State Finances: A case for increasing monthly tax devolution to states

By: |
June 28, 2021 6:30 AM

At existing levels, devolution of nearly a third of the taxes budgeted for FY22 would get pushed to March 2022, which is inefficient from a cash-flow perspective for states

The CTD was further lowered to Rs 37,200 crore during October-January FY21 (4.7% of the budgeted CTD).The CTD was further lowered to Rs 37,200 crore during October-January FY21 (4.7% of the budgeted CTD).

The central tax devolution (CTD) forms a substantial ~25% of the states’ combined revenue receipts, although its share varies across various states. The monthly pattern of tax devolution used to be fairly stable in earlier years imparting predictability to the cash flows of the state governments. With the Covid-19 pandemic affecting the Centre’s tax inflows in FY21, this monthly pattern of devolution underwent some change.

The growth of CTD embedded in the GoI’s FY22 budget estimates (BE; Rs 6.7 lakh crore) relative to the FY21 provisional actuals (Rs 5.9 lakh crore) is moderate, at 11.9%. While there have been concerns related to the impact of the second Covid-19 wave on tax revenues, the net direct tax collections of the in Q1 FY22 (as on June 15, 2021) were twice as high as the year-ago period. Even if the cesses on fuels are reduced to cool the inflationary pressures, since these are not shareable with the states, it will not affect the CTD. Therefore, in our view, the FY 22 BE y-o-y growth of 11.9% in the tax devolution appears realistic at present.

However, the devolution has contracted by 14.9% to Rs 39,200 crore each in April-May FY22 from Rs 46,000 crore each in the year-ago period. This is because the FY22 BE CTD is 15.1% lower than the Rs 7.8 lakh crore that was budgeted for FY2021, and the Centre has released 5.9% of the budgeted CTD monthly to the states in April-May FY21 and April-May FY22. If the monthly amount of CTD is retained at Rs 39,200 crore in June-February FY22, the release of more than a third of the taxes budgeted for FY22 would get back-ended to March 2022 (presuming that the CTD for FY2022 is not revised below the budgeted level), which would be inefficient from a cash-flow perspective for the states.

We have constructed two scenarios for stepping up the CTD in the remaining months of FY21, assuming that the Centre will retain the gross tax revenues and the CTD in the FY22 revised estimates (RE) at the budgeted level. Under Scenario (1), the monthly CTD for June-February of this fiscal may be increased to one-fourteenth of the BE (in line with the past practice), or Rs 47,500 crore per month. This would leave a balance of Rs 1.6 lakh crore to be transferred in March FY22, which would be a modest 5.6% higher than the amount released in March FY21, although it would still be a substantial one-fourth of the annual CTD. Under Scenario (2), the amount to be released in March FY22 has been placed at Rs 1 lakh crore. Based on this, the monthly devolution to the states during June-February FY22 would rise to Rs 54,100 crore. This would ease the pressure on the state governments’ borrowings in the interim months and allow them more flexibility in undertaking expenditure during the year, which would be growth-supportive in our view.

In line with the accepted recommendation of the Fifteenth Finance Commission (FC XV), the Centre would be transferring 41% of its divisible pool as CTD to the states during FY22-FY26, unchanged from the level in FY21.

Typically, the amount of devolution by the Centre to the states for the months of April-January of a fiscal, is based on the BE of the former’s gross tax revenues and CTD for that year. At the time of publication of the next fiscal’s Union Budget during Q4, the GoI publishes its revised estimates (RE) for its gross tax revenues, based on the underlying trend of the actual taxes collected during the year. Reflecting the change in the later, the CTD for that fiscal is also modified. Subsequently, the Centre adjusts the amount devolved in February-March, to align the total tax transferred in that fiscal, with the RE for the CTD for that year. At the end of March, if the actual tax collections turn out to be lower than the amount included in the RE (as was the case in FY20), the excess CTD transferred is adjusted from the subsequent year’s devolution. In contrast, if by the end of March, the Centre’s actual tax collections turn out to be higher than the RE (as was the case in FY21), it may devolve the additional CTD in the same fiscal or in the subsequent fiscal.

For FY22, the Centre has projected its gross tax revenues at Rs 22.2 lakh crore and the CTD at Rs 6.7 lakh crore. These estimates are a moderate 9.5% and 11.9% higher, respectively, than the gross tax revenues (Rs 20.2 trillion) and CTD in FY21.

The growth embedded in the budgeted gross tax revenues and CTD for FY22, relative to the FY21 provisional actuals, is lower than ICRA’s forecast of nominal GDP expansion of 15-16% for FY22.

The latter factors in the impact of the second wave of Covid-19 on the economic activity, as well as ICRA’s projections for the CPI and WPI inflation for FY22.

Despite the realistic CTD for FY22 BE, the actual taxes devolved in April-May 2021 (Rs 39,200 crore each), are 14.9% lower than April-May 2020 (Rs 46,000 crore each). We observe that the monthly tax devolution in both these periods has remained steady at 5.9% of the budgeted CTD in both FY21 and FY22. Therefore, the reason for the y-o-y decline in the amount devolved in April-May 2021, is that the budgeted CTD for FY22 (Rs 6.7 lakh crore) is 15.1% lower than the CTD budgeted for FY2021 (Rs 7.8 lakh crore).

The Covid-19 pandemic led to a substantial variation in the Centre’s gross tax revenues as well as CTD in FY21 relative to the budgeted level. The lockdown-led disruption in economic activity dented the tax inflows of the Centre and it devolved Rs 42,000 crore to the states during June-September FY21 (5.4% of the budgeted CTD). The CTD was further lowered to Rs 37,200 crore during October-January FY21 (4.7% of the budgeted CTD).

In FY22 Budget, the Centre revised its gross tax revenues for FY21 by a sharp 21.6% to Rs 19 lakh crore from Rs 24.2 lakh crore budgeted prior to the onset of Covid-19 pandemic and the CTD was revised by a deeper 29.9% to Rs 5.5 lakh crore from Rs 7.8 lakh crore for the same period. In February FY21, the Centre devolved Rs 35,300 lakh crore to the states, which was 6.4% of the revised CTD of Rs 5.5 lakh crore for that fiscal.

However, the subsequently released provisional actuals for FY21 revealed that the Centre’s gross tax revenues stood at Rs 20.2 lakh crore, 6.6% higher than the FY21 RE of Rs 19 lakh crore. The provisional actuals for FY21 have pegged the CTD to all states at Rs 5.9 lakh crore, 8.2% higher than the FY 21 RE of Rs 5.5 lakh crore. Accordingly, the Centre devolved Rs 1.5 lakh crore to the states in March FY21, or a substantial 25.4% of the provisional CTD of Rs 5.9 lakh crore for FY21.

Unless the monthly amount of CTD is imminently increased from Rs 39,200 crore, the balance left to be devolved in Q4 FY2022 would be substantial, which would be inefficient from a cash-flow perspective for the states. For instance, if the GoI continues to devolve Rs 39,200 crore during June-February FY22, then a massive Rs 2.4 lakh crore (36% of the FY22 BE) will be left for devolution in March 2022, assuming that the CTD for FY22 is retained at Rs 6.7 lakh core in the revised estimates. Accordingly, we believe that the monthly amount of CTD could be stepped up in FY22, unlike the situation in FY21.

We have constructed two scenarios in this note, both of which assume that the FY22 RE for CTD will be the same as the FY22 BE.

Scenario (1): Prior to FY19, the Centre typically used to devolve one-fourteenth of the budgeted CTD in April-February of each fiscal year and made adjustments based on the RE in March. If the GoI chooses to modify the monthly CTD for June-February of this fiscal to one-fourteenth of the FY22 BE, this would imply a monthly devolution of Rs 47,500 crore during these months.

Adding the Rs 39,200 crore each released during April-May 2021 would entail a cumulative release of Rs 5.1 lakh crore in 11M FY2022. Assuming that the FY22 RE for CTD would be unchanged from the BE, the balance amount to be devolved in March 2022 would be Rs 1.6 lakh crore, which is a modest 5.6% higher than the amount released in March 2021. However, even this will entail that the amount released in March 2022 would be one-fourth of the annual CTD, similar to the situation in FY21.

Scenario (2): The amount of CTD to be released to the states in March 2022 has be placed at Rs 1.0 lakh crore (~15% of the FY22 BE). Assuming that the FY22 BE for CTD does not need to be revised, the monthly amount to be devolved to the states during June-February FY22 would rise to Rs 54,100 crore. This would ease the pressure on the state governments’ borrowings in the interim months and allow them more flexibility in undertaking expenditure during the year, which would be growth-supportive in our view.

With Neetika Shridhar & Jaspreet Kaur, ICRA

The author is Chief economist, ICRA

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