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Modi changes the state of play for Indian federalism

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In Brief

India’s 14th Finance Commission has made some fairly revolutionary statutory recommendations.

The commission proposed increasing the share of the ‘divisible pool’ — the pot of tax revenue that is allocated between the federal and state governments — that goes to states without any strings attached from the 32 per cent recommended by the last commission to 42 per cent. This would represent a historic increase.


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Adding together both conditional and non-conditional transfers, states get around 60 per cent of the divisible pool, so 42 per cent of this sum would mean that about 70 per cent of the transfers to states came without strings attached, making this kind of transfer the primary method of resource transfers to states.

By doing that, the 14th commission has killed a few birds with one stone. Together with grants to local bodies, grants in aid for revenue deficits for 11 states and the states’ share in coal auctions means that there will be huge increases in fiscal transfers to states. This would reduce the fiscal capacity of the centre, discouraging it from getting involved in states’ affairs. The huge increase in untied resources would give states the fiscal space to design their own developmental schemes and programs according to their specific circumstances.

The recommendations of the commission have been accepted by the Modi government, which has expressed a commitment to cooperative and competitive federalism.

The commission took into account the views of both the union and state governments with respect to tax devolution and grants in aid. The general demands from states, as always, included an increase in the extent of tax devolution, an expansion of the divisible pool by including non-shareable cesses, surcharges and non-tax revenues (like telecom and coal auctions), and a reduced role of centrally sponsored schemes (CSS) — federally funded programs that are implemented by states.

The CSS, with their conditions and matching grants, impinge on the fiscal autonomy of states, which have very little say in designing and implementing the schemes devised by the federal government. The commission considered the fiscal position of the central government before finalising the extent of tax devolution to the states. The total expenditure of the union government in 2013–14 was 13.94 per cent of GDP whereas gross tax revenues amount to only 10.2 per cent of GDP, resulting in a sizeable deficit. More importantly, the federal government’s capital expenditure declined from 16.79 per cent of the budget in 2001–02 to 12 per cent of total expenditure in 2013–14.

But the commission recognised that, all in all, transfers to the states have made up more than 60 per cent of the total divisible pool in recent years, meaning that there is little room to increase the states’ share at the expense of the central government. Changing the composition of these transfers is therefore the primary aim. Unlike previous commissions, this time there was no distinction made between general and ‘special category’ states. Instead, the report focuses on the exact fiscal and cost disabilities of the states that make delivering equivalent services more or less difficult in different states, as well as the spending responsibilities of the special category states.

In its recommendations on how to distribute tax revenues across states, the commission mostly follows previous commissions. States are allocated money depending on a number of factors, including the extent to which their per capita income is below that of the state with the highest per capita income (although in practice the state with the third highest per capita income, Haryana was used as a benchmark, as Sikkim and Goa, which are richer, are very small). The actual and historical population of states is also considered, as is the proportion of forest cover in each state (not only because large forests make it hard to use land for other purposes, but also to encourage environmental protection).

The commission has recommended ‘revenue deficit grants’ in addition to the tax devolution. For fiscal decentralisation, the 14th Financial Committee recommended a grant of around 2.8 trillion rupees (about US$46 billion) to the 25,000 local governments in India: this compares to a figure of around US$14 billion recommended by the previous commission. This is a huge increase, which could assist local bodies to deliver the public services they are charged with providing. But the quality of governance and institutions at this layer of government varies widely, so there is a danger that much of this additional money could be wasted.

Some are wary of giving the states more money without any strings attached. The quality and capacity of state administration varies widely across the country, so increasing the amount of untied fiscal transfers and reducing the number of tied developmental schemes may lead to misuse of money. Already eight out of the 66 CSS schemes have been abolished completely in this year’s budget. Another 24 schemes will see reduced funding from the central government.

Of course, well-governed states with proper institutions and vision may prosper with more funds. Only time will tell whether the bold decentralisation proposed by the commission and endorsed by the Modi government bear fruit by encouraging states to take responsibility for their own growth and development agendas.

Pravakar Sahoo is Associate Professor at the Institute of Economic Growth, Delhi.

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