Predictability in monthly tax devolution could benefit state finances

For state governments, tax devolution is a formula-linked and untied source of revenue, which they can spend according to their expenditure priorities.

Tax devolution from the Centre to states accounts for a little over a quarter of the total revenue receipts of the latter. The government of India (GoI) devolved a higher amount of taxes to the states in June 2023 and July 2023 vis-a-vis the amount released in each of the two previous months.
Predictability in this important revenue stream may help the states to plan their capital spending and narrow the gap between the actual and the indicated issuance of state government securities (SGS).

The proportion of gross tax revenues (excluding cesses and surcharges) that the GoI should transfer as tax devolution to state governments is decided by the Finance Commission (FC). The commission is appointed by the President of India to give recommendations for a period of five years. We are in the third year of the Fifteenth Finance Commission’s award period of FY2022-26, and based on its recommendations, the GoI has been transferring 41 percent of its divisible pool as devolution to the states. For state governments, tax devolution is a formula-linked and untied source of revenue, which they can spend according to their expenditure priorities.
Individual states’ share in the tax devolution depends on the criteria and weights recommended by each FC.

Rise In Transfers

The GoI makes an estimate of tax devolution in its budget for each fiscal and shares a varying proportion of that each month with the states. The actual amount that the states receive as tax devolution in a fiscal may differ from the budget estimate (BE). For instance, the actual tax devolution to states in FY2021 trailed the BE by a considerable Rs 1.6-1.9 trillion due to the lower-than-estimated gross tax revenues of the GoI. This trend reversed in FY2022: the GoI released Rs 9 trillion as tax devolution to the states, sharply exceeding the budgeted Rs 6.7 trillion. This massive increase included some prior period adjustments not just for FY2021 but also for FY1997-2018. This trend of higher-than-budgeted tax devolution continued in FY2023, with the GoI releasing Rs 9.5 trillion to the states compared to the budgeted Rs 8.2 trillion.

The GoI typically used to transfer ~6-7 percent of the budgeted tax devolution per month in the April-January period of each fiscal and would adjust the devolution amount for February-March based on the revised estimate (RE). This imparted an element of predictability to the cash flows of state governments. However, with sharply lower-than-budgeted tax revenues in FY2021, amidst the pandemic, monthly tax devolution was uneven. As the economy and tax revenues began to recover from the pandemic, the GoI released two instalments of tax devolution at one go on two occasions during FY2022 and FY2023 — in November and January of FY2022 and August and November of FY2023.

Tax devolution has been stepped up significantly in FY2024. The GoI released Rs 591 billion or 5.8 percent of the budgeted tax devolution (Rs 10.2 trillion) each in April and May 2023, which was around 24 percent higher on a YoY basis. It then released two instalments totalling Rs 1.2 trillion in June 2023, around the time of the advance tax inflows, a huge step up from the Rs 476 billion devolved in June 2022. In July, the GoI released Rs 729 billion, exceeding the monthly transfers of April-May 2023. This amount was 25 percent higher than the transfers made in July 2022. With this, the aggregate tax devolution in April-July of the current fiscal has risen to Rs 3.1 trillion, which is about 30 percent of the projected transfers for the year, and a massive 54 percent growth over April-July of FY2023.

Clarity On Devolution

The GoI has to release another Rs 7.1 trillion to the states in the next eight months to match the FY2024 BE. Interestingly, this sum is 5 percent lower than the amount devolved in the same period of FY2023. Is this a signal that the GoI is confident that its budgeted tax revenues will be overshot? If not, the states should be prepared that the devolution they receive in at least some of the remaining months of FY2024, may trail the amount transferred in the same months of FY2023.

Clarity on the amount of devolution the states should expect to receive in August-January FY2024, with the balance adjustments to be made in February-March, would help on two major counts. Firstly, the states may be able to better plan their capex spending for this period. State capex has been woefully back-ended and also lower than budgeted in recent years.

Second, the states may be able to better assess their borrowing needs for the last two quarters of this fiscal. The issuance of SGS has varied quite sharply from the amount indicated by the states for 10 consecutive quarters, which has been a source of consternation for the bond market participants. A portion of this deviation can be attributed to an unexpected size/timing of Central transfers such as tax devolution, GST compensation, etc. Clarity on the amount of devolution in the upcoming quarter by the GoI to the states, prior to their finalisation of the borrowing calendar, may narrow the gap between the indicated and actual SGS issuances. This, in turn, may infuse stability to SGS yields.

Aditi Nayar is Chief Economist and Head - Research & Outreach, ICRA Ltd. Views are personal, and do not represent the stand of this publication.