If there is way to measure, today, the level of trust between the Centre and the States when it comes to fiscal federalism, the result will predictably be at an all-time low. Across the political spectrum, the feeling is that the Centre is not treating the States with due respect and are often forced to ‘beg’ for the funds that are rightfully theirs. The Centre, they add, considers States as subservient to it.

Ironically, this comes at a time when States are most empowered fiscally. They get as much as 42 per cent (14th Finance Commission) of the Centre’s gross tax revenues. Almost two-thirds of India’s public capital expenditure is done by the States. According to the Reserve Bank of India, this is the highest decentralisation in the world. Also, the States are compensated for Goods and Service Tax (GST) shortfall assuming a 14 per cent assured annual rate of growth. They have never had it so good.

So, what is causing the distrust? A combination of factors, some stemming from a strong Central government (first in many decades), is contributing to this.

Shift in balance : Between the 11th Finance Commission and the 14th, the quantum of devolution has risen sharply from 29.5 per cent to 42 per cent. The 15th Finance Commission has put it at more or less the same level (41 per cent). The sharp increase coincided with a weak Centre (era of coalition governments) and, consequently, strong regional parties. This level of devolution left the Centre short of funds, which it started to claw back through cess and surcharges.

Cess and surcharge : In 1980-81 the share of cess and surcharge, as a percentage of the gross tax revenue (GTR), was just 2.3 per cent. It rose to 7.53 per cent in 2000-01, 13.14 per cent in 2013-14 and in 2019-20, it stood at 15.3 per cent. It will go up rather sharply post the Agri Infrastructure Cess imposed in the latest Budget.

Cess and surcharge do not form part of the divisible pool of resources that are shared with the States and remains with the Centre. This, in effect, has meant that while States got 43.2 per cent of the divisible pool in 2019-20, their share as a proportion of the GTR was just 36.6 per cent due to cess and surcharges. The States see this as an illegitimate way of depriving resources that are rightfully due to them.

GST compensation : States agreed to give up the power to levy taxes and sign up for the GST on the basis of a guaranteed 14 per cent growth in GST revenues per annum. Any shortfall, per the Compensation Act, will be made good by the Centre in bi-monthly instalments for five years. As the economy slowed in FY20, the shortfall in GST collection ran up to ₹70,000 crore and compensation payments got delayed.

When Covid struck, the situation got exacerbated. The shortfall in FY21 was projected at ₹2.3-lakh crore. Even as the States were clamouring for the release of compensation dues, the Centre tried broaching the subject of revisiting the compensation package at the Goa GST Council meet. This caused a major lapse in trust. Fortunately, the Centre did not pursue that route and found a way to compensate the States through borrowings.

Conditional grants : The 14th Finance Commission not only increased the devolution share to 42 per cent but also recommended that the grants are free from various conditions. The untied funds, it argued, would give the States the flexibility to spend based on their priorities. Almost 80 per cent of the grants were basic grants with no conditions and 20 per cent were with minimal norms. Today, the States complain that share of conditional grants have substantially increased.

To make matters worse, some States say that no performance-based grants have been released since 2017-18. The Centre, it appears, has chosen to do so as many States do not act responsibly and waste precious resources on expenditure such as crop loan waiver or other freebies.

Welfare schemes : The Constitution gives the States the responsibility of executing welfare schemes. But over the years, Centrally-sponsored welfare schemes have increased exponentially forcing the States to claim that the Centre was intruding into their domain. Those in support of Centrally-sponsored welfare scheme have pointed out that this is nothing new and has been there from the beginning of the Plan era.

Also, in Lok Sabha elections, people do not evaluate the Centre’s performance based on just its foreign policy, defence or internal security success. More recently, the States are aghast at the way the Centre appropriates credit for various schemes by naming it a ‘PM Yojana’ even if it is eventually funded by the States predominantly.

Article 293 (3) : Frictions have also risen over the Centre’s attempt to perpetually control borrowings by the States. The recent 50-year loan announced by the Centre is a case in point. It has no pre-payment clause and any State tapping the scheme will need to take Centre’s permission for all future borrowing as per Article 293 (3) of the Constitution, at least for the next 50 years.

It is important that this trust deficit is eliminated. After all, reforms have to happen at the State level for rapid economic growth in the future. This is unlikely if the Centre and States are at loggerheads.

The Centre can take the first step by agreeing to cap the quantum of cess and surcharge. Also, any such levies should have a sunset clause. A cess or surcharge levied over a long time should be treated like another tax. The Centre should also trust the States to handle bulk of the welfare schemes. After all, many of the national schemes like Mid-Day meals, insurance for poor and affordable housing emanated from the States.

It should devolve more untied funds and allow States to spend based on their priorities. At the same time, it should find ways to penalise States that end up wasting resources on unproductive politically inspired populist schemes. States, on their part, should keep politics aside and approach fiscal federalism in a manner that boosts the country’s development and economic growth.

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