Context:

• The 16th Finance Commission (FC) faces growing demands from Indian states to increase their share in the divisible tax pool - with some suggesting a rise from the current 41% to as high as 50%.
• This has reignited a crucial debate on fiscal federalism, central transfers, and the nature of India’s intergovernmental fiscal architecture.

Background - Decline in States’ Effective Share:

• History of devolution trends:
  • 14th Finance Commission (2015–20): Increased states’ share in divisible pool to 42%.
  • 15th Finance Commission (2020–25): Maintained it at 41% (due to reorganization of J&K as a Union Territory).
• Shrinking divisible pool:
  • Despite higher nominal devolution, Centre imposed more cesses and surcharges, which are non-shareable with states.
  • As per RBI data:
    • Shareable tax pool reduced from 88.6% (2011–12) to 78.9% (2021–22) of gross tax revenue.
    • States have effectively received only 32% of total gross tax revenues over six years.

Key Issues for the 16th Finance Commission:

• Fiscal constraints of the Union government:
  • Increased devolution reduces the Centre’s fiscal capacity.
  • Centre already borrows to transfer to states.
  • Challenge to create fiscal space for Union List priorities amid politically-driven centrally sponsored schemes (CSS).
• Tied vs untied transfers: Refer to the conditions placed on how the funds are used.
  • States already spend around 60% of general government expenditure.
  • Thus, the states’ demand for greater fiscal autonomy could be met by increasing the share of untied transfers.
  • This would require the need to rationalize CSS to allow more untied funds. However, rationalizing CSS is complex due to political and developmental compulsions.
  • Also, untied transfers may lead to increased revenue expenditure on populist schemes like cash transfers and subsidies, rather than on productive capital investments.

Concerns Over States' Spending Quality:

• Rising revenue deficits:
  • States increasingly borrow for revenue expenditure (e.g. salaries, subsidies).
  • Examples: Karnataka slipping into revenue deficit; Punjab's high revenue deficit hampers capital expenditure.
• Risk of populist spending:
  • 14 states have launched cash transfer schemes (adding up to 0.6% of the GDP).
  • As India is moving towards some form of quasi-universal income transfer (driven by electoral politics), these cash transfers are being financed through a combination of expenditure switching and higher borrowings.

Equity and Efficiency in Public Service Delivery:

• Inter-State disparities:
  • Spending by low-income states (e.g. Bihar) is much lower than richer states.
  • Concern: Will increasing untied funds narrow or widen inequality in service delivery?
• Devolution to local governments (3rd tier):
  • Indian third-tier governments (Panchayats, Municipalities) get much less compared to peers in China, South Africa.
  • States are often reluctant to devolve functions and finances.
  • Question: Will higher state share incentivize more devolution to local bodies?

Conclusion and Way Forward:

• The 16th Finance Commission must strike a balance between:
  • Enhancing states’ fiscal autonomy.
  • Ensuring fiscal sustainability of the Centre.
  • Promoting efficient and equitable spending.
  • Encouraging genuine federalism through local empowerment.
• A holistic approach is required, considering constitutional, economic, and political dynamics that shape India’s fiscal federalism.