To ensure fiscal discipline, government at all levels must be made to face the financial consequences of its decisions.” This is a quote from Anwar Shah’s paper, ‘Balance, Accountability, and Responsibility: Lessons About Decentralisation’. Some states may not have dispensation read this. Following in the footsteps of Rajasthan and Chhattisgarh, the Punjab government has also given in-principle approval to restore the old pension scheme for its employees. An attractive addition to the new pension scheme Rather than providing imputation, the move backfires on one of the key reforms that helped state governments avoid the ‘fiscal bullet.’ How is it possible to perform seemingly useless actions?
At the heart of such fiscal negligence by the states lies the transfer system, which is considered a solution to the problem of imbalance between revenue and expenditure powers. However, at times, it also encourages “fiscal mango raids”. From an equity perspective, the concept of fiscal transfer is a practical consideration. Its objective is to correct the spatial imbalance to ensure the economic stability of the Union. It helps that it cannot raise enough revenue due to historical and geographical limitations. Similar structures exist elsewhere in the world, whereby a federal government plays a balancing role in the allocation of resources. This is inevitable as real revenue is generated from a handful of urban agglomerations.
However, almost half of the weight in India’s transfer formula is income distance: that is, distance from the state with the highest per capita GSDP per capita GSDP. This could lead to cases of distorted incentives, with some states relying heavily on these transfers. However, it is essentially inversely linked to the economic performance of a state. According to the state budget for 2022-23, the expected share (sum of tax transfers and grants) from the Center in total revenue receipts for states ranges from 76 per cent in Bihar and 57 per cent in West Bengal to 47 per cent in Andhra Pradesh. . and 27% in Punjab and Gujarat. The state’s low reliance on its own tax resources may partly explain how Bihar banned the sale of alcohol, an important tax source for most states, without affecting its financial health or stability.
For a state, the primary source of budgetary resources is tax revenue (the state is a major part of GST) and devolution of 41% of the general pool of taxes. The current paradigm has resulted in a situation where a large portion of the state budget is a bifurcation from the central government, while a higher limit of growth was guaranteed for the largest tax component in the state list (GST, ie.
To bring states on board for the GST regime, they were provided with financial assurance by the ‘Protected Revenue’ clause. The central government guarantees a minimum ceiling revenue (compounded at 14% of 2015-16 levels) annually at a uniform rate, regardless of the economic performance of the individual state. As a result, the state’s largest tax head (SGST) has been detached from the current economic climate of the state. The effects, though unexpected, were clearly visible when states were given the autonomy to decide on lockdown/mobility restrictions during the last waves of the COVID pandemic. Barring a few notable exceptions, there was hardly any effort by states to balance the economic fallout and extended lockdowns became the norm.
Protected revenue and high devolution have discouraged states to reform. This is where the competitiveness framework comes in. As M Govinda Rao puts it, “Competition drives innovation and increases productivity.”
A Productivity-Based Competitiveness Definition by Michael Porter looks at competition through the lens of a location’s productivity level. Productivity drives the standard of living of the people there. Healthy competition among Indian states for investment, encouraging political innovation and development, is thus very important. This will result in an overall favorable economic environment by fostering competition among states, thereby contributing to higher overall growth.
The adoption of a competitive framework that transfers a state and its financial resources in general is tied to its economic performance. Presently, this link is broken, as the incentive mechanism at the state treasury level is different from the state’s GSDP performance. States have to be encouraged to compete. Such a system would give impetus to the revenue mobilization efforts by the State Governments and would also improve the quality of public expenditure.
The development of India is nothing but the development of its constituent states. The link between a state’s economic performance and its budgetary resources must be revived. This economic stimulus of reforms is crucial for the long-term financial health of both the Center and the states. Abhijit Sen, one of the dissatisfied members of the 14th Finance Commission, pointed out the disadvantages of the huge increase in unconditional tax transfers. Going forward, we must ensure an increased share of conditional transfers (possibly at least 5% of the divisible pool) based on reforms, expenditure quality and fiscal stability in place of the current regime. Only then can we ensure that state governments face the financial consequences of their financial misadventures.
These are the personal views of the authors.
Aditya Sinha and Chirag Dudani are Additional Private Secretary (Research) and Assistant Advisor, Economic Advisory Council to the Prime Minister, respectively.
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