Terms of References of 15th Finance Commission: A Critical Appraisal

Context: The Terms of References (ToR) of the 15^th Finance Commission has raised considerable criticism

Finance Commission:

• The Finance Commission is appointed every five years by the President of India under Article 280 of the constitution.

Functions of the Finance Commission:

It is required to make recommendations to the President of India on the following matters:

1. Sharing of central taxes with states,
2. Distribution of central grants to states
3. Measures to improve the finances of states to supplement the resources of panchayats and municipalities, and
4. Any other matter referred to it

Important terms:

1. Vertical Devolution: Distribution of tax revenues between the Centre and States
2. Horizontal Devolution: Allocation among the states.

Note: Recommendations made by the Finance Commission is only advisory in nature and not binding on the government.

15^th Finance Commission:

• The 15th Finance Commission was constituted in 2017
• The recommendations of the 15th Finance Commission headed by NK Singh will come into effect from April 1, 2020 to March 31, 2025.

Key Terms of References (ToR) of 15^th Finance Commission:

The mandate of the Finance Commission is defined by its ToR

1. Recommend a fiscal consolidation roadmap for sound fiscal management
2. Assess the impact of Goods and Service Tax (GST) on finances of the Centre and States
3. Usage of 2011 population data in the tax distribution formula
4. Review the need for revenue deficit grants to states
5. Review the increased tax devolution of the 14th FC
6. Conditions on state borrowings
7. Providing performance based incentives to states on the basis of following indicators:

• States’ efforts on tax net under GST
• Efforts in moving towards replacement rate of population growth
• Progress in increasing capital expenditure, eliminating losses of power sector
• Promoting digital economy
• Ease of doing business
• Implementation of GoI’s flagship schemes
• Degree of States’ Populist measures
• Efforts towards improving sanitation, solid waste management and end open defecation

Critical Evaluation:

1. Review the need for revenue deficit grants to states

• Revenue deficit grants are additional transfers made to states to fill the gap between the state’s revenue share and expenditure- Gap filling approach of fiscal transfer
• These grants are given under the Article 275(1)
• Critics argue that denial of revenue deficit grants conflict with the mandate of Finance Commissions 
• The gap filling approach has been widely criticised for the adverse incentives that it generates.
• However, its needed to be highlighted that the ToR does not imply discontinuing the grants given under Article 275 (1)
• According to the Article, the Finance Commission first needs to determine a principle governing grants in aid and then calculate the sums to be paid
• Therefore, economists like C. Rangarajan argues that it’s better to discontinue the gap filling approach and recommend grants based on better principles

2. Using 2011 Population Data

• Population data used by successive Finance Commissions have resulted in a ‘scaling factor’- larger the population, higher the share of resources
• The southern states apprehend that using 2011 data would result in lower resource allocation. Post 1970’s the southern states have made remarkable progress in implementing family planning measures thus reducing fertility levels
• The southern states feel that they are being disincentivised and penalized for achieving replacement rate of population growth
• However, it important to note that one of the major inefficiency with fiscal transfer in India is the use of outdated data based on 1971 census.
• Fiscal transfer is determined in per capita GSDP and then scaled up to cover entire population. GSDP is always calculated using current population. Scaling per capita transfer to the outdated population is entirely flawed.

Did you know?

• 42nd amendment to the Constitution in 1976, mandated a freeze on the population figures; with 1971 Census to be used for purposes of delimitation
• The freeze was legislated for a period of 25 years. This worked as an incentive for the states to control rising population without the prospect of their seats reducing in Lok Sabha.
• However in 2001, with the 84^th amendment it was extended to another 25 years

3. Devolution of taxes:

• The 14^th Finance Commission raised the proportion of sharable taxes to states from 32% to 42%.
• Though tax devolution increased, the plan transfers and grants reduced – thereby the aggregate transfers were marginally higher than that of 13^Th Finance Commission.
• The critics argue that there is not much scope for reduction and any reduction would undermine the fiscal autonomy of states

4. Performance-based incentive grants:

• Critics argue that indicators determining performance mostly relate to flagship programmes and schemes of the Union government and not that of State governments. This constricts independent decision-making by the states and is against the spirit of federalism

5. Additional Conditions on state borrowings:

• The Union government is empowered to approve or disapprove a state’s borrowing programme against conditions imposed by it under Article 293 if the state has any outstanding loan to the Union
• Critics argue any conditions on the state’s ability to borrow will have an adverse effect on the spending by the state.

Way Forward:

1. Economist C. Rangarajan suggests a Comprehensive equalisation approach through:
2. Proper estimation of states fiscal capacities reflecting their tax base: both GST taxes and non-GST taxes to be considered
3. Proper assessment of expenditure needs of states: Needs, cost and disabilities to be incorporated.

For example:

• Need for higher health expenditures for Kerala as population is ageing
• Cost of environmental load for mineral rich states.
• Remoteness as cost related disability for hilly states

Efficient fiscal transfer to ensure equity among states, balanced regional development, stability and integrity in the federal structure and uphold cooperative federalism.