The next Finance Commission will have a tough task

Source– The post is based on the article “The next Finance Commission will have a tough task” published in “The Hindu” on 15th June 2023.

Syllabus: GS3- Government budgeting

Relevance– Issues related to taxation laws

News- The government will appoint a Finance Commission in the next few months to determine how much of the Centre’s tax revenue should be given away to States and how to distribute that among States.

What are issues related to horizontal distribution by the Finance Commission?

Terms of reference– Finance Commission in 2017, considered the 2011 population figures in determining the expenditure needs of a State. This was a departure from the standard practice of using the 1971 population numbers.

States which had done well in stabilising population growth rates protested against this change in the base year. They called it a ‘penalty for good performance’.

Revenue deficit– The rationale for revenue deficit grants is that every State should be able to provide a minimum level of service to its residents even if it involves cross-subsidisation.

This has become a perverse incentive for states. States do not make efforts to raise revenues on their own because the Finance Commission compensates them.

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.

Division among states– These fault lines across States have deepened in recent years along political, economic and fiscal dimensions.

Southern States of the country are doing better in terms of infrastructure, private investment, social indicators and the rule of law. It has widened the north-south gap.

The nature of horizontal distribution is such that richer States compensate poorer States. There is a need to ensure that this happens without deepening the divide. It creates a challenge for the government in defining the terms of reference of the Finance Commission.

What should be the focus area of the next Finance Commission?

Cess and Surcharges– Centre is increasingly resorting to a levy of cesses and surcharges rather than raising taxes. Proportion of cesses and surcharges in the Centre’s total tax revenue had nearly doubled from 10.4% in 2011-12 to 20.2% in 2019-20.

The Constitution was amended in the year 2000, it gave States a share in the Centre’s total tax pool. The implicit understanding was that the Centre will resort only sparingly to cesses and surcharges, and not as a matter of routine.

As a result of this breach, States have felt cheated out of their legitimate share of national tax revenue.

The next 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.

Freebies– The Finance Commission should look at the government spending on freebies. All political parties are guilty on this count.

The restraints imposed by the FRBM Act should have acted as a check on such populist spending. But, governments have found ways of raising debt without it appearing in the budget books.

The next Finance Commission should lay down guidelines on the spending on freebies.