Centre-State Financial Relations

Context (IE | IE | TH): Several south Indian states (Karnataka, Kerala) are fighting against the Centre over the distribution of central funds.

What are the concerns of the Karnataka government?

Significant Reduction in the devolution of taxes: The 15th Finance Commission reduced Karnataka’s share in central taxes from 4.71% to 3.64% (a decrease of 22.5% compared to the 14th Finance Commission). This sharing formula made Karnataka the biggest loser in terms of percentage points.
15^th Finance Commission (FC) recommendations were rejected by the Centre: The 15th FC recommendations were,
- One-time grant of Rs 5,495 crore for the 2020-21 fiscal year (Suggested in 15^th FC 1^st report).
- Rs 6,000 crore was recommended for the improvement of water bodies and the peripheral ring road for Bengaluru (Suggested in the 15^th FC final report).
Inadequate GST compensation: Karnataka lost Rs 62,098 cr (2020-21 to 2025-26) however, it was not adequately compensated.
- For instance, in 2017-18, when it was eligible for a compensation of Rs 11,044 cr, GST compensation received from the Centre was a paltry Rs 6,246 cr.

Karnataka ranks second in the country in terms of Goods and Services Tax (GST) collection and is one of the biggest contributors to the country’s revenue.

About GST compensation

After the GST was introduced in 2017, the Centre said a compensation amount would be extended to states for up to five years to compensate for the shortfall in their revenue collection.
The Centre had promised to ensure an annual tax growth rate of 14 per cent under GST as part of resolving the loss of tax entitlements due to GST.
Due to shortcomings in the implementation of the GST system, natural calamities and COVID-19, this growth rate has not yet materialised.
However, the proposed GST compensation was terminated after five years.
Currently, the decrease in revenue for states after the implementation of GST is reducing their fiscal capacity.

Issue of Cess and Surcharges: Rs 55,000 cr (2017-18 and 2023-24) were collected using cess and surcharge (only in Karnataka), which are not to be shared with the states and are impacting state revenue.

Cess & Surcharge

Cess: is a tax on tax, and it is used for a specific purpose.
Different types of Cess in India
- Infrastructure cess on motor vehicles.
- Krishi Kalyan cess on service value.
- Swachch Bharat cess.
- Education cess.
- Cess on crude oil.
Surcharge: it is applicable on those persons whose income is more than Rs 50 lakh. This money is not collected for any specific purpose but can be used for any reason as seen as reasonable by the Central government.
Article 271: Cess and surcharges are levied by the Central government for the purpose of the Union.The proceeds of such surcharge and cess go towards meeting certain specific needs, such as financing of centrally sponsored schemes.
Article 270: excludes the surcharge on taxes and any cess under any law made by Parliament from being distributed between the Union and the states.

Discrepancy in Tax Devolution: States Receive Only 30% Instead of the 41% recommended by the 15th FC.

What are the concerns of the Kerala government?

Fiscal Shortfall:
- Kerala claims a cut of Rs 57,400 crore in its current fiscal receipts by the Centre.
- Additionally, citing an RBI report, the government claims that it receives only Rs 21 against its own tax collection of every Rs 79. However, as per the statistics of 2021-23, on the national average, the Centre is to provide Rs 35 for every Rs 65 collected by the states.

Uttar Pradesh gets Rs 46 out of Rs 100 from the Centre. Bihar gets Rs 70 out of Rs 100.

Goods and Services Tax (GST) compensation issue: Kerala lost a significant revenue source of Rs 12,000 crore this year after the Centre ended the GST compensation.

Consistent Decrease in the devolution of funds: Kerala’s share in tax devolution during the 10th FC period was 3.87%. This has come down to 2.5% in the 14th FC and to 1.925% in the 15th FC.
15^th Finance Commission criteria is unfavorable.
- The FC, for deciding the share of taxes for states, sets various parameters and looks at the states’ performances in that regard. (Parameters are mentioned in the diagram)

14th & 15th FC formula — **14^th & 15^th FC formula**

But Kerala states that its effective birth control measures (demographic performance) have contributed to the fall in the allocation of central tax.
The state wants the Centre to consider second-generation development problems, lifestyle diseases, and the growing proportion of elderly in the population.

Issues regarding Centrally Sponsored Schemes
- Kerala had submitted proposals for financial assistance under the Scheme for Special Assistance for Capital Expenditure, but it did not comply with some norms, particularly branding/naming of five central-sponsored projects in Kerala.
- Kerala is against co-branding of these projects as the state contributes 40 per cent of the share. This results in the delayed transfer of both Capex and Central Share of Centrally Sponsored Schemes.
- Further, Rs 600 crore under the National Health Mission and Rs 2,500 crore under Special Assistance for Capex have not been released so far.
Unexpected Cut in Borrowing Limits: Under the Centre’s guidelines, Kerala’s approved borrowing limit is Rs 39,626 crore. However, Kerala has been restricted to borrowing only Rs 28,830 crore so far. The borrowing limit was unexpectedly reduced without prior notice.

The net borrowing ceiling of a state (the amount that it can borrow) for each financial year is determined by the Union Finance Ministry.

Inclusion of off-budget borrowings as state loan
- Kerala has undertaken off-budget borrowings mainly for the Kerala Infrastructure Investment Fund Board (KIIFB) and Kerala Social Security Pension Limited (KSSPL).
- In 2017, the Union Finance Ministry stipulated that all such borrowings of state government entities will also be taken into consideration while setting the state’s borrowing limits.
- Thus, the Kerala budget had to make provisions for repaying the borrowings by KIIFB and KSSPL.
- The inclusion of such off-budget borrowings as the state’s borrowing has, therefore, brought down its net borrowing ceiling.

Off-budget borrowings are loans obtained by government entities such as PSUs or special purpose vehicles on behalf of the government to finance expenditures.
Though the state government is responsible for paying the loan and servicing the debt from its budget, these borrowings are not included when computing the debt and fiscal deficit of the state governments (CAG).

How do states receive income from the central government?

Devolution (States’ share of taxes): As states share of taxes from the Gross Tax Revenue. (This is extra-budgetary)
Scheme-related transfer: For example, centrally sponsored schemes based on budget allocations.
Finance Commission Grants: They are based on budget allocations. it includes,
- Revenue Deficit Grants
- Sectoral-specific Grants
- State-specific grants.
- Grants to local bodies
- Grants-in-Aid for State Disaster Mitigation Fund

Major Recommendations of the 15^th Finance Commission (2021-2026)

The Finance Commission is a constitutional body formed by the President of India to give suggestions on centre-state financial relations.

It was recommended to be 41%.
This is less than the 42% share recommended by the 14th FC for the 2015-20 period.
The adjustment of 1% is to provide for the newly formed union territories of Jammu and Kashmir, & Ladakh.

Grants

Revenue deficit grants

17 states will receive grants worth Rs 2.9 lakh crore to eliminate revenue deficit.

Sector-specific grants

Rs 1.3 lakh crore will be given to states for eight sectors.
(i)health, (ii) school education, (iii) higher education, (iv) implementation of agricultural reforms, (v) maintenance of PMGSY roads, (vi) judiciary, (vii) statistics, and (viii) aspirational districts and blocks.
A portion of these grants will be performance-linked.

State-specific grants

The Commission recommended state-specific grants of Rs 49,599 crore.
These will be given in the areas of: (i) social needs, (ii) administrative governance and infrastructure, (iii) water and sanitation, (iv) preservation of culture and historical monuments, (v) high-cost physical infrastructure, and (vi) tourism.
The Commission recommended a high-level committee at state-level to review and monitor utilisation of state-specific and sector-specific grants.

Grants to local bodies

The total grants to local bodies will be Rs 4.36 lakh crore.
- For rural local bodies Rs 2.4 lakh crore
- For urban local bodies Rs 1.2 lakh crore,
- Health grants through local governments Rs 70,051 crore.
A portion of grants to be performance-linked.
The grants to local bodies will be available to all three tiers of Panchayat- village, block, and district.
Grants to local bodies (other than health grants) will be distributed among states based on population and area, with 90% and 10% weightage, respectively.
Conditions for availing of these grants (except health grants).
- Publishing provisional and audited accounts in the public domain.
- Fixation of minimum floor rates for property taxes by states
- Improvement in the collection of property taxes (for urban bodies).
- No grants will be released to local bodies of a state after March 2024 if the state does not constitute a state finance commission.

Disaster risk management

The Commission recommended retaining the existing cost-sharing patterns between the centre and states for disaster management funds. The cost-sharing pattern between the centre and states is
- 90:10 for north-eastern and Himalayan states.
- 75:25 for all other states.
State disaster management funds will have a corpus of Rs 1.6 lakh crore (the Centre’s share is Rs 1.2 lakh crore).

Criteria for devolution

Criteria for devolution for 15th Finance Commission

Income distance: it is the distance of a state’s income from the state with the highest income. A state with lower per capita income will have a higher share to maintain equity among states.
Demographic performance: This criterion has been used to reward states’ efforts to control their population. States with a lower fertility ratio will be scored higher on this criterion. The commission used 2011 population data.
Forest and ecology: This criterion has been arrived at by calculating the share of the dense forest of each state in the total dense forest of all the states.
Tax and fiscal efforts: This criterion has been used to reward states with higher tax collection efficiency.

Fiscal roadmap

Fiscal Deficit

The Commission suggested that the
- The Centre should bring down the fiscal deficit to 4% of GDP by 2025-26.
- For States (as % of GSDP) of 3% during 2023-26.

Borrowings

Extra annual borrowing worth 0.5% of GSDP will be allowed to states during the first four years (2021-25) upon undertaking power sector reforms, including:
- Reduction in operational losses.
- Reduction in revenue gap.
- Reduction in payment of cash subsidy by adopting direct benefit transfer.
- Reduction in tariff subsidy as a percentage of revenue.
The Centre, as well as the states, should not resort to off-budget financing or any other non-transparent means of financing for any expenditure.
States should have more avenues for short-term borrowings other than the ways and means advances and overdraft facility from the RBI.

Revenue mobilisation

Provisions related to tax deduction and collection at source (tds/tcs) should be expanded.
Stamp duty and registration fees needs to be rationalized to increase state revenue.
- Computerised property records should be integrated with the registration of transactions, and the market value of properties should be captured.

Creation of Fiscal bodies

It recommended forming a high-powered inter-governmental group to:
- Review the Fiscal Responsibility and Budget Management Act (FRBM).
- Recommend a new FRBM framework for centre as well as states and oversee its implementation.
An independent Fiscal Council should be established with powers to assess records from the centre as well as states. The Council will only have an advisory role.
States may form an independent debt management cell to manage their borrowing programmes efficiently.

Health

States should increase spending on health to more than 8% of their budget by 2022.
Primary healthcare expenditure should be two-thirds of the total health expenditure by 2022.
All India Medical and Health Service should be established.

Funding of defence and internal security

A dedicated non-lapsable fund called the Modernisation Fund for Defence and Internal Security (MFDIS) will be constituted.
Aim is to bridge the gap between budgetary requirements and allocation for capital outlay in defence and internal security.
The fund will have an estimated corpus of Rs 2.4 lakh crore over the five years (2021-26).
Of this, Rs 1.5 lakh crore will be transferred from the Consolidated Fund of India.
The rest of the amount will be generated from measures such as the disinvestment of defence public sector enterprises and monetisation of defence lands.

Centrally sponsored schemes (CSS)

A threshold should be fixed for annual allocation to CSS below which the funding for a CSS should be stopped.
Third-party evaluation of all CSS should be completed within a stipulated timeframe.