India should incentivize state-level fiscal responsibility

Source: The post is based on the article “India should incentivize state-level fiscal responsibility” published in Livemint on 7th November 2022. 

Syllabus: GS 2 – Devolution of powers and finances up to local levels and challenges therein.

Relevance: About the state-level fiscal responsibility.

News: To ensure fiscal discipline, the government at all levels must be made to face financial consequences of their decisions.

What are the recent decisions that led to a debate on state-level fiscal responsibility?

Earlier, Rajasthan and Chhattisgarh restored the old pension scheme. Following them, the Punjab government too has given in-principle approval to restore the old pension scheme.

These are the states with two of India’s highest debt-to-GDP levels taking such fiscally extravagant action. The move backtracks on one of the crucial reforms that helped state governments bypass a ‘fiscal bullet’.

What is the importance of fiscal devolution?

The transfer system is supposed to address the problem of imbalance between revenue and expenditure powers. The fiscal devolution aims to correct spatial imbalances to ensure the economic stability of the Union. It aids states that cannot raise sufficient revenue on account of historical and geographical limitations. This is inevitable as substantive revenues are mobilized from a handful of urban agglomerates.

Nearly half of the weight in India’s devolution formula is income distance: i.e., the distance of a state’s per capita GSDP from the state with the highest per capita GSDP. This can lead to cases of perverse incentives, wherein some states over-rely on these devolutions.

As per the state budgets for 2022-23, of the total revenue receipts for states, the share expected from the Centre (sum of tax devolution and grants) ranges from 76% in Bihar and 57% in West Bengal to 27% in Gujarat.

How fiscal devolution is causing a lack of state-level fiscal responsibility?

Protected revenue and high devolutions have disincentivized the states to carry out reforms. This is because,

a) Under-reliance on the state’s own tax resources might be the reason Bihar prohibits the sale of alcohol, a significant tax source for most states, without affecting its fiscal health or sustainability, b) For a state, the primary source of budgetary resources is tax revenue (the predominant part being state GST) and the devolution of 41% of the general pool of taxes. This has resulted in a situation where a substantive portion of the state’s budget is an apportionment from the Union government. This led to a poor fiscal decision by state governments, c) To get states on board for the GST regime, financial assurance was provided to them by a ‘Protected Revenue’ clause.  It has resulted in a scenario wherein the state’s largest tax head (SGST) is divorced from the prevailing economic environment in the state.

What needs to be done to improve state-level fiscal responsibility?

1) Healthy competition between Indian states for investments, incentivizing political innovation and development, is critical to improving the fiscal responsibility of states, 2) The Union government has to adopt a competitiveness framework that transfers fiscal resources based on the state’s GSDP performance, 3) The government has to increase the share of conditional transfers (possibly at least 5% of the divisible pool) based on reforms, quality of expenditure and fiscal sustainability in place of the current regime.

All this will raise revenues and improve the quality of public expenditure. Apart from that, it will also ensure state governments face the financial consequences of their fiscal misadventures.