Charting the path for the Sixteenth Finance Commission

General Studies Paper 2

Context

• The Sixteenth Finance Commission is due to be set up shortly. Many critical changes have taken place since the constitution of the Fifteenth Finance Commission in November 2017 that includes COVID-19 and the subsequent geopolitical challenges.

The vertical and horizontal dimensions

• The Fourteenth Finance Commission had raised the share of States in the divisible pool of central taxes to 42% from 32%.
• This was revised to 41% when the number of States in India was reduced to 28.
• During 2020-21 to 2023-24 (BE), 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 from 12.8% during 2015-16 to 2019-20.
• This heavy reliance on cesses and surcharges requires scrutiny by the Sixteenth Finance Commission. One option is to freeze the share of cesses and surcharges to some base number.
• An issue of concern in recent years has been the poor performance of the Goods and Services Tax (GST) and the consequent decline in total divisible pool. Fortunately, this is not an issue now as GST collections have maintained good buoyancy in the last two years. GST still needs restructuring to make it a good and simple tax.
• 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.
• 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.
• In fact, equalisation of the provision of education and health services should be prioritised in the overall scheme of resource transfers.
• Instead of using a large number of tax devolution criteria, the transfer of resources to individual States may be guided by the equalisation principle using a limited number of criteria such as population, area and distance, supplemented by a suitable scheme of grants.
• The equalisation principle is consistent with both equity and efficiency. It is used in federations such as Canada and Australia.

Recommendations

• 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 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.
• The Twelfth Finance Commission had recommended a target of 28% consistent with an underlying nominal GDP growth of 12%.
• It is also clear that the adjustment needed for the central government is larger than that for State governments.
• At the same time, 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.

Way forward

• One innovation which may be relevant in this context is to set up a loan council, as recommended by the Twelfth Finance Commission. This independent body should oversee the loan magnitudes and profiles of the central and State governments.
• The Sixteenth Finance 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 provide carrots to States maintaining fiscal deficit.