The financial capacity of States is being weakened

ECONOMY/ GOVERNANCE

Topic: General Studies 2,3:

• Fiscal Policy and Government Budgeting
• Functions and responsibilities of the Union and the States, issues and challenges pertaining to the federal structure 

The financial capacity of States is being weakened

Context: Through various means the Union government has substantially reduced the fiscal resource capacity of the States.

States need resources to deliver the developmental aspirations of its citizens but unfortunately, the financial capacity of the States is structurally being weakened. Some of the factors that has caused this weakness are:

1. Declining Actual devolution

• Finance Commissions recommend the share of States in the taxes raised by the Union government. Their recommendations are normally adhered to. 
• The year 2014-15 commenced with a shock: actual devolution was 14% less than the Finance Commission’s projection. Subsequent devolutions have been consistently less every year, ending the period 2019-20 with a whopping -37%
• Between 2014-15 and 2019-20, the States got ₹7,97,549 crore less than what was projected by the Finance Commission. 
• This is an undeniable and substantial reduction of the fiscal resource capacity of the States.

2. Shrinking the divisible pool

• Various cesses and surcharges levied by the Union government are retained fully by it. They do not go into the divisible pool. This allows the Centre to raise revenues, yet not share them with the States. 
• CAG has also recently highlighted the misuse of Cess pool by Union Government. For details click here
• When taxes are replaced with cesses and surcharges, as has been done repeatedly by the government in the case of petrol and diesel, the consumer pays the same price. But the Union government keeps more of that revenue and reduces the size of the divisible pool. As a result, the States lose out on their share. 
• Between 2014-15 and 2019-20, cesses and surcharges has increased from 9.3% to 15% of the gross tax revenue of the Union government
• In 2019-20 alone, the Union government expected ₹3,69,111 crores from cesses and surcharges. This will not be shared with the States. 
• This government has exploited this route to reduce the size of the divisible pool.

3. GST Shortfall

• The ability of the States to expand revenue has been constrained since the Goods and Services Tax (GST) regime was adopted.
• Under the GST (Compensation to States) Act, states are assured compensation for the gap between revenues at a compounded growth rate of 14 per cent over the base year revenue of 2015-16 and the actual revenues from GST for five years ending June 2022 through levy of cess on demerit and sin goods
• GST compensation to States will end with 2021-22. But cesses will continue.
• During 2019-20, the cess collected was ₹95,444 crore. With the abnormal exception of this year, the years ahead will generate similar or more cess revenue.
• Due to COVID-19 induced lockdown, it is expected that there will be nearly ₹3 lakh crore GST shortfall to the States and the Centre is saying that it will to only compensate ₹1.8 lakh crores.
• On the other hand, states have been arguing that the Union government should borrow this year’s GST shortfall in full and release it to the States. The entire loan borrowed can be repaid out of the assured cess revenue that will continue to accrue beyond 2022.

Consequences

• Reduced Grants: Apart from the streams discussed above, Central grants are also likely to drop significantly this year. For instance,₹31,570 crore was allocated as annual grants to Karnataka. Actual grants may be down to ₹17,372 crore.
• Revenue Shortfall: Due to all these reasons, the States may experience a fall of 20%-25% in their revenues this year.
• Increased borrowings by States: To overcome such extreme blows to their finances and discharge their welfare and development responsibilities, the States are now forced to resort to colossal borrowings. Repayment burden will overwhelm State budgets for several years. 
• Social Impact: After paying loans and interest, salaries and pensions, and establishment expenses, there will be little available for development and welfare. As a result, adverse consequences will be felt in per capita income, human resource development and poverty

Conclusion

States are at the forefront of development and generation of opportunities and growth. Strong States lead to a stronger India. The systematic weakening of States serves neither federalism nor national interest.