On fiscal federalism, all CMs sail in the same boat

Every state is under pressure to attract additional industrial investment in the state, competing with other states.

What makes the chief ministers of BJP-ruled Haryana, Gujarat and Odisha join hands with their counterparts from Opposition-run Tamil Nadu, Karnataka and Kerala, to make the self-same demand to the 16th Finance Commission, that the share of central taxes to be devolved to the states should be increased from 41 percent of the total to 50 percent?

The easy answer is populism. A new political economy is taking root in the country, in which state governments compete to announce liberal welfare payments to their citizens. States need more money at their disposal to pander to such voter expectations. But that is not the only reason.

Mismatch between locus of spending and revenue collection

The states together account for some 63-64 percent of general government expenditure, the combined total of the spending by the states and the Centre. The Constitution, and the compulsions of practicality, place the primary obligation for development spending on the states. But the most productive taxes are under the Centre’s control: taxes on income, including corporate profits, and import duties. Until GST subsumed excise duty on manufacturing and services, these too were the Centre’s to tax.

This is not because the Constitution makers wanted to the Centre to appropriate the proceeds of these taxes. Take corporate profits. They could be generated from sales across the country, but would cumulate wherever the company has its headquarters, would be reported there, and be taxed there. If location determined entitlement to tax on profits, states with the biggest cities would monopolise taxes on profits.

That would apply to taxes in imports, too; these would accrue to the coastal states with big ports, even if the imports have a landlocked state like Madhya Pradesh or Uttar Pradesh as their destination. It makes sense for the Centre to collect such taxes and share them with the states. It is for this purpose that the Constitution seeks the appointment of a Finance Commission every five years to recommend what proportion of the taxes collected by the Centre should be shared with the states (called vertical devolution, in the jargon of public finance) and how the states’ share should be allocated to different states (horizontal devolution or distribution inter se the states).

Divisible pool- Source of friction

It was the 10th Finance Commission that came up with the proposal to give states a share of the combined proceeds of all taxes collected by the Centre—it recommended a share of 29 percent. The share rose subsequently to 32 percent, and after the Planning Commission and Plan transfers were abandoned, to 42 percent as per the recommendation of the 14th Finance Commission. The 15th Finance Commission brought it down to 41 percent. The 16th Finance Commission is now on the job, and touring states to ascertain their views.

While the Finance Commission has recommended devolving 41 percent of the taxes collected by the Centre to the states, the Centre has managed to dress up assorted taxes or portions of taxes as cesses, to keep them outside the divisible pool of taxes. The effective devolution is only about 33 per cent. These contribute about a quarter of the revenues of the states, as the RBI’s survey of state finances makes clear.

Their own tax collections, including their share of GST, is about half the states’ revenues. A quarter comes from non-tax sources: interest earned on loans, dividends from state-owned enterprises, tolls, fines and penalties, user charges for water, electricity and the like.

Cost of attracting investments

It is not just the transfer payments that place a burden on the states. Every state is under pressure to attract additional industrial investment in the state, competing with other states. GST being decided at the GST Council, states cannot really compete by giving tax concessions, as they used to in the past. They now have to compete by offering larger and larger subsidies. These do not take the form of cash subsidies, but as plug-and-play facilities in an industrial park, readymade worker housing, and the like. These have the advantage of showing up on the state’s books as investment, rather than as subsidy. However, money needs to be found for such expenses.

Municipal finances depend on transfers from state governments, since making proper use of their potential tax base of property tax is politically challenging. Well-functioning municipalities call for additional transfers from the state governments.

Under the Constitution, a state cannot borrow even one rupee without the Centre’s permission, if it owes the Centre any money by way of an outstanding loan. So, the Centre controls the borrowings of states. The only way the states can spend more, therefore, is by increasing its revenues. The choices are: increase user charges, increase taxes that still remain under the state’s purview, increase devolutions from the Centre.

The political economy demands free power and water, not pricier power and water. Liquor is already taxed to the hilt. Taxing agricultural income, either via an agricultural income tax, which the Constitution authorizes states to levy, or as land revenue, which used to finance the British colonial enterprise at one point, calls for rare courage.

Federal fiscal structure dissolves political differences

It is far simpler to demand a larger share of the Centre’s taxes as devolutions. The compulsions of federal finance force chief ministers to come together, overcoming political differences.

And, after all, a much-praised chief minister of a state that got an entire development model named after it, chief minister Narendra Modi of Gujarat, had raised the demand for devolving 50 percent of central tax collections, before the 14th Finance Commission.