The National Democratic Alliance (NDA) regime period has witnessed the emergence of a new slogan: “double engine government”. It virtually declares that a State where voters elect a BJP government will receive special fiscal support from the Centre. There cannot be a more obnoxious form of political favouritism in the devolution of funds to State governments. It has become the practice of the Prime Minister to declare special packages for BJP-ruled States on the eve of elections or other such critical junctures.
The Union Budget of 2024-25 took the slogan to a new level by allocating special funds to Bihar and Andra Pradesh, where the ruling regional parties have made such special treatment a condition for support to the NDA government in Parliament. Worse, the Union Finance Minister showed no embarrassment as she elaborated on this special treatment in her Budget speech. No wonder the Budget has been described as “kursi bachaane wala” (a save-the-chair exercise) by the opposition. This unabashed political discrimination has opened a new front in the ongoing Centre-State confrontation.
An important question to be answered is how the Central government has access to funds enabling such largesse to its favourites.
There are three routes for the devolution of Central funds. The first is statutory transfers from Centre to State as recommended by the Finance Commission (FC). This constitutional body determines the vertical and horizontal distribution of tax resources raised by the Centre. Despite the heated debates generated by FC reports, their awards are undeniably based on certain norms and cannot be changed arbitrarily by the Centre.
INDIA bloc MPs, including Akhilesh Yadav, Rahul Gandhi and Sonia Gandhi, protest against unfair distribution of Central funds in the Union Budget, on Parliament premises, July 24. | Photo Credit: Manvender Vashist Lav/PTI
The second route was that of the erstwhile Planning Commission, which drew up the national plan. The Planning Commission was also responsible for dovetailing the plans of the States to the national plan and allocating Central aid to support the State plans. This allocation was also, to an extent, norm-based (the famous Gadgil Formula), and was formalised at the National Development Council after extensive discussions with the States.
The third route comprises discretionary grants given by the Centre. According to the assessment of the late K.K. George, economist and expert on public finance, between 1951 and 1984 the FC transfers constituted 40 per cent of overall gross resource transfer from the Centre, while plan transfers and discretionary transfers accounted for around 30 per cent each.
The discretionary grants were disbursed by invoking provisions of Article 282 of the Constitution, classified under “Miscellaneous Financial Provisions” meant to be used sparingly under special circumstances. But this constitutional provision has now become the basis for routine disbursal of grants by the Centre to the States.
Centre opens another chapter in ongoing fiscal confrontation with States
- The Union Budget of 2024-2025 has allocated special funds for Bihar and Andra Pradesh, where the ruling regional parties have made such special treatment a condition for support to the NDA government in Parliament.
- The States have been generally critical of discretionary transfers because they are liable to be subject to political bargaining and horse-trading. States have always preferred criteria-based transfers by the Finance Commission and Planning Commission.
- Hopes raised by the recommendation of the Fourteenth Finance Commission have come to nought and successive Budgets have pushed back the actual share of the States from 42 per cent to 32 per cent through dubious ways.
According to George, during the Sixth Plan period, 35 per cent of the discretionary grants went to Central plan schemes and Centrally sponsored schemes. Loans from small savings and short-term advances constituted nearly 40 per cent. These transfers also included Central assistance for relief expenditure. Therefore, the true discretionary transfers over which the Centre had full freedom were very much limited.
The States have been generally critical of discretionary transfers because they are liable to be subject to political bargaining. States have always preferred criteria-based transfers by the Finance Commission and Planning Commission.
How economic reforms impacted transfers from Centre to States
With the economic reforms starting in 1991, there has been a sea-change in the composition of transfers from the Centre to the States. After Narendra Modi came to power in 2014, the Planning Commission was abolished and replaced by NITI Aayog (in January 2015), an advisory think tank that has no resource allocation function. The vast resources once allocated by the Planning Commission are now available to the Union Finance Ministry for discretionary allocation.
There is an exaggeration in this statement because a major part of the plan aid was in the form of Central loans or market borrowing. As part of the economic reforms, direct lending by the Centre to the States was eased out, and the importance of small savings loans declined. State borrowing is now determined by the provisions of the Fiscal Responsibility and Budget Management (FRBM) Act.
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Yet another important change was initiated by the Fourteenth Finance Commission against the background of the impending demise of the Planning Commission. Traditionally, the FCs were concerned only with the non-plan account of the Union Budget. But with the abolition of the Planning Commission already on the cards in 2014, the Fourteenth Finance Commission considered the entire revenue account, not just the non-plan revenue account, in determining the tax devolution. Therefore, it increased the divisible pool from 32 per cent to 42 per cent, which would have substantially increased the quantum of devolution to the States.
The recommendation of the Fourteenth Finance Commission was much hailed and feted. But these expectations have come to nought. The successive Budgets of the Union government under the NDA have managed to push back the actual share of the States from 42 per cent to 32 per cent through dubious ways.
As Chief Minister of Gujarat, Narendra Modi had campaigned hard for a divisible pool of 50 per cent of the Central taxes. By the time the Fourteenth Finance Commission submitted its report on December 15, 2014, Modi had become Prime Minister. Having learned that the recommendation was for enhancing the divisible pool to 42 per cent, he tried to pressure the FC to scale down the devolution.
NITI Aayog CEO B.V.R. Subrahmanyam spilled the beans inadvertently in a seminar of the Centre for Social and Economic Progress in January 2024, and Al Jazeera reported it, but the Chairman of the Fourteenth Finance Commission did not capitulate. According to the grapevine, some of the draft budget figures had to be revised because of the higher devolution to the States. A past master in improvisation, Modi took credit for this and even joked in Parliament that “some States would not have treasuries big enough to keep all this money”, much to the merriment of BJP members.
The Central government then set out to systematically undermine the divisible pool. Of the taxes imposed by the Central government, cess and surcharge are excluded from the calculation of the divisible pool. So, the NDA government has been systematically increasing cess and surcharge to reduce the share of the divisible pool of revenues and increase the non-divisible part that is retained by the Union government. As a proportion of gross tax revenues of the Centre, surcharges and cesses have jumped from 9.5 per cent (in 2011-12) to 20.2 per cent (in 2020-21) even after excluding GST compensation cess. In 2023-24 the ratio was 14.4 per cent.
Businessmen in Licknow watch Union Finance Minister Nirmala Sitharaman present the Budget on television on July 23. | Photo Credit: Nand Kumar/PTI
To cite three examples to further illustrate this point: in the 2017-18 Budget, the rate of income tax (up to Rs.5 lakh) was reduced from 10 per cent to 5 per cent, and the loss of revenue was sought to be compensated for by imposing a surcharge on taxes on incomes above Rs.50 lakh. Had this been done by raising the slab rates, the divisible pool would not have become smaller.
Similarly, in the 2018-19 Budget, the excise duty on petroleum products (which is shareable with the States) was reduced by Rs.9 per litre, but road cess, which is not shareable with the States, was increased by an equivalent amount.
In 2021-22, excise duty rather than road cess was reduced to give relief to consumers hit by the petroleum price hike. Consequently, between 2015-16 and 2018-19, the States lost, due to the shrinking of the divisible pool, a shocking Rs.5,26,747 crore. This translates to an average of about 3 per cent of the GDP at current prices.
Modi’s hostility to the Finance Commission recommendations
Modi’s hostility to the FC recommendations did not end with this manipulation. The terms of reference (ToR) of the Fifteenth Finance Commission explicitly mandated the commission to review the “substantial enhancement” of tax devolution recommended by the Fourteenth Finance Commission. However, the outbreak of the COVID-19 pandemic and the economic recession obviously did not make for an appropriate environment for fiscal conservatism, and the States were spared.
The deliberations of the Sixteenth Finance Commission have started. It is not going to be a tame affair. Against the background of huge discretionary funds in the hands of the Centre, there is going to be a clamour for enhancing the divisible pool to 50 per cent of the Central taxes. There will also be a demand for limiting cess and surcharge and deduction for collection expenses.
The present approach to inter se distribution will also be challenged. Any federal transfer scheme will have to consider equity and the resultant redistribution of resources to backward States, but redistribution cannot be raised to an unsustainable level where it begins to undermine the growth process of the advanced States.
Backwash market effects of backwardness
The fact remains that the present high redistribution of resources in favour of the backward States in the FC awards has not positively impacted their growth. If we compare the ratio of per capita income of different States between 1981 and 2021, a startling pattern emerges. The ratio of State per capita income to national average per capita income of almost all the backward States slips down. For example, Bihar slips from 56 to 29, Uttar Pradesh from 78 to 42, Madhya Pradesh from 83 to 71, and Odisha from 81 to 71. Rajasthan marginally improves from 75 to 79.
In contrast, the ratio of per capita income of almost all advanced States improves with respect to the national average per capita income. For example, Haryana rises from 145 to 157, Karnataka from 93 to 151, Tamil Nadu from 92 to 143, Gujarat from 119 to 142, and Kerala from 93 to 133. Andhra Pradesh and Maharashtra are currently above the national average but both have been slipping.
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The widening of inter-State inequality despite enhanced redistribution of resources to the backward regions raises serious questions regarding the growth strategy adopted in these States. The backwash market effects of backwardness are well known. The enhanced redistribution of resources flows back to the advanced regions through trade and financial mechanisms.
But what prevents the backward States from undertaking investment in education, health, and social sectors to initiate a spiral of virtuous growth, a lesson to be learnt from the Kerala and Tamil Nadu growth experience? The Budget of 2024-25 has further embittered many States, and the issues discussed above are going to be hotly debated in the coming days.
T.M. Thomas Isaac is a central committee member of the CPI(M) and former Finance Minister of Kerala.
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