Context:

• The debate on states’ fiscal autonomy has intensified in recent years, particularly in the backdrop of changes introduced by the 14th, 15th, and 16th Finance Commissions (FCs).
• States argue that their fiscal space is shrinking, especially due to rising non-sharable cesses and surcharges, evolving devolution formulas, and post-GST structural issues.
• Fiscal space consists of states’ own revenue receipts and the total transfers that they receive from the Centre, including the FC transfers.

Understanding Fiscal Transfers - Components and Trends:

• Structure of transfers:
  • Transfers from the Centre to the states consist of tax devolution (largest share) and FC and non-FC grants.
  • Tax devolution and FC grants (tied, untied, sector-specific grants) are determined by the FC whereas non-FC grants are at the discretion of the central government.
  • States’ own revenue receipts (SORR) consists of both tax and non-tax revenues.
• Combined revenue receipts: Measured as the sum of Centre and states’ revenue receipts, used to assess relative fiscal space.

Major Changes Across Finance Commissions (14th FC - A Landmark Shift):

• States’ share in the divisible pool increased from 32% (13th FC) to 42%.
• States’ share in combined revenue receipts rose from average of 15% (13th FC) to 19.2%, that is an increase of 4.25 percentage points.
• The share of states after transfers (fiscal space) increased from 63.85 to 68.08% of combined revenue receipts. Thus, the relative shares of Centre and states were reversed.

15th Finance Commission - A Mild Contraction:

• Fall in States’ fiscal space: States’ share of aggregate revenue receipts fell from 68.08% (14th FC) to 67.39% - a drop of 0.70 percentage points.
• Reasons for decline:
  • Reduction in tax devolution share - fell by 1.05 percentage points to 18.2%.
  • Rise in cesses and surcharges - these are non-sharable, reducing states’ share in the divisible pool.
  • Decline in states’ own revenue receipts - fell by 0.47 percentage points.
  • It may be noted that for the 15th FC period, the number of states had been reduced to 28 (post J&K bifurcation).
  • Offsetting increase in FC and non-FC grants - net fall in transfers is only 0.23 percentage points.

Sharper Impact on High-Income States:

• States considered: Haryana, Karnataka, Kerala, Maharashtra, Tamil Nadu.
• Trends:
  • From 13th to 14th FC, there is no net change in fiscal space, but higher transfers offset by lower SORR.
  • From 14th to 15th FC, fall in the fiscal space of high-income states, amounting to 0.38 percentage points of combined revenue receipts (decline in SORR - 0.25 percentage points, decline in transfers - 0.13 percentage points).
• Causes of decline:
  • Higher cesses and surcharges, reducing sharable pool.
  • Horizontal devolution formula potentially less favorable.
  • Post-GST issues like GST 2.0 reforms (rate reductions) and the discontinuation of the GST compensation cess.

Key Challenges:

• Rising non-sharable cesses and surcharges: Dilutes the divisible pool, and reduces predictability of transfers.
• Declining States’ own revenue: As they depend on the Centre increases, and GST structural issues affect buoyancy.
• Horizontal devolution concerns: High-income states claim that the FC transfer formula penalizes efficiency. For example, distance criterion in the horizontal distribution may disadvantage developed states.
• Greater expenditure responsibilities: Fiscal stress post-COVID on social sector, infrastructure, climate adaptation.
• GST compensation cess withdrawal: Affects fiscal capacity of manufacturing-heavy and consumption-heavy states.

Way Forward:

• Reforming the transfer architecture: Ensure equitable yet efficiency-enhancing distribution. Hopefully, the 16th FC has taken into account these concerns and modified the weight attached to the distance criterion in the horizontal distribution.
• Limiting non-sharable levies: The Centre should curb excessive use of cesses and surcharges, and move towards greater transparency and predictability.
• Strengthening revenue buoyancy: Improve GST compliance and widen base. Enhance states’ own tax capacity (property tax, excise reforms).
• Cooperative federalism: Institutionalise Centre-state dialogue on fiscal reforms. Strengthen GST Council mechanisms for compensation alternatives.
• Rationalising expenditure: Outcome-based budgeting, better targeting of subsidies.

Conclusion:

• Factors such as rising cesses and surcharges, changes in devolution formulas, and GST-related challenges have constrained states’ autonomy.
• As the 16th Finance Commission submits its recommendations, ensuring a balanced, predictable, and equitable system of fiscal transfers is essential for strengthening fiscal federalism.
• This will improve development outcomes, and enable both the Union and states to meet mounting socio-economic challenges.