Karnataka must make a strong case for a bigger share of tax devolution

The Union Finance Secretary is reported to have stated that the Sixteenth Finance Commission (16th FC) will be appointed by the end of November this year. The recommendations of the 15th Finance Commission (15th FC) will cover up to 2025-26, and the 16th FC will have to submit its recommendations for five years from 2026-27. Most states are faced with severe fiscal stress in the post-pandemic times and particularly after July 2022, when the period for compensation for loss of revenue under GST ended. In addition, with elections on the horizon, a number of states will extend several social welfare measures, which will only add to their fiscal stress. The 16th FC itself will have a challenging task as it has to balance the requirements of the Union and the state governments, deal with equity and efficiency, and work towards achieving sustainable fiscal policy.

For Karnataka, making a proper representation before the 16th FC is extremely important. Karnataka’s share in tax devolution got reduced from 4.713 per cent under the 14th Finance Commission to 3.647 per cent under the 15th FC. With additional expenditures of Rs 52,000 crore budgeted to meet the Congress’ five guarantees, announced in the recent election manifesto, the state is faced with a difficult fiscal situation.

To keep the deficits under control, the state had to cut down the capital expenditure relative to GSDP from 2.4 per cent in 2022-23 (revised estimate) to just about 2 per cent in the budget estimate for the current year.  Faced with a hardened constraint, Chief Minister Siddaramaiah is reported to have written to Union Finance Minister Nirmala Sitharaman to release the special grant of Rs 5,495 crore recommended by the 15th FC for 2020-21 in its first report and Rs 6,000 crore recommended in the final report for the improvement of water bodies and the peripheral ring road for Bengaluru. It must be noted that the Union Finance Ministry had not accepted these recommendations in the Explanatory Memorandum placed in parliament.

Chief Minister Siddaramaiah’s letter also expressed concerns about the decreasing share of the state in tax devolution. While it may not be possible to remedy the past situation, the state government will have to make a strong case for an increased share in the devolution in its memorandum to be submitted to the 16th FC as and when it is appointed.

The Finance Commission’s methodology of determining transfers to balance the fiscal positions of the Union and the states is to make projections of revenue receipts and revenue expenditures of the Union government, make normative assessments of states’ own revenues and expenditures, and determine the share of all the states together in the divisible pool of taxes and the share of that for each state based on some indicators of fiscal capacities and needs. Those states still left with a revenue deficit after the estimated devolution are recommended grants-in-aid to cover these deficits, under Article 275 of the Constitution.

Notably, in the fiscal assessments made by the last few Finance Commissions, Karnataka was not a recipient of a revenue deficit grant. In fact, even for the states qualifying for the grants, following the terms of reference (ToR) to the 15th FC that it may consider whether revenue deficit grants should be given at all, the 15th FC jacked up the revenue growth and reduced the expenditure growth in its projections to phase out the post-devolution revenue deficits in all non-special category states in the terminal year of its recommendation. 

In this situation, Karnataka will have to focus on making a strong case for a larger share in tax devolution in order to honour the election commitments while safeguarding infrastructure spending and containing its fiscal deficit below 3 per cent of GSDP, as mandated under the Fiscal Responsibility and Budget Management (FRBM) Act.

How can the state make a strong case for a larger share of the tax devolution with the 16th FC? There is a popular argument that Karnataka is a major contributor to the income taxes collected by the Union government and, therefore, it should get a larger share in tax devolution. In fact, until, the 6th Finance Commission, when the divisible pool consisted of only individual income tax, which was compulsorily shareable under Article 270, and Union excise duty, which was shareable optionally under Article 272, 10-20 per cent weight was given to the collection factor in the case of income tax.

However, this was discontinued after the 7th FC to give greater weight to equity in tax devolution. Besides, the Finance Commission is intended to be an agency to bring about fiscal balance between the Union and state governments, on the one hand, and among the states, on the other, to provide comparable levels of public services at comparable effort at raising revenues assigned to them.

The 16th FC is unlikely to deviate from this path, and equity will continue to receive significant weight in the devolution formula. The per capita incomes of the southern states, in general, and Karnataka, in particular, have increased faster than their northern counterparts and they are likely to lose in the bargain. In this environment, making a case for larger devolution lies in projecting the state’s growth expenditure needs and better fiscal performance in terms of raising revenues, higher capital expenditures, and containing deficits within the targets set by the state’s FRBM Act. These issues are discussed in the second part of the article.

(The writer is a former Director, NIPFP, and Member, 14th Finance Commission)

(This is the first of a two-part series)