Once bitten, twice shy: Why states doubt centre will share taxes fairly

States are understandably wary even after getting half the Centre's gross tax revenue in the first quarter of 2020-21

The Union government’s gross tax revenue collections in the first quarter of 2020-21 fell to Rs 2.7 trillion, a decline of over 32 per cent over the same period of 2019-20. However, the Centre’s net tax revenue collections in the same period this year fell by a sharply higher margin of over 46 per cent to Rs 1.35 trillion. This divergence is not usual.

The difference between the Centre’s gross tax revenue and net tax revenue is largely accounted for by transfer to the states, as mandated by the Finance Commission. But the extent of fall in the net tax revenue for the Centre and for the tax devolution to the states was strikingly dissimilar for the April-June 2020 period.
 

 Against the Centre’s net tax revenue taking a big hit with a 46 per cent decline, the devolution of central taxes to the states saw a much smaller decline of just about 10 per cent. Indeed, the Centre and the states almost equally shared the total gross tax collections in the first quarter of 2020-21 — the states got  Rs 1.34 trillion and the Centre got the remaining Rs 1.35 trillion.

 Why is this unusual? The Fourteenth Finance Commission’s recommendations had mandated that about 42 per cent of the Centre’s gross tax collections (excluding cess and surcharges) should be shared with the states from 2015-16 to 2019-20. For 2020-21, the Fifteenth Finance Commission’s recommendation is that 41 per cent of the divisible tax pool should be shared with the states.

 But what the Centre shared with the states in the first quarter of 2020-21 is about 50 per cent of its gross tax collections. And the Centre’s gross tax revenue included cess and surcharges, which have about a 10 per cent share in it. In other words, the actual devolution to the states would be a little more than half of the Centre’s gross tax collections without cess and surcharges!

 Compared with what happened last year, this increase in the share of tax transfer to the states is unusual. In the first quarter of 2019-20, the Centre’s net tax revenue went up by 6 per cent to Rs 2.51 trillion. But the taxes transferred to states in this period declined by 6 per cent to Rs 1.48 trillion. Thus, the Centre pocketed more and the states got less. More significantly, the states had a share of only 37 per cent in the gross tax collections of the Centre.

Illustration: Binay Sinha

A long-term perspective shows that the trends for the Centre’s net tax revenue and tax devolution to the states in the first quarter of 2020-21 have completely reversed from what they were in the same periods of 2018-19 and 2019-20. The share of the states in the Centre’s gross tax revenue in the first quarter of 2018-19 was about 40 per cent, it went down to 37 per cent in the same period of 2019-20, but went up sharply to 50 per cent in April-June 2020-21.

The states had every reason to complain about their low relative share in central taxes in 2018-19 and 2019-20. But can they justifiably raise the same issue in the current year, going by the numbers available in the first quarter? Yet, many states are worried that they are not getting their due from the Centre. What could be the reasons?

It is possible that the states are worried because they fear that the current trend seen in the first quarter of 2020-21 may not continue in the subsequent quarters. Past trends do indicate that the first-quarter transfers to the states are always higher, but that share declines by the time the year ends. For instance, the tax devolution for the full year of 2018-19 was Rs 7.61 trillion or 37 per cent of the total gross tax collections by the Centre, down from 40 per cent in the first quarter. In 2019-20, the tax share of the states for the full year was  Rs 6.5 trillion or just 32 per cent of the Centre’s total gross tax collections, down from 37 per cent in the first quarter.

But are the states’ fears a little exaggerated? Whatever be the extent of the decline in the coming quarters from a high share of 50 per cent, recorded in the first quarter, the annual devolution share cannot most likely take it below 32-37 per cent of gross tax collections seen in the previous two years, unless there is a major squeeze in the coming months.

Another possibility is that the Centre might have been clearing the 2019-20 tax devolution arrears in the first quarter of 2020-21, as a result of which the states’ share in gross tax collections has gone up sharply. But clearance of arrears must be happening in the first quarter of every financial year. So, why was the share in the first quarter of 2019-20 only 37 per cent and why did it go up to 50 per cent in the same period of 2020-21?

Or has the Centre expedited the process of clearing all past dues of the states to prevent any further criticism from them at a time when they are starved of funds and are falling short in their own tax revenue efforts? The strategy perhaps could be to gradually bring the states’ share down over the next three quarters, when the situation might improve. Remember that the states were originally budgeted to have a share of only 30 per cent in the Centre’s gross tax collections in 2020-21.

There is another reason for the states to become apprehensive about a fall in their share in the devolution of central taxes. This pertains to recent consultations that the Fifteenth Finance Commission held with the finance ministry on how the Centre could find the resources needed for recapitalising the state-owned banks. Fiscal policy experts have questioned the need for the Finance Commission to engage with the government on the latter’s need for providing bank equity. This, according to them, is outside the purview of a Finance Commission.

The states, nevertheless, fear that there may be an attempt to force them to share the Centre’s burden of recapitalising public-sector banks. This might result in a decline in the total tax devolution amount. Already, the Fifteenth Finance Commission is expected to make recommendations on reducing the total divisible pool of central taxes by an amount equivalent to a part of the Centre’s defence and internal security expenditure. This, too, will effectively result in a reduction in tax transfer to the states. 

The Fourteenth Finance Commission had raised the states’ share in central taxes by almost 10 percentage points to 42 per cent from 2015-16. The Centre accepted the formula, but began relying more on cess and surcharges (not shareable with the states) and curtailed the central expenditure share in many development schemes that were implemented in the states. The share of cess and surcharges in the Centre’s gross tax revenue used to be about 6 per cent in 2014-15, but it has exceeded 10 per cent in each of the last two years, reducing the devolution share to states. The Centre’s decision to curtail expenditure on development schemes has also led to a financial squeeze for many states, which have been forced to find their own resources to keep those schemes running.

The states’ suspicion about the Centre’s intentions on further squeezing their financial flows grew in July 2019, when the Centre decided to add to the terms of reference of the Fifteenth Finance Commission, thereby asking it to examine whether there should be a separate mechanism for funding of defence and internal security. States are worried that a part of the expenditure on defence and internal security, incurred by the Centre, might be sequestered from the divisible pool of resources. Now, with the ongoing discussion between the Commission and the finance ministry over the question of recapitalising public-sector banks, the states fear a similar sequestration could take place to provide funds for equity infusion for banks.

The sharp rise in their share in gross tax collections to 50 per cent has thus failed to assuage the states’ fears on declining devolution. The unpleasant experience of the past several months has made the states wary about both the sudden rise in the transfer of central taxes and the future trends in devolution.