India - Respect the fiscal compact

It's time to plug legal loopholes to curb inconsistencies in the Centre-state fiscal compact.
In an article on May 10 in Business Standard, I had discussed and evaluated the efficacy of the Fiscal Responsibility and Budget Management Act, 2003 (FRBMA). The law was enacted to lower and cap the central government’s fiscal and revenue deficits over the medium term. Judging performance against quantitative (outcome) benchmarks, the evidence in favour of self-imposed rules as stipulated in the FRBMA was found to be patently thin.
It would seem that the FRBMA is not the only fiscal rule that has been the victim of central government behaviour (in spirit, if not in letter). A case in point is the sharing of Union taxes with states. Most readers of this paper would be aware that the Finance Commission every five years, inter alia, determines the states’ share of taxes imposed and collected by the Centre. Until 1999-2000, only income tax and Union excise duty were shared with the states; the 10th Finance Commission recommended a major change, specifically, that all union taxes should be included in the shareable pool. Prior to the enactment of the Constitution (Eightieth Amendment) Act, 2000, the sharing of Union tax revenues with the states was in accordance with the provisions of Articles 270 and 272, which, respectively, provided for the compulsory sharing of income tax (excluding corporation tax) and Union excise duty. The amendment altered the pattern of sharing of Union taxes in a fundamental way. Article 272 was dropped and Article 270 was changed, which provided for sharing all taxes and duties except those referred to in Articles 268 and 269 — respectively, surcharges on taxes and duties, and cess levied for specific purposes. There are three well-known advantages (to my mind) emanating from these changes: (i) removal of the anomalous incentive for the central government to concentrate its tax efforts on those taxes that it did not have to share with the states like corporation tax and customs duty; (ii) imparting flexibility and elbow room to the central government for pursuing tax reforms in a coherent manner; and (iii) allowing states to share the aggregate buoyancy of taxes that are under the remit of the Centre.
The 11th Finance Commission, in this context, had recommended that states’ share for the five-year period, 2000-01 to 2004-05, be 29.5 per cent (28 per cent plus 1.5 per cent on account of additional excise duties levied in lieu of sales tax), which was accepted by the Union government. Subsequently, the 12th Finance Commission recommended the share at 30.5 per cent for the period 2005-06 to 2009-10. Against this background it is apposite to briefly examine states’ shares in central taxes.
From the table it is clear that the allocation to states has been substantially and consistently less than the stipulated percentage. In none of the years has it been close to the Finance Commission recommendations accepted by the central government, which underscores the increasing importance of cesses and surcharges on taxes imposed by the Centre, which the latter is not required to share with the states. A quick back-of-the-envelope exercise from the Budget documents reveals that for 2007-08 the aggregate of revenue from cess and surcharge on income tax, corporation tax, customs duty, excise duty and service tax was of the order of Rs 70,000 crore (at about 1.5 per cent of GDP it is a number not be sniffed at!).

While there may be credible reasons to allow the central government to impose a cess/surcharge, the subject merits consideration on several counts: First, while surcharges and cesses could, under specific circumstances, be justified (for example, extraordinary financing for a national public good like defending against an enemy border incursion), the extant surcharges/cesses seem to be enduring irrespective of circumstances and the dispensation at the Centre. Second, despite the large quantum of revenue from cesses and surcharges, there is a virtual absence of formal proposals to share the cess revenues with states on grounds of fairness (based on principles of vertical equity established by successive Finance Commissions). Third, the dearth of compelling motivation justifying the seemingly ad hoc compromise of sound public finance practice; in other words, tax reform is undermined by fiddling.
Allocating revenue from a specific cess for stipulated expenditure implies that the Centre’s spending priorities are somehow more worthwhile than the states, or, that “Delhi knows better”. The central government on its part may contend that, for example, the education cesses are finding their way to states anyway and, that too, for an unexceptionable objective, viz. enhancing human capital of the young. However, with justification, it could be reasoned that some states may want to spend more on enhancing human capital through subsidising primary health and prenatal care or, even on law and order in these difficult times. In other words, “a one size fits all” approach structured by the Centre is not easily defensible when it comes to prioritising social expenditure.
Conceivably more insidious is that the cess and surcharge revenues that the Centre spends at its discretion underline the rule-based inter se allocation of revenues between states determined by a constitutional authority, viz. the Finance Commission. It is instructive that in the past decade there have been several instances of individual states complaining about favouritism/discrimination in allocation of central government largesse. The larger the revenue stream from shareable taxes that are not allocated according to rules (implemented in both letter and spirit), the higher the likelihood of heartburn among states that feel that they have had the unfavourable end of the stick. Perhaps the time has come to plug embedded legal loopholes to curb the possibility of time- inconsistent choices eroding the Centre-state fiscal compact.