India’s fiscal federalism crisis is not the pandemic’s creation


The Centre has refused to immediately compensate the states for an expected shortfall of Rs 2.35 lakh crore, which they are constitutionally entitled to, although it has committed to paying the money after the compensation cess is extended. The states have been asked to borrow (to make good either the shortfall in compensation arising from GST implementation or the overall shortfall ), but the controversy has given fiscal federalism a jolt. At the root of this crisis are three factors. The first is the structural deceleration in the Indian economy along with a fall in tax buoyancy. The pandemic’s economic shock has only made things worse. The second is a growing squeeze on states’ share in central taxes. These two factors have been compounded by an ongoing political struggle between the centralization which has been unleashed in India’s polity due to the continuously growing political capital of the Bharatiya Janata Party (BJP) and the insecurity it has generated among the non-BJP state governments.

Falling tax buoyancy has compounded the growth problem’s revenue impact

Data from Controller General of Accounts (CGA), which works under the ministry of finance, shows that tax buoyancy in India went into negative territory in 2019-20. This is a first since 1962-63. Tax buoyancy is the ratio of change in centre’s gross total revenue and change in GDP. So, a negative tax buoyancy in a period of positive GDP growth implies that taxes actually fell even though GDP was rising. Tax buoyancy has fallen sharply between 2017-18 and 2019-20. It was 0.16 in 2016-17, 0.12 in 2017-18, 0.09 in 2018-19 and -0.05 in 2019-20. The sharp fall in tax buoyancy, when read with the equally sharp fall in nominal growth — the last few budgets have been grossly overestimating this — has only compounded the slowdown’s revenue impact.


This matters because over-optimistic projections of tax buoyancy and nominal growth lead to higher revenue projections, and therefore a higher revenue share for state governments. When these projections do not materialise, states face a retrospective hit in their receivables.

The Centre has passed on a greater burden of the tax shortfall to states

India’s constitutional framework provides for a rules-based distribution of tax revenues between the centre and the states. The revenue sharing formula is updated every five years by the Finance Commission. The 14th Finance Commission set the share of states in central taxes at 42%. This promise has not been realised. States’ share reached a peak of 36.6% in 2018-19 and has fallen sharply since.


Why has this happened?

The centre does not share cess and surcharges with states. Over time, the share of these heads has been rising in central taxes. Research by ICICI Securities PD shows that it was less than 10% in 2014-15, but has gradually increased to 15% in 2019-20. A more granular analysis shows that the centre’s tax policy works with this objective in mind.

RBI’s report on state finances gives the share of states in different central taxes. In 2019-20 (Budget Estimates), states received the smallest sharer in union excise duties (14.5%) collected by the centre. Their receivable share was greater for other taxes. It was 34.5% for corporate tax, 40.3% for income tax and 34.7% for custom duties.

Corporate tax collections took the biggest hit in 2019-20, thanks to the sharp reduction in tax rates announced in September last year. The government slashed corporate tax rates for domestic manufacturers from 30% to 22%, while for new manufacturing companies, the rate was reduced from 25% to 15% provided they did not claim any exemptions. This was expected to lead to a revenue loss of Rs 1.45 lakh crore. The actual shortfall, according to Controller General of Accounts numbers, turned out to be Rs 2.09 lakh crore.

This decision is in sharp contrast to the present tax policy, where the centre has announced a large hike in excise duty on petrol and diesel. An HT analysis had found that between April 1 and July 1, the share of central and state taxes in petrol and diesel prices in Delhi increased from 45% to 63% for diesel and 54% to 64% for petrol. Central taxes per litre were almost twice state taxes. Because the additional duty is not meant to be shared with the states, the centre will keep all the windfall revenue gains from fall in international crude prices. Tax collection data from CGA shows that union excise duties are the only tax component which shows an increase in cumulative collections up to July in the current fiscal year compared to a year ago.


BJP’s politics has been provoking states rather than offering reconciliation

All along, one of the key constituents of the BJP’s political strategy has been to portray the Narendra Modi government as a sole harbinger of welfare benefits. This has helped the BJP in squeezing its opponents in national elections. The biggest proof of this success can be seen in the vote share premium the BJP enjoys in national elections in comparison to state elections. A recent paper by Yamini Aiyar and Neelanjan Sircar attributes this to three factors: the Modi government putting into place an administrative environment where state governments, and therefore regional parties, are not seen as critical for delivery of welfare benefits; a technology enabled welfare regime which claims to be more efficient and also leads to further centralization of welfare handouts; and the use of ground-level BJP cadre to popularize these schemes, and, by extension the Prime Minister’s popularity.

The BJP’s political offensive on state governments led by other parties, when read with stylised facts on the state of fiscal federalism – states’ share in central taxes never reached the promised 42%, it has fallen sharply in the recent past, and they are now staring at the centre delaying guaranteed GST compensation payments – is bound to vitiate political trust rather than create an amicable environment for solving what is now a deep rooted crisis. This will only render the challenge of preserving India’s fiscal federalism framework, both in letter and spirit, more difficult.

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