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Are Centre-State Relations At A Crossroad? YV Reddy Weighs In

A set of events over the last few years have changed the balance of power between the central and state governments.

These developments, when taken together, suggest that ‘Fiscal Federalism’ is at a crossroad in India, argues a recently released book called ‘Indian Fiscal Federalism’, authored by former Reserve Bank of India Governor YV Reddy and co-authored by GR Reddy.

These events include:

  • The setting up of the GST Council
  • The 14th Finance Commission and subsequently the terms of reference of the 15th Finance Commission
  • Replacement of the Planning Commission with the NITI Aayog
  • Reduced flexibility for states in revenue generation along with an increased burden of expenditure
  • The review of the Fiscal Responsibility And Budget Management Act undertaken by a committee headed by NK Singh

These events taken together give the impression that an attempt is being made to shift the balance between centre and states, YV Reddy and GR Reddy told BloombergQuint in an interview. These events have led to an erosion of trust between the centre and states, which must be corrected, the authors argued.

They highlighted that the burden of fiscal adjustments is falling on state governments more than it is on the central government. This, even as questions have been raised on the correctness of the central government’s own fiscal management by the Comptroller and Auditor General of India. “The impression given (by the CAG report) is that the centre is concealing the fact that it is not consolidating...On a judgemental basis, we can say that states are bad but the centre is worse in fiscal management as per the fiscal parameters,” YV Reddy said. Co-author GR Reddy said while the states have stayed within the limit set for them under the Fiscal Responsibility and Budget Management, the centre continues to a run a large revenue deficit which it should have eliminated by now.

The authors weighed in on some of the recent developments in centre-state relations.

GST Council

Among the more positive developments in centre-state relations has been the establishment and early functioning of the GST Council. “The GST Council is a shining example of cooperative fiscal federalism at its best,” the authors wrote. “While the arrangement is yet to stand the test of time, the functioning so far gives rise to hope that it will be a pillar of strength on the indirect revenue side, just as the Finance Commission is on the revenue expenditure side of the centre-state fiscal relations,” they said.

Still, there are some lingering concerns following the implementation of GST.

Among them is the fact that states have yielded more fiscal space than the centre. “The centre has yielded only 30-32 percent of its fiscal space whereas up to 47 percent of the fiscal space of states has been subsumed under GST,” said GR Reddy. Value added tax, the more elastic source of tax revenue available to states, was subsumed except on some items, including petroleum products and alcohol. The authors said the council should not rush to include petroleum products under GST as that will further hurt fiscal flexibility of states. Meanwhile, the centre still has access to income tax, corporation tax and customs duty and retains greater revenue flexibility.

Generally, as the economy gets more and more integrated, the advantage is more centralised revenue collection. But the services are local. So as the economy progresses, the gap between the centralised revenue and decentralised expenditure increases. That is what we are seeing in some ways.
YV Reddy, Former RBI Governor & Author of Indian Fiscal Federalism

The Cess Debate

The authors weighed in on the tendency of the government to recoup revenue flexibility via the imposition of cess and surcharge, which is not shared with the states. About 14 percent of the centre’s gross tax revenue came from cess, said GR Reddy.

This has been a constant complaint from states, said YV Reddy, adding several Finance Commissions have recommended that use of cess be avoided. “After the introduction of GST, the recourse to cess is totally unjustified.”

GR Reddy explained that some 13-14 cess had been subsumed under GST but the government resorted to introducing cess on customs duty and others. This means that the percentage of gross tax revenue coming via cess remains the same.

The CAG had recently questioned whether the cess in some cases is being used in a timely and appropriate manner. “The CAG is the right authority and I am glad they pointed this out,” said YV Reddy.

Fiscal Management: Centre Vs States

YV Reddy also highlighted that the CAG had questioned whether there was an understatement of the fiscal deficit by the centre. The government’s auditor has raised questions about off-budget items being used to keep the fiscal deficit artificially low.

“The CAG itself has certified that there is a bit of understatement,” the former RBI governor said, adding this is akin to the centre concealing that it is not achieving the fiscal consolidation that it intended to.

Broadly states have adhered to the fiscal targets set for them under the FRBM Act, GR Reddy said.

In contrast, the centre continues to ignore the crucial aspects of fiscal consolidation such as the revenue deficit which remains above 2 percent of GDP. “Consistently, the centre has been failing to adhere to the fiscal norms more than the states,” GR Reddy said.

Yet, the burden of consolidation will lie more heavily on states under the revised FRBM Act provisions set by the NK Singh Committee. The committee targets to bring down the general government debt to 60 percent by 2022-23.

The Fifteenth Finance Commission

The book weighs in on the debate around the terms of reference of the Fifteenth Finance Commission. A number of issues have emerged with respect to these terms. Among them is the use of the 2011 census as the population benchmark over the 1971 census. States have argued that using the more recent census will put states, which have prioritised population control, at a disadvantage.

YV Reddy said neither is the optimal solution since the sharing of revenues over a period should be decided based on the expected population picture over that period. As part of the Fourteenth Finance Commission, which Reddy chaired, the census was only given a certain weight in the final decisions and was not the only benchmark, he said.

Commenting on certain other contentious terms of reference such as assessing state performance in implementing centrally sponsored schemes and so-called ‘populist schemes’, both authors felt that the terms of reference are not binding on the commission.

The Non-System Of The NITI Aayog

According to the authors the abolition of the Planning Commission has left a crucial gap, which has not been filled successfully by the NITI Aayog.

Among other things, the Planning Commission used to be a central agency which incorporated the view of states in central government transfers aside from those mandated by the Finance Commission. Such transfers make up two-thirds of the total transfers.

“Now there is a vacuum...Each ministry has its own centrally sponsored schemes. So there are no coordinated discussions between the centre and the state on the developmental thrust,” YV Reddy said. This is not because the NITI Aayog lacks the mandate.

“NITI Aayog has a wide canvas but it needs political authority and adequate expertise and stature. NITI Aayog is far below (what is needed),” Reddy said.

Watch the full interview below: