Given prime minister Narendra Modi’s pre-election promises of cooperative federalism, the big test of the February budget will be what it does with the Finance Commission recommendations. Right now, with over half of total transfers from the Centre to the states (R7.8 lakh crore according to the budget estimates for FY15) in the form of grants and loans, there is a tremendous hold that the Centre has on states. This is why, for instance, chief ministers of BJP-ruled states like Rajasthan have been asking for, for many years now, an end to this practice of ‘tied aid’ where central ministries decide the priority areas of spending for states, and then also lay out the formula for such spending. Indeed, in their presentations to the 14th Finance Commission, BJP states like Gujarat, Madhya Pradesh, Rajasthan and Chhattisgarh asked for the automatic tax devolution amount to be raised from the current 32% to 50%. News reports suggest that the Finance Commission has raised this amount to 42% which effectively works out to around R1.5 lakh crore more going the way of states, money which they are free to spend as they like.
So far, Modi had been saying that if a state wanted to spend on irrigation, his government would ensure it shouldn’t be forced to spend on roads, and vice versa. Under the current scheme of things, there is no way to give such operational flexibility. Greater devolution of taxes, however, allows this to happen. The corollary to this, of course, will be that the central government will have to, in the next budget, drastically prune the level of centrally-sponsored schemes, usually pet projects of the central government. If the NITI Aayog follows this up, as many believe it will, with abolishing the distinction between Plan and Non-Plan expenditure, that will be another major expenditure reform.
Apart from the tremendous flexibility this will give states in formulating their expenditure strategies—they will also be more accountable to the electorate for the results of this expenditure—the move will also be a big boost to the plan for introducing the Goods and Service Tax (GST). Right now, the biggest complaint of states is that their tax revenues are likely to suffer under GST, but in one single shot, there will be a 25-30% increase in their revenues from central taxes. It would also help if the government dismantled what has derisively been called the Indian Cess Service. In FY15, if the 13th
Finance Commission’s 32% formula was to be used, the states would have got R4.36 lakh crore; what they are budgeted to get, however, is an amount lower by R54,000 crore—this is due to the prevalence of cesses and surcharges on various taxes that are not shared with the states. Given this adds up to over 14% of tax revenues that the states get, the amount is a significant one—perhaps this is something the next Finance Commission needs to look at.