Amid India's Silent Fiscal Crisis and Fragile Federalism, 16th Finance Commission Has an Uphill Task

At a time when the federal faith in Centre-state relations is at its weakest link and remains deeply politicised, it would be interesting to see how Aravind Panagariya and his team go ahead with the difficult work cut out for them.

Arvind Panagariya has been recently appointed as the head of the 16th Finance Commission, a constitutional body appointed by the President of India, to give suggestions on Centre-state financial relations.

At a time when the federal faith in Centre-state relations is at its weakest link and remains deeply politicised, it would be interesting to see how Panagariya and his team at the Finance Commission go ahead with the difficult work cut out for them.

The 15th Finance Commission under chariman N.K. Singh was required to submit two reports at the time. The first report, consisting of recommendations for the financial year 2020-21, was tabled in parliament in February 2020. The final report with recommendations for the 2021-26 period was tabled in parliament on February 1, 2021.

Some key recommendations from these reports may be worth reiterating:

Devolution and share of states

The share of states in the central taxes for the 2021-26 period was recommended to be 41%, the same as that for 2020- 21. This is less than the 42% share recommended by the 14th Finance Commission for the 2015-20 period.

Table 1 below shows the criteria used by the Commission to determine each state’s share in central taxes, and the weight assigned to each criterion.

The criteria for the distribution of central taxes among states for the 2021-26  period is the same as that for 2020-21. However, the reference period for computing criteria like income distance and tax efforts are different (2015-18 for 2020-21 and 2016-19 for 2021-26), hence, the individual share of states may still change.

The use of ‘income distance’ reflects how a given state with a lower per capita income will have a larger share assigned in the devolution of funds to maintain equity with other states. On ‘demographic performance’, this criterion has been used to reward efforts made by states in controlling their population. States with a lower fertility ratio will be scored higher on this criterion.  On ‘Tax and fiscal efforts’, this criterion has been used to reward states with higher tax collection efficiency. It is measured as the ratio of the average per capita own tax revenue and the average per capita state GDP during the three years between 2016-17 and 2018-19.

In principle, these are all good incentive markers in assigning devolution of funds for states while promoting developmental possibilities for internal state action and collective measures and enable their performance on different social indicators.

For example, on health alone, the Finance Commission reports suggested states increase spending on health to more than 8% of their budget by 2022. Primary healthcare expenditure should be two-thirds of the total health expenditure by 2022. Centrally sponsored schemes (CSS) in health should be flexible enough to allow states to adapt and innovate. The focus of CSS in health should be shifted from inputs to outcome.

On creating a fiscal consolidation roadmap for states to follow

The earlier Finance Commissions had suggested that the Centre bring down the fiscal deficit to 4% of GDP by 2025-26. For states, it recommended the fiscal deficit limit (as % of GSDP) of: (i) 4% in 2021-22, (ii) 3.5% in 2022-23, and (iii) 3% during 2023-26.

“If a state is unable to fully utilise the sanctioned borrowing limit as specified above during the first four years (2021- 25), it can avail the unutilised borrowing amount (calculated in rupees) in subsequent years (within the 2021-26 period). Extra annual borrowing worth 0.5% of GSDP will be allowed to states during the first four years (2021-25) upon undertaking power sector reforms including: (i) reduction in operational losses, (ii) reduction in revenue gap, (iii) reduction in payment of cash subsidy by adopting direct benefit transfer, and (iv) reduction in tariff subsidy as a percentage of revenue.”

The Commission also observed that the recommended path for fiscal deficit for the Centre and states will result in a reduction of total liabilities of: (i) the Centre from 62.9% of GDP in 2020-21 to 56.6% in 2025-26, and (ii) the states on aggregate from 33.1% of GDP in 2020-21 to 32.5% by 2025-26. It recommended forming a high-powered inter-governmental group to: (i) review the Fiscal Responsibility and Budget Management Act (FRBM), (ii) recommend a new FRBM framework for centre as well as states, and oversee its implementation.

Also read: ‘Why the 16th Finance Commission’s Struggles Will Be Significant’

The ‘real’ context

But there are recommendations made by a constitutionally safeguarded Commission then there are realities that have a different social, political, and economic context layered to it.

The political economy of actual fiscal devolution observed over the last few years has been that of extensive ‘politicisation’ by the Modi Government. Economic or social criteria are hardly shaping the way the Union transfers funds to states.

As argued recently, this has been observed in the way the Modi government has squeezed some states’ fiscal freedom to borrow. In the backdrop of the grave financial crisis that state governments are facing currently, Kerala finance minister K.N. Balagopal said his state’s net borrowing limits have been reduced by Rs 4,000 crore.

The Union government’s coercive attitude remains consistent in its treatment – and interpretation of clauses – with most non-BJP ruled states too. Recently, the Telangana and Tamil Nadu governments too made similar observations about the need to preserve constitutionally safeguarded state autonomy in being able to manage its fiscal priorities (including for borrowings made).

This results in a trust deficit between the Centre and states and makes the task of any Finance Commission recommendations to be followed extremely difficult. Irrespective of what the FC says, the Union government can hardly be trusted at this point to see the recommendations being realised when it becomes to processing (and following) actual transfers.

The numbers below also reflect the contemporary realities of Centre-state finances.

On the actual devolution of funds in Centre-state financial relations

Our research team at InfoSphere, Centre for New Economics Studies (CNES), O.P. Jindal Global University, recently completed a study observing the Centre-state fiscal relationship more closely. A detailed version of our findings was earlier discussed here.

The factsheet shared by the ministry of finance triggered a further investigation by our team studying the available data (from 2019 onwards) on tax devolution – the share from Centre to state governments, drawn from government sources.

Some observations follow:

Source: Authors Calculations (InfoSphere, CNES)

The figure above presents the overall net tax devolution proceeds (in Rs. crores) from the year 2019 onwards transferred by the Union government to all state governments. These exclude Union territories (UTs) from our list.

The figure (above) gives a macro-trend of the tax devolution from the Centre on a year-to-year basis. This is a function of the accrued fiscal revenue capacity of the Central government over the last few years. The pandemic year (2020-21) was tough for the fiscal purse of the government as a whole and as a result, saw the lowest tax devolution level from the Centre to states.

This, in fact, made more states to borrow extensively to cover healthcare – and other pandemic-induced costs from these ‘borrowed resources’, thereby, as a result, seeing their fiscal deficit-debt levels rise. As argued earlier, there has been increasing evidence of the Union government arbitrarily squeezing the borrowing power of certain states, currently governed by opposition parties. Most state finance ministers have put this on the record.

The figures below provide a ‘select’ look at the Centre to state tax devolution levels for a few opposition-governed versus BJP-governed states (refer here for source on this).

States like Bihar and Uttar Pradesh get most of the tax-devolution share from the Centre- largely because of their spatial, demographic, and socio-economic needs. States like Haryana, Punjab, and Kerala haven’t seen any critical growth in their tax-devolution share over the last five years.

It is pertinent to note, how each of these states, has also seen its worst fiscal position scenario – accompanied by a decline in GSDP levels over these years too (worsening since the pandemic), which warranted a more interventionist, counter-cyclical fiscal support from the Centre.

Further, states like Tamil Nadu, Chhattisgarh, Himachal Pradesh, and Uttarakhand, haven’t seen any drastic shift in their net-devolution share too, even though states like Tamil Nadu- given their strong GSDP position contribute a lot more to Central Government’s tax-revenue share.

On the states’ fiscal position and debt landscape

One of the key areas for the 16th Finance Commission (headed by Panagriya) would be to also provide a suitable fiscal consolidation strategy for high-debt affected states to reduce their indebtedness while balancing their spending priorities and welfare needs.

A few debt numbers below provide an illustrative account of Indian states’ fiscal position. The debt-to-GDP ratio at the state level is crucial for assessing specific financial conditions and policies. This localised ratio significantly influences credit ratings, budget decisions, and fiscal strategies, allowing states to uphold long-term financial stability and responsible fiscal management. Calculated by dividing a state’s total outstanding debt by its GDP and multiplied by 100 to express it as a percentage, monitoring and managing this ratio empowers states to make informed economic policy choices.

Outstanding debt to GDP percentage for Indian states

Mizoram currently grapples with the highest debt-to-GDP ratio among Indian states, standing at 53%, according to recent budget estimates. Following closely are the states of Punjab and Nagaland with ratios of 44% and 47%, respectively. Several factors contribute to the escalation of the debt-to-GDP ratio in Indian states. Notably, investments in infrastructure development, social welfare programmes, and public services can strain state finances.

The state of Odisha maintains a low level of accrued debt by adhering to a stricter fiscal discipline. The state abides by annual budget deficit targets, averting elevated interest rates and decreasing borrowing expenses. Odisha’s performance is primarily ascribed to its savvy control of expenditures rather than its ability to generate money, considering the limited opportunities for the latter.

Although the state is a key producer of paddy, it manages to avoid incurring a substantial subsidy cost, unlike Punjab, which has unpredictable rainfall patterns while producing a substantial amount of India’s wheat. Odisha’s capacity to uphold budgeted spending without making compromises, especially in the face of economic constraints, enhances the maintenance of fiscal discipline. Conversely, Punjab is experiencing strain on various fiscal fronts, which underscores the contrasting financial approaches among different states in India.

As observed for Assam, increasing debt has been driven by loans for development projects, sourced from financial institutions and the Central government.

Critics from the opposition argue that chief minister Himanta Biswa Sarma’s populist measures are exacerbating the financial pressure. Concerns have arisen due to outstanding payments to contractors and a legislative decision to elevate the debt-to-GSDP ratio.

The Comptroller and Auditor General’s criticism emphasises the need for enhanced fiscal management, urging the state to address challenges in meeting repayment commitments and curbing the expansion of public debt.

State-market borrowings

As seen above there has been a 250% increase in market borrowings for the state of Himachal Pradesh – the surge in market borrowing in Himachal Pradesh is associated with fiscal mismanagement under the previous BJP administration, favouring extensive borrowings over resource mobilisation.

Deputy chief minister Mukesh Agnihotri ascribes the state’s precarious financial condition to the Union government’s lack of supportive measures, denying additional resources. The current government inherited significant direct liabilities, primarily debt, leading Himachal Pradesh to be ranked as the fifth highest debt-stressed state by the Reserve Bank of India. The White Paper underscores the difficulties posed by amassed liabilities, indicating a challenging fiscal landscape.

Madhya Pradesh and Punjab, as noted earlier, are also grappling with elevated market borrowing to address their respective state expenditures. In Madhya Pradesh, the financial scenario suggests challenges akin to Himachal Pradesh.

The state’s reliance on market borrowing may stem from a combination of factors, including fiscal policies, developmental initiatives, and economic considerations. Similarly, Punjab faces significant market borrowing, potentially influenced by factors such as infrastructure projects, social welfare programs, or economic exigencies. Both states need to carefully manage their borrowing strategies, considering long-term fiscal implications and economic

What do we learn?

A lack of vision in the medium to long-term fiscal policy approach, from the Union government’s tax-based disbursements has therefore inadequately addressed this challenge/question: What role has the Union government, which, by law and constitutional power, is assigned more fiscal capacity and discretion to raise and spend tax-based revenue resources, played in supporting states through spending?

What one broadly sees in these trends are three broader, consequential categorical imperatives:

1. The Union government has merely maintained the status quo when it comes to giving states ‘what they need’, they haven’t transferred more, or envisioned to transfer more tax revenue to enable a given state’s own welfare or growth needs/revenue requirements.

The available data on transfers for both BJP-governed and non-BJP-governed states tell a tragic tale of a lopsided growth pattern evident across states, which is more of a continuum from the past, than seeing/realising change. This raises a more troubling question (for point b)

2. What this says is the Union government under the Modi administration (since the last few years, read 2019 onwards from our data) has increasingly seen a gradual erosion in its fiscal capacity and will support states, which need more revenue for growth and welfare requirements.

This fact subsequently has little to do with the political parties governing the states, but over time, the larger issue has become more aligned with the Union government’s own poor revenue collection capacity (i.e. failing to collect the revenue what the Central Government projects in its own Union Budget estimate).

2. Poor quality government data makes it extremely difficult for anyone to effectively analyse the potential gains/losses being made from the allocated tax-devolution proceeds shared by the Central Government for States over the last few years.

See the RBI Handbook of Statistics here, for data on GSDP (2008-09 is the last year mentioned), or for Poverty (the last year mentioned because the last Census remains 2000-2002). The current administration, it seems, has done everything in its power to not even collect ‘good’ data which can help recognise fiscal challenges/potentials, to strengthen policy for a long term good.

This is a marked sign of a ‘fiscally weak’ and ‘insecure’ government, which is content to project empty riddles of economic ‘optimism’ built merely around rhetorical hope, pasting ‘India Shining data’ on relative comparisons of ‘good growth performance’ (made with countries industrially far more advanced and at a higher order of development), but underneath its own core, India suffers from a ‘silent fiscal crisis’ and under ‘poor macroeconomic fundamentals’.

These indicate an economy moving towards a state of permanent decline, sourced from structural weakness, in which any Union government will be able to do (fiscally) very little for states even if they want to do more (assuming there is a willingness to do so).

Deepanshu Mohan is a professor of economics and director, the Centre for New Economics Studies, Jindal School of Liberal Arts and Humanities, OP Jindal Global University.