Funds to states way below 42%; why that hurts growth

As the Centre prepares the next Budget to be presented on February 1, 2022, one of the top priorities must be to devolve more funds to states – which it has failed to do since 2015.

States not only spend more on capital investment than the Centre, thereby boosting growth prospects of the economy, they are fiscally more disciplined than the Centre. They face resource crunch especially after surrendering their rights to many indirect taxes while adopting the GST in 2017 and they are also denied their legitimate share of disinvestment proceeds – all of which were detailed in Fortune India article ‘Why states are denied share of CPSE sale proceeds?’

There is yet another critical aspect that has not received attention: The Centre has been consistently violating the Finance Commission awards since 2015 in devolving tax revenues.

Devolution of more funds to states assumes critical importance as India battles to regain growth after the pandemic. The latest GDP numbers (first advance estimates), released on January 7, show the GDP growth would be 9.2% in FY22 – less than 9.5% the RBI has been projecting. This would mean a 1.3% growth over FY20 – that is, two years of growth is lost.

Even this growth (9.2%), from a low base of -7.3% in FY21, is uncertain as Omicron cases skyrocket faster than the Delta variant. Discounting Omicron, there are other reasons to worry. Consumption demand (PFCE) – the main growth engine contributing to more than 55% of the GDP – is substantially below the FY20 level (Rs 80.8 lakh crore in FY22 against Rs 83.21 lakh crore in FY20). Capital formation (GFCF) – the second main growth engine contributing more than 30% to the GDP – is marginally up with a 2.6% growth over FY20 level.

Low consumption demand and low capital formation (including fixed capital formation) means the onus is on government spending (GFCE) – the third engine of growth that contributes less than 12% to the GDP – which grew by 10.7% over FY20. Though high in growth, its low contribution to the GDP means relatively smaller impact.

In such a situation, India needs more fiscal spending on capital investment and here lies the critical role of states in reviving the economy.

Centre violates Finance Commission awards

The Centre took all credit for the 14th Finance Commissions (FC) award of 42% tax devolution (of gross tax) to states – up from 32% by the 13th Finance Commission. This was in spite of the fact that the new government that came to power at the Centre in May 2014 had strongly opposed such a raise in its representation before the 14th FC, as the latter recorded in its 2015 report.

Analysis of actual devolution of tax by the Centre shows the Centre didn’t honour the awards. Budget documents reveal that during the 14th FC period between FY15 and FY20, the actual average devolution was 33.6% – grossly below the award of 42%.

The 15th FC (for 2021-26) reduced states’ share to 41% by arguing that the Centre’s expenditure would go up with the downgrading of Jammu and Kashmir to two union territories. The latest budget document shows, the actual devolution was 28.9% in FY21 (RE) and is estimated at 30% in FY20 (BE).

This is a massive departure from the FC awards.

In sharp contrast, the previous UPA governments shared an annual average of 25.9% of the gross tax with states during FY05 to FY10 and 27.9% during FY11 to FY15 – when the 12h and 13th FC awards were 30.5% and 32% for the corresponding periods.

How the Centre shortchanged states since FY15 can be presented in terms of percentage of difference between the award and the actual devolution.

During the first term of the UPA, the annual average difference (between the FC award and actual devolution) was 4 percentage points and during the second 4.1 percentage points. In comparison, the first term (FY15 to FY20) of the current government saw the annual average difference jumping to 8.4 percentage points and in the second (FY21 and FY22) to 11.5 percentage points.

This is just one way in which states have been hurt.

There is yet another one: surge in the number and collection of cess and surcharge, which are not shared with states.

Surge in cess and surcharge

Research body PRS India in its December 2020 study presented the rise in cess and surcharge. It found a vertical climb in such collections by the Centre – from 0.9% of the GDP in FY13 to 1.7% in FY20. It said this “increasing share of cess and surcharge in the gross tax revenue has reduced the size of the divisible pool”. In terms of gross tax revenue, the rise in cess and surcharge was equally remarkable – up from 9% of the gross tax in FY13 to 17% in FY20.

The Centre for Policy Research found that cess and surcharge rose further to 18% of the gross tax in FY21. What is even more appalling is the misuse of cess and surcharge. The Comptroller and Auditor General of India (CAG) reports of 2020 and 2021 have found instead of using cess and surcharge for the specific purposes they are meant for, the Centre deposited it in the Consolidated Fund of India (CFI) for general purpose use, in violation of the relevant laws that enable imposition of such cess and surcharge.

The CAG report of 2020 found 40% of the cess and surcharge collection in FY19 were misappropriated. It said: “Audit observed, however, that out of the ₹2,74,592 crore received from 35 cesses, levies and other charges in 2018-19, only ₹1,64,322 crore had been transferred to Reserve Funds/Boards during the year and the rest was retained in the CFI… A sum of ₹8,871.19 crore collected from the Social Welfare Surcharge on Customs but there was no dedicated fund for it – it went to the CFI contrary to the stated policy.”

It explained the consequences too: “Consequently, not only was the revenue/fiscal deficit understated due to the non-transfer of these amounts to Reserve Funds, failure of the Ministry of Finance to create/operate essential Reserve Funds makes it difficult to ensure that the cesses etc., had been utilised for the specific purposes intended by the Parliament.”

The CAG report of 2021 for FY20 revealed more such misappropriation and misuse. For example, it said “no funds out of the net proceeds of cess were transferred to Oil Industry Development Board” (not unique to this government, although the amount collected witnessed quantum jump post-2014) and out of ₹72,384 crore collected from cess on oil in the past five years (FY16 to FY20), only ₹15,506 crore had been spent on “activities pertaining to development of oil industry.”

There is more.

The Centre stopped paying the GST compensation to states in 2020, against the principles of the very Goods and Services Tax (Compensation to States) Act of 2017, under which it continues to collect a cess for the purpose nevertheless. The Centre now borrows money and gives loans to states instead – ₹1.1 lakh crore in FY21 and ₹1.58 lakh crore in FY22 – which states would have to pay back.

In September 2020, Finance Minister Nirmala Sitharaman dismissed the demand for paying GST compensation from the CFI, telling the Parliament that the Attorney General of India found no such provision. But what she didn’t reveal that by then, her ministry had taken ₹47,272 crore of the GST cess collected in FY18 and FY19 into the very same CFI, instead of passing on to states, as the CAG report of 2020 would reveal three months later in December 2020.

The CAG report of 2021 (Financial Audit No. 7, table in November 2021) for FY20 reveals that in response to its criticism, the Centre transferred ₹24,945 crore to the GST Compensation Fund in FY20 – still short by ₹22,327 crore. The Centre then transferred another sum of ₹33,412 crore to the GST Compensation Fund in June 2020 (post closure of accounts) from another head, the IGST, which had an unshared balance of ₹1,76,688 crore of FY18! The IGST collection is divided equally by the Centre and states, which didn’t happen in FY18.

The CAG also highlighted a complete mess in the Centre’s fiscal accounting and conduct by commenting that this transfer (from IGST to GST Compensation Fund) was done “without any disclosures of implications in gross terms for various heads of accounts covered by these transactions”.

There is yet another way the Centre hurts states: years of delay in giving the agreed dues to states.

This is an annual grievance of states. At the December 30 pre-budget meeting of finance ministers, Tamil Nadu Finance Minister Thiaga Rajan sought immediate release of at least ₹19,577 crore of dues pending since FY18. The Bihar government’s presentation talked of the pending Centre’s contributions to the Pradhan Mantri Gram Sadak Yojana (PMGSY). The shortage of funds for the MGNREGS works because of non-release of funds by the Centre, even during the pandemic crisis of FY21 and FY22.

But such acts must stop with the forthcoming budget. Lack of fiscal resources with states would mean further delay in the economic recovery and immensely avoidable pain to the people.