Special Category Status: Raising tax transfers to states a good alternative

The clamour for the ‘Special Category Status’ for Bihar and Andhra Pradesh came back into the spotlight after the Janata Dal (United) and Telugu Desam Party emerged as the key constituents of the National Democratic Alliance, which formed the coalition government after the recent Lok Sabha elections. But what is the Special Category Status (SCS), and why are these states asking for it?

Bihar and Andhra Pradesh have shown mixed fiscal and macroeconomic trends. Bihar's fiscal deficit for 2024-25 is targeted at 3% of Gross State Domestic Product (GSDP). However, in 2023-24 (RE), the fiscal deficit was expected to be 8.9% of GSDP, significantly higher than the budgeted 3% of GSDP. The fiscal deficit of Andhra Pradesh for 2023-24 is targeted at 3.8% of GSDP. In 2022-23, as per the revised estimates, the fiscal deficit is expected to be 3.6% of GSDP. The GSDP of Bihar for 2024-25 is projected to be growing at 13.5% over the previous year. On the other hand, the GSDP of Andhra Pradesh for 2023-24 is projected to grow by 10% over 2022-23 at current prices.

It is broadly argued that fiscal deficits are significant for the economic growth recovery process in the post-pandemic fiscal strategy, and a sudden containment of deficits can result in negative growth. Therefore, high deficits are substantiated if they are significantly used for public infrastructure investment. However, the fiscal risks for public debt management – the debt servicing dynamics – are high, as the Reserve Bank of India (RBI) retained the interest rates status quo in the last Monetary Policy Committee (MPC) meetings at 6.5%. High interest rates make public debt servicing expensive.

The polycrisis emanating from the debt crisis, along with the climate crisis, energy crisis, geopolitical uncertainties, and wars, makes the macro-fiscal management of state governments difficult, as states are equally exposed to macroeconomic uncertainties. Against the backdrop of these macroeconomic challenges, both states continue to push for SCS status, citing their unique developmental needs and challenges.

The Special Category states receive special financial assistance and other benefits from the central government due to their unique developmental needs and challenges. The SCS is determined based on five factors: hilly terrain, low population density or sizeable tribal population, strategic location along borders, economic and infrastructure backwardness, and non-viable state finances. Currently, 11 states enjoy SCS status: Jammu and Kashmir (now a Union Territory), Assam, Nagaland, Himachal Pradesh, Manipur, Meghalaya, Sikkim, Tripura, Arunachal Pradesh, Mizoram, and Uttarakhand.

However, the central government has repeatedly turned down the SCS status demands from Bihar, Andhra Pradesh, and Odisha, based on the 14th Finance Commission's meaningful recommendations to abolish it for all states except the Northeastern region and three hill states. Despite this, the JD (U) has passed a resolution seeking SCS status for Bihar, citing the state’s high poverty levels. The proponents of special status for Andhra Pradesh cited its reduced fiscal space and revenue loss after the bifurcation of the erstwhile state to create Telangana. Odisha has also demanded SCS status, citing its climate change vulnerabilities and large tribal population.

So, what are the advantages of SCS status? While the Constitution doesn't provide for SCS, the 5th Finance Commission recommended it in 1969. SCS states receive a higher share of central assistance, with a 90:10 funding formula for centrally sponsored schemes, compared to 60:40 for other states. They also enjoy tax concessions and can carry forward unutilized funds.

Is there an alternative to the SCS classification? Raghuram Rajan has proposed a multidimensional index-based classification, but the 14th Finance Commission's decision to increase tax transfers to states from 32% to 42% has been seen as a more effective way to close the resource gap in each state. The 16th Finance Commission could consider increasing tax transfers further as an alternative to declaring more states as SCS.

These are technical details. However, the political and economic questions are crucial here. The new coalition dynamics of fiscal federalism will identify its plausible way out, and the decision by the 16th Finance Commission has a major role to play here. An increase in the tax devolution from the present 41% to around 50% may be in the offing, instead of granting SCS to the states. The increase in the magnitude of tax transfer devolution will be an attractive solution to the demanding states as well to tackle their constrained fiscal space, robust growth path, and developmental needs.

(The writer is a professor at NIPFP and a member of the Governing Board of the International Institute of Public Finance, Munich)