Charting the path for the Sixteenth Finance Commission

Source– The post is based on the article “Charting the path for the Sixteenth Finance Commission” published in the “The Hindu” on 29th July 2023.

Syllabus: GS2- Constitutional bodies. GS3- Government budgeting

Relevance: Finance Commission

News- The Sixteenth Finance Commission is due to be set up shortly.

What are the issues that should be taken into consideration by the 16th Finance Commission?

Share of states-

The Fourteenth Finance Commission increased the share of States in the divisible pool of central taxes from 32% to 42%. When the number of States in India was reduced to 28, this share was revised to 41%.

The Center was able to handle this situation due to the withdrawal of Planning Commission grants following the abolition of the Planning Commission.

Centre is facing fiscal imbalances. So, there is no strong case for proposing any additional increase in the States’ share of central taxes.

Role of non-shareable cesses and surcharges-

Between the fiscal years 2020-21 and 2023-24, the effective share of States in the Center’s gross tax revenues averaged approximately 31%. It was notably lower than the previous share of nearly 35% observed during 2015-16 to 2019-20.

This decline was primarily attributed to a significant increase in the share of cesses and surcharges.

It increased to 18.5% of the Center’s Gross Tax Revenues during 2020-21 to 2023-24 from 12.8% during 2015-16 to 2019-20. During the period of the Thirteenth Finance Commission, this share was merely 9.6%.

One possible recommendation could be imposing an upper limit of 10% for the share of cesses and surcharges as a percentage of the Center’s GTR.

If this proportion exceeds 10%, the share of States should be increased accordingly. The Sixteenth Finance Commission, using the most recent data, could refine this formula to make it more effective.

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 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.

It is essential to give proper consideration to the requirements of the lower-income States. These States will have a greater contribution to India’s ‘demographic dividend’ in the future.

One approach could involve maintaining the weight of the distance criterion at its current level or even reducing it to 40%.

However, to address the needs of the economically disadvantaged States, it might be beneficial to make some upward adjustments in the resources allocated to them through grants.

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. This approach could be complemented by an appropriate system of grants.

The equalisation principle aligns with both equity and efficiency and has been successfully implemented in federations like Canada and Australia.

Debt burden of centre and states–

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

These numbers are showing improvements. But, still above the corresponding FRBM norms of 40% and 20%. The 2018 amendment to the Centre’s FRBM needs to be re-examined.

A few State governments have relatively larger debt and fiscal deficit numbers relative to their GSDPs.

There is proliferation of subsidies and the re-introduction of the old pension scheme in States However, the financing sources for these subsidies and the resulting fiscal burdens are not clearly identified.

What reforms can be suggested by the 16th Finance Commission?

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.

It needs to thoroughly investigate the issue of non-merit subsidies. The 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.