April 05, 2015

The Devolution of Resources From the Centre to the States

Prabhat Patnaik

THERE is a common perception that with the government accepting the recommendation of the Fourteenth Finance Commission to raise the share of the states in the divisible pool to 42 per cent, there has been a substantial increase in the resources available to the states; and that a new “progressive” era has dawned in the Indian economy, since the states, which are the main spenders on welfare and social sector activities, will now have more resources at their command.

                This perception is the very opposite of the truth. The Finance Commission’s raising the share of the states is of course commendable, and is in line with the long-articulated demand of Left-led state governments which have wanted the share to be raised to at least 50 per cent. What has happened at the same time however is that the centre has reduced the transfers to the states through other channels, so that the total transfers to the states, as a percentage of the GDP, which have been on a downward trend of late will continue to persist on this downward trend.




Transfers to the states from the centre occur through three channels: through the transfers recommended by the Finance Commission which is a constitutional body; through Plan assistance that is decided by the Planning Commission which essentially is no more than a departmental body of the central government; and through discretionary transfers, such as for calamity relief, whose magnitude is entirely at the mercy of the central government. While the states’ demand has always been for an increase in the transfers through the first of these channels, so that the centre cannot play “favourites” among states, it has also been for an increase in the total magnitude of transfers. And not surprisingly, the Modi government which has claimed  much virtue on account of its acceptance of the Finance Commission recommendations, has so drastically cut down transfers through other channels that the states will actually be financially squeezed, rather than enriched.

                Table 1 gives the share of total transfers to the states from the centre as a percentage of the GDP.

Table 1: Total transfers from centre to states as percentage of GDP

2010-11 (Actuals)                 6.4

2011-12 (Actuals)                 6.1

2012-13 (Actuals)                 5.8

2013-14 (Actuals)                 5.6

2014-15 (BE)                          6.1

2014-15 (RE)                          5.4

2015-16 (BE)                          5.8

Source: Sona Mitra “The Myth of Increased Resources for the States”, www.macroscan.com

                The steady decline in the share of total transfers from the centre to the states as percentage of GDP is clear from the table: from 6.4 per cent to 6.1, to 5.8, to 5.6, to 5.4 according to revised estimates for the last year (the actual for the last year may turn out to be even lower). And it is also clear that notwithstanding the FC recommendations, this share is even lower in the budget estimates for 2015-16 than it was in the budget estimates for 2014-15. It is a well-known fact, attested to by many, that the revenue estimates in the current budget are highly exaggerated, as indeed they had been in the 2014-15 budget. When the actual revenues for the current year fall short of the estimated amounts in the budget, as they inevitably will, the states are going to face cuts in transfers relative to the budget estimates in the current year, exactly as they had faced in the previous year. In such a case, assuming a similar order of cuts as last year, the actual for the current year will be even lower than for last year, which will only perpetuate the downward trend observed in recent years. It follows that the claim of increased resources for states is a total myth.

                But this relative decline in central transfers to the states has to be located within a larger context, which has received little public attention so far. And this relates to the growing wealth and income inequalities in the country. The Credit Suisse report for the current year has shown the sharp increase in wealth inequality between the beginning of the present century and now. And accompanying this increase in wealth inequality there has also been an increase in income inequality. Now, in any democratic society where keeping income and wealth inequalities in check must be an objective of State policy, the fiscal instrument is the obvious one through which this can be achieved. What would the use of the fiscal instrument in such a context entail?

If an increase in pre-tax income inequality is to be rectified through fiscal policy, then the share of tax revenue in GDP must increase, especially of central tax revenue, since it is the central government which has the major tax instruments at its command in India; and this increasing share of tax revenue should in turn be used for redistribution. A simple example will make the point clear.

Suppose the pre-tax shares of work income and surplus income move over three successive years as follows: 50:50, 40:60, and 30:70. If fiscal policy is to rectify this and keep the post-tax shares at 50:50, then the additional tax required is 10 per cent of GDP in year 2 (to be levied upon surplus incomes for distribution to the working population), and 20 per cent of GDP in year 3. In other words, as inequality increases, an increase in the share of tax revenue in GDP must occur, as a necessary condition for countering this increase.

But that is not all. This increased tax revenue must be redistributed in favour of the working population. If it is handed back to the surplus earners themselves, then there is no reduction in income inequalities through fiscal policy; hence it must be handed over to the working population. This handing over can take any number of different forms, but the most obvious one is through increased social sector and welfare expenditures for the benefit of the working population. In India where the state governments are the main spenders on such items, a second necessary condition for countering increasing inequality therefore is a rise in the share of transfers from the centre to the states for effecting increased expenditures under these heads.

These conditions, to be sure, are necessary, and not sufficient, conditions. Even when transfers are made to the state governments for effecting larger welfare expenditures, there is no guarantee that they would actually spend these resources on welfare programmes for the working population. But in the absence of such transfers we can be sure that expenditure on such programmes will not pick up at all in which case nothing would have been done to counter growing inequality.

It follows therefore that the two necessary conditions for countering growing inequality in India, given the nature of our economic arrangements, are: first, a growing ratio of central tax revenue to GDP; and second, a growing ratio of transfers from the centre to the states as a percentage of GDP. Neither of these necessary conditions however is being fulfilled in India; on the contrary what we find is a reduction in both these ratios along with the increase in income inequality.

The reduction in the ratio of central devolution to the states has already been shown in Table 1. Table 2 shows the decline in the ratio of central tax revenue to the GDP.

Table 2: Gross Central Tax Revenue as percentage of GDP

2010-11 (Actual) : 10.2

2011-12 (Actual): 10.1

2012-13 (Actual): 10.4

2013-14 (Actual): 10.0

2014-15 (BE)          : 10.8

2014-15 (RE)          : 9.9

2015-16 (BE)          : 10.3

Source: Same as Table 1

Barring one year, 2012-13, there has been a steady downward trend in the proportion of gross central tax revenue to GDP, from 10.2 per cent in 2010-11 to 9.9 per cent according to the revised estimates last year (the actual may be even lower). And given what was said earlier about the overestimation of revenue in the current year’s budget, exactly as had happened last year, the actual figures for the current year are likely to turn out to be even lower than the actual for the last year. It follows therefore that neither of the necessary conditions for offsetting the increase in income inequality is being met in India. And what is more, if the Finance Commissions are serious about combating the increase in equality then they will have to provide for a growing ratio of central transfers to states through the FC route, and not just a once-for-all step up; and also prevent the effect of their recommendations from being nullified through a curtailment of transfers by other channels.




In other words, far from a new “progressive” era of federal finance being inaugurated, what we find today is an actual retrogression in the sense that even the necessary conditions for combating the rapidly growing wealth and income inequality through the fiscal instrument are not being met. A reduction in both the central tax revenue/GDP ratio and the central transfers to states/GDP ratio is major cause for concern and constitutes a threat to the democratic fabric of the country.

There is also retrogression in another sense. Since the overall transfers as percentage of GDP have not gone up, but have rather come down, and within these transfers those effected through the FC have come to substitute Plan transfers, including what the centre was earlier spending by way of its contribution to welfare programmes, those states which were particularly successful in implementing welfare programmes would become net losers owing to this switch. Implicit in the switch from Plan transfers to FC transfers therefore is a punishment for those states like Tripura that were energetically implementing welfare schemes under their plans and a reward for those states which were not.

It will become more difficult in the face of the squeeze on Plan transfers from the centre, including on welfare schemes, for a state like Tripura to maintain its vigorous pro-people welfare agenda. And this becomes particularly serious because the states’ capacity to tax according to their will is also being progressively eliminated through the introduction of nation-wide uniform tax schemes (like the VAT earlier and the GST now). Tripura had suffered greatly under the Thirteenth Finance Commission; its suffering continues under the Fourteenth Finance Commission.