Context

• State governments drive a majority of the country’s development programmes. States need resources to deliver these responsibilities and aspirations. Unfortunately, the financial capacity of the States is structurally being weakened. 
• Through various means the Union government has substantially reduced the fiscal resource capacity of the States.

Factors responsible

• The ability of the States to expand revenue has been constrained since the Goods and Services Tax (GST) regime was adopted. 
• The Centre’s resource mobilisation space vis-a-vis that of the States is now far greater. 
• While both face a very challenging fiscal environment, the Centre, instead of finding mutually beneficial solutions, has repeatedly opted to undermine the current and future fiscal capacities of the States through the following means.

Declining devolution

• Finance Commissions recommend the share of States in the taxes raised by the Union government. Their recommendations are normally adhered to. 
• Prior to 2014, devolution of funds to the States were consistently and cumulatively more than 13th Finance Commission’s projections. 
• The year 2014-15 witnessed the actual devolution which was 14% less than the Finance Commission’s projection. 
• Subsequent devolutions have been consistently less every year, ending the period 2019-20 with a whopping -37% whis is an undeniable and substantial reduction of the fiscal resource capacity of the States.

Shrinking the divisible pool

• Various cesses and surcharges levied by the Union government are retained fully by it. They do not go into the divisible pool. This allows the Centre to raise revenues, yet not share them with the States. 
• Hence, the Union government imposes or increases cesses and surcharges instead of taxes wherever possible and, in some cases, even replaces taxes with cesses and surcharges. When taxes are replaced with cesses and surcharges, the consumer pays the same price. But the Union government keeps more of that revenue and reduces the size of the divisible pool. As a result, the States lose out on their share. 
• Between 2014-15 and 2019-20, cesses and surcharges soared from 9.3% to 15% of the gross tax revenue of the Union government. This systematic rise ensures that the revenue that is fully retained by the Union government increases at the cost of the revenue that is shared with the States. 

GST shortfall

• Shortfalls have been persistent and growing from the inception of GST. 
• Compensations have been paid from the GST cess revenue. 
• GST cesses are levied on luxury or sin goods on top of the GST. These are levied irrespective of compensation needs. GST compensation will end with 2021-22 however the cesses will continue.
• During 2019-20, the cess collected was ₹95,444 crore. With the abnormal exception of this year, the years ahead will generate similar or more cess revenue. 
• Of the nearly ₹3 lakh crore GST shortfall to the States this year, the Centre will only compensate ₹1.8 lakh crore.
• Many States have been insisting that the Union government should borrow this year’s GST shortfall in full and release it to the States. The entire loan can be repaid out of the assured cess revenue that will continue to accrue beyond 2022. 

Consequences

Reduction in revenue

• Due to the combined effect of cutbacks in devolution, the shrinking divisible pool, failure to pay full GST compensation this year and fall in Central grants, the States may experience a fall of 20%-25% in their revenues this year. 

Increased borrowings

• To overcome such extreme blows to their finances and discharge their welfare and development responsibilities, the States are now forced to resort to large borrowings. Repayment burden will overwhelm State budgets for several years. 

Developmental impact

• After paying loans and interest, salaries and pensions, and establishment expenses, there will be less resources available for development and welfare.
•  The fall in funds for development and welfare programmes will adversely impact the livelihoods of crores of Indians. Adverse consequences will be felt in per capita income, human resource development and poverty. 

Conclusion

• States are at the forefront of development and generation of opportunities and growth. Strong States lead to a stronger India. The systematic weakening of States serves neither federalism nor national interest.

Reference:

1. https://www.thehindu.com/opinion/lead/the-financial-capacity-of-states-is-being-weakened/article33024573.ece