Navigating Centre-state fiscal ties
India is a “Union of states”. The Constitution, in its Seventh Schedule, lays down separate and concurrent responsibilities shared by the Union government and states. Politics, however, has blurred these boundaries. Successive central governments have unleashed their centralising impulse to gain political control by directing expenditures through central schemes on state subjects.
In 2015, three structural reforms fundamentally reset the terms of Centre-state fiscal relations. First, the 14th Finance Commission enhanced the share of states in the divisible pool, thereby reducing fiscal space for the Centre to direct expenditure through schemes. Second, the Planning Commission was dismantled and with it, the practice of plan funds transferred to states (perceived as a tool for centralisation) was discontinued. Third, with the roll-out of the Goods and Services Tax (GST), states traded fiscal autonomy for expected revenue enhancement and deeper cooperation with the Centre.
These structural changes created new sites of tension and, in the ensuing tug-of-war, the Centre secured the upper hand. It retained fiscal space through increased levies on cess and surcharges (not shareable with states), thus reducing the size of the divisible pool. In the revised estimates for FY 20, cess and surcharge (not counting GST cess) accounts for 21% of gross revenue receipts. The divisible pool accounts for merely two-thirds of the Centre’s gross revenues. The practice of central schemes continued, and indeed expanded, and simultaneously, state contribution to schemes also increased.
The final victory was in drafting the Terms of Reference (TOR) of the Fifteenth Finance Commission (FFC). The controversial TOR sought to bias FFC by nudging it to reduce the share of states in the divisible pool, explore separate mechanism for defence funding and direct State expenditure toward centrally determined goals for “New India 2022”. FFC has done a credible job of navigating this controversial TOR. However, in doing so, it has not only re-enacted the centralisation vs decentralisation tug-of-war, but opened newer sites of contestation at the local level.
Consider the two key recommendations. First, on vertical devolution. To its great credit, FFC has retained vertical devolution at 41% of the divisible pool of taxes. It has also navigated the controversy over using 2011 rather than the 1971 Census as the base for determining revenue share, which the southern states feared would result in reductions in their resource pool by incorporating the demographic performance criterion in its devolution formula. On defence, FFC has artfully avoided dipping into the divisible pool and recommended the creation of a non-lapsable defence fund.
But, in the fine print, the Centre has ample room to maintain, indeed deepen, the status quo. FFC has accommodated for the practice of using cess and surcharge to retain revenue. In fact, by its calculation, cess will increase during its award period. FFC is clear on the need to rationalise and reform central schemes. But it has recommended performance-based sectoral grants to states. The Centre on its part, is contemplating, in its Action Taken Report, to link these grants with existing schemes, thus reinforcing the status quo.
Second, on states vs local governments. FFC recommends generous grants to local governments, but the nature of these recommendations reflects the tensions inherent in the refusal of state governments to fulfill their constitutional obligation to local governments. As Raj Chelliah infamously said, everyone wants decentralisation, but only until his level. With rare exceptions, states have deprived local governments of funding, reducing them to mere implementing agents. In responding to this failure, FFC has imposed conditions on states. No local government grants will be released if states do not set up finance commissions and implement recommendations by March 2024. It is unclear what incentives states will have to comply with. Local governments will now be more dependent on the vagaries of states than they have in the past when FC grants were assured. Moreover, funds to local governments are carefully directed to achieve central priorities rather than allowing local governments to fulfill their role as elected governments responding to the needs of their electorate.
Finally, FFC’s observations on the federal structure raise important questions for the future of fiscal federalism. FFC rightly calls out the fundamental tension in India’s fiscal relations — the growing central intervention in state and concurrent subjects. In interviews, FFC chairman NK Singh has argued for re-visiting the Seventh Schedule.
What this debate misses, however, is the fundamental reality of a politics that incentivises centralisation. Addressing this requires an institutional site to negotiate Centre-state dynamics. Ironically, in dismantling the overly centralising Planning Commission, the only available institutional space for these negotiations has been lost.
More than revisiting the Seventh Schedule, India needs mechanisms for institutionalised deliberation with states. FFC has opened the debate. The real question is whether a government that actively seeks to centralise can credibly respond and navigate the growing tensions in Centre-state fiscal relations.
Yamini Aiyar is president and chief executive, Centre for Policy Research
The views expressed are personal