Bihar, Andhra Pradesh special status demand throws up fiscal, political dilemmas

Narendra Modi, N Chandrababu Naidu and Nitish Kumar at and NDA meeting.

India’s return to the coalition system of government after a decade has seemingly seen old demands rise again and new ones emerge with the Bharatiya Janata Party (BJP) forced to rely on support from the Telugu Desam Party (TDP) and Janata Dal United JD(U) for a third term.

The TDP, which has been voted to power in Andhra Pradesh and the Janata Dal (United) who won majority of seats in Bihar together contribute 29 parliamentarians helping the National Democratic Alliance (NDA) cross the majority mark of 272, required to stake claim to form a government.

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Both Bihar and Andhra Pradesh want special category status. The category first came into being in 1969 under the 5th Finance Commission, which sought to provide central assistance and tax breaks to states that were disadvantaged on account of factors such as hilly and difficult terrain, low population density, a large tribal population, and economic/infrastructural backwardness

Bihar and Andhra Pradesh have been demanding special category status because of their bifurcation. Jharkhand was carved out of Bihar in 2000, leading to the state losing a resource-rich region. Telangana was carved out of Andhra Pradesh in 2014. The bifurcation triggered significant economic challenges for Andhra Pradesh, not the least of which was the loss of its administrative and financial capital, Hyderabad.

Former Prime Minister Manmohan Singh had assured special category status to Andhra Pradesh for five years. This would have meant additional central assistance, tax concessions, and other financial benefits to foster economic growth. But this never happened as the Congress-led government was voted out in 2014.

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In April 2015 the 14th Finance Commission chaired by former central bank governor YV Reddy had discontinued the distinction between special category and other states. This was done as the 14th FC increased the quantum of tax devolution by 10 percentage points to 42 percent. On account of the radical increase in the share of states in tax proceeds, it was felt that conferring special category status was no longer justified. The only exceptions currently are states in the North-East and hilly regions, getting a higher share of funds for certain parameters.

Most of these states have very small revenue bases, and high local government spending, mostly financed by transfers from the Centre.

Former finance secretary Subash Chandra Garg says funding for central schemes, and loans from multilateral and bilateral agencies, among others, are transferred under more liberal terms to such states.

"For example, multilateral loans are transferred as 90 percent grant and 10 percent loan to special category states whereas non-special category states receive them as 100 percent loans. Likewise, in most centrally sponsored schemes, the proportion of central grants is 70 percent to 90 percent for Special category states whereas it is 50-60 percent for other states," Garg explains.

Garg is referring to the practice for special category states, wherein around 90 percent of the allocated funds is given as grants that does not need to be repaid and only 10 percent is in the form of loans, which have to be returned.

It is interesting to note that former finance minister Arun Jaitley had pointed out back in 2018 that it would not be possible for the Centre to provide special status to Andhra Pradesh given that the 14th Finance Commission had discontinued the practice, barring a few exceptions.

What then are the options? Jaitley's comments from back in 2018 offer a clue. The former finance minister had then also said that the Centre is committed to giving 90 percent of the funds, equivalent to special category states, through other means, like transferring loans from external agencies on more liberal terms, to Andhra Pradesh.

The Centre's spending on certain transfers may go up if special status is given to AP and Bihar, which comes with fiscal implications as well.

Garg says the fiscal implications of potentially providing special category status to two more states depends on how the additional central funds are provided.

"These two states will roughly receive 30 percent more by way of central grants (in case they receive special category status). If the central government decides to increase the size of schemes by this amount of additional funds, only then will such a decision impact its fiscal deficit. If the government decides not to increase the size of central schemes, the other states will bear the brunt. If the central government extends the special category state formulation to external agency loans, there will be an impact on its fiscal deficit equal to loans transferred as grants," Garg explains.

Though the extent of the fiscal implications of such a move is not yet clear, there seems to be more clarity on the political consequences.

"When you provide a devolution formula for funds you are required to take into account the economic situation. If you are giving more than what is available, the funds to the rest of the states will have to be reduced," said a finance commission member, who spoke on condition of anonymity.

Garg agrees. "Special category status to any state other than the hill states of India will be highly contentious and inequitable. All other states will oppose this. It might boomerang politically as well," he said.

According to Lekha Chakraborty, professor at the National Institute of Public Finance and Policy (NIPFP), any demand from Bihar and Andhra Pradesh to be given special category status needs to be meticulously analysed by the 16th Finance Commission in terms of its impact on devolution of funds.

The 16th Finance Commission was constituted on December 31, 2023, with Arvind Panagariya, former Vice-Chairman, NITI Aayog, as its Chairman. The panel will recommend the formula for sharing of taxes as well as other funds between the Centre and states for a period of five years, from April 1, 2026.

“The special category status requires 90:10 devolution, which needs a relook from the ‘fiscal rules’ perspectives,” Chakraborty said, recalling a report by the Raghuram Rajan committee on a multidimensional index, which categorised Bihar as a least developed state.

Chakraborty is referring to a 2013 report by a high-level panel led by former central bank governor Rajan that recommended new criteria for measuring the backwardness of states. It identified Odisha and Bihar as the least developed states.

The Rajan panel also suggested doing away with the “special category” methodology used for allocating money to backward regions and instead recommended that each state get a fixed basic allocation of 0.3 percent of overall funds, which would be decided based on their need and performance.

The Rajan-led committee's methodology was never adopted.