithstanding, there is one argument in favour of the union government. It is seen as an implicit guarantor of state government debt. In a note published in February 2017 (What Is The State Of India’s Public Finances), Sajjid Chinoy of JP Morgan argued that there was an absence of price-disciplining market signals on state government debt.

He wrote that the 14th Finance Commission did not provide incentives to reduce their gross fiscal deficit below 3% of state GDP and that the disincentives for breaching the 3% limit were not strong enough.

In 2015-16, Bihar with a deficit of 6% of GDP and Gujarat with a deficit of 2.3% of GDP paid the same cost of borrowing. There was also no correlation between borrowing costs and underlying debt positions. A big part of the reason for the lack of differentiation between states is the market perception of an implicit guarantee of the Union government on states’ debt. It is doubtful if this situation has changed materially in the last two years. RBI’s latest annual study of the budgets of Indian states released in July 2018 makes for worrying reading.

Therefore, as long as there is a market perception of an implicit sovereign guarantee, the union government may be justified in asking the Finance Commission to come up with performance-based incentives while tax devolution to states continues as mandated by the Constitution. That is an obligation and not a privilege of the Union government.

There is no conclusive evidence, sustained over time, that the union government has a longer horizon and a better record on the quality of fiscal expenditure and the quantum of fiscal deficits incurred by the Union government than that of the state governments.

Indeed, Indian fiscal health is a federal problem.

V. Anantha Nageswaran is the dean of IFMR Graduate School of Business (KREA) University.

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