Pragati Manifesto

Public Finance: Simplify Taxes. Strengthen the States

This section of the Pragati Manifesto outlines how to manage public finances better. Empowering states is key. Read the other pieces here.

India’s system of fiscal federalism is characterised by significant vertical and horizontal imbalances. 58% of all government expenditure is done by states but they raise only 38% of total government revenue. This vertical imbalance reflects the more-than-proportionate expenditure obligations of the states and also the lesser revenue raising powers vis-à-vis the union. At the same time, Haryana’s per capita GSDP in 2017-18 was nearly 5.5 times that of Bihar, a reflection of the underlying horizontal imbalances in the revenue-raising capabilities of states. These two factors make India’s public finance management a typically wicked problem.

Given below are a few ideas for the next union government to manage this challenge better.

One: Reduce Centrally Sponsored Schemes (CSS) to a Maximum of 10

Union governments are eager to announce new schemes, even if they fall in the constitutional domain of the states. While the number of CSS is down to 28 in Budget 2017-18, many thinly spread and underfunded schemes get launched every year. Consider these schemes being run by the union government today — Blue Revolution (₹4.01bn), Mission for Protection and Empowerment for Women (₹11.56bn), and Rashtriya Gram Swaraj Abhiyan (₹6.75bn). Such schemes exist only to posture how ‘benevolent’ union governments are.

If the next government limits itself to a maximum of ten meritorious services having significant country-wide externalities, the money saved can be devolved to the states so that they can determine their own priorities. Also, by ending a range of thinly spread schemes which have paltry allocations, the union government can increase allocations for key meritorious services such as health, education, water supply, road infrastructure etc.

Two: Redesign Existing Centrally Sponsored Schemes

The grants made to states — even in the case of flagship union government schemes such as National Health Mission (NHM) — tend to be arbitrary in scope and incremental in time. So the states with the lowest health indicators do not get higher per capita health grants and the states which are educationally backward do not get higher per capita education grants. As Dr Govinda Rao suggests in a NIPFP paper, this ineffectiveness of grants can be addressed by following these steps:

The government should first define the desired outcomes from a CSS. The allocation to the states should be made purely on the basis of shortfalls in infrastructure and services according to the specified norms. Then, introduce different matching requirements from different states depending on their taxable capacity so that low capacity states will find it easier to contribute their marching requirements and avail the central transfers.

Three: Reduce Amount Raised Via Cesses and Surcharges to Zero.

Cesses are evil. Not only do they indicate grossly misplaced priorities, revenues raised through them are not shared with state governments. From ₹744bn in 2014-15, cesses and surcharges revenue had shot up to ₹1986bn by 2017-18. The next government should end this practice of levying cesses and surcharges that are antithetical to cooperative federalism.

Four: Create a Truly Independent Fiscal Council

Governments the world over tend to make unrealistic budgets by overstating revenues and underestimating expenditure. They tend to start new schemes with little consideration for the long-term impact of such schemes on the fiscal health of states and the union. Hence, countries such as Australia, Canada, and the US have institutionalised independent fiscal councils to restrain government profligacy. The 14th Finance Commission recommended setting up of a similar council in India that is answerable to the Parliament. The next government should implement this recommendation in its true spirit.

Five: Create an Institution for Intergovernmental Bargaining and Conflict Resolution

Another institutional gap in Indian federalism is the absence of a regular consultation between the union and state governments for minimising discretion, improving the design of transfers, and avoiding duplication. The 14th Finance Commission recommended that the present role of the Inter-State Council should be expanded to perform these functions. We now have the GST Council – an arrangement for intergovernmental bargaining on raising revenues. The next step is to have a similar mechanism for managing expenditure.

Six: Simplify Taxation

The Indian GST started with five rates and since then the number of rates and exemptions have only increased. Recent moves even allow bypassing the input credit mechanism – the key element that aligns the incentives of suppliers and buyers towards formalisation. The next government should reduce the number of tax rates and get rid of tax exemptions failing which compliance will be low and states will not receive any gains from GST.

These public finance reforms will go a long way in reducing the friction between states, and between states and the union.

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Read the rest of the Pragati Manifesto here.

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About the author

Pranay Kotasthane

Pranay Kotasthane heads the geostrategy programme at the Takshashila Institution. His research interests focus on geostrategy, geopolitics of the Indian subcontinent, public policy, economic reasoning and urban issues.