States Mount United Front Against Centre's Fiscal Devolution Formula, Demand Greater Autonomy

New Delhi, 14 May 2024 – A political firestorm is brewing ahead of the critical GST Council meeting, as a growing chorus of non-Bharatiya Janata Party (BJP) ruled states, joined by some allies, prepares to launch a united front against the Union Government's latest fiscal devolution proposals and perceived inequities in resource allocation.

The discontent signals a deepening rift in Centre-state financial relations, threatening to stall key economic reforms and redefine the contours of India's cooperative federalism.

Several state finance ministers, speaking off the record during preparatory discussions, indicated that the upcoming Council meeting would not merely be about technical adjustments but a fundamental reassertion of states' financial autonomy.

Their grievances range from the alleged inadequacy of the 15th Finance Commission's recommendations for horizontal and vertical devolution to the contentious issue of extending GST compensation beyond its original five-year term and the increasing centralisation of revenues through cesses and surcharges that do not form part of the divisible pool.

Key points

* Non-BJP ruled states, supported by some allies, are forming a united front to challenge the Centre's fiscal policies and resource allocation.

* Primary grievances include the perceived inadequacy of the devolution formula, delays in GST compensation, and the increasing reliance on central cesses and surcharges.

* States are demanding greater financial autonomy, a more equitable share of central tax revenues, and a re-evaluation of centrally sponsored schemes (CSS).

* The impending GST Council meeting is expected to be highly contentious, potentially leading to an impasse that could affect national economic policy and investment climate.

* Economists and political analysts warn that the escalating dispute could severely test the spirit of cooperative federalism in India.

Reported Detail

The heart of the current dispute lies in the recommendations of the 15th Finance Commission, which suggested a vertical devolution of 41% of the divisible pool of central taxes to states for the 2021-26 period, a slight reduction from the 42% recommended by the 14th Finance Commission, after accounting for the newly formed Union Territories of Jammu & Kashmir and Ladakh.

While seemingly minor, states argue that this, coupled with specific horizontal devolution criteria that favour certain metrics (like demographic performance), has unfairly impacted their share, especially those with higher fiscal prudence and population control measures.

Further exacerbating the tension is the fate of the Goods and Services Tax (GST) compensation cess.

States were guaranteed compensation for any revenue shortfall arising from the GST implementation for five years, ending in June 2022.

While the Centre did borrow heavily to meet these shortfalls during the pandemic, the underlying structure of the compensation mechanism and its discontinuation has left several states scrambling to bridge significant revenue gaps.

Many states have repeatedly called for the extension of the compensation period, citing persistent economic challenges and unforeseen fiscal pressures.

“Our states are being increasingly straitjacketed by a rigid central funding model that fails to account for regional disparities and specific developmental needs,” stated Dr.

T.M.

Thomas Isaac, former Finance Minister of Kerala, who has been a vocal critic of the Centre's fiscal policies. “The spirit of cooperative federalism, once a cornerstone of our federal structure, is being eroded as states are left with limited fiscal space to innovate and deliver on their own development agendas.

We are reduced to mere implementers of centrally designed schemes.”

Palanivel Thiaga Rajan, Tamil Nadu's former Finance Minister, echoed similar sentiments, highlighting the growing proportion of central tax revenues collected through cesses and surcharges.

These levies are not part of the divisible pool and thus do not need to be shared with states, effectively reducing the overall share available for devolution. “The increasing reliance on non-shareable cesses by the Union Government is a deliberate strategy to centralise resources and undermine state autonomy,” he remarked in a recent policy brief. “It starves states of funds crucial for sectors like health, education, and local infrastructure, which are primarily state responsibilities.”

This concern is not limited to South Indian states.

Punjab, West Bengal, Rajasthan, and Telangana have also consistently raised alarms over their shrinking fiscal space and increasing dependence on central grants, which often come with stringent conditions attached to centrally sponsored schemes (CSS).

States argue that the design of many CSS does not always align with local priorities and often requires significant state matching funds, further straining their budgets.

Official Data and Numbers

The 15th Finance Commission recommended a vertical devolution of 41% of the divisible pool of central taxes to states.

However, the effective share of states in the total Gross Tax Revenue (GTR) of the Centre has often been lower due to the increasing share of cesses and surcharges, which grew from approximately 10.4% of GTR in FY12 to over 20% in FY21.

For instance, in FY21, cesses and surcharges constituted ₹3.7 lakh crore of the Centre's GTR, funds that were entirely retained by the Union Government.

Post-GST compensation, several states have reported significant revenue shortfalls.

For example, states like Punjab and Himachal Pradesh, heavily reliant on consumption taxes, faced steeper drops in revenue post-GST and continued fiscal pressures.

Data from the Reserve Bank of India (RBI) consistently points to increasing debt-to-GSDP ratios for many states, partly attributed to higher expenditure commitments and constrained revenue sources.

Dr.

Pronab Sen, former Chief Statistician of India, weighed in on the issue: “The current trajectory risks transforming states into mere implementation agencies for central programmes, undermining their democratic accountability to their own electorates.

A re-evaluation of the fiscal compact is imperative for India's long-term economic stability and democratic health.

The centralisation of resources, even with the best intentions, can lead to inefficiencies and a disconnect from ground realities.”

A senior official from the Union Ministry of Finance, speaking anonymously due to the sensitivity of the ongoing discussions, defended the Centre's position. “The Union Government remains committed to equitable distribution and strengthening state finances within the framework of national economic priorities.

The devolution formula is based on expert recommendations from the Finance Commission, an independent constitutional body, and aims for balanced regional development while ensuring fiscal prudence at the national level.

Discussions are ongoing within the GST Council and other forums to find common ground that benefits all stakeholders and upholds the federal spirit.”

Background

India's fiscal federalism is primarily governed by the recommendations of the Finance Commission, a constitutional body mandated to define the financial relations between the Union and state governments.

Over the decades, these recommendations have shaped the devolution of taxes and grants.

The introduction of GST in 2017 was a landmark reform, unifying multiple indirect taxes into a single national tax, promising economic efficiency but also raising concerns about states' fiscal autonomy, leading to the compensatory mechanism.

The COVID-19 pandemic severely strained state finances, compelling the Centre to borrow ₹1.1 lakh crore in FY21 and ₹1.59 lakh crore in FY22 to compensate states for GST revenue shortfalls, a move that temporarily assuaged some concerns.

However, the underlying structural issues – particularly the increasing centralisation of funds through cesses and surcharges – remained unaddressed.

The debate also touches upon the quantum and conditions of central grants for specific schemes, with states often arguing for greater untied funds to tailor development initiatives to local needs.

What it means

The escalating fiscal dispute has profound implications for India's cooperative federalism.

If states continue to feel financially constrained and unheard, it could lead to policy paralysis, delays in critical infrastructure projects, and a general weakening of the federal structure.

It directly impacts states' ability to fund crucial social welfare programmes, improve healthcare and education, and invest in local economic development – areas that directly affect citizens.

Furthermore, prolonged political confrontation over fiscal issues can deter both domestic and foreign investment, as businesses prefer a stable and predictable policy environment.

The Centre-state relationship is foundational to India's economic growth story, and a sustained period of friction could undermine the trust necessary for effective governance and collective national progress.

The outcome will set a precedent for future fiscal interactions and the balance of power within the Indian federal system.

Reactions

The primary opposition parties, notably the Indian National Congress and regional parties like the DMK, Trinamool Congress, AAP, and BRS, have been vociferous in their support for the states' demands.

They view the Centre's approach as an attempt to centralise power and undermine regional autonomy, accusing the BJP-led Union Government of chipping away at the federal structure.

BJP leaders, conversely, argue that the Centre is ensuring fiscal discipline and equitable development across the nation, maintaining that resources are allocated based on expert recommendations and national priorities.

Academics and policy think tanks have largely urged for a more collaborative approach.

Dr.

Arvind Subramanian, former Chief Economic Advisor to the Government of India, has often highlighted the need for a 'grand bargain' in fiscal federalism to ensure both stability and growth.

Industry bodies, such as the Confederation of Indian Industry (CII) and FICCI, have expressed concern over potential policy uncertainties. “Uncertainty in fiscal transfers can translate into delays in critical infrastructure projects and impact business sentiment,” stated a CII spokesperson. “A stable and predictable fiscal environment is crucial for private sector investment and job creation.”

Public sentiment, while not directly on the technicalities of fiscal devolution, is often shaped by the visible impact of state-funded services.

Any reduction in social welfare schemes or delays in local development projects due to financial constraints can generate public discontent, potentially influencing electoral outcomes at both state and national levels.

What happens next

The immediate focus is on the upcoming GST Council meeting, which is expected to be a test of political will and negotiation.

States will likely push for a resolution on the extension of GST compensation, a review of the Finance Commission's criteria, and greater transparency in the utilisation of cesses and surcharges.

The Centre, while acknowledging concerns, will aim to balance states' demands with its own fiscal prudence goals and national economic agenda.

Should an impasse occur, it could lead to further political escalation, potentially spilling over into other areas of Centre-state cooperation.

While legal challenges on broad fiscal devolution are rare, states might explore avenues to contest specific central mandates or the non-disbursement of promised funds.

The outcome will not only determine the financial health of states but also signal the future trajectory of cooperative federalism in India, profoundly impacting governance and economic strategy for years to come.

The dialogue is set to continue, but the urgency for a consensus is paramount for India's federal stability.