ARTICLE 1 of the Constitution stipulates that ‘India, i.e. Bharat, shall be a union of states.’¹ Hence, fiscal powers – to tax, charge for services, acquiring of assets, spending resources, acquiring and repayment of debt – have to be exercised at two levels of government. How these powers are exercised depends on the distribution of revenue assignments and expenditure responsibilities; the degree of political alignment on state objectives between the two levels; and the degree of variance in fiscal capabilities between different states.

The Indian Constitution provides a regulatory framework within which these ‘governments of India’ pursue their agendas. If it is accepted that India is a development state, then the intergovernmental fiscal framework (IFF) must address development objectives, functioning within the constitutionally defined regulatory framework.

Macroeconomic imperatives also superimpose a regulatory framework upon the IFF. When governments raise revenues, they have to be mobilized from economic actors who must consume and/or save correspondingly less. When governments borrow, then, apart from this consideration there is the question of solvency and sustainability of debt.

In the seventh schedule, the Constitution specifies separate and concurrent responsibilities of the two levels of government. It unambiguously places the responsibility of providing ‘regrettable necessities’ – defence, justice, foreign affairs etc. – on the Union government, which is also responsible for public debt. Economic and social functions that would be classified as developmental are either in the state list or the concurrent list. On the revenue side, taxes on incomes (except agricultural income) and on international trade are levied and collected by the Union government. These are then shared between the two levels, following the recommendations of a constitutionally mandated Finance Commission, which meets quinquennially. The commission also decides a formula by which taxes devolved are shared between the states and, more recently, makes recommendations regarding rules for limiting borrowing by both entities.

With the introduction of the Goods and Services Tax, there is a GST Council comprising both levels of government, which decides tax rates on items on which this tax is levied and their devolution, currently fifty per cent, to each level.

 

India’s IFF is almost seventy years old. It has operated in circumstances that have changed quite considerably, with important political economy implications. The most important, in my view, is that the uses to which borrowing is deployed have diverged considerably. Borrowing can be used to finance recurrent and capital expenditure. The first is, broadly, measured by the revenue deficit which is the excess of recurrent expenditure (called revenue expenditure in India), over revenue receipts.

As Figure 1 shows, from 1990-91 the ratio of the revenue deficit to overall borrowing (measured by the fiscal deficit) was rising for the Centre as well as the states, and by fiscal year 2001-02 the majority of borrowing by both levels of government was for recurrent expenditure. Since then there has been a dramatic fall in such borrowing in the case of the states, with states even accruing a surplus (revenue expenditure minus total revenues) until 2012-13. In the case of the Centre however, the bulk of borrowing continues to be for recurrent expenditure.

The relative size of the central government, measured as the ratio of its total expenditure to GDP, has shrunk from 17.21 per cent in 1990-91 to 12.83 per cent in 2016-17. In contrast, the size of the states (measured as total expenditure less grants as percentage of GSDP) has been rising steadily from 11.7 per cent in 1990-91 to 14.7 per cent in 2016-17. This has happened despite the fact that the states completed their fiscal consolidation faster than the Centre. Thus, this increase was driven by revenue, not borrowing. The Centre and the states had similar tax-GDP ratios in 1990-91 but in 2016-17 the states’ ratio has increased to 10.8 per cent, while the Centre’s ratio has stagnated (Figure 2).

There have been important structural changes in the relative fiscal position of the states, although their relative ranking in terms of per capita state domestic product has not changed much over the last thirty years. From 1993 to 2015-16 (Figure 3), higher and middle income states like Gujarat, Karnataka and Maharashtra have seen falls in state size while Bihar, Uttar Pradesh and Odisha have seen significant increases.

 

It is also interesting to note that the steep fall in the aggregate revenue deficit of the states has not been because rich states are more fiscally prudent than poor ones. In 1990-91, 20 states had revenue deficits, and in 2001-02, 22 states. In 2003-04, the number dropped to 14 and fell to 7 in 2016-17. In that year, Rajasthan was the only low income state to run a revenue deficit. The others – Kerala, Maharashtra, Punjab, Tamil Nadu, Uttarakhand and West Bengal – were all high or middle income states.

It is also not the case that changes in OTR (own tax revenue – taxes collected and retained by the states) show any correlation with state domestic product. This ratio has been static for all states since 1990. In both 1990-91 and 2016-17, Karnataka had the highest OTR-GSDP ratio and, Assam had the lowest. But across this period, the states that improved their OTR-GSDP ratio by at least 1 per cent were all poor states, and the states that saw a deterioration were all relatively rich states (Table 1).

Over time (Table 2) successive Finance Commissions have steadily increased the share of the divisible pool of taxes accruing to the states (vertical devolution). This recognized that the mandate of the IFF increasingly focused on development transformation through the delivery of public goods and services, and therefore, expenditures on items in the state and concurrent lists were likely to increase. Thus, the 13th Finance Commission recognized that the introduction of rights based approaches meant an increase in the expenditure responsibilities of the states and accordingly increased their share to 32 per cent – up from 30.5 per cent recommended by the previous commission. The 14th Commission raised the share significantly to 42 per cent, but argued that the ending of a number of grants would make this, in effect, a substitution for transfers.

On the formulas determining the shares of individual states (horizontal devolution), it is interesting that despite controversies regarding the population parameter, the majority of transfers have been explicitly redistributional (income distance parameter²). The poorer a state, the greater its relative share in the horizontal devolution. Fashions of the day, like fiscal incentives, environment and infrastructure provisions came and went, but the distributional component has remained the most important parameter.

 

The decreasing size of the central government has two important political economy implications. First, the central government has, for some time now, not been the locus of public investment. Less than a third of the Centre’s borrowing is deployed for investment. In the case of the states, over the past fifteen years, 80-90 per cent of borrowing is for public investment, and in years when there was a revenue surplus, even more. The common notion that the prime mover of public investment is the central government has not been true for some time. The action has shifted to the states. Yet, when it comes to counter cyclical policy, or initiatives to secure public private partnerships, the gaze continues to be on the Centre and not the states.

The imperatives of fiscal consolidation have also constrained the central government. This is because the states completed fiscal consolidation over ten years ago with their average fiscal deficit falling from 4.8 per cent of GSDP in 2000-01 to 2.1 per cent in 2012-13. While this has increased in recent times, it is still well below that of the Centre. This, in part, is due to incentives provided by successive Finance Commissions to the states. However, central fiscal deficits only began to reduce appreciably since 2013-14 (Table 3) and this reduction happened principally through expenditure control as revenue receipts remained sluggish and volatile. This was compounded by the fact that over two-thirds of central expenditures are committed, in the sense that these cannot be significantly reduced to make room for other expenditures.

 

Inevitably, such serious structural pressure on central government fiscal space causes actions by the Centre to reduce the fiscal space of states. The 14th Finance Commission mandated that the state’s share in the divisible pool of taxes (GTR) should be 42 per cent of gross tax revenue. This has never been achieved (Table 3), and the share has hovered around a third of GTR since 2015-16. This is because the Centre has misused a constitutional provision intended for times of financial contingency.

The Constitution provides for cesses to be levied by the Centre for specific expenditures such as war, natural calamities etc. The Centre has for some time now been levying such cesses on a permanent basis, formally earmarking them for specific expenditures, but using the revenues as part of the general pool. These cesses are not shareable with the states. For this reason, the state share of gross tax revenue is now well below that recommended by the 14th Finance Commission.

 

In the face of a decrease in its size, one would expect the Centre to confine itself fiscally to providing for ‘regrettable necessities’, and to focus more on important activities that do not involve public spending such as better regulation, institutional reform, and improved macroeconomic policy frameworks. However, the rhetoric of electoral democracy does not immediately reward such a shift, with the fulfilment of expectations being measured in terms of how much is spent on things that directly improve people’s lives.

Responding to this, successive central governments have increasingly begun to finance expenditure on items in the state and concurrent lists. Despite a shrinking fiscal space these are either directly undertaken by the Centre (central sector schemes – CS) or cost shared with the states (centrally sponsored schemes – CSS). They have grown from 3.3 per cent of total expenditure in 2000-01 to 6.2 per cent in 2016-17. This mission creep reflects an important contestation being played out in the fiscal sphere. Recently, this contestation has exacerbated. In 2016-17, central sector schemes and centrally sponsored schemes both accounted for 9 per cent of total central expenditure. In the 2019-20 budget estimates, the share of central sector schemes had risen to 12 per cent, while the share of centrally sponsored schemes remained at 9 per cent.³

 

Thus, the federal compact is being broken on two fronts. States are getting less as their share of tax revenue, and less in terms of their share of centrally sponsored schemes. Indian politics exacerbates this tendency to squeeze the states. National parties can aspire to control central, but not state, finances due to the robust presence of regional parties in a majority of states. But the central government is fiscally weak: unless structural constraints are addressed, the Centre can, at best, make infra-marginal changes to its fiscal policy. But national parties make grand promises and then, when in power, scramble to find even meagre additional resources. This causes both volatility in spending and fiscal competition with the states.

The political economy between states has also changed considerably. Lower income states have increased fiscal space, improving OTR in parallel with receiving more of the divisible pool from Finance Commissions. Higher income states have ceded fiscal space both on OTR and on expenditure; they have also tended to run revenue deficits. As a consequence, being a rich state does not mean more financing for public services.

It is well known that there is a large gap between promises and performance in spending in areas like health and education in every state. One would expect this gap to be lower in rich states if inadequate finance is the reason for such a gap. However, this is not the case for, if it was, rich states would be spending more than poor states as a proportion of their GSDP. But the rank correlation coefficient between total expenditure and per capita GSDP was almost zero in 1993-94. In 2000-01, it was -0.3 rising to -0.71 in 2015-16. Thus, richer states incur less, not more, public expenditure as their GSDP increases. This trend has exacerbated over time, which is why the rank correlation coefficient has turned negative and is increasing.⁴

 

There have also been important changes in states’ spending on CSS and CS. In 1990-91, CSS and CS spending accounted for 1.22 per cent of total expenditure in Gujarat and 13.9 per cent in Rajasthan. In 2013-14, it accounted for 13.12 per cent in Gujarat and 3.2 per cent in Rajasthan. In general, there was an upward drift in the share of such spending in many rich states and a downward drift in poor states.⁵ In part, this was a vicious circle, where richer states were better able to cope with Centre imposed conditionalities on such spending compared to the poor states. Whatever the reason, it appears that rich states have done rather better in the contestation for fiscal space in shared centre-state spending. This in some measure, countervails the redistributive thrust of successive Finance Commission horizontal devolutions. A deeper investigation of the political logic would yield valuable insights into what this means for inter-state fiscal dynamics.

 

The theoretical literature on inter-governmental fiscal relationships begins with an inquiry into their political foundations. However, this is not normally done in India, which is puzzling, given that the IFF is as much an arena for political contestation as it is an organizing framework for intergovernmental relationships. The analytical points in this essay have received little attention and therefore have not been the topic of much discussion despite their obvious political relevance.

This essay has focused on variance in fiscal capabilities of different government actors. These include: a shrinking central government in contestation with states that, taken collectively, are increasingly fiscally bigger actors; the imperatives of electoral politics then causing contestation for fiscal space; the differential impacts of the imperatives of fiscal consolidation on the two levels of government; the change in size of government with poorer states tending to run larger budgets than richer ones; the increased share of richer states in shared spending involving central transfers despite the high element of redistribution in the horizontal devolution formulas of successive Finance Commissions. Many of these are counter-intuitive and therefore should excite research curiosity. More generally, these important fiscal features of the IFF should propel political economy research to develop a better granular understanding of the evolving federal structure.

 

Footnotes:

1. The so-called third tier of government is in my view not a serious fiscal player. Their share in the tax base is derisory, state finance commissions are largely dysfunctional, and there has been minimal transfer of functions and functionaries to this level.

2. This parameter is based on a measure of the inverse of the per capita GSDP in some form.

3. Rathin Roy, ‘Govt’s Shrinking Fiscal Space’, Business Standard, 5 February 2019.

4. Finance Accounts, respective states; courtesy: NIPFP data bank. The rank correlation coefficient measures the correlation between states ranked in order of GSDP and in order of the ratio of total expenditure of GSDP per capita. A zero value implies no correlation. A high negative value implies a strong inverse correlation.

5. Ibid.