Small states should give priority to increasing their revenue to reduce their dependence on the central government
The financial health of India’s states has attracted significant attention in recent times. Despite ample data on state finances, most analysis focuses on large states. The fiscal position of small states (i.e. states with less than 1 crore population) needs more discussion. Most of these small states have distinctive features that limit revenue collection. Recognizing these inefficiencies, the Constitution has provided mechanisms to address them. But these states are heavily dependent on the central government for revenue. This dependence creates weaknesses for the states as well as for the union.
The total revenue receipts for a state constitute transfers from the central government such as the state’s share of central taxes including income tax, corporation tax and grants, and the state’s own revenue from tax and non-tax sources. States can collect their own taxes (Owned Tax Revenue or OTR) from businesses, property, goods, etc. It can raise non-tax revenue (Own Non-Tax Revenue or ONTR) from social and economic services, profits, dividends, etc. ,
The revenue receipts of every small state have increased. Six of the nine states grew faster than the Gross State Domestic Product (GSDP). But these increases are mainly on account of union transfers rather than states’ own revenue. In other words, the dependence on the Sangh has not reduced. Revenue receipts for three states – Mizoram, Sikkim and Tripura – have grown slower than the state GSDP, meaning limited financial space to operate.
While the share of union devolution in the revenue receipts of all states combined remains between 40% and 50%, the proportion is much larger for smaller states. Except for Goa, the Centre’s share in the revenue receipts of all other small states is more than 60% (2022-23 budget estimates). For five states, the share is around 90% (Chart 1),
Chart 1 | The chart shows the ratio of current transfers to revenue receipts. Figures are in %.
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The economies of the states have grown over time, but this has not necessarily translated into higher revenue-raising capacity. This is best reflected in the continued dominance of current transfers in revenue receipts (2014-2023).
The ability of smaller states to raise their own taxes remains limited. Eight out of nine states perform worse than the all-state average OTR-GSDP ratio (Chart 2),
Chart 2 | The chart shows Own Tax Revenue (OTR) times Gross State Domestic Product (GSDP). Figures are in %.
The distinctive features of these states restrict economic activity and consequently make it challenging to generate tax revenue. What is of particular concern, however, is that the tax-raising capacity of states is yet to improve significantly over time. At best, it has fluctuated, with many states experiencing a peak in their OTR-GSDP ratio around 2017-18. Smaller states tend to do relatively better in mobilizing their ONTR, with six states performing better than the entire state average. However, states like Manipur, Tripura and Nagaland continue to struggle and do comparatively poorly in terms of their ONTR-GSDP ratio.
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The limited capacity of small states to generate their own revenue results in heavy dependence on the central government, leaving the states exposed to various vulnerabilities. First, the states rely on the political goodwill of the central government. A sudden drop in union devolution can have an adverse effect on the expenditure of the states. In the last few years, there has been a growing disagreement between the Union and the States over resource sharing (for example, GST compensation). Second, greater dependence on the Union may lead to less financial independence for the states. A significant portion of federally devolved funds are tied to specific purposes, which limits the flexibility of the states. In some cases, given their current revenue position, states may be unable to match transfers. Third, the lack of own revenue can weaken the capacity of the state, affecting the delivery of social, economic and general services. This situation becomes more serious as many small states share international boundaries. Developmental concerns in these states may have implications for national security.
To reduce these vulnerabilities, states should prioritize identifying new sources of tax revenue or find ways to leverage existing sources more effectively. A study by Manipur University evaluating the state finances of Manipur has shown how its alcohol prohibition policies have resulted in substantial revenue losses without reducing the negative consequences of drinking alcohol. Another study of Arunachal Pradesh’s finances identified the potential to generate more revenue from transactions on land and sales tax.
In addition, there is a need to reform tax administration in the states. This will not only mobilize more resources, but also reduce the actual deviation from the budgeted tax revenue. States can boost their collection of non-tax revenue by revising 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. States should consider reviving and corporatizing these enterprises to improve their revenue performance. Some states, such as Mizoram, have closed loss-making public sector enterprises believing that these entities are a liability.
Sarthak Pradhan is Assistant Professor at Takshashila Institute. The research for this article was made possible by The International Center Goa Research Grants. Email ID: [email protected]
Source: “State Finances: A Study of Budgets”, Reserve Bank of India
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