The fiscal stress that has been building up at various levels of the government has been aggravated by the COVID-19 pandemic. The collapse in general government revenues, and the consequent rise in the deficit levels has not only disrupted the glide path of fiscal consolidation, but has also deepened the faultlines in Centre-state fiscal relations. Against this backdrop, the 15th Finance Commission is expected to submit its report in about four months from now.
That the terms of reference of the Commission were contentious to begin with is beyond debate. Attempts by the Centre to claw back the fiscal space ceded to the states and assert its dominance over the country’s fiscal architecture, now coupled with the fiscal constraints exposed by the pandemic have made it harder to maintain the delicate balance needed to manage the contesting claims of the Centre and the states. It will be ironic if the ongoing health crisis that has ended up exposing the limitations of a centralised approach, ends up reversing the trend towards fiscal decentralisation.
The Commission’s report will be critical on two counts: First, it will determine how India’s fiscal architecture is reshaped, and second, how Centre-state relations are reset as the country attempts to recover from the COVID-19 shock.
To begin with, the glide path of fiscal consolidation laid out by the FRBM review committee had envisaged bringing down general government debt to 60 per cent of GDP by 2022 — this is unlikely to materialise now. Factoring in the additional borrowings, the debt-to-GDP ratio may well be over 80 per cent this year. Thus the fiscal consolidation roadmap will have to be reworked, and as per its terms of reference, the Finance Commission will lay out the new path to be followed by both Centre and states. But the question is: Will the burden of debt reduction fall equally upon the Centre and states? Or will the Commission allow the Centre to have greater leeway when it comes to fiscal consolidation?
Then there is the issue of state borrowings. Recently, the Centre eased the states’ budget constraint, allowing them to borrow more this year, conditional upon them implementing reforms in line with the Centre’s priorities. Despite protests, most states are likely to comply with the conditions, to varying degrees. But the issue is: As the hit from the ongoing crisis spreads over multiple years, state governments may want to maintain their expansionary fiscal stance next year as well. Then, will the Finance Commission, in line with its terms of reference, go along with the Centre’s stance and recommend imposing conditions on additional borrowing and formalise this arrangement? It is difficult to see such an arrangement being rolled back once formalised.
There is also the issue of the GST compensation cess. The GST council, in which the Centre effectively has a veto, is yet to clearly spell out its views on the extension of the compensation cess to offset states losses beyond the five-year period. The Commission will have to weigh in on this too. At a time when the Centre is struggling to fulfil its promise of assuring states their GST revenues, will the Commission argue in favour of extending the compensation period, as states desire, but, perhaps, lowering the assured 14 per cent growth in compensation and linking it to nominal GDP growth? As GST revenue accounts for a significant share of states’ income, how this plays out will also have a bearing on their ability to bring down their debt levels.
Next comes the issue of tax devolution to states. In some sense, accepting the recommendations of the 14th Finance Commission was a fait accompli. However, the present dispensation’s unease with extending greater fiscal autonomy to states is apparent in the framing of the terms of reference of the 15th Finance Commission. But is clawing back fiscal space now a prudent approach? A cash-strapped Centre will surely welcome greater say over the diminished resources. And not only is there a strong argument for the Centre to have far greater fiscal space than it currently enjoys — the fiscal multiplier of central government capital spending is greater than that by the states — but the nature of politics may well push in that direction. Centralisation of political power may well lead to demands for centralisation of resources. However, surely fiscal space can be created by a review of the Centre’s own spending programme.
Over the past decades, there has been a substantial increase in the Centre’s spending on items on the state and concurrent list. While political considerations may well have forced central governments, irrespective of ideology, to greatly expand spending on these items, this shift has occurred even as grants by the Centre to states exceed the former’s revenue deficit. This, as some have pointed out, effectively means that the Centre is borrowing to transfer to states. Surely, a relook at the Centre’s expenditure priorities would create greater fiscal space for it.
Any attempt to shift the uneasy balance in favour of the Centre will strengthen the argument that this government’s talk of cooperative federalism serves as a useful mask to hide its centralising tendencies. As a neutral arbiter of Centre-state relations, the Finance Commission should seek to maintain the delicate balance in deciding on contesting claims. This may well require giveaways especially if states are to be incentivised to push through legislation on items on the state and concurrent list.
The fiscal stress at various levels of the government necessitates a realistic assessment of the country’s macro-economic situation, the preparation of a medium-term roadmap, as well as careful calibration of the framework that governs Centre-state relations. At this critical juncture, the Finance Commission should present the broad contours of the roadmap. Though it could request for another year’s extension to present its full five-year report citing the prevailing uncertainty.
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