Questions are being raised about the changing patterns for resource sharing between the Centre and the state governments. While the formation of the 16th Finance Commission has set the stage for a long trial, the Supreme Court (SC) is reviewing the financial relationship between the Centre and states from the constitutional standpoint, on a petition filed by the Kerala government. Former Cabinet secretary K M Chandrasekhar discusses the issues involved in the matter with K G Narendranath. Excerpts:

How do you view the legal battle between Kerala and the Union government over “fiscal federalism”?

I have not read the entire text of the state government’s petition before the Supreme Court. So far as borrowing limits are concerned, it looks to me that they have a strong case. Article 293(1) of the Constitution specifically says, “Subject to the provisions of this article, the executive power of a State extends to borrowing within the territory of India upon the security of the Consolidated Fund of the State within such limits, if any, as may from time to time be fixed by the Legislature of such State by law and to the giving of guarantees within such limits, if any, as may be so fixed.”

The Seventh Schedule under Article 246 further reinforces this view. “Public Debt of the Union” comes under the Union List as item 35, while the “Public Debt of the States” is shown as entry 43 in the State List. Thus, on the face of it, decisions relating to the debt of the State are to be controlled by the State Legislature, not the Government of India.

This has implications not only for the current case but all the limits that the Centre has set for the States from time to time. The Centre may argue that Article 293(1) is governed by Article 291(3) and 291(4), which read as follows: “A State may not without the consent of the Government of India raise any loan if there is still outstanding any part of a loan which has been made to the State by the Government of India or by its predecessor Government, or in respect of which a guarantee has been given by the Government of India or by its predecessor Government.

“A consent under clause (3) may be granted subject to such conditions, if any, as the Government of India may think fit to impose.”

The two clauses, read together, clearly indicate that they apply only to borrowing by States from the Central government or to State loans guaranteed by the Central government. The Supreme Court is the final arbiter and could take this or any other view.

The fact is that States have generally been following the limits laid down by the Centre on the recommendations of the 12th Finance Commission. In recent years, however, there has been too much interference, too many conditionalities, and insufficient consultation with the States, leading to the current situation.

The Centre, after taking into account Kerala’s past off-budget borrowings, restricted its FY24 market borrowings to below the 3% ceiling prescribed under the state FRBM law. Is this tenable?

It does not appear that the Centre has the power under the Constitution to set any limits. At the same time, unlimited powers to either the Centre or the States to borrow from the market is not desirable from an economic point of view. Only as much should be borrowed as is sustainable. This requires consultation between the Centre and the States, as has happened so efficiently concerning GST.

States’ share from the divisible tax pool rose 10 percentage points or 30% (to 42%) in the 14th and 15th Financial Commission award periods, compared to the level in 13th Commission period. Yet, tax devolution to the States is estimated to be just 36.5% of the Centre’s gross tax revenue in FY24. Does this amount to foiling the FC mandate?

Until the 13th Finance Commission, the mandate of the Commission was restricted to non-plan finances. The 14th FC was the first to consider all the resources, plan and non-plan. The plan share was 6.5%; hence, the State resources automatically increased to 38.5%. The 13th FC had also given many grants to States for specific projects. The 14th FC, on the other hand, decided not to provide individual grants, except where necessary, and to pass on the amount as an allocable share; this meant an additional 1.5%. Thus, all that occurred was a “compositional shift,” not a significant actual increase in the share of States.

However, the Centre used this misconception (that states’ share has risen) to reduce the share of States. A new government had just come into being at the Centre with the stated intention of improving relations with the States. Hence, the chief ministers heeded the request of the prime minister at the first meeting of Niti Aayog to reduce central shares in centrally sponsored schemes.

To this was added a sharp increase in cesses and surcharges, which do not have to be shared with the States. The Centre also borrowed liberally, and the share of Central debt in GDP is now about 58%, even though it has come down from 80% a couple of years ago. Thus, the situation is that the Centre has plenty of resources, and the States need more. The 16th FC will have to look carefully at how to rectify this imbalance.

Formula for horizontal distribution of shareable tax proceeds among states is meant to address the issue of equity and seek balanced regional development, among other things. Where must the line be drawn between horizontal equity and the need to keep rewards for performance?

“Rewards based on performance” looks good in theory, but there can be differences when we question what constitutes performance. There will be one view that it should be based on capex created or inflow of FDI. There could be others based on employment created or rise in per capita income, multidimensional poverty index, SDG index, or contribution of taxes. Agreeing on standard performance parameters will be challenging as States have grown according to their priorities.

GST compensation (assured 14% annual revenue growth) for states ended in June 2022. Revenue deficit grants are seemingly being phased out. Do these steps make the fiscal position of states weaker?

The critical point is that the present imbalance between the Centre and States should be corrected. There should be some mechanism to ensure that the Centre does not violate the sharing system mandated by the Finance Commission. How this is to be achieved is one of the principal tasks before the 16th FC.

The redesigned Centrally Sponsored Schemes allow the Centre to influence state’s spending patterns much more than earlier, and even in regard to items on the State List like public health. Is this a salutary development?

This is not a salutary practice for two reasons. First, the requirements of states vary. What is suitable for Uttar Pradesh may not be ideal for Kerala, as a consequence of which, the amount allocated to Kerala may remain unspent while UP will absorb the allocation quickly and ask for more. Second, they are inflexible and will not be modified according to the State’s requirements. This can be dealt with by allocating Central shares in bulk to each State based on the horizontal devolution formula laid down by FC and having a menu of options from which each State may select the suitable schemes. Besides, there should be inbuilt flexibility to add new schemes as requested by the States and to modify schemes according to local requirements.

The Centre’s resource transfers to states are increasingly being linked to assorted reforms. Does this amount to curtailing the states’ legitimate policy space?

Some reforms are desirable, such as power, transport, agriculture, and land reforms. A certain measure of arm twisting by linking resource allocations is not a bad idea. However, there must be regular interaction and building trust between the Centre and states. Loose talk should be avoided, like some states being “double engine,” and therefore preferred by the central government.

States’ aggregate budget spending is roughly 1.5 times the Centre’s, while the latter levies and collects more taxes. Is this justified?

As I have mentioned earlier, there is an imbalance in the allocation of resources between the Centre and the States, which needs to be corrected. After correction, there should be no deviation from the principles for vertical devolution.

In tax legislation, no concurrent jurisdiction was allowed. The GST laws changed it for the sake of uniform pan-India system of indirect taxes. Has this any adverse fallout for resource sharing between the Centre and states?

I believe GST is a good reform. The mechanism of GST was built after a long and arduous discussion between the Centre and the States. It is a self-policing system which ultimately will lead to higher resources for both and lower levels of corruption. It is being implemented jointly by the Centre and the States through a Council of State Finance Ministers. It currently has many lacunae, which will take time to correct in a country as large as India. Undoubtedly, it will eventually stabilise and benefit the nation as a whole.