India’s Charade of Cooperative Federalism and State Debt Traps

India’s policies towards fiscal federalism are grounded in a colonial legacy that favours the power structure to be tilted towards the centre.

In its recently released interim report for 2020–21, the Fifteenth Finance Commission has decreased the share of states in the divisible pool of central taxes from 42% to 41%, accounting for the conversion of the erstwhile state of Jammu and Kashmir into two union territories. Additionally, and perhaps most importantly, it revised the criteria and weights under which funds are allocated to states. That is, now 15% weight will be given to the population of a state, as compared to the previous term of assignment, which was 17.5%. Moreover, it raised the weight for demographic performance from 10% to 12.5%. The recomposition of weights means that the tax share of most southern states has gone down, while that of states like Bihar, Punjab, Maharashtra and Gujarat has gone up.

As per reports, though the centre’s share of total debt (as a percentage of the gross domestic product [GDP]) fell from 47.5% in 2014 to 46.5% in 2017–18, that of states has increased from 24% in 2017–18 to 24.3% in 2018–19. Moreover, Moody’s, the international credit rating agency, predicts that the debt burden of state governments would continue to increase, given the overall economic atmosphere and infrastructural spending. 

Similar apprehensions and concerns have been raised by the Comptroller and Auditor General of India in a 2017–18 report, where the authority mentioned Goa’s impending fall into a debt trap. With the state liable to pay Rs 888 crore in 2018–19, Rs 1,676 crore in 2019–2020 and Rs 2,126 in 2021–22, the state’s future budget would be predominantly marked by repayments to the centre. Such an increase in the states’ dependency on the centre as well as the inequitable devolution of central taxes has given rise to concerns regarding the practice of fiscal federalism in India. 

In lieu of this, we revisit the EPW archives to understand how centre–state relations have been conceptualised in India, and what are some of the major concerns that have propped up along the way. 

How Have Centre–State Relations Come to Be Conceptualised in India?

Chirashree Das Gupta and Surajit Mazumdar chart the evolution of fiscal federalism in India since the reforms of 1991 and state that after liberalisation, federalism was seen in two parts, that is, political and fiscal. The latter was grounded in the “sound finance paradigm,” which is itself problematic, and became the most preferred way of efficient organisation. Over the years, the sound finance paradigm has contributed to a techno-managerialism manner of structuring the state–centre relationship. This paradigm treated the state as an individual entity operating within a free market and acting in accordance with the principles of bounded rationality.It is this neo-liberal conception of the relationship that redefined the state into a linear and monolithic “facilitator of private investment.” The sound finance paradigm itself lent a certain fixation with keeping taxes and fiscal deficits within stipulated limits, resulting in the obsessive tendency to compress expenditure. This not only contributed to growth marked by increasing inequality, but reinforced existing inequalities as well. Overall, the treatment of centre and state relations since the liberalisation of the economy in 1991 has been an attempt at the mechanical replication of the Maastricht Treaty of 1992, which birthed the common market of the European Union.

This goal of fiscal federalism in India to create a common market follows once again from the Maastricht Treaty that led the basis of the formation of the European common market. This was an attempt to create a political and economic union of sovereign nation states in Europe—an experiment that is now in crisis due to inherent contradictions. The blind import of the understanding of a common market in the professed goal of creating one in India is testimony to our earlier observation of the lack of a theory of the state and especially the nation state in the rubric of the ‘sound finance architecture.’

This emphasis on sound finance and, therefore, tax structures has meant that the economic independence of states, or the lack thereof, with respect to the centre, has become the most crucial determinant of centre and state relations. Keeping this in mind, it is worthy to investigate the history of the economic relationship between the two. T M Thomas Isaac, R Mohan and Lekha Chakraborty root this history in the colonial legacy of centralisation under the British rule. The imperial government’s impending financial crisis spurred measures to discontinue the assignment of expenditure and revenue functions to the provinces. As a result, provinces were asked to devolve a portion of their respective surpluses (pre-determined through the Meston awards) to the imperial government so as to finance the deficit of the latter. The differentiation of power between the centre and provinces was made clearer through the Government of India Act, 1935, which institutionalised the centralising tilt of discretionary powers. Eventually, the 1935 act was included in the Constitution without any revisions. Therefore, though there is a general concept of cooperative federalism that is espoused by the government, in practice, the law is far from it. 

With respect to the own tax revenue, states have substantially lost the power to vary tax rates of items de facto since 1 April 2005, when value added tax (VAT) was implemented on intra-state trade of goods, and de jure since 1 July 2017, when goods and services tax (GST) was introduced. On the expenditure side, there has been a rise in the share of conditional and tied grants that essentially deal with items in the state list of the seventh schedule of the Constitution. This restricts the freedom of the states in its spending priorities that takes into account the local specifications. There are also constraints arising from Fiscal Responsibility and Budget Management (FRBM) acts, which lay down uniform targets across states ignoring the differing fiscal needs. In short, the domain of the states, which should be unrestrained insofar as their constitutional assignment is concerned, is being constrained in more than one way.

How Cooperative is India’s Fiscal Federalism?

Constituted so as to keep the fiscal balance between the state and centre, the Finance Commission is a quinquennial ritual. Till date, there have been 15 commissions, with each being given the task of reviewing the state of finances of the union and the state, and suggest ways in which the governments can bring about a restructuring of public finances and restore budgetary balance. Writing about the Eleventh Finance Commission, Madhav Godbole commented on a recurring limitation that impacted the Eleventh as well as all the past finance commissions. That is, the government’s continuous demand for forecasting revenue and expenditures of both the centre and the state for the five-year period. Godbole observes that such a feat has been “meaningless and irrelevant.” This is largely because states underestimate revenues and inflate expenditures in their respective forecasts, while the commissioners themselves do the opposite. Moreover, the commissioners focus all too much on revenue, and do not pay adequate attention to the expenditure being calculated or envisioned by the centre and the state. Hence, the reports and the policies they espouse are scarcely grounded in reality. 

There is too much preoccupation with revenue- whether of the centre or the states- as compared to the expenditure of these entities. In fact, none of the past finance commissions has analysed expenditures closely. As a part of any such exercise. it is necessary to take a look at the primary functions of the state and central government. The devolution of funds should be only with relation to these functions. If the centre or the states want to have the luxury of running airlines and producing bread they should be asked to find their own resources for the purpose. The entire question of the size of the government and down-loading its responsibilities to outside agencies such as the private sector, co-operatives, non-governmental organisations and so on needs to be seriously explored. Some may consider it a heresy but no expenditure need be treated as sacrosanct. The question is whether we are prepared to raise such basic issues when we arc on the door-step of the 21st century.

Commenting on the Twelfth Finance Commission and the overall state-debt burden, S Gurumurthi observes another limitation of the fiscal structuring between the centre and the state. The author elaborates that under each five year plan, the market borrowings for the state are fixed by the Reserve Bank of India. These gross borrowings are pre-determined and calculated, accounting for any repayments due by the state in the concerned year. This takes away the burden of the state to find additional resources to meet its repayment obligations. However, over the years, due to a rising debt and interest burden, deductions for repayments have constituted a large part of the net loan. As a result, the amount eventually received by the state to use for other activities decreases. Although successive finance commissions have recommended debt relief for the states through rescheduling or writing off loans, the same has not been acknowledged by the centre. This has adversely impacted their ability to spend on any real development in their respective regions. 

The outstanding stock of debt of the states amounted to Rs 504,248 crore or 23.1% of GDP at the end of March 2001. The states’ debt to GDP ratio has increased steadily from 17.9% in 1995-96 to 23.9% at the end of March 2002. The rising debt levels have led to growing interest burden of the states. The interest payments preempted 21.6% of the revenue receipts of the states in 2001 as against 13% in 1990-91. Besides loans from the centre and market borrowings, the other sources of growth in liabilities in the recent years have been loans from financial institutions and the public account liabilities. According to an analysis by the Reserve Bank of India, the overall impact of the rising debt level has reduced the flexibility of states to release funds for basic infrastructure and the social sector.

Bakshi Amit Kumar Sinha and Barna Ganguli further note that the current fiscal management system actually castigates low-income states, rather than assisting them. Under the Fourteenth Finance Commission, eight states showed revenue deficits and claimed the grant for the same. However, all of these states were high-income or average-income. Low-income states, on the other hand, have generated revenue surpluses by compromising on social and economic needs, and not fully utilising their debt potential. Instead of rewarding these states, the finance commission penalised the revenue-surplus generating states for maintaining fiscal discipline. Grants were then given to states that have not followed FRBMA (Fiscal Responsibility and Budget Management Act) norms, instead of those who suffer from a high population burden, lower levels of literacy, urbanisation and health facilities since the beginning. Moreover, the share of low-income states in receiving the central divisible pool of taxes has gradually reduced from 48.289% during the time of the Eleventh Finance Commission to 42.89% in the period of the Fourteenth Finance Commission. Even average-income states have seen a decline in share from 26.22% to 24.97% for the same period. 

For all-India, the total transfer under FC14 [Fourteenth Finance Commission] increased by 149.6% compared to FC13 (from 17.07 lakh crore under FC13 to 42.60 lakh crore under FC14). But, not all states have benefited equally from that enhanced kitty. Among the major states, the increase is the highest for Chhattisgarh (211.2%) and the lowest for TN (103.7%). The figures for AP are not comparable due to the bifurcation of the state in 2014 to create the new state of Telangana. The increase for Bihar (136.8%) is the second lowest, just above TN ... Most developed states like Punjab, Maharashtra, and Kerala benefited the most (with an average 186.7% hike) and poor states like Bihar, Odisha, Rajasthan, and UP benefited the least (with an average 132.2% hike) from the total central transfers. So, the data reveals that the principle of equalisation is a myth, thus supporting the argument of the augmentation of disparities.