16th Finance Commission: Explained, pointwise

Introduction

The 16th Finance Commission is due to be set up shortly to 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 sharing formula). 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. 

What is the Finance Commission?

The Finance Commission is constituted by the President under Article 280 of the Constitution, mainly to give its recommendations on distribution of tax revenues between the Union and the States and amongst the States themselves.  

Two distinctive features of the Commission’s work involve redressing the vertical imbalances between the taxation powers and expenditure responsibilities of the centre and the States respectively and equalization of all public services across the States. 

It is the duty of the Commission to make recommendations to the President as to—   

1. the distribution between the Union and the States of the net proceeds of taxes which are to be, or may be, divided between them and the allocation between the States of the respective shares of such proceeds; 
2. the principles which should govern the grants-in-aid of the revenues of the States out of the Consolidated Fund of India;
3. the measures needed to augment the Consolidated Fund of a State to supplement the resources of the Panchayats in the State based on the recommendations made by the Finance Commission of the State;
4. the measures needed to augment the Consolidated Fund of a State to supplement the resources of the Municipalities in the State based on the recommendations made by the Finance Commission of the State;
5. any other matter referred to the Commission by the President in the interests of sound finance.

Over the years the core mandate of the Commission has remained unchanged, though it has been given the additional responsibility of examining various issues. For instance, the 12th Finance Commission evaluated the fiscal position of states and offered relief to those that enacted their Fiscal Responsibility and Budget Management laws.  The 13th and the 14th Finance Commissions assessed the impact of GST on the economy. The 13th Finance Commission also incentivised states to increase forest cover by providing additional grants. 

Why is there a need for an FC? 

Resolving vertical fiscal imbalance: 

Vertical fiscal imbalance occurs due to the asymmetry in the constitutional scheme of assignment of resources and responsibilities between the central and the state governments.

The central government has been assigned a relatively larger share in the collection of tax revenues, while the state governments have relatively larger expenditure responsibilities. 

Reducing horizontal fiscal imbalance: 

Horizontal fiscal imbalances arise from the inter-state differences in tax bases and due to the varied ground conditions of the states regarding needs and costs of provision of public goods. 

LPG Reforms: 

In the pre-reform period, the Finance Commission’s recommendations were relatively less significant. The Central government had alternative methods to provide compensation to States through plan financing and investments in public sector undertakings (PSUs). 

However, after the reforms, the frequency of new PSU investments decreased, and the Planning Commission was abolished in 2014. Consequently, the Finance Commission has become the primary authority responsible for shaping India’s fiscal federalism. 

What are a few of the successful recommendations made by the Finance Commissions? 

Over the years, Finance Commissions have made various impactful recommendations concerning public finance, governance, and development in India. Here are some successful examples:  

1. Introducing tax devolution as a major component of vertical transfers, gradually increasing the states’ share from 10% to 42% over time. 
2. Implementing performance-based incentives for states to promote fiscal discipline, population control, forest conservation, power sector reforms, and other crucial initiatives. 
3. Establishing disaster relief funds for states and local bodies to enhance their preparedness and response capabilities for natural calamities. 
4. Introducing grants for local bodies to strengthen their fiscal autonomy and accountability in delivering essential services. 
5. Introducing grants for specific sectors like health, education, justice delivery, and statistical systems, addressing critical gaps and needs in these areas.

What are the challenges that Finance Commissions face? 

Lack of compliance: Both the Union and state governments sometimes overlook or ignore the recommendations. They may not agree with them or have other priorities. 

Complex reforms: Some of the suggested reforms can be complicated to implement. They require significant changes in government processes and policies. 

Resource constraints: The governments, particularly at the state level, might face resource constraints. This can make it hard for them to put the recommendations into practice. 

Policy prioritization: The governments often focus more on resource distribution. The recommended reforms may not align with their policy priorities. 

Conditionalities: Some states object to the conditions attached to grants. They believe these restrictions limit their expenditure options. 

Insufficient data: There can be a lack of necessary data to implement the recommendations. For instance, the 13th FC pointed out statistical gaps that hindered implementation. 

Performance-Based Grants: The 15th FC proposed performance-based grants. However, this requires the establishment of clear and efficient performance metrics, which can be challenging. 

What are some novel challenges before the 16th Finance Commission? 

Impact of Covid-19 Pandemic: The 16th Finance Commission must consider the repercussions and consequences of the pandemic on the fiscal condition and performance of both the Central and State governments. Additionally, the Commission needs to factor in their respective expenditure requirements and priorities. 

The GST Council: The decisions made by the GST council can impact on the revenue projections and calculations undertaken by Finance Commissions when distributing fiscal resources. 

What are the key areas that the 16th FC should prioritize? 

Cesses and surcharges:  

The effective share of States in the Center’s gross tax revenues (GTR) declined from nearly 35% during 2015-16 to 2019-20, to approximately 31% between the fiscal years 2020-21 and 2023-24 (BE). 

This decline was primarily attributed to a significant increase in the share of non-shareable cesses and surcharges in the Center’s GTR which increased to 18.5% of the GTR during 2020-21 to 2023-24 (BE) from 12.8% during 2015-16 to 2019-20. 

Horizontal distribution: 

Historically, Finance Commissions have struggled to determine how much a state’s deficit is due to its fiscal incapacity and how much is due to fiscal irresponsibility.  

They have tried to modify the distribution formula to support deficit States without penalizing responsible States which is impossible as the total funds for distribution are limited. Every horizontal distribution formula has been criticized as being inefficient or unfair or both.  

The concept of horizontal distribution inherently involves wealthier States providing compensation to poorer States. Ensuring this process doesn’t exacerbate the divide between the rich and poor states presents a challenge for the government when defining the terms of reference for the Finance Commission.  

Per capita income criteria:  

The share of individual States in the Centre’s divisible pool of taxes is determined by a set of indicators. Per capita income is one of the criteria. Per capita income is the distance of a State’s per capita income from a benchmark. It is usually determined by the average per capita income of the top three States. 

This criterion ensures relatively larger shares for relatively lower income States. At present, it has the highest weight of 45%. Many of the richer States want a lower weight for this criterion.  

But it is essential to consider the requirements of the lower-income States. These States will have a greater contribution to India’s ‘demographic dividend’ in the future. 

Restraining freebies: 

In theory, the restraints imposed by the Fiscal Responsibility and Budget Management (FRBM) Act should have acted as a check on populist spending.  

But governments have found inventive ways of raising debt without it appearing in the budget books. 

The 16th Finance Commission should lay down guidelines on the spending on freebies in the interest of long-term fiscal sustainability. 

Equalisation provision: 

It is essential to give priority to equalising the provision of education and health services in the overall framework of resource transfers. 

Resource allocation to individual States could be guided by the equalisation principle, by utilising a limited number of criteria such as population, area, and distance. 

Debt burden of centre and states: 

The combined debt-GDP ratio of central and State governments peaked at 89.8% in 2020-21. Centre’s debt-GDP ratio is 58.7%, and it is 31%.for states. 

These numbers show improvements. But it was still above the corresponding FRBM norms of 40% and 20%. 

What should be the way forward? 

The Finance Commission should make recommendations that are simpler and more practical. It should also work with governments to understand and overcome their challenges. 

Governments should prioritize these recommendations, gather needed resources, adjust grant conditions, and fill data gaps. 

The 16th Finance Commission should lay down guidelines for when cesses and surcharges might be levied. It should suggest a formula to cap the amount that can be raised. 

A mechanism is necessary for Finance Commissions to reevaluate their figures in response to the decisions made by the GST Council, or vice versa. 

A loan council can be set up. It was recommended by the Twelfth Finance Commission. It should keep a watch on the loan magnitudes and profiles of the central and State governments. 

The 16^th Finance Commission should take a firm stance on States adhering to fiscal deficit limits. It can offer incentives to States that maintain fiscal discipline and penalties for those exceeding the fiscal deficit limits. 

Sources: The Hindu (Article 1 and Article 2), Indian Express