Data | The risk of small States’ heavy reliance on the Union government

Small States must prioritise raising their own revenue to reduce their dependency on the Union government

The fiscal situation of India’s States has garnered significant attention in recent times. Despite ample data on State finances, most of the analysis is centred around larger States. There needs to be more discussion on the fiscal position of small States (i.e. States with a population of less than 1 crore). Most of these small States have distinctive characteristics that limit revenue mobilisation. Recognising these disabilities, the Constitution has provided mechanisms to address them. But these States continue to rely heavily on the Union government for revenue. This dependence creates vulnerabilities for the States as well as the Union.

The total revenue receipts for a State constitute transfers from the Union government such as the State’s share in Union taxes including income tax, corporation tax, and grants, and the State’s own revenues from tax and non-tax sources. The State can raise its own taxes (own tax revenue or OTR) from professions, property, commodities, etc. It can mobilise non-tax revenue (own non-tax revenue or ONTR) from social and economic services, profits, dividends, etc.

The revenue receipts of each of the small States have increased. For six of the nine States, they have grown faster than the gross state domestic product (GSDP). But these increases are primarily due to Union transfers rather than States’ own revenues. In other words, dependence on the Union has not decreased. For three States — Mizoram, Sikkim and Tripura — the revenue receipts have grown slower than the State GSDP implying limited fiscal space to operate.

While the share of Union transfers in the revenue receipts of all States combined hovers between 40% and 50%, the ratio is quite large for the small States. Except for Goa, the Union’s share in all the other small States’ revenue receipts is more than 60% (2022-23 Budget Estimates). For five States, the share is around 90% (Chart 1).

Chart 1 | The chart shows the current transfers to the revenue receipts ratio. The figures are in %.

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The States’ economies have grown over time, but this has not necessarily translated into higher revenue mobilisation capacities. It is best reflected in the continued dominance (2014-2023) of current transfers in the revenue receipts.

The capacity of small States to raise their own taxes continues to be limited. Eight out of nine States fare worse than the all-State average OTR-GSDP ratio (Chart 2).

Chart 2 | The chart shows the own tax revenue (OTR) to gross state domestic product (GSDP). The figures are in %.

The distinctive characteristics of these States restrict economic activity and consequently make it challenging to generate tax revenue. However, what is particularly concerning is that the States’ ability to mobilise taxes has yet to show significant improvement over time. At best, it has fluctuated, with several States experiencing a peak in their OTR-GSDP ratio around 2017-18. The small States do relatively better in mobilising their ONTR, with six States performing better than the all-State average. However, States such as Manipur, Tripura, and Nagaland have consistently struggled in terms of their ONTR-GSDP ratio, performing poorly in comparison.

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The limited capacity of small States to generate their own revenues results in a heavy dependence on the Union government, exposing the States to various vulnerabilities. First, the States rely on the Union governments’ political goodwill. A sudden decline in Union transfers can adversely affect the States’ expenditures. In the last few years, there have been increasing disagreements concerning resource sharing (for example, GST compensation) between the Union and the States. Second, high dependence on the Union might imply less fiscal freedom for the States. A significant portion of the funds transferred by the Union is tied to specific purposes, limiting the States’ flexibility. In some instances, given their existing revenue situation, the States might be unable to match the transfers. Third, the lack of their own revenues can lead to weakened State capacity, affecting the delivery of social, economic, and general services. This situation becomes even more critical as many small States share international borders. The developmental concerns in these States can have implications for national security.

To mitigate these vulnerabilities, the States must prioritise identifying new sources of tax revenue or explore ways to leverage existing ones more effectively. A study by Manipur University evaluating the State finances of Manipur identified how its liquor prohibition policies have led to substantial revenue losses without significantly reducing the negative consequences of drinking. Another study of Arunachal Pradesh’s finances identified the potential to generate more revenue from transactions on land and sales tax.

Additionally, there is a need to improve the tax administration in the States. Not only will this lead to higher resource mobilisation, but it will also reduce the deviation of actual from budgeted tax revenues. The States can boost their collection of non-tax revenues by revising the existing charges and rates for various services and enhancing administrative revenue collection efficiency. Many state public sector enterprises in these States are not in good shape and do not contribute enough revenue. The States must consider revitalising and corporatising these enterprises to improve their revenue performance. Some States such as Mizoram have closed down loss-making public sector enterprises, recognising that these entities are a liability.

Sarthak Pradhan is an Assistant Professor at the Takshashila Institution. The research for this article was made possible by The International Centre Goa Research Grants. Email ID: [email protected]

Source: “State Finances: A Study of Budgets”, Reserve Bank of India

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