Against the backdrop of recent Union Budget 2024, there is a transition in the framework of intergovernmental fiscal relations from Cooperative federalism to competitive federalism . Quite contrary to the expectations that 16th Finance Commission will look into these Centre-State financial relations, in the recent Union Budget, the Finance Minister has announced the significance of competitive federalism to achieve optimum 'Total Factor Productivity' by initiating the structural reforms to all the factors of production - land, labour, capital and investment - by urging the States to do heavy lifting in terms of these reforms. This is in addition to the emphasis on the Capex in the Union Budget 2024-25, in the sense that high fiscal deficit and debt is closely tied to strengthening capital formation at the Centre and State levels, and to reduce the 'output gaps'. This is also inclusive of capital transfers to the states of around Rs one lakh crore for capital infrastructure investment from the Union Budgets.
The cooperative federalism
The cooperative federalism primarily works through the intergovernmental tax transfers , which is unconditional in nature. In India, the tax transfer is designed in the basis of a scientific formula . The criteria incorporated in the tax transfers formula are population, income distance , area, climate change , demographic transition and tax effort. This tax transfers happen through Finance Commission, which is a constitutional body appointed by the President of India every five years. With the coalition government in power, the States like Bihar and Andra Pradesh have asked for 'Special Category Status' based on the socio-economic backwardness, propensity to natural calamities and the constrained fiscal space. However, given the available fiscal space amidst geopolitical risks and uncertainties, it will be difficult for the Government to fulfil their demands for the Special Category Status. It can also create a bandwagon effect that more States including Odisha might strengthen their demand for Special Category Status due to their high frequency exposure to natural calamities. There is a shadow of these concerns in the recent Union Budget . How to solve this, given the coalition politics on board? Ideally, the 16th Finance Commission can solve the issue by increasing the magnitude of tax transfers from the existing 41 percent. The constrained fiscal space and the challenges emanating from the poly crisis affect the subnational governments .
According to the 'principle of subsidiarity', the best decisions are taken at the level of government closest to the people. As per Schedule 7, significant functions are assigned at the subnational level, while the dynamic taxes are at the centre. This creates vertical and horizontal fiscal imbalances in the intergovernmental fiscal mechanism and institutions like Finance Commissions are constitutionally mandated to look into these imbalances.
Given the tremendous shrinkage in the divisible pool due to disproportionate increase in cess and surcharge, I do urge the 16th Finance Commission to increase the magnitude of devolution to approximately 50 percent as any downward revision in the magnitude of tax transfer devolution from 41 percent can be fiscal waterboarding. There is debate about efficiency versus equity in the criteria used in the intergovernmental fiscal relations. The States which have controlled the population over the years and have materialised economic growth are getting penalised as significant weightage is given for on 'equity' related criteria. The States have increased their bargaining in terms of these concerns, as it is seriously affecting the fiscal space of the States.
The debt- deficit dynamics :
At the State level, the dynamics of debt and deficit has been re-articulated and the fiscal deficit to GDP needs to be maintained at 3.5 percent . Above the 3 percent deficit threshold to GDP, the extra borrowing powers are allowed to a magnitude of 0.5 percent cent if the States engage in power sector reforms.
As per the Section 4 of the FRBM, the fiscal rules stipulate that the general government debt cannot be over 60 percent cent of GDP with States' public debt to GDP ratio at 20 percent . Given the revenue uncertainties in the post pandemic space and the polycrisis manifested in the form of mounting global inflation, energy crisis, climate change crisis, supply side disruptions, war and geopolitical uncertainties, the centre and States have been engaging in 'hidden debt' in the form of off budget borrowings through public sector entities. India is yet to construct the time series data on 'Public Sector Borrowing Requirement ( PSBR) , to capture these hidden debt components at 'general government ' level incorporating the borrowing through public sector entities.
The golden principle of the fiscal rule is zero revenue deficit . However, in the Union Budgrt 2024-25, the revenue deficit GDP ratio has reduced from 2.5 percent in FY24 to 1.8 percent in FY25. High levels of revenue deficit gives the indication that there was no drastic cuts in public spending, given the fact that revenue receipts were buoyant.
Transition towards Competitive Federalism:
A distinct feature of Union Budget 2024 is the emphasis on competitive federalism . Albert Breton , a Canadian economist , has written extensively on competitive federalism . He narrates the importance of 'benchmarking ' a jurisdiction or a Province to incentivise other units to emulate. However these mechanisms of benchmarking in the competitive federalism frameworks can be nebulous in the context of an emerging country like India.
Benchmarking a few States in the competitive federalism framework, with preferential support from centre, can also widen the fissures in the already acrimonious Centre-State relations in India. The adhoc and arbitrary fiscal announcements for the States in the Union Budget can only be a second best principle in tackling the expenditure needs at the State level. It is beyond the purview of Union Budget, to address the expenditure needs of the States and the tax transfer devolution .
The political economy of the Union Budget 2024-25 is compelling. A re-articulation of fiscal rules in terms of threshold ratios are crucial to keep the fiscal policy accommodative, given the constraints of RBI in the growth recovery process. As States are urged to do the heavy lifting in terms of Capex infrastructure and also to strengthen the Total Factor Productivity through all factors of production, unconditional fiscal transfers can best support the fiscal space of the States.
The conditional fiscal support through line ministries in the form of more centrally sponsored schemes can affect the fiscal autonomy of the States and the flexibility of finances at the subnational level of government . Any transition in the intergovernmental fiscal transfers towards more unconditional tax transfers through an objective tax transfer formula is welcome.
This article was first published in The New Indian Express dated July 30th 2024.
Lekha Chakraborty is Professor, NIPFP and Research Associate of Levy Economics Institute of Bard College, New York and Member, Governing Board of International Institute of Public Finance (IIPF) Munich.
The views expressed in the post are those of the authors only. No responsibility for them should be attributed to NIPFP.