As is customary after every budget, most economists engage in in-depth commentary about the budget documents produced every year. This year, however, it is another document that was tabled, that may be of great interest to fiscal policy experts at the state level. The interim report tabled by the 15th Finance Commission has prescribed within it the formula that they will be using to determine the devolution of gross tax revenue for the next six years.

The government mandated Terms of Reference for this Finance Commission however, had already condemned the final formula to extreme politicisation. By mandating the commission to use the 2011 census figures as opposed to the 1971 figures, the Union government has already been perceived as favouring populous states as opposed to states that invested in public health and education to ensure their birth rates remained low.

While several state governments had already raised concerns about the partial use of 2011 figures in the 14th Finance Commission, the full impact of this prioritisation becomes quite apparent with its full use in the 15th Finance Commission. With the new formula, states in the south, notably Kerala, Karnataka, Andhra Pradesh and Telangana have seen a significant cut to the finances that they are entitled to, while states like Gujarat, Maharashtra, Bihar, and Rajasthan have made significant gains.

For a state like Kerala however, the consequent cut in devolved funding poses within it a much deeper threat. The rate of central tax revenue to the state has already been in decline. From 3.5% during the 10th Finance Commission to 2.5% during the 14th, the new formula is part of a longer trend that will now see Kerala getting only 1.94%. The net loss in revenue is approximately Rs 4,300 crore.

This damage is further compounded by the fiscal conduct of the Union government in terms of the transfer of revenues to states. When opting into the GST paradigm, states were given a statutory 5-year guarantee of compensation if revenue growth fell below 14%. In Kerala, the Finance Minister has noted that revenue growth has fallen below 10%, while expenditure continues to grow at 15%. Till December 16 last year, the state had still not been compensated the Rs 1,600 crore that it was owed for the months of August and September, and the Union government finally relented only two days before the meeting of the GST council amidst mounting pressure and threats of litigation from fiscally stressed state governments.

The compensation provided to states comes from the GST compensation cess pooled at the Centre. However, with the government badly failing at hitting its own GST collection targets, it has balked at keeping its compensation commitments to states. In this year's budget speech, the Finance Minister has added to this worry by stating that the balances for the first two years will be transferred in two instalments, following which transfers will be limited to the amount collected by the cess.

This is particularly worrying for two reasons. Firstly, it is FY20 where states have faced their most significant shortfalls in GST compensation from the Union. By compensating the balance only for the FY18 and FY19 years, there are genuine concerns as to whether dues for the remainder of this financial year will be cleared by the Union government. Secondly, the caveat, that following these two years, compensation will be subject to amount collected by the GST cess poses a serious risk to the financial health of states.

The premise upon which states signed away a degree of fiscal independence and opted into the GST regime was the statutory guarantee that they would be compensated if revenue growth fell below 14%. The new caveat seems to imply that this compensation will now be subject to cess collections, which fall significantly short of the amount owed to states. Hence, if the new caveat were to be applied in principle, the government would not be able to fund its statutory commitments, raising the serious possibility of litigation by state governments and larger questions about fiscal federalism. At a time when multiple states have asked for an extension for the compensation guarantee for an additional five years (beyond the existing 2022), such a conflict would only serve to rock the boat further.

For a state like Kerala, the remote possibility of a reduction in GST compensation, in the context of reduced devolution by the Finance Commission, is a serious cause of concern. Though Kerala has successfully brought down its fiscal deficit from a precarious 3.91% in 2017-18 (actuals) to 3.06% in 2018-19 (revised) it remains one of the states with the highest amount of committed expenditure. At 52.3% in 2018-19, more than half of Kerala’s budget is already committed to paying pensions, salaries and interests. A cut in the devolved amount by the Finance Commission, followed by a cut (or even a delay) in GST compensation could leave the state unable to make these critical payments, leaving aside larger goals of social welfare and capital expenditure.

At this critical juncture, the Union government must clarify its position with reference to GST compensations, while the state government must look to lock in central support to offset the fiscal damage done by the 15th Finance Commission. A lack of centre-state cooperation here could prove devastating to both the state, as well as the larger goal of a substantive fiscal federalism.

The author is the Asia Democracy Network Fellow at the Centre for Policy Research Delhi. Views expressed are the author’s own.