The frequency and intensity of disputes between the Centre and States regarding allocation of resources have increased in recent years, creating persistent frictions in India’s federal system. The recurrent disputes have led to a short-term financial crisis in many States, especially those ruled by opposition parties.
The current context of economic relations between the Centre and States is very different from the 1980s and 1990s. While some of the controls on investments were relaxed with the economic reforms that begun in 1991, providing some fiscal space for States, the autonomy regarding resource mobilisation and expenditure policies is not absolute. This creates asymmetries in the federal system as State governments depend on the Centre for their revenue receipts and grants. The leeway established since the 1990s has also shrunk with the introduction of goods and services tax (GST), which has curtailed the available avenues for States to mobilise resources, making them more dependent on the Centre.
As a result of the tendency towards centralisation, there has been a constant pushback from States on the Centre’s policy measures. The “give and take” relation between the Centre and States is slowly giving way to a more hardened stand by both, leaving little room for negotiation. In the long run, increasing abrasions in Centre-State relations will strain the spirit of cooperative federalism and pose a significant challenge to the country’s federal system.
Rising asymmetries
The Constitution permits both the Union and States to raise revenues from different sources of taxation. The Seventh Schedule of the Constitution assigns responsibilities to incur expenditure through subjects in three lists: the Union List, the State List, and the Concurrent List. This distribution, by constitutional design, has assigned the Union government higher and more buoyant taxation and resource-raising powers and the States higher responsibilities for incurring expenditures.
To highlight this imbalance, it has to be noted that in 2018-19, the Union government raised 62.7 per cent of the aggregate resources raised by both the Union and States, while States spent 62.4 per cent of the aggregate expenditure of the Union and States. There is thus a structural vertical imbalance, which necessitates the orderly transfer of resources from the Union to States, which is essential for the latter to carry out their expenditure commitments.
In 2023, Tamil Nadu suffered two natural disasters. To handle the crisis, the State sought Rs.37,906 crore from the Centre but got a paltry Rs.276 crore. The picture captures the impact of Cyclone Michaung. | Photo Credit: JOTHI RAMALINGAM B
At an aggregate level in 2018-19, States could generate their own resources to meet only 44.8 per cent of their total expenditure, which means that the remaining 55.2 per cent had to be financed through vertical resource transfers and/or by contracting debt. This basic design has led the Constitution to mandate the Finance Commission to assess the vertical fiscal imbalance, which is likely to arise during its award period, and recommend the sharing of resources on the basis of such realistic assessments.
The Sixteenth Finance Commission is expected to take into account this vertical imbalance in its recommendations. States would benefit if the devolution of taxes from the divisible pool were made at a minimum of 50:50 between the Union and State governments, especially given the declining share of the divisible pool in gross revenues. The basic argument here is that States have much larger expenditure responsibilities compared with the Union, especially in sectors such as education, health, police, law and order, agriculture and allied activities, irrigation, forests and environment preservation, power, roads, social welfare, and drinking water and sanitation.
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This higher share of responsibilities was apparent during the COVID-related lockdown, when the States had to bear the brunt of the expenses to combat the spread of the pandemic. Further, committed expenditures on sectors falling within the States’ responsibilities are disproportionately much higher than their own tax and non-tax resources. To meet expenditure responsibilities, States hence need a large devolution of gross revenues.
Highlights
- Increased disputes between the Centre and States regarding resource allocation have led to short-term financial crises in many States, especially those ruled by opposition parties.
- The introduction of the goods and services tax (GST) has curtailed the available avenues for States to mobilise resources, making them more dependent on the Centre.
- A delay in funding for the Chennai Metro Rail project and the limited amounts received from the Central release of funds for natural disasters. are affecting Tamil Nadu’s finances.
The introduction of GST has resulted in States significantly losing the financial autonomy to impose differential tax rates for resource mobilisation. In the pre-GST era, States could take individual measures for additional resource mobilisation by calibrating their tax rates, but now the GST Council has to approve any tax rate changes. Practically all taxable commodities are covered under GST; States have lost much of their individual resource-raising ability.
Under the GST regime, States had hoped to gain from the sharing of service tax revenues. However, in the aggregate, States have had to contribute a larger proportion to the common GST pool compared with the Union.
Tax devolution from the divisible pool is the most seamless way for States to receive their share of resources as these are unconditional transfers that protect the autonomy of States. However, the Union has significantly shrunk the divisible pool over time through excessive and rising cesses and surcharges, which are, under the Constitution, non-shareable with States.
The main determinants of horizontal devolution of taxes among States have been need, equity, performance, fiscal disabilities, and fiscal discipline. However, the weightages assigned to variables to determine the formula have varied over time, posing disadvantages for many States, especially the southern States.
Tamil Nadu’s scenario
Tamil Nadu’s share in all State devolution was 5.30 per cent according to the Twelfth Finance Commission award. According to the Fifteenth Finance Commission, the share of tax devolution declined and Tamil Nadu’s share is 4.07 per cent. Owing to the decline in the share of Tamil Nadu in the divisible pool of taxes, the tax devolution as a percentage of the gross State domestic product (GSDP) declined from 1.69 per cent of the GSDP in 2011-12 to 1.34 per cent in 2022-23. High levels of committed liabilities due to interest payments, pensions, and salaries, along with a reduction in the share of the tax divisible pool, have resulted in a decline in capital expenditure as ratio of the GSDP to meet the target of fiscal responsibility legislation.
Apart from the decline in the share in the divisible pool and loss of autonomy to raise revenues because of GST implementation, Tamil Nadu’s finances are hit by three other factors. First, there has been an inordinate delay in getting funds for Phase 2 of the Chennai Metro Rail project, which got the approval of the Public Investment Board as a Central Sector Project under the equity-sharing model in August 2021. It has been awaiting the approval of the Cabinet Committee on Economic Affairs since then.
In anticipation of the green signal, the State government has borne the entire expenditure from its own funds, which is creating enormous stress on its finances. Presenting the State Budget in February 2024, the Tamil Nadu Finance Minister observed that the “inordinate delay” by the Centre in approving the project resulted in an expenditure of Rs.9,000 crore in 2023-24, expected to go up to Rs.12,000 crore this year.
Ahead of the release of the State Budget 2024-25, Chief Minister M.K. Stalin with Finance Minister Thangam Thennarasu on February 19. | Photo Credit: PTI
Second, Tamil Nadu gets very small amounts from the Central release of funds for natural disasters. Consider the case of 2023; the year witnessed two natural disasters in quick succession. The State submitted two detailed memoranda to the Union government seeking Rs.37,906 crore, but the latter released a paltry sum of Rs.276 crore. In an April order, the Union Ministry of Home Affairs approved an assistance of Rs.285.54 crore and Rs.397.13 crore for the two spells. However, the total funds disbursed under the National Disaster Response Fund (NDRF) were only Rs.115.49 crore and Rs.160.61 crore.
The Central government’s view is that it can provide funds for immediate relief and temporary restoration work but not for long-term rebuilding works. In the case of rebuilding projects, the State will have to approach the Centre with separate proposals, which would be considered under any of the programmes or projects for funding.
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It is important to note that a State such as Tamil Nadu, which is prone to cyclones and other natural calamities, requires budgeting resources under two broad heads, that is, relief and restoration. Relief demands lesser outlays, that is, immediately after the hazard—short-term expenditure accounts for smaller portions—but restoration involves long-term expenditure and demands more outlays. Thus, without adequate assistance from the Centre, the State’s finances will be under stress both in the short term and long term, forcing it to divert funds that could be used for other development activities.
Third, the State’s finances are put under pressure because of the unreasonable share it has to bear in the case of Centrally Sponsored Schemes (CSS). Consider the example of the unit cost of houses under the affordable housing scheme being implemented in partnership with the Pradhan Mantri Awas Yojana (Urban). The Central government’s share in this is only Rs.1.5 lakh a unit against the Tamil Nadu government’s contribution of Rs.7.5 lakh to Rs.13 lakh a unit.
In the case of the rural housing project, the former provides Rs.72,000 a house and the latter, Rs.1.68 lakh. It is a known fact that liveable houses cannot be built with this small share from the Centre, and the State contributes a disproportionately higher amount and executes a CSS by stretching its budget. Similar is the case with social security pension, where realising the inadequacy of the amount from the Centre, the State government contributes more than three times the Centre’s share a month per beneficiary.
Centralisation of resource mobilisation and decentralisation of activities that impact the life of citizens with less and delayed assistance do not augur well for the federal structure. States must receive their legitimate share in devolution in order to accelerate economic growth and achieve balanced regional development. It is important to note that India grows only when the States grow, for which they need adequate resources.
M. Suresh Babu is Director. Madras Institute of Development Studies. The views expressed are personal.
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