Date: 03/09/2022

Relevance: GS-2: Functions and responsibilities of the Union and the States, issues, and challenges pertaining to the federal structure, devolution of powers and finances up to local levels, and challenges therein.

Key Phrases: Fiscal Federalism, Goods And Services Tax Regime, Centrally Sponsored Schemes, Finance Commission, Shrinking The Divisible Pool Of Resources, Inequality, Politicized Institution, Political Centralization.

Context:

• Central bankers driving the current round of monetary tightening in the world are of the view that fiscal leniency can increase inflation even though the monetary policy is being followed.

How is India doing on the fiscal front?

• The Centre’s budgeted fiscal deficit for 2022-23 stands at 6.2 % of the likely GDP for 2022-23 of ₹269.5 trillion.
• Aggregate state borrowing was set at 3.5 % of GDP by the Fifteenth Finance Commission (FFC), with an extra 0.5 % for power-sector reforms.
• Even if only 60 % of the added target is reached, a state aggregate deficit of 3.8% added to 6.2 % at the Centre is a consolidated deficit of 10% (pre-Ukraine).
• This is manageable as long as no other borrowing outside the budget is financing the government expenditure.

What is the status of borrowings by the Centre and States?

• Off-budget borrowings of the Centre had indeed grown alarmingly since 2016-17 but were (largely) brought on the budget in 2020-21.
• The states have also indulged in off-budget borrowing much before 2016-17, but these have not been brought on budget so far.
• In March 2022, the Finance Ministry at the Centre notified states that their off-budget borrowing during 2022-21 and 2021-22 (the first two years of the FFC period) would have to be brought on budget during 2022-23 and deducted from their FFC entitlement for the year.
• These actions by the Centre are permissible under Article 293(3) of the Constitution.
• The state's new borrowing will therefore be lower than their total permissible limit of 3.5%.
• The excess of budgeted over actual revenue expenditure by states in the past two years stands at ₹6 trillion, which is 2.2% of GDP, which would leave states with new borrowing of just 1.3% of GDP out of their permissible total of 3.5%.

What are the reasons for the huge off-budget borrowings by states?

• The off-budget borrowings by states before 2020-21 outside the budget are because of the two severe fiscal threats at the state level, which are:
  1. Pensions:
     • The transition towards a defined contribution system has not gone well at the state level.
     • In a recent notification, the Finance Ministry has permitted additional borrowing for states to incentivize that transition.
     • Some re-structuring of the new system is needed, or else states will slide back to the earlier defined benefit system with wage indexation, a uniquely Indian and fiscally disastrous feature.
  2. Power sector:
     • The dire state of the power sector, which falls within the jurisdiction of states under the Constitution.
     • Power distribution companies (Discoms)are unable to pay off their suppliers (Gencos), because of unreformed tariffs.
     • States promise to compensate subsidies to Discoms, which are not paid most of the time.
     • Discoms cover their losses by borrowing from public sector banks, or, more recently, from non-bank financial intermediaries like the Power Finance Corporation (PFC) and these loans are either explicitly or implicitly underwritten.
     • Alternatively, Discoms are owing outstanding payment of an estimated ₹1 trillion to Gencos.

What are the reasons for the declining fiscal capacity of states?

1. Declining revenue and increasing expenditure: While the expenditure of the States has been shooting up, their revenues did not. They still spend 60% of the expenditure in the country — 85% on education and 82% on health.
2. GST implementation: Since States cannot raise tax revenue because of curtailed indirect tax rights which were subsumed in GST, except for petroleum products, electricity, and alcohol — the revenue has been stagnant at 6% of GDP in the past decade.
3. Shrinking divisible pool of resources: Even the increased share of devolution, mooted by the Fourteenth Finance Commission, from 32% to 42%, was subverted by raising non-divisive cess and surcharges that go directly into the Union government. This non-divisive pool in the Centre’s gross tax revenues shot up to 15.7% in 2020 from 9.43% in 2012, shrinking the divisible pool of resources for transfers to States.
4. Decrease in corporate tax rate: The drastic cut in corporate tax, with its adverse impact on the divisible pool, and ending GST compensation to States have had huge consequences.
5. Politicisation of Finance Commission: Finance Commission has become a politicised institution with arbitrariness and inherent bias toward the Union government.
6. Differential interest rates: States are forced to pay differential interest of about 10% against 7% by the Union for market borrowings.
7. Centrally sponsored schemes: States are turned into mere implementing agencies of the Union’s schemes, thus, curbing their autonomy. These schemes, driven by the one-size-fits-all approach, are given precedence over State schemes, undermining the electorally mandated democratic politics of States. In fact, the schemes conceived by States have proved to be beneficial to the people and have contributed to social development.

Conclusion:

• A contraction in such expenditure at the state level can have adverse distributional consequences, with a regression already being observed in state-level performance outcomes on access to education, healthcare, and social security, particularly for the vulnerable and marginalised sections.
• Welfare-driven expenditure needs are not part of ‘freebies’ politics but are about fulfilling a government’s basic responsibility to its people.
• Hence, state governments, irrespective of their party affiliation, need all the support they can get at this point to either borrow ‘more freely’, under a mutually agreed fiscal roadmap, for their developmental needs or be otherwise supported to manage their finances on their own, or through borrowing-financed support offered by the Union government.

Source: Indian Express

Mains Question:

Q. What are the reasons for the declining fiscal capacity of states? Analyze and suggest the way forward for the smooth functioning of Indian governance. (250 words).