Letter from Karnataka: New fault-lines in fiscal federalism

The stage is set for a new battle between the Union government and state governments in India. The Centre will, in the coming months, appoint the 16th Finance Commission (FC). In preparation, state governments are being consulted to offer their suggestions for the Terms of Reference (ToR) for the commission. Appointed every five years, the FC is constitutionally mandated to determine the share of taxes (divisible pool) between the Union and the states and, crucially, the formula by which taxes are to be shared between states.

Given the significance of this exercise, seeking states’ input for the ToR is a routine task, one that is in keeping with established principles of federalism. But what makes this routine exercise significant in the present moment are the underlying shifts in India’s contemporary political and economic trajectories that have created new fault-lines in our precarious fiscal federal compact.

At the heart of the matter is India’s widening spatial inequality and the fiscal pressures that it is bringing to state and national politics. This is the crux of the Government of Karnataka’s communique to the Union government, recently reported in this newspaper. The crux of Karnataka’s argument is that the FC must re-prioritise the devolution formula away from redistribution toward incentivising growth. “Though traditionally higher emphasis has been given on equity parameter”, the Karnataka government argues, “the importance of spillover effects of sustaining greater growth in developed states has been neglected…(therefore it demands) a change in the approach of the Finance Commission towards incentivising high-growth states to perform better instead of the traditional approach of supporting less-developed states.”

This is a complete reversal of accepted principles of redistribution that have guided successive Finance Commissions. Historically, population and income distance have been the two key criteria for determining devolution, with income distance being given the largest weight. Consequently, India’s richest states have been routinely subsiding India’s poorer ones, in line with first principles of public finance.

Till recently, there has been, as economist Rathin Roy has argued, a widespread consensus or “fraternal” acceptance, which has characterised India’s inter-governmental fiscal relations. But, Roy has warned, widening inequity between states has broken the basis for this consensus. After all, he argues, “when Uttar Pradesh is poorer than Nepal and Tamil Nadu almost as rich as Indonesia…the more difficult it is to convince people that the tax base should be viewed as a single entity”. This is exactly the challenge that the 16th FC will now face.

The fraying of the fraternal feature of India’s fiscal federal relations was already visible in the debate that surrounded the terms of reference of the 15th FC back in 2018. The 15th FC was mandated to use the 2011 population census, rather than the 1971 census data for the devolution formulae. The southern states (inevitably the richer states), who’ve had greater success in controlling population, rallied together to challenge this, arguing that it would penalise them for successful policy. It took deft handling by the 15th FC to avoid a crisis while rightly, in my view, using the 2011 census.

But six years down, spatial inequality has likely widened, thus placing greater pressures on the fraternal consensus, and in 2023, the 2011 population criterion and income distance are being questioned. And it’s not just Karnataka. Other states like Tamil Nadu, too, have repeatedly raised this issue and, in the coming months, these protestations are likely to become louder.

The challenge is exacerbated by the fact that this deep structural imbalance in India’s economy and the new fault-lines are emerging against the backdrop of an extremely fraught federal politics. New Delhi has always tended toward fiscal centralisation. However, in recent years, this has intensified significantly. On the fiscal front, the Centre has failed to keep to its promise. Having accepted the 14th and 15th FC recommendations to enhance states’ share in the divisible pool of taxes from 32% to 41% (15th FC), the Centre has carefully avoided fulfilling it. Worse, it has resorted to the unsavoury practice of increasing cesses and surcharges on taxes, which are not shareable with states, to ringfence tax revenues for its own purposes. All states can do in this scenario is protest, loudly.

And then there is politics. From converting states into Union Territories without any debate to deploying central government welfare schemes -- remember the recent controversy over PDS rice for the Anna Bhagya scheme -- for personalised political credit, the BJPs “one nation” political framework dominates. The result is a deep distrust between states and the Union, which makes any negotiation difficult.

But states, too, have recognised the political power of personalised welfare politics. Within states, governments are struggling with growing intra-state inequality, for which the blunt fiscal instrument of cash transfers is proving to be a potent palliative. The truth is, no political party in India today has the imagination to address the reality of jobs, inequality and low social mobility – the real drivers of inequality. And thus, like the Union government, they too have been seduced by the opportunity to consolidate political power through direct cash transfers. This raises the fiscal pressure on states and thus raises the stakes for a Centre-state battle. This is articulated well by Karnataka in its communique arguing that the 16th FC must find a way of dealing with intra-state disparities in calculating the income criterion.

Resolving the deep structural imbalances in India’s economy is beyond the remit of the 16th FC. But to arrive at a devolution formula against the backdrop of these challenges will require political maturity, sagacity, and patient negotiation. Unfortunately, at present, the political landscape is sorely missing these critical elements. And so, we are likely to witness grandstanding and crude bargaining between the Centre and states, which will result in poor compromises. I don’t envy the 16th Finance Commission and its soon-to-be-appointed members!