Post-Covid federalism: How Centre can build and keep trust with states

The covidvirus has attacked lives and livelihoods. It has attacked the finances of households, the balance sheets of companies, and the fiscal positions of the Centre and state governments. Assessing the scope of all this damage is still in progress, but already it is clear that the repair work will be enormous. That means we need to start thinking now of the principles that will guide the economic rebuilding.

Consider just one part of the problem: Protecting state finances in future downturns. The Covid crisis has thrown into high relief the vulnerability of state finances — and the immense difficulty of addressing this problem in the midst of a crisis. In the short term, a political solution will need to be found, as one of us has discussed in a recent article. But this would just be a short-term expedient. The Fifteenth Finance Commission (FFC) will need to provide a more durable solution, a framework that would guide the handling of transfers during the next downturn.

One possibility would be to modify the existing devolution framework to offer states crisis “insurance”. This would take the form of a new transfer from the Centre that would have three critical features:

  • Counter-cyclical, provided only during crises; 
  • Targetted to fiscally responsible states that have brought their debt below certain levels, or reduced their debt by certain amounts; and  
  • Automatic, avoiding the delays and the political jockeying that would come into play if the transfers were to be discretionary. How would the mechanism work in practice? One possibility would be for the Finance Commission to define a crisis that would trigger such a transfer, say, a decline in GDP growth of 3 percentage points (the exact number could be refined later). When this occurs, the normal vertical transfer to states, which is currently 41 per cent of eligible taxes (the “divisible pool”), would be increased by, say, 3 percentage points. This additional devolution would be parcelled out in accordance with the standard horizontal devolution formula — but only to the qualifying states.

Would this principle be new? In some ways, yes. But a large step toward counter-cyclical transfers was already taken under goods and services tax (GST), when the Centre guaranteed states a 14 per cent annual increase in their GST receipts. This guarantee was meant to be a fiscal stabilisation mechanism, since it called for the Centre to compensate the states if GDP growth was poor and GST collections fell short of expectations. In fact, in the pre-Covid period, de facto insurance was provided to the states because underlying GST revenues grew at a rate below the compensation guarantee of 14 per cent.

But of course this mechanism has not worked well. The promise of 14 per cent revenue growth has proved difficult for the Centre to afford, in part because it created a moral hazard for the states, allowing them to propose rate reductions without fear of revenue consequences. The key lessons are that any transfer mechanism needs to promote desirable incentives, be affordable, and be credible.

Illustration: Binay Sinha

The proposed targeted, counter-cyclical, and automatic transfer meets all three requirements. Precisely because it would be given to fiscally prudent states, it would promote fiscal responsibility. And because it would be provided only to those states during certain periods (crises), and the costs to the Centre would be limited. For that reason, the promise would be credible.

How would such a transfer benefit the Centre’s policy objectives? Perhaps the most important benefit is that it would provide states with an incentive to rebuild their shattered finances. And this incentive would be a powerful one, because states will long remember this year’s immense fiscal pain, and will be eager to avoid it by securing crisis insurance.

The transfer would have a further benefit and a key one at that: It would aid macro management of the economy. A key principle of fiscal policy is counter-cyclicality: When the economy faces a negative shock and economic activity goes down, the government should cushion its impact by spending more and taking fewer taxes from the private sector. In this way, aggregate demand and output are stabilised, increasing economic welfare.

Right now, the existing fiscal framework doesn’t really allow this to happen. True, the Centre can allow its deficit to widen, as it has during the current pandemic. But states must constrain their deficits under their fiscal responsibility laws, so they are forced to cut expenditures, thereby offsetting part of the fiscal stimulus provided by the Centre. If instead states were to receive counter-cyclical transfers to bolster their revenue, they would no longer need to engage in this macro-economically inefficient behaviour.

Of course, there is another potential solution. One could simply allow states to expand their deficits during downturns, borrowing to make up for the revenue shortfalls. But this would violate the optimal allocation of responsibilities in a federal system, as set out by Richard Musgrave many years ago. The optimal borrower for counter-cyclical purposes is the Centre, partly because it has greater financing options (it can even borrow abroad) but mainly because it has much greater taxing authority under the Constitution. The Centre’s enormous potential to raise resources to repay debt is reflected in the relatively low rates at which it can borrow — always at lower rates than any other entity, including state governments. For this reason, it is the Centre that should provide the public good of counter-cyclicality, by borrowing and transferring funds to states.

It is important to be clear. The crisis insurance we are proposing is unlikely to work in extreme shocks of the Covid variety, when even the Centre’s revenue base is damaged severely. But in these circumstances it should at least provide a framework which could guide attempts to resolve the transfer problem. And in normal downturns, it should work well.

There is one last benefit from introducing a counter-cyclical transfer that needs to be considered, perhaps the most important one of all: It could help restore trust between the Centre and states. As India contemplates its post-Covid economic framework, it is important to bear in mind that trust between the Centre and states will be critical for solving a whole range of problems. That trust requires an equitable sharing of resources in good and, especially, bad times.

In fact, trust is built and lost almost only in bad times. Automatic, counter-cyclical transfers can build trust — and, crucially, they can help prevent trust from being corroded.  
Subramanian is professor at Ashoka University and former chief economic adviser to the government of India. Felman is principal of JH consulting

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