Fiscal Challenges Faced by Small States in India

Context:

The fiscal landscape of India’s States has been a subject of great interest lately. However, most analyses focus on larger States, leaving the small States (with populations less than 1 crore) underrepresented. These small States possess unique characteristics that hinder revenue generation, despite constitutional provisions aimed at addressing their challenges. Consequently, these States heavily rely on the Union government for revenue, creating vulnerabilities for both the States and the Union.

Relevance:

GS-03 (Fiscal Policy, Growth and development)

Prelims:

  • Annual Study on State Finances
  • Fiscal Deficits
  • GDP, GST (Goods and Services Tax)
  • Finance Commissions, Human Capital

Mains Question:

  • Discuss the fiscal challenges faced by small States in India and the implications of their heavy dependence on Union transfers. Suggest measures to mitigate these vulnerabilities and enhance revenue mobilization. (250 words)

Dimensions of the Article:

  • The Rising Tide of Revenue Receipts
  •  The Weight of Union Transfers
  •  Limited Capacity for Own Tax Revenues (OTR)
  • The Struggle with Own Non-Tax Revenues (ONTR)
  • Vulnerabilities Arising from Union Dependence

The Rising Tide of Revenue Receipts:

  • Revenue receipts for small States have seen an uptick in recent times, with six out of nine States experiencing growth faster than their gross state domestic product (GSDP).
  • However, this growth is primarily driven by Union transfers rather than the States’ own revenues.
  • For some States, such as Mizoram, Sikkim, and Tripura, the revenue receipts have grown slower than their respective GSDP, indicating limited fiscal maneuverability.

The Weight of Union Transfers:

  • Small States bear a disproportionate burden of Union transfers in their revenue receipts. While the share of Union transfers in all States combined ranges from 40% to 50%, small States, except Goa, face a significantly higher burden, with the Union’s share surpassing 60% for all small States except Goa (2022-23 Budget Estimates).
  • Shockingly, five States even experience a colossal 90% share.
  • Economic growth hasn’t translated into robust revenue mobilization, as current transfers continue to dominate revenue receipts.

Limited Capacity for Own Tax Revenues (OTR):

  • The small States grapple with limited capacity to raise their own taxes. Eight out of nine States fare worse than the all-State average in terms of OTR-GSDP ratio.
  • The unique characteristics of these States restrict economic activity, hampering their ability to generate tax revenue.
  • Furthermore, the States’ efforts to mobilize taxes have been lackluster, with only marginal improvements observed in recent years.

The Struggle with Own Non-Tax Revenues (ONTR):

  • While small States perform relatively better in mobilizing ONTR, several States, such as Manipur, Tripura, and Nagaland, consistently face challenges in this regard.
  • The ONTR-GSDP ratio remains suboptimal for these States, impacting their overall fiscal performance.

Vulnerabilities Arising from Union Dependence:

  • The heavy reliance on the Union government exposes small States to numerous vulnerabilities.
  • The States are subject to the whims of the Union’s political goodwill, leaving them susceptible to sudden declines in Union transfers that can disrupt their expenditures. Disagreements over resource sharing, like GST compensation, have fueled tensions between the Union and the States.
  • Excessive dependence on the Union constrains the fiscal freedom of small States, as a significant portion of transferred funds is earmarked for specific purposes. This hampers their flexibility in resource allocation.
  • Inadequate own revenues weaken the States’ capacity to deliver essential services, impacting social and economic development and, in border-sharing States, even national security.

                                                               

Way Forward:

  1. Diversification of Revenue Sources: To mitigate the vulnerabilities stemming from Union dependence, small States must explore new sources of tax revenue and optimize existing ones. For example, learning from Manipur’s experience, policies regarding liquor prohibition can be reevaluated to strike a balance between revenue generation and social consequences. Similarly, potential revenue streams from land transactions and sales tax can be tapped, as identified in the case of Arunachal Pradesh.
  2. Strengthening Tax Administration: Improving tax administration can lead to higher resource mobilization and reduce the variance between actual and budgeted tax revenues. States can revise charges and rates for services and enhance administrative efficiency to boost non-tax revenue collection. Additionally, revitalizing and corporatizing state public sector enterprises can enhance their revenue contribution, as exemplified by Mizoram’s closure of loss-making enterprises.

Conclusion:

The fiscal situation of small States in India calls for urgent attention, as their heavy dependence on Union transfers poses substantial challenges. Diversification of revenue sources, bolstering tax administration, and reviving public sector enterprises are pivotal in mitigating vulnerabilities and enhancing revenue mobilization. Strengthening the fiscal capacities of small States is not just a matter of economic concern but also vital for ensuring their sustainable development and national security.