By Nageshwar Patnaik in Bhubaneswar, March 4, 2022: India is the largest democratic federal nation in the world. The federal system of India, however, has not been able to implement the principle—“finances follow functions” successfully and shows an inherent “centripetal” bias in the division of fiscal powers.

The latest example is the announcement of loans to the state governments by Finance Minister Nirmala Sitharaman in the Union Budget 2022-23 apparently to enable the states to increase their capital expenditure. Many states, however, are least enthused to buy the scheme as they apprehend that through such an arrangement, the Centre is virtually compelling the states to borrow which will ultimately lead to their debt intensity.

The budgetary provision also raises larger questions over the framework that governs Centre-state fiscal relations at a time when States’ liabilities towards the Centre have in fact been declining as per the 15th Finance Commission as the Union government has done away with the loan component in the central plan assistance in the last decade.

The budget has hiked provisioning for special assistance as 50-year interest free loans to states for capital expenditure under the ministry of finance to Rs.1 trillion in 2022-23 from Rs.150 billion in 2021-22.

The concerned states refer to Article 293(3) of the Constitution which says, without the consent of the union government; states may not raise any loan, as long as “there is still outstanding any part of a loan which has been made to the state by the Government of India.” Similarly, loans from multilateral agencies to states have to be routed through the Centre making it clear that state borrowings are constrained by the Centre’s approval.

Besides, a declining trend in devolution of states shares in taxes has been witnessed over the years. These budgetary trends conflict with fiscal federalism as enshrined in the Constitution through successive Finance Commissions. This will add to the existing fiscal stress of the state finance. The total devolution to the States as % of Gross Tax Revenue (GTR) has declined from 30.02% in 2021-22 (B.E.) to 29.61% in 2022-23 (B.E.).

CESS and surcharges have phenomenally increased to 16% of GTR. This reflects that states are denied of the shared tax to the extent of 16% of GTR. This is equivalent to Rs.439361 crore. In 2016-17, it was 1,26,664 crore. Instead it is totally diverted to Central government. This smacks of Modi’s hype on cooperative federalism as excess financial centralisation will severely weaken the financial position of the states.

The Constitution of India makes a clear demarcation between the functions and finances for each level of Government and assigns responsibilities and powers to each level of Government following the principle of comparative advantage.

Way back in 1990, the then Odisha chief minister Biju Patnaik virtually threw a gauntlet at the centre by demanding ‘fiscal autonomy’. Ever since many states have sought more fiscal freedom and later several chief ministers including even the present Odisha chief minister, Naveen Patnaik has raised his father’s demand saying that the centre is not discharging its constitutional responsibility of enshrining true federal spirit.

The assignment of functions and finances following the principle of comparative advantage has resulted in significant “vertical fiscal imbalances.” In terms of revenue authority, the Constitution vests important powers in fiscal matters with the Centre and also gives it an inherent advantage in raising revenues from the most buoyant, broad-based, mobile, and progressive tax sources (e.g., corporation tax, customs, personal income tax, service tax, excise duty), creating a relatively centralized nation.

The States, on the other hand, are assigned some relatively less buoyant and least elastic taxes like a tax on agricultural income and wealth, registration fees, excise duty on sale of alcoholic products, stamp duties, tax on purchase and sale of goods, motor vehicle tax, tax on passengers and goods transported through inland waterways and roads, general sales tax and so forth.

The Constitution of India, recognizing the mismatch between revenue capacity of the States and its expenditure needs, has mandated formation of a Finance Commission under Article 280 every 5 years to make recommendations on the assignment of revenues (includes those taxes which are levied by the Centre) to States, share the proceeds of certain centrally levied taxes with the States, and provide the States grants-in-aid (Article 275).

The 80th Amendment to the Constitution in 2000, made a provision to share all the Central taxes with the States, laying the foundation of fiscal decentralization in India’s federal system. These transfers constitute a significant portion of the total revenue receipts of the States and play a significant role in bridging the resource gap between their expenditure commitments and their resources.

Undoubtedly, greater leeway to states is necessary for more fiscal flexibility, especially during periods of crisis like the one now being faced by the states across the country with economic activities virtually coming to a halt with massive disruption in the wake of the COVID-induced lock down for more than two months.

In fact, many thought under Modi, relationship between Centre and states might break from the past tradition of keeping as much power in Delhi as possible. Modi was a three-time chief minister himself and had often spoken of the humiliation of having to go to the Planning Commission in Delhi to ask for funds.

The BJP made a commitment to “co-operative” federalism in its 2014 election manifesto. The manifesto contained a pledge to put “Centre-State relations on an even keel through the process of consultation” in which “national development” would be “driven by the states.” Incidentally, in 1983, the Sarkaria Commission emphasized co-operative federalism in India.

Given the ongoing distrust between the Centre and the States, the issue of fiscal autonomy versus greater centralization has once again emerged as a deeply contentious political issue.

It is also true, at the same time, that the Centre is responsible for the country’s overall macroeconomic stability.

Some have also voiced concerns over the possibility of conditions being attached to these loans — will the Centre’s expenditure priorities match those of states? Further, there has also been criticism of this amount not being transferred to the states in the form of a grant — a grant is shown as part of revenue expenditure, while loans have been shown as capital expenditure.