BY Sumalatha BS, Aswathy Rachel Varughese & Anitha Kumary L
A pressing issue in India’s fiscal federal landscape that demands due attention is the declining share of Finance Commission (FC) grants to states. Its share in total central transfers to the states plummeted from 6 percent to a mere 3.6 percent over a decade as per the revenue receipts data 2023-24.
Total central transfers of the fiscal resources to states include tax devolution, FC and non-FC grants. FC grants, owing to their unconditional nature, provide states with the autonomy to allocate funds according to their specific requirements. The major fall in FC grant’s share and its small size in overall transfers have far-reaching implications for the state finances.
It also distorts the transfer dynamics, leading to fiscal contention between the Union and the state governments. Besides, the fiscal imbalance may escalate under the existing transfer mechanism as there is a stark mismatch between the expenditure responsibilities and resource generation capacity between the union and state governments. Therefore, in the wake of the 16th Finance Commission finalizing its report, the critical matter of the dwindling share of FC grants must be addressed to enhance states’ autonomy.
Changing patterns of fiscal federal resource allocation
Recent years have witnessed significant shifts in the pattern in which the union government disburses federal resources to the states. The central share of taxes, through tax devolution, commands the largest share in total transfers, followed by non- FC and FC grants.
Tax devolution to the states hovered around 21 percent to 28 percent of the total resource transfers while FC grants have considerably decreased from 6 percent to 3.6 percent during 2009-10 to 2022-23.
On the other hand, non-FC grants, particularly grants for Centrally Sponsored Schemes (CSS) have risen from 13.4 percent to 17.2 percent during the same period. Notably, the non-FC grants are conditional, discretionary, or tied in nature, giving nil autonomy to the states. The increasing share of conditional grants is clear evidence of an increasing tendency toward centralization rather than decentralization. It poses a significant threat to the fiscal federal landscapes of the country.
Dwindling share of FC grants
Out of the total grants-in-aid, FC grants now account for only 17.4 percent of total central grants to states while the non-FC grants which are often conditional, make up 82.6 percent.
Despite constitutional provisions stipulating that grants-in-aid should come from the Consolidated Fund of India (CFI), the Finance Commissions have been allocating these grants from the divisible pool. The divisible pool is the source from which the states receive their share of fiscal resources from the Union government. The 14th FC set aside only 5.72 percent of this pool for grants in aid to the states, while the 15th FC increased this allocation to 10.03 percent.
Under this allocation, the share of non-FC grants, which are conditional, has been rising. During the 14th FC tenure, conditional grants comprised 16 percent of the divisible pool. It increased to 19 percent under the 15th FC. These conditional grants pose a challenge for states, as they are earmarked for specific purposes, limiting states’ ability to allocate funds according to their unique development needs and priorities. This lack of flexibility can hinder states’ capacity to address their most pressing issues effectively.
A case for increasing the base of FC grants
The constitution of the 16th Finance Commission is in a period where the states grapple with mounting fiscal pressures, hence the call for enhanced FC grants grows louder. With the growing Vertical Fiscal Imbalance (VFI), shrinking divisible pool, contracting volume of FC grants, and increasing share of discretionary transfers, the woes of state finances have worsened in recent times. The loss of fiscal autonomy due to paradigm shifts in tax regimes like the Goods and Services Tax (GST) exacerbated the concerns.
After transfers through devolution and grants-in-aid, the revenue retained by the union government comes to around 50 percent while the state governments shoulder a whopping 62.4 percent of expenditure responsibilities. Their revenue-generating capacity stands at a mere 37.3 percent of the total capacity. In stark contrast, the Union government, with only 37.6 percent of expenditure duties, commands a formidable 62.7 percent of revenue capacity. With the declining share of unconditional FC grants, these imbalances further exacerbate.
There is an urgent need to argue for a recalibration of the FC grants system advocating for the increasing share of FC grants relative to conditional allocations. This will enhance the states’ autonomy and cater to the specific development needs of the state. Expanding the base for FC grants to include gross revenue or the Consolidated Fund of India is another recommendation that requires immediate attention. It is also justified by the growing revenue kitty of the union government. By increasing the share of FC grants, there will be greater alignment between state-specific needs and grant allocations.
Addressing these concerns, the 16th FC could play a pivotal role in bridging the widening resource gap between the Union and state governments, nurturing a more equitable and efficient federal financial structure.
(Sumalatha BS and Aswathy Rachel Varughese are Assistant Professors, Gulati Institute of Finance and Taxation, Thiruvananthapuram, and Anitha Kumary L is Visiting Faculty.)
Views are personal and do not represent the stand of this publication.
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