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Sunday, January 29, 2017

Are States Really at the Centre? Myth and Reality

By M. Govinda Rao.

Ever since the Fourteenth Finance Commission (FFC) recommended the tax devolution of 42% of the divisible pool to the States, many have held it responsible to the fiscal woes of the Union government. It is not surprising when the Finance Minister complains about it for all his fiscal difficulties, as he has to find a scapegoat. However, when a respectable senior editor such as Mr. Ninan, in his widely read editorial ruminates about "...the overly generous recommendations of the Finance Commission" resulting in the "... Central transfers to State governments ballooning by an astonishing 60 per cent in 2014-15" resulting in the total revenues in that year growing by 32%, we need to look at the matter more seriously.

Is the FFC really the demon responsible for the Centre's fiscal woes, or is it a fall guy? Incidentally, the FFC's recommendations came into effect in 2015-16 and not in 2014-15, and there must be something missing in Ninan's story of transfers to States ballooning by 60% in 2014-15 that needs unravelling. But, before that, it is important to understand how generous the FFC's "bonanza" really was. Indeed, 42% tax devolution, as compared to the 32% recommended by the previous Commission, looks a quantum jump. But, as the Terms of Reference of the FFC required it to consider total revenue expenditure requirements of the states without making a distinction between plan and non-plan, the Commission had to subsume the grants for State plan schemes (Gadgil formula grants) in its recommendations. This was equivalent to 5.5% of the divisible pool.

In addition, as the Commission included the area under forest cover as one of the factors to determine the share of individual States in tax devolution, and also decided that it will not give any grants other than those to achieve the States' budgetary balance, local governments and disaster relief. The amount saved on those discretionary grants was equivalent to 1.5% of the divisible pool. Thus, the increase actually is from 39% to 42%! How did it translate in terms of actual numbers? The accompanying table and the graph give the real picture of the volume of Union transfers to States.

Central Transfers to States
% of GDP % of Central Tax Revenues (Gross)
Years Tax Devolution Grants Total Transfers Tax Devolution Grants Total Transfers
2011-12 2.89 3.43 6.32 28.70 34.09 62.80
2012-13 2.91 2.99 5.90 28.10 28.90 57.00
2013-14 2.78 2.46 5.24 27.95 24.67 52.62
2014-15 2.71 2.74 5.45 27.13 27.40 54.53
2015-16 RE 3.73 2.31 6.04 34.68 21.51 56.19
2016-17 BE 3.79 2.32 6.11 35.00 21.46 56.46

In terms of % of GDP, tax devolution increased by one point in 2015-16 due to FFC's recommendation, but grants declined by 0.4 of a percentage point. Similarly, the share of tax devolution in Union taxes increased by 7.5 percentage points in 2015-16 over the previous year, but the increase in total transfers was just 2 percentage points! In fact, if one looks at a slightly longer time series, despite the Finance Commission's "bonanza", the total transfers relative to GDP actually declined from 6.3% in 2011-12 to 6% in 2015-16. The decline in the grants was due to the inclusion of plan grants in FFC's recommendations and partly due to the restructuring of the Centrally Sponsored Schemes.

Central Transfers to States (% of GDP)

As mentioned earlier, FFC's recommendations came to effect in 2015-16 and the sharp increase in the transfers noticed in 2014-15 was actually not an increase, but an accounting change. It may be recalled that until 2013-14, grants to various Central schemes were given directly to the implementing agencies, bypassing the States. This practice was reversed in 2014-15 and the increase was due to change in budgetary practice and nothing else. Why did FFC decide to give slightly higher tax devolution, albeit marginal of about 3% of the divisible pool? FFC's analysis showed that between 2002-05 and 2005-11, Union government's revenue expenditures on State subjects increased from 14% to 20%, and on Concurrent subjects the increase was from 13% to 17% (see para 6.17 of the report). Thus, the Union government never found the lack of fiscal space a constraint in foraying into spending on various activities in the State List, quite a few of them in the nature of transfer payments. The arguments by the States was that why should the Finance Commission leave so much fiscal space for the Union government to intrude into their area though various Centrally Sponsored Schemes? While some of the Central Schemes are meritorious and it is therefore important to ensure minimum standards of services in respect of them across the country, FFC decided to provide greater flexibility to the States to spend on the subjects under their jurisdiction. The fact of the matter is, in the prevailing situation, it is not the Finance Commission, but the Union government that determines the total volume of transfers to the States, and blaming it for Centre's fiscal woes is like looking for a fall guy. The Finance Commission can only determine the volume of untied transfers, and that is what FFC did. The Finance Commission cannot be held responsible if the Union government did not pass on the benefits of lower oil prices but decided to levy cesses and surcharges on petroleum products to use the funds to initiate more schemes and expand on the existing ones.

The author is an Emeritus Professor, NIPFP and Chief Economic Adviser, Brickwork Ratings. He was a Member of the Fourteenth Finance Commission. The views are personal.

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