Budget 2025: Fixing fiscal faultlines and balancing among states

As the Centre gets ready to present the next Budget, the Thiruvananthapuram conclave of finance ministers of southern states on September 12 and sit-ins at New Delhi’s Jantar Mantar by representatives of some of the states after the Interim Budget of February 1, 2024, will weigh heavy on its mind. The states, Kerala, Tamil Nadu, Karnataka and Telangana, also joined by Punjab, were protesting against discrimination in devolution of funds, that is, receiving proportionately less funds vis a vis their contribution to the central kitty, discontinuation of GST compensation, restrictions on borrowings, inadequate flood and drought assistance and lack of funding for projects. On November 9, Karnataka chief minister Siddaramaiah took to ‘X’: “PM @NarendraModi’s relentless favouritism towards Gujarat is clear as day, with major investments—from semiconductor plants to key manufacturing hubs—being coaxed away from thriving states like Karnataka, Tamil Nadu and Telangana, and handed to Gujarat with exclusive subsidies and incentives.”

The ‘exclusive subsidies and incentives’ here refer to production-linked incentives and design–linked incentives with an outlay of ₹3.56 lakh crore. Siddaramaiah’s accusation is not isolated. Several states such as Maharashtra, Tamil Nadu and Telangana have also complained about big projects shifting to Gujarat, allegedly at the behest of the Centre. Four of the five semiconductor projects announced in recent months are in Gujarat. An investigative report, released on November 12, says the Centre has allocated 39.6% of rural houses under the PMAY-G in FY25 to BJP-ruled Chhattisgarh (22.8%) and poll-bound Maharashtra (16.8%). This is a massive jump as during the previous nine fiscals, FY16-FY24, Chhattisgarh’s share was 4% and Maharashtra’s was 4.6%. Chhattisgarh was under a Congress government from 2018-2023 and Maharashtra was under a non-BJP coalition from 2019 to 2022. The other major gainers in FY25 are BJP-ruled Madhya Pradesh (10%), Gujarat (8%) and Bihar (6%).

One issue is India’s quasi-federal constitutional system that gives the Centre more powers. Fiscal/financial de-centralisation grew during the ’90s and 2000s but the trend has reversed in the recent decade. “There is inadequate understanding of the role of states in the development process,” says Pronab Sen, who headed the Standing Committee on Statistics and has worked with various Central governments.

A scrutiny of the Centre’s financial management makes it clear why systemic distortions must take priority in the Budget.

Choke On State Finances

The Centre devolves funds to states via Finance Commission (FC) -mandated tax sharing; FC’s grants-in-aid to cover revenue deficit; local body funding; grants for state disaster relief funds; and funds for central sector schemes and centrally sponsored schemes. The FC has mandated 42% devolution for FY20 and 41% for FY21-FY25. But if we look at “total transfers” to states and UTs as a percentage of the Centre’s total revenue, it becomes clear that this is not happening. In FY21-FY25 (BE), the average is 31.7%, a shortfall of 9.3 percentage points compared to 4.1% during the 13th FC period (FY11-FY15) and 7.1% during the 14th FC period (FY16-FY20). Total transfers are improving but, at an average of 32.6% of central revenue, are lower than the FC’s award (42% of central tax). This used to be far higher earlier. The 14th FC report of December 2014 said, “Aggregate transfers accounted for around 50% of gross revenue receipts of the Union.” One reason for the lower devolution is an expansion of the Centre’s cess and surcharge and a rise in the number of central schemes and centrally sponsored schemes. Both constrain states’ finances and limit their control over resources and development projects.

A Rajya Sabha answer and Budget papers show that cess and surcharge collections and funds for central schemes and centrally sponsored schemes have been slowing since FY21. But here is the rub: Both are still at an elevated level. Cess and surcharge are not part of the divisible pool and, hence, not shared with states. The CAG reports of 2020 and 2021 pointed out that cess collections were misused, with a good part going into the Consolidated Fund of India, instead of the specific purposes for which these were raised. The Centre also doesn’t share capital receipts from disinvestment and privatisation despite states’ demands and the 14th FC’s recommendation.

Sudipto Mundle, chairman of the Centre for Development Studies who has co-authored a study on the fiscal performance of the Centre and states, says the expansion in cess and surcharge “happened in response to the 14th FC award” as the Centre tried to get around the higher tax devolution. The 14th FC had raised states’ tax share from 32% to 42%. The Centre accepted the recommendation but only after opposing it in its deposition before the 14th FC in September 2014 (just after the new government came in May 2014) arguing that it needed “to retain fiscal space for its development agenda.” Mundle says though the share of cess and surcharge hasn’t gone up in the past few budgets, it’s at an “elevated level” and “to that extent constrains states’ fiscal space.” N.R. Bhanumurthy, director of the Madras School of Economics, says cess and surcharge are a “major issue” and the possibility of their “merger with the divisible pool” should be considered.

The Centre has traditionally used central schemes to address development concerns. For a decade, the number of centrally sponsored schemes was being reduced and funds were handed over to states. There was a sudden spike in FY19, and new highs were scaled in FY21. Despite moderation, these account for over 40% of the Union budget.

Mundle points to two outcomes of centrally sponsored schemes. One is “crowding-out” of states’ own schemes even if they are better suited to their needs. Two, states’ share of funding has risen, without the flexibility to adopt to their requirements “because of the one-size-fits-all design (of centrally sponsored schemes).”

“On the revenue side, the Centre is choking states through cess and surcharge, and on the expenditure side, it is reducing untied grants and increasing tied grants; the reverse was true in the earlier decades,” says Pronab Sen. He says funding for centrally sponsored schemes was formula-based, which isn’t the case now.

Capex Push: Who Gains?

Contrary to perception, states have been fiscally more prudent. “More states, barring some outliers, are performing well. They mainly depend on their own resources. Central transfers are relatively small,” says Mundle. His study shows ‘high economic development states’ raised 75-80% of their revenue, ‘balanced development states’ about two-thirds, ‘high social development states’ about 50% and ‘laggard development states’ 44% in FY23 (out of 20 states studied).

The RBI’s 2023 report on state finances shows states’ own tax revenue as a proportion of their overall tax revenue (including central transfers) was 62.8% during pre-GST FY16-FY17. It went up to 63.6% in post-GST and pre-Covid FY19-FY20 and 65.4% in post-Covid FY22-FY23 (18 states). Mundle’s study shows continuity in FY24 (RE) and FY25 (BE) .

Ironically, New Delhi’s power corridors are abuzz with self-congratulatory messages around how the Centre is handholding states into higher capex, especially by giving 50-year interest-free loans. The following backgrounder makes it clear how far-fetched the idea is:

(i) The 50-year loan was launched in FY23 under the “Scheme for Special Assistance to States for Capital Investment” without consultations with states. It coincides with the termination of GST compensation from FY23 (as initially intended) but the Centre had stopped paying GST compensation in FY21 and FY22. Instead, it gave loans of ₹1.1 lakh crore in FY21 and ₹1.58 lakh crore in FY22, which were to be paid back (another violation of the law). But later, the Centre decided to continue with GST compensation cess until FY26 to recover the loans.

(ii) The Centre announced an end to GST compensation on September 20, 2019, at the Goa GST Council meeting. The decision was communicated in writing in November 2019. The plea was fiscal constraints but the same day it announced a corporate tax cut estimated to cost the exchequer ₹1.45 lakh crore. This took corporate tax collections below income tax collections in FY21, FY23 and FY24. In FY14, corporate tax collections were 1.6 times the money raised from income tax. Weeks earlier, on August 26, 2019, the RBI had announced the transfer of a surplus reserve of ₹1.76 lakh crore to the Centre. Further, a 2020 CAG report said the Centre didn’t give states ₹47,272 crore GST compensation cess and put it into the Consolidated Fund of India. Also, the Centre’s capex push was a desperate act—first in 2019 in response to the fact that all other growth engines were sputtering. The RBI’s October Bulletin said the private capex was showing some encouraging signs. The finance ministry’s October report said “hopefully” revival in government spending will boost investment. But private capex isn’t happening even in the infrastructure sector and, hence, the FY25 Budget announced a new viability gap funding (for the non-road sector). The Centre’s own capex fell 15.4% in H1 of FY25, forcing it to direct ministries to speed up spending.

Pronab Sen points out a big flaw in the Centre’s approach. “One part of the problem is that most of the direct investment is capital-intensive and executed by large companies. So, the multiplier effect is relatively smaller. The other part is that states’ capex has a much larger multiplier effect due to localised activities and the involvement of MSMEs. If the Centre’s investment rises at the cost of states, the multiplier effect will reduce.”

Further, the Centre has limited states’ borrowing to 3% of gross state domestic product or GSDP (relaxed to 4% for the pandemic fiscal but tied to specific reforms). This is despite states outperforming the Centre on all fiscal parameters, including debt. Consider this: States’ revenue deficit averages 0.7% of GDP against the Centre’s 4.3%. A total of 18 states/UTs were in revenue surplus in FY22; that number increased to 19 in FY23 (RE) but came back to 18 in FY24 (BE). States’ deviation in fiscal deficit averages 0.3 percentage points against the Centre’s 3.3 percentage points (FRBM limits for both are 3% of GDP). The Centre’s debt increased three-fold in 10 years. The interest burden jumped from 3% of GDP in FY20 to 3.6% in FY24 and FY25 (BE). It was 22.1% of gross tax collections in FY23, 23.9% in FY24 and 24.1% in FY25 (BE). A high tax burden reduces the fiscal space to invest in productive activities.

Whatever way one looks at it, a fairer deal for states is definitely in order.