Haseeb Drabu writes: What the 16th Finance Commission needs to do differently

Source– The post is based on the article “Haseeb Drabu writes: What the 16th Finance Commission needs to do differently” published in “The Indian Express” on 14th September 2023.

Syllabus: GS2 – Issue pertaining to federalism. GS3- Government budgeting

News– The article highlights the need for relook at federal fiscal transfer due to the introduction of GST.

Why is there a need for reconsideration of federal fiscal transfer  after the implementation of GST?

Earlier, the taxation system was based on production. Now, it is centered on consumption. It alters the dynamics of federalism both vertically and horizontally.

Previously, the central sales tax shifted the tax burden from wealthy manufacturing states to consuming states. It contributed to horizontal imbalances.

Now, the destination principle ensures that consuming states benefit at the expense of industrialized ones. The IGST levied during interstate supply of goods or services is transferred to the destination state.

This transition from the origin-based tax principle to the destination-based principle is reshaping the power balance among states.

However, the federal fiscal transfer system remains structured for the origin-based tax era. Its criteria for distribution also adhere to the previous system.

What should be the way forward for the 16th Finance Commission?

The upcoming formation of the 16th Finance Commission should include a mandate to reassess the principles governing tax distribution. It should take into account the changed landscape of fiscal federalism in India.

Its terms of reference should reflect the consolidation and inclusion of the indirect tax base shared by both the Union and the states.

There is a need for reconsideration of the statutory sharing of indirect taxes, both in terms of vertical and horizontal distribution.

To align the principle of vertical distribution with the new system, it’s crucial to redefine the divisible pool.

For example, the 16th Finance Commission will need to specify how IGST can be fully integrated into this pool. Currently, only IGST without any input tax credit is shared with the states.

There should be a standardized basis for including unsettled IGST with credit in transition into the divisible pool.

The altered administration of GST has led to a substantial increase and considerable variation in the reported cost of tax collection. It is ranging from 7% to 10%.

Therefore, the SFC should recommend a method for calculating and distributing the cost of collecting indirect taxes and proposing ways to reduce these costs and enhance collection efficiency.

Regarding horizontal distribution, the criteria for distributing the divisible pool among states will need to be reexamined.

The existing criteria have evolved in the context of a production-based tax system. This needs to be reconfigured to suit a consumption-based tax system.

The SFC should evaluate the necessity for GST compensation. It’s crucial to reassess the need, feasibility of the compensation scheme in light of the revenue performance of GST over the past six years.

Additionally, clear guidelines should be established for allocating the remaining amount of GST compensation cess collection to the divisible pool of taxes.

Furthermore, within the new institutional framework of federal finance, there should be a formal institutional relationship between the GST council and the Finance Commission.

The SFC should investigate how the GST Council can function as a Fiscal Council to oversee the implementation of its award during the periods when it is not actively in operation.