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Emerging Issues in Union–State Fiscal Relations

Pinaki Chakraborty (pinaki.chakraborty@ is with the National Institute of Public Finance and Policy, New Delhi.

The restructuring of non-Finance Commission Grants is an improvement when it comes to scheme-related transfers. However, when 10 schemes constitute 90% of core grants, there is further scope for rationalisation of these schemes. The implications of following a sustainable debt path under the new Fiscal Responsibility and Budget Management framework in the budget indicate a larger fi scal correction at the state level vis-à-vis the union government.

The author gratefully acknowledges the invaluable research assistance provided by Shatakshi Garg.

In a multilevel fiscal system, the federal dimensions of the Union Budget cannot be ignored. Though discussions have so far concentrated on the macro-stabilisation aspects of the budget in terms of levels of deficits, debt and allocations for key sectors, including infrastructure, nothing much has been said about the implications of the Union Budget 2017–18 on transfers to states and on union–state fiscal relations. There are two specific aspects I would like to address in this article: First, what is the big picture emerging in union–state fiscal relations and the quantum of transfer with the abolition of the plan and non-plan distinction in the budget? Second, what are the likely implications of new Fiscal Responsibility and Budget Management (FRBM) framework indicated in the budget for states’ borrowings?

Quantum of Transfers

This budget has done away with the distinction between plan and non-plan expenditure. Thus, transfers under the five year plan have been discontinued. In the absence of the plan, a significant part of the total transfer has become scheme specific. Total transfers now comprise tax devolution recommended by the Finance Commission, Finance Commission Grants, and a new category called Schemes Related and Other Transfers. In the Union Budget 2017–18, aggregate transfers to the states have increased from ₹9,84,764 crore (2016–17 revised estimates or RE) to ₹1,081,078 crore (2017–18 budget estimates or BE), an increase of ₹96,314 crore (Table 1). An increase of ₹66,565 crore in tax devolution, ₹3,986 crore in grants recommended by the Finance Commission and ₹25,763 crore in other central transfers constituted this overall nominal increase.

However, it is interesting to see the change in the composition of this aggregate transfer of resources from the centre to the states. While the share of Finance Commission Grants and Other Central Transfers has declined from 10.07% and 28.19% in 2016–17 (RE) to 9.54% and 28.06% in 2017–18 (BE) respectively, the share of Tax Devolution to States has increased from 61.74% in 2016–17 (RE) to 62.40% in 2017–18 (BE). Thus, if we take tax devolution and Finance Commission Grants, their combined share in total transfers is expected to be around 72%. It is thus evident that Finance Commission transfer is the route through which most funds are being transferred to the states. This increase in unconditional flow of resources to states is the most significant development after the Fourteenth Finance Commission (FFC) award.

While in nominal terms the aggregate transfers to states and union territories have increased, transfers as a percentage of gross domestic product (GDP) have declined marginally to 6.41% in 2017–18 (BE) from 6.53% in 2016–17 (BE). At a disaggregated level, this overall decline can be seen coming from a decline in all three components of total transfers, namely, devolution of states’ share in taxes (from 4.03% to 4.00%), Finance Commission Grants (from 0.66% to 0.61%) and, other central transfers (from 1.84% to 1.80%).

As is evident from Table 2, with respect to the outlay on major Centrally Sponsored Schemes (CSS), there is an increase in the outlay from ₹2,45,435 crore in 2016–17 (RE) to ₹2,78,432 crore in 2017–18 (BE). An increase of ₹1,215 crore in Core of the Core Schemes (CCS) and ₹31,782 crore on Core Schemes constitutes the total increase of ₹32,997 crore outlay on CSS from 2016–17 to 2017–18. While there has been a nominal increase, there has also been an increase in the total outlay on CSS as a percentage of GDP, albeit marginal in magnitude (Table 2). However, the composition of CSS reveals that the share of CSS under Core Schemes has increased from 71.5% of total CSS to 74.2%.

It is interesting to note that out of the six CCS, roughly two-thirds of the total outlay is on the Mahatma Gandhi National Rural Employment Guarantee Scheme (₹48,000 crore out of ₹71,756 crore in 2017–18). Amongst the 22 Core Schemes, 10 schemes constitute around 90% of the total outlay, with the top five within these —National Education Mission (14.30%), the Pradhan Mantri Awas Yojana (14.05%), the National Rural Health Mission (13.13%), the Integrated Child Development Services (10.04%), and the Pradhan Mantri Gram Sadak Yojana (9.19%)—accounting for around 60% of the total outlay. While the restructuring of non-Finance Commission Grants to states following the FFC recommendations is a major improvement over the previous arrangements of scheme-related transfers, particularly with respect to CSS, there is further scope for rationalisation given the fact that 10 out of 22 Core Schemes account for around 90% of total outlay on the Core Schemes. However, when it comes to scheme-related transfers in the absence of five year plans, there is a need for a framework for predictability and certainty of transfers. In the long run, in a dynamic and competitive federal system, all transfers, including scheme-related transfers require a framework. It is true that scheme-related transfers are discretionary transfers and reflect central government priorities in select sectors. But one cannot ignore the fact that states make matching contributions to most of these schemes and state resources get tied to central programmes. This top-down approach to conditional grants has not changed despite restructuring of transfers, including abolition of plan grants in budget 2017–18. The restructuring of scheme-related and other transfers from the centre to the states has placed a larger burden on the latter to finance these schemes, thus reducing the untied fiscal space to the states due to the higher tax devolution recommended by the FFC.

New FRBM Framework

Finance Minister Arun Jaitley in his budget speech mentioned that the FRBM Review Committee has recommended a sustainable debt path which should be the macroeconomic anchor of our fiscal policy.

The Committee has favoured a Debt to GDP ratio of 60% for the General Government by 2023, consisting of 40% for Central Government and 20% for State Government. Within this framework, the Committee has derived and recommended 3% fiscal deficit for the next three years. The Committee has also provided for ‘Escape Clauses,’ for deviations upto 0.5% of GDP, from the stipulated fiscal deficit target. Among the triggers for taking recourse to these Escape Clauses, the Committee has included ‘far-reaching structural reforms in the economy with unanticipated fiscal implications’ as one of the factors.

This budget announcement relating to new FRBM framework should be studied in light of the fiscal road map laid out by the FFC. The deficit path in the cases of states, as recommended by the FFC, has provided a flexibility of up to 0.5% of gross state domestic product (GSDP) under the following conditions: (i) zero revenue deficit, (ii) fiscal deficit not exceeding 3% of GSDP, (iii) interest payment to revenue receipt ratio not exceeding 10%, and (iv) debt-to-GSDP ratio not exceeding 25%. In the FFC’s assessment of union and state finances, the combined debt-to-GDP ratio should be brought down to 58.24% of GDP by the end of 2019–20. The debt adjustment path proposed by the FFC shows an increase in the debt-to-GDP ratio of all states from 21.9% to 22.38% (Table 4, p 45) between 2015–16 and 2019–20. At an aggregate level, state debt-to-GDP ratio for 2016–17 (BE) stood at 22%, well within the target set by the FFC. State-specific debt-to-GSDP ratios are shown in Table 4.

As is evident from Table 3 (p 44), the debt-to-GSDP ratio path is asymmetric across states. Among the major states, West Bengal has the highest debt-to-GSDP ratio of 32.9%, followed by Punjab (31.4%), Uttar Pradesh (30.1%) and Kerala (28.1%). On the other hand, Chhattisgarh has the lowest debt-to-GSDP ratio of 15.5% followed by Odisha (18.8%), Madhya Pradesh (20.1%) and Maharashtra (20.3%). Given this asymmetry in the debt profile of states, it is important to calibrate state-specific sustainable fiscal deficit targets to achieve the targeted debt-to-GSDP ratio of 20% by the end of 2023.

In the case of the union government, the FFC recommended a larger correction in the debt-to-GDP ratio, and the correction is expected from 43.6% in 2015–16 to 36.3% in 2019–20. This asymmetric correction path is primarily to ensure fiscal discipline for the union government, given its large deficit and debt (above the FRBM target) (Table 4). In the new FRBM framework, this seems to have been reversed with union government reducing its debt stock to 40% of GDP by the end of 2023, while states are undertaking a bigger correction in debt ratios to reach 20% of GDP by the end of 2023.

In view of the FFC recommendation, it is pertinent to acknowledge that if the FRBM paths proposed up to 2023 for both union and states are to be adhered to, states may have to undertake a larger fiscal correction than what is envisaged in the FFC report. Targeting debt as a policy anchor instead of deficit is certainly an improvement. Given the subdued economic environment and the decline in GDP growth rate predicted in the Economic Survey 2016–17, realising the debt-to-GDP ratio targets would have to happen through fiscal contraction. It is another issue as to whether there should be fiscal contraction when the economy is contracting. However, it needs to be emphasised that in the present context, the burden of fiscal adjustment should squarely fall on the central government as states are already under the FRBM framework proposed by FFC and implementation of which is monitored by the union government. Any change in that framework in between would be ad hoc and arbitrary.

Updated On : 7th Mar, 2017


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