Centre-State Fiscal Discontent: Why is the Second Engine Protesting?

Karnataka CM Siddaramaiah and Deputy CM D K Shivakumar.

(Photo: PTI)

The chief minister and deputy chief minister of Karnataka recently led protests in Delhi against the reduction of their state's share in the allocation of the central government's taxes. The CM of West Bengal has also had a running battle against the Centre’s alleged attempts to obstruct the flow of funds to central schemes like MG NREGA. 

Many opposition-ruled states seem to have strong discontent in the matter of Centre-state financial relations.

Has the Modi government done something to deprive the states, particularly those ruled by opposition parties, of their legitimate share of central taxes and grants? 

Reduced Share of States in Central Taxes

The Fourteenth Finance Commission (FC) increased states’ share in distributable central taxes significantly from 32 per cent to 42 per cent.  

The Modi government was not quite pleased with this recommendation, although BJP states like Gujarat and Rajasthan had asked for a much higher share, i.e., 50 per cent. Nonetheless, the Modi government implemented the award, at least on paper. The Centre’s gross tax revenues (GTR) minus cesses and surcharges broadly equal the distributable central taxes.

It decided to claw back some of the ‘loss’ by converting sharable taxes into cesses and surcharges. Over the years, more than 95 per cent of excise duties on petroleum products have been converted into cesses and surcharges (for example, only Rs 14,186 crores out of Rs 3,08,100 crores in 2023-24 RE [revised estimate] is sharable).  

The cesses and surcharges component in income taxes and customs have also increased. As a result, against 37 per cent of GTR being shared with the states in 2018-19, the states’ share has come down to less than 32 per cent in the second term of the Modi government.  

This sharp practice, however, has adversely impacted the states in general. 

Modi Government Not Primarily Responsible for Karnataka's Lower Share

The states’ collective share is further distributed by the Finance Commission. This happens after it assesses individual states' needs and already present fiscal resources.  

While the Commission considers many factors to quantify the needs of the states, the population and the poverty level end up primarily determining a their individual shares. The poorer states, after all, have weak fiscal resources/capacity.  

The Modi government did do away with in 2017 (for the 15th FC) the practice of binding the Commission to consider the population in the year 1971.

Based on the fundamental construct of the population and poverty representing ‘equity’, FCs have recommended disproportionately larger shares to poorer and populous states like Uttar Pradesh and Bihar, and smaller shares for less populous and relatively fiscally rich states like Maharashtra and Karnataka.  

Karnataka’s share was reduced over the years. The 15th FC made the largest cut bringing Karnataka’s share dramatically to 3.647 per cent from 4.713 per cent during the 14th FC's period. Other developed states like Tamil Nadu did not suffer such a fate. This sharp reduction needs to be understood. But this is not on account of any particular scheming by the Modi Government. 

Modi Government Has Altered the Rules of the Game for Loans

The Constitution envisages states as sovereigns for raising debt, subject only to the limits fixed by state legislatures. The Centre’s approval, however, is required, if any state is indebted to it.  

The central government has been a financier of states and provided them with all sorts of loans until the 1990s, making them over-indebted, with their finances coming under massive trouble. In 2002-03, many states, unable to honour their bills, had to close their treasuries for months.

The Centre effectively terminated lending to states in 2005-06 and adopted a rule-based approach of granting permission to states, only to the extent allowed by their fiscal responsibilities and the limits recommended by FCs, whichever is higher.  

Over the years, this made states responsible for their fiscal deficits, whereas the Modi government has routinely violated its own fiscal deficit limits. The government has made three major changes which have constrained states’ ability to borrow unreasonably. 

First, it imposed many discretionary conditions on additional borrowing during the COVID period and, thereafter, for the power sector. Second, it started reducing its annual borrowing limits for amounts raised by some public sector enterprises and authorities of state governments. Third, it re-started providing loans to states in the name of capital expenditure loans and imposed many political conditions like not renaming CSSs (Centrally Sponsored Schemes).

These conditions have made life for the opposition governments more difficult.

Politics Seem to Have Impacted the Disbursement of Central Grants

The Centre provides many discretionary and optional grants, mostly as CSSs. The 14th FC wanted the Centre to reduce such grants to keep the overall central outgo unaffected while increasing the share in central taxes.  

The grants are, however, political instruments in the hands of the central government. The Modi government tried to reduce the flow of grants initially by raising the counterpart share of states, which brought down the grants outgo somewhat in the first three years of its tenure.

However, fewer grants mean the lesser political influence of the central government in states. The grants came back with new names, in most cases, "Prime Minister" was attached as a prefix. For example, the Ayushman Bharat Pradhan Mantri Jan Arogya Yojana, PM KISAN etc.

The political messaging was clear. The schemes or grants were promoted as emanating from Prime Minister Modi. The states were prevented from altering the names of the schemes, though, in many cases, they effectively contributed more than 50 per cent of the costs.  

The BJP states had no issue with this. But the opposition states found the political messaging discomforting. Some states chose not to implement some of the schemes. Others tried to retain the old name or alter the messaging in their states.  

This had its consequences. In some cases, central agencies began investigating the implementation of particular schemes, impacting the flow of funds to opposition-ruled states. No wonder that the opposition governments complained. 

It is Fiscal Unionism, Not Fiscal Federalism

The Indian Constitution envisages fiscal federalism in India. As states are primarily responsible for development, their expenditure responsibilities are greater than their resources. Independent FCs take care of this resource mismatch. The central grants are supposed to be exceptional.  

The Modi government’s excessive use of cesses and surcharges has altered the tax resource flow from the Centre to the states.The imposition of numerous conditions in the borrowing space and the micro-management of borrowing limits has needled the states. The capital expenditure loans are designed to keep them under the thrall of central government. And central grants have become instruments to promote the Prime Minister. 

States are truly the second engine of development. While the BJP states don’t mind behaving more like a trolley attached to a tractor instead of a second engine, the opposition states, which truly form the double-engine sarkars, have understandably raised their voice.  

Instead of the Indian centre-state relationship being informed by fiscal federalism, it is fiscal unionism now. The discontents arising from this altered constitutional structure are likely to reverberate in the times to come.  

(The author is a former Economic Affairs Secretary and Finance Secretary of India. This is an opinion piece and the views expressed above are the author’s own. The Quint neither endorses nor is responsible for the same.)