States are losing India's federal war

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States are losing India's federal war

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• Few funds for many mouths: Since 2018, as the economic momentum of India has slowed down, the Centre and States are up against each other for sharing the public resources (tax revenues). The bitter issues are - (i) use of cess by the Centre, (ii) compensation for GST shortfall, (iii) the 15th FC's extraordinary demand for extra funds for defence and internal security. [FC - Finance Commission]
• The scheme: Since 1950s, the Centre has always had a greater share in use of public funds, but States have the bigger share in welfare spending. This imbalance was corrected gradually by successive Finance Commissions (every 5 yrs). 
• Net proceeds: Article 279 of the Constitution defines "Net proceeds" as GTR of Centre less surcharges and cesses, and cost of collection. From the 11th FC to the 14th, share of net proceeds devolved to States went from 29.5% to 30.5% to 32% to 42%. The coalition era politics (1991 to 2014) ensured that everyone agreed for such a shift. Hence, States started taking a lead in public capital expenditure (more than Centre). Worldwide, India's states do the most capex at 66% of total - highest decentralisation anywhere! [RBI Report]
• Modi era: The era of centralisation of power commenced 2014, and Centre fought back against its shrinking revenues. It simply brought newer and higher cesses and surcharges, which are not shared with states at all. The FC cannot tackle these in the devolution formula. So the non-divisible pool of cesses and surcharges grew faster than the divisible pool, leading to stagnation in states' tax revenues. From 2018, it's nothing short of a disaster for states.
• 15th FC report submitted: The 5 year report for 2021-26 has been submitted to the President but not made public. It's reported that the 42% share may have been slightly reduced, but not by much. 

1. From the 14th FC, the nature of transfers also changed.
2. Larger share was in the form of unconditional devolution to states, and statutory grants paid went down.
3. It was good for states (more discretion) but also bad as it became dependent on Centre's tax revenue.
4. Since tax shares enjoy both upside buoyancy as well as downside risks, 2018 onwards the states are hit hard.
5. 2020's lockdowns have crushed the State finances, and the Centre simply made it worse by not paying the due share of GST.
6. Overall divisible pool is already down due to cesses and surcharges.

• States not blameless: Some states launched the farm loan waiver schemes, thereby taking on more fiscal stress. The UDAY scheme also didn't do well in states, which tried restructuring power sector. Covid-19 was the final blow! [UDAY - Ujjwal Discom Assurance Yojana]
• State revenues: Lockdowns meant that states lost revenues from liquor, fuel, and slump in real estate market. Year 2020 is seeing a historic contraction across Indian states, which are now forced to pursue austerity. State-funded capex will suffer the most.
• States' fiscal reaction: So states are forced to borrow more from the markets, and yield gaps between the SDLs and benchmark GoI rate has widened. So states are getting loans at costlier rates. The RBI tried to help by its OMOs in SDLs. The ratio of state-level debt to GSDP has gone from 22.6% (2013) to 26.3% (2020). Some states are doing very badly viz. Punjab, West Bengal and NE. [SDL - State Development Loans; OMO - Open Market Operations] 
• Summary: The political fallout will be bitter, with a lot of blame-game. The FC won't be able to resolve any of it, and the Centre needs to step in with solutions. 

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