Kerala: Declining local body grants may fuel further debate on fiscal federalism

At a time when Kerala is engaged in a battle with the Centre over “unfair” tax devolution, it has emerged that the share of grants received by the state’s local bodies from the Finance Commission has also been declining steadily over the past two decades, raising questions about the criteria used to allocate funds and the impact on the state’s decentralized governance model.

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Kerala is not the only state that is grappling with a fiscal challenge. Other southern states, such as Karnataka and Tamil Nadu have also been voicing their concern over their diminishing share of central tax revenue, a consequence of their declining populations.

Changes in allocation criteria

A recent analysis of the recommendations made by the 10th to the 15th Finance Commissions reveals that Kerala’s share of local body grants has dropped significantly, particularly during the two latest commission eras. This decline comes despite Kerala’s reputation as a pioneer in democratic decentralization and effective local governance.

The study, conducted by Shency Mathew, a research associate at the Gulati Institute of Finance and Taxation in Thiruvananthapuram, highlights how changes in allocation criteria have adversely affected Kerala and several other states.

Sole focus on population, area

According to the report, when the 12th Finance Commission considered factors such as revenue effort, income distance, and an index of deprivation alongside population and area, Kerala received a more substantial share of resources. However, the shift to primarily population and area-based criteria in the 14th and 15th Finance Commissions has led to a marked decrease in Kerala’s allocation.

“When a state like Kerala is concerned, the share of local body grants is declining over the period and during 14th and 15th FC periods, when population and area are considered as the criteria — the share earmarked for the state is very less as compared to the previous periods,” the report states.

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Punishment for efficiency, reward for inefficiency

MB Rajesh, the Minister for Local Government in Kerala, told The Federal that “the criteria need to change”. “States such as Kerala, facing second-generation developmental challenges, require more allocation to maintain their progress on social development indicators. Instead, the current criteria punish efficiency and reward inefficiency, which is totally unfair,” he pointed out.

“Apart from the decline in the amount awarded, even the allocated grants are not fully disbursed. For instance, the 15th Finance Commission grant was withheld for 25 local bodies on the pretext that the local self-government’s original tax revenue had not matched the state’s average GDP. Later, 19 of them received the funds after we submitted the bills, but six are still awaiting payment,” Rajesh added.

“The Union government is imposing conditions that neither the Finance Commission’s recommendations nor the government’s operational guidelines stipulate, thereby blocking the funds, which is in a way unconstitutional too,” he summed up.

Affected states

This change has affected not only Kerala but also states such as Tamil Nadu, Andhra Pradesh, Karnataka and Maharashtra. In contrast, the shares of states with bigger populations and geographical areas, such as Uttar Pradesh, Rajasthan, Bihar, and West Bengal, have gone up. They have also consistently remained top recipients of local body grants along with Maharashtra and Madhya Pradesh, even though the last two have lost a bit of their share with the new criteria.

Kerala’s situation is particularly noteworthy, given its history of strong local self-governance. The state was at the forefront of implementing the 73rd and 74th Constitutional Amendments, which aimed to strengthen local bodies. The declining share of grants could potentially hamper the state’s ability to maintain and improve its decentralized governance model.

Need to reinvent distribution criteria

The report suggests that future Finance Commissions should consider reinventing the criteria for the distribution of local body grants among states. It advocates a more nuanced approach ensuring “equity, efficiency and performance by adding suitable criteria as some of the previous commissions were used”.

Some of the criteria suggested include the “distance from the highest per capita income” (used by the 11th, 12th, and 13th Finance Commissions), an “index of decentralization” (used by the 11th Finance Commission), and an “index of utilization of local grant” (used by the 13th Finance Commission).

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Vertical imbalance

The study also highlights a broader issue of vertical fiscal imbalance between the central government and local bodies. Despite the Constitutional mandate to augment the consolidated fund of states to supplement the resources of panchayats and municipalities, there remains a significant gap between the resources transferred to local bodies and their expenditure responsibilities.

This vertical imbalance is evident in the disparity between the amounts proposed by the Ministry of Rural Development (MoRD) and Ministry of Urban Development (MoUD) for local bodies and the actual recommendations made by the Finance Commissions. For instance, during the 15th Finance Commission period, MoRD and MoUD together proposed a transfer of 25 per cent of the divisible pool to local bodies, but the actual transfer was only 4.2 per cent.

The GST hurdle

The report argues that this underfunding of local bodies could hinder their ability to deliver essential services and carry out their Constitutional mandates effectively. It calls for the 16th Finance Commission to recommend an increase in the share of local body grants transferred to states “to perform the fundamental tasks unhindered at the local level by realising the fiscal gap between the expenditure responsibilities and resource requirement”.

The situation has been further complicated by the introduction of the Goods and Services Tax (GST), which has reduced the taxing powers of sub-national governments. This makes local bodies even more dependent on transfers from higher levels of government to meet their fiscal needs.

One-size-fits-all approach won't do

The case of Kerala serves as a stark reminder that a one-size-fits-all approach based solely on population and area may not be sufficient to address the diverse needs and capacities of local bodies across the country.

The findings of this report are likely to fuel further debates about fiscal federalism and the need for a more nuanced approach to supporting local governance in India. As the country prepares for the recommendations of the 16th Finance Commission, states such as Kerala will be keenly watching to see if their concerns are addressed and if a more equitable system of resource allocation can be devised.