Context

• Many critical changes have taken place since the constitution of the Fifteenth Finance Commission in November 2017 and the Sixteenth Finance Commission is due to be set up shortly.
• The 16th FC will primarily determine how much of the Centre’s tax revenue should be given away to States (the vertical share) and how to distribute that among States (the horizontal share).

Fifteenth Finance Commission Recommendations (applicable from 2021 to 2026)

• Distribution of Tax Proceeds: The Commission has recommended a fair distribution of tax proceeds between the central government and the states, ensuring a balanced fiscal sharing mechanism.
• Impact of GST
  • The FC emphasises the need to study the impact of the Goods and Services Tax (GST) on the economy.
  • This assessment aims to understand the implications of GST implementation and its effects on various sectors.
• Performance-based Incentives: These incentives would be based on the efforts of the States to address issues such as population control, ease of doing business, and other relevant factors.
• Grants to States
  • The FC has proposed the provision of revenue deficit grants, grants to local bodies, and disaster management grants to the states.
  • These grants aim to support the financial needs of the states and ensure effective governance.

Critical Changes Since the Constitution of 15^th FC

• The biggest challenge and change were the pandemic COVID-19 and the subsequent geopolitical challenges i.e., China’s aggression on LAC.
• The combined government debt-GDP ratio had shot up close to 90% at the end of 2020-21.
• Many States are facing large fiscal imbalances.

Expected Deliberations upon the Constitution of the 16^th Finance Commission

• Assessment of the Vertical and Horizontal Distribution
  • The 14th Finance Commission had raised the share of States in the divisible pool of central taxes (Vertical Distribution) to 42% from 32%.
  • This was revised to 41% when the number of States in India was reduced to 28.
  • It is likely that during the deliberation on 16^th FC, states will demand that this proportion be raised, but there is not much room for stretching this further given the Centre’s expenditure needs and the constraints on its borrowing limit.
  • Therefore, much of the debate will centre on the horizontal distribution formula (Distribution among states).
• Discussion on Cesses and Surcharges
  • During 2020-21 to 2023-24, the effective share of States in the Centre’s gross tax revenues (GTR) averaged close to 31%, which was significantly lower than the corresponding share of nearly 35% during 2015-16 to 2019-20.
  • This was due to the inordinate increase in the share of cesses and surcharges to 18.5% of the Centre’s GTR during 2020-21 to 2023-24 (BE) from 12.8% during 2015-16 to 2019-20.
  • This heavy reliance on cesses and surcharges requires scrutiny by the 16^thFinance Commission. 
  • One option is to freeze the share of cesses and surcharges to some base number.
  • Under the 13th Finance Commission, this share was just 9.6%.A 10% upper limit of the share of cesses and surcharges as a percentage of Centre’s GTR may be recommended.
  • The share of States must be increased if the proportion crosses 10%.Thus, there will be one proportion, say 42%, if cesses and surcharges exceed 10%, and another share of 41% if they are 10% or below.
  • The formula may be nuanced by the 16^thFinance Commission with the help of the latest data. 
• Decline in Total Divisible Pool
  • The share of individual States in the Centre’s divisible pool of taxes is determined by a set of indicators that includes population, per capita income, area, and incentive-related factors such as forest cover and demographic change.
  • In the case of per capita income, it is the distance of a State’s per capita income from a benchmark, usually kept at the average per capita income of the top three States that is used as a determining factor.
  • This distance criterion implies relatively larger shares for relatively lower income States. At present, it has the highest weight of 45% — it had an even higher weight previously.
  • Many of the richer States have argued for a lowering of the weight given to this criterion.
  • However, due attention needs to be paid to the needs of the lower income States.
  • These States are expected to provide a relatively larger share of ‘demographic dividend’ to India in future provided attention is paid to the educational and health needs of their populations.

Possible Recommendations for the 16^th FC

• Re-examination of 2018 Amendment to the Centre’s FRBM 
  • This was also recommended by the 15^thFinance Commission.
  • The debt-GDP ratio for the combined account of central and State governments had peaked at 89.8% in 2020-21, of which the Centre’s debt-GDP ratio excluding any on-lending to the States amounted to 58.7%, and that of States was 31%.
  • While these numbers have begun coming down, these are still considerably above the corresponding Fiscal Responsibility and Budget Management (FRBM) norms of 40% and 20%, as in the 2018 amendment.
  • In 2020-21, the Centre’s fiscal deficit had shot up to 9.2% of GDP and that of States to 4.1%.
  • In view of the large departures of the debt and fiscal deficit to GDP ratios from their corresponding norms and the reduction of the States’ debt-GDP target to 20%, the 2018 amendment to the Centre’s FRBM needs to be re-examined.
• Restraint on Freebies
  • A few State governments appear to have relatively larger debt and fiscal deficit numbers relative to their GSDPs.
  • In this context, two concerns appear: these relate to the proliferation of subsidies and the re-introduction of the old pension scheme in States without a clear identification of the sources of financing and the resultant fiscal burdens.
  • Often, such subsidies are sought to be financed by raising the fiscal deficit.
  • All political parties are guilty on this count, some more than others, but trying to apportion blame will be a wrong start.
  • In a poor country, where millions of households struggle for basic human needs, it sounds cruel to argue against safety-nets for the poor.
  • But it is precisely because India is a poor country, we need to be more cautious about freebies.
  • The next Finance Commission should issue clear guidelines in the interest of long-term fiscal sustainability and the spending on freebies. 

Reform Needed to Restrain Freebies

• One innovation which may be relevant in this context is to set up a loan council, as recommended by the 12^thFinance Commission.
• This independent body should oversee the loan magnitudes and profiles of the central and State governments.
• The 16^thFinance Commission should examine the subject of non-merit subsidies in detail.
• The Finance Commission should be strict about States maintaining fiscal deficit within limits.
• It should incentivise States maintaining fiscal deficit (for example including fiscal performance as a criterion in horizontal distribution) and sticks for those that exceed fiscal deficit limits (by suitably acting on the extent of borrowing allowed). 

Conclusion

• In the pre-reform period, the Finance Commission recommendations were not that critical because the Centre had other ways to compensate States.
• But after abolition of Planning Commission, Finance Commission remains virtually the sole architect of India’s fiscal federalism. Its responsibility and influence are, therefore, much larger.
• The recommendation made by 16^thFC will be crucial as India is moving towards becoming the world’s third largest economy.