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Why states are demanding more from the 15th Finance Commission

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Five years ago, when the 14th finance commission recommended an increase in devolution of funds to state governments and a hike in the share of untied funds they received, it was heralded as a new era for fiscal federalism in the country, and one that would significantly empower state governments at a time when they were facing rising developmental demands.

Five years later, the reality is more sobering. The share of Union transfers to states (as a proportion of gross tax revenues) has actually declined over the past few years as compared to the earlier era (13th finance commission period). This holds true even if we exclude the budget estimates for fiscal 2020, which appears extraordinarily low because of the denominator effect (the unrealistic expansion in gross tax revenues baked into the budget estimates).

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It is not surprising therefore that states are demanding a higher share in revenues from the 15th Finance Commission, whose recommendations will determine revenue sharing for the next five years.

One big reason why states’ share in gross tax revenues has not risen (despite the increase in their share in the divisible pool recommended by the 14th finance commission) lies in the rise of cesses and surcharges. As these pages have pointed out earlier, cesses and surcharges have increased sharply in recent years. While they add to the Union government’s tax kitty, they are not part of the divisible pool that needs to be shared with states. As a result, while the share of states in the divisible pool grew, their share in overall tax revenues stagnated since the non-divisible pool of cesses and surcharges grew faster.

Reliance on cesses and surcharges have gone up under Modi govt

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This trick is not completely new: cesses and surcharges were used even by earlier governments to corner a larger share of funds for the centre. In fact, it was partly the growing use of these cesses and surcharges that prompted the 14th finance commission to recommend raising the share of states in the divisible pool (giving them a share in the non-divisible pool would have required a constitutional amendment). But the centre seems to have simply upped its game in raising revenues through cesses and surcharges once again, diluting the promise of the 14th finance commission formula.

The other reason why transfers to states have not moved up much lies in the launch of several central sector schemes such as the Pradhan Mantri Ujjwala Yojana, which are financed directly by the centre to claim political ownership, said Indira Rajaman, economist and a former finance commission member. Unlike centrally sponsored schemes, these schemes are not routed through state government treasuries, she pointed out.

To be sure, the year in which the 14th finance commission was implemented (2014-15) did see a rise in the share of transfers to states (it rose to 57% from 55% earlier). But aggregate transfers to states (including different kinds of grants) were much higher in earlier years, a 2016 research paper by Mita Choudhury, Ranjan Kumar Mohanty, and Jay Dev Dubey of the National Institute of Public Finance and Policy (NIPFP) showed.

Despite the lack of extra resources from cesses and surcharges, which are gobbled up by the centre, states have managed to be much more fiscally responsible compared to the centre. To be sure, aggregate fiscal deficit of state governments did spike in 2015-17 as several state governments took on the debt burden of distressed power firms under the Ujjwal Discom Assurance Yojana (UDAY) scheme, it has since then returned to normalcy. And excluding UDAY-related borrowings, state government borrowings have not risen much.

States remain more fiscally prudent compared to the central government

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Discounting UDAY liabilities, consolidated states debt has not seen any dramatic increase in recent years

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While the centre was riding on central public sector enterprises to lighten its debt and to make its fiscal deficit numbers appear respectable, the reverse process was underway in the case of state governments. State governments were taking on debt of distressed state enterprises under the UDAY scheme initiated by the centre even at the cost of inflating their fiscal deficit numbers. While the UDAY program earned them a temporary reprieve from the fiscal deficit targets, the burden of debt lay on the books of state governments. And yet despite this ownership of public sector liabilities, state governments have managed to maintain greater fiscal rectitude compared to the centre.

The quality of state government expenditure also appears to be superior to the centre, with significantly higher allocation for capex spending.

States’s allocation towards capital expenditure is higher than the centre’s

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All of this suggests that there is sufficient ground for the 15th finance commission to raise the share of funds state governments receive. However, what complicates matters for the commission is the onerous terms of reference that compel it to pay greater attention to the needs and demands of the centre. In its latest move to secure resources for the centre, the Union cabinet last week asked the commission to consider setting aside “adequate, secure and non-lapsable” funds for defence. Earlier, the commission’s terms of reference had attracted controversy as it listed achievements in implementation of central ‘flagship schemes’ as a possible criteria for devolution of funds.

With state governments losing autonomy over a large part of their revenues thanks to the goods and services tax (GST), the recommendations of the latest finance commission have acquired much greater importance than before. Unlike the centre which can raise cesses and surcharges at will, states lack an equivalent mechanism to raise resources. How far they are able to function with financial autonomy in the years ahead will depend to a great extent on the 15th finance commission recommendations due later this year.



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