THE CONTEXT: The Fifteenth Finance Commission, headed by Mr NK Singh has submitted its main report for the period of 2021-2026 on March 2021 to the President. Earlier the commission has also presented an interim report for the period 2020-2021. This writes up discusses the various recommendations of the commission in the main report and examines whether it was able to perform the role of the balancing wheel of fiscal federalism.
THE TERMS OF REFERENCE OF THE XVth FINANCE COMMISSION
- The Fifteenth Finance Commission was constituted on 27 November 2017 against the backdrop of the abolition of Planning Commission, removal of the distinction between plan and non-plan expenditure and the introduction of GST.
- These developments have redefined the federal fiscal relations and the terms of reference (ToRs) of the commission reflect these realities.
- Apart from the mandatory ToRs provided under Art 280 of the constitution, the commission was given additional ToRs by the union government. These are outlined below.
TRADITIONAL TERMS OF REFERENCE
- The distribution of net proceeds of taxes in the divisible pool between the Union and the states and the states inter se.
- The principles governing the Grants in Aid to the revenue of the states.
- The measures needed to augment the resources of the local bodies of the states on the basis of the recommendation of the State Finance Commission
ADDITIONAL TERMS OF REFERENCE
- Review the current status of the finances of the union and states and suggest a fiscal consolidation roadmap.
- Examine if revenue deficit grants should be provided to the states by the Union government.
- While making recommendations the commission needs to keep in mind the demand on the resources of the union due to defence, internal security, climate change, and National Development Programme-New India 2022.
- The conditions that the Union required to impose on the borrowing programme of the states under Art 293(3).
- Performance-based incentives to states on factors like tax net under GST, population management, progress in implementation of centre’s flagship programmes, quality of capital expenditure, ease of doing business etc.
- The population data of the 2011 census will be used by the commission in arriving at its recommendations
- Review the pattern of financial contribution by the Union and states under the Disaster Management Act 2005.
THE RECOMMENDATIONS OF THE 15TH FINANCE COMMISSION
SHARE OF STATES IN CENTRAL TAXES
- The share of states in the central taxes also known as vertical devolution, for the 2021-26 period is recommended as 41%.
CRITERIA FOR DEVOLUTION
- The commission has chosen Income distance, area, population, demographic performance, forest and ecology, tax and fiscal efforts as criteria for horizontal devolution.
RECOMMENDATION FOR VARIOUS GRANTS
- Revenue deficit grants: 17 states will receive grants worth Rs 2.9 lakh crore to eliminate the revenue deficit.
- Sector-specific grants: Sector-specific grants of Rs 1.3 lakh crore will be given to states for eight sectors: (i) health, (ii) school education, (iii) higher education, (iv) implementation of agricultural reforms, (v) maintenance of PMGSY roads, (vi) judiciary, (vii) statistics, and (viii) aspirational districts and blocks. A portion of these grants will be performance-linked.
- State-specific grants: The Commission recommended state-specific grants of Rs 49,599 crore. These will be given in the areas of: (i) social needs, (ii) administrative governance and infrastructure, (iii) water and sanitation, (iv) preservation of cultural and historical monuments, (v) high-cost physical infrastructure, and (vi) tourism.
- Grants to local bodies: The total grants to local bodies will be Rs 4.36 lakh crore (a portion of grants to be performance-linked) including:
Rs 2.4 lakh crore for rural local bodies, (ii) Rs 1.2 lakh crore for urban local bodies, and (iii) Rs 70,051 crore for health grants through local governments.
The grants to local bodies will be made available to all three tiers of Panchayat- village, block, and district.
Grants to local bodies (other than health grants) will be distributed among states based on population and area, with 90% and 10% weightage, respectively.
The Commission has prescribed certain conditions for availing these grants except health grants. - Disaster risk management: It recommended retaining the existing cost-sharing patterns between the centre and states for disaster management funds. The cost-sharing pattern between centre and states is: (i) 90:10 for north-eastern and Himalayan states, and (ii) 75:25 for all other states.
FISCAL ROADMAP
- For the centre, the commission recommended a fiscal deficit of 4% of GDP by 2025-26. For states, it recommended the fiscal deficit of: (i) 4% in 2021-22, (ii) 3.5% in 2022-23, and (iii) 3% during 2023-26.
- If a state is unable to fully utilise the sanctioned borrowing limit, the unutilised borrowing amount can be availed in subsequent years.
- Following this fiscal deficit path will reduce the total liabilities of the centre and states from 62.9% of GDP in 2020-21 to 56.6% in 2025-26, and the states on aggregate from 33.1% of GDP in 2020-21 to 32.5% by 2025-26 respectively.
- Extra annual borrowing of 0.5% to states which fulfil power sector reforms like reducing operational losses and DBT mode of transfer of subsidy etc.
- It recommended forming a high-powered inter-governmental group to review the Fiscal Responsibility and Budget Management Act and recommend a new FRBM framework for the centre as well as states and oversee its implementation.
- The inverted duty structure between intermediate inputs and final outputs present in GST needs to be resolved. . Rate structure should be rationalised by merging the rates of 12% and 18%. States need to step up field efforts for expanding the GST base and for ensuring compliance.
MANAGEMENT OF PUBLIC FINANCES
- A comprehensive framework for public financial management should be developed. An independent Fiscal Council should be established with powers to access records from the centre as well as states. Governments can adopt accrual-based accounting and they must desist from off-budget financing.
HEALTH
- States should increase spending on health to more than 8% of their budget by 2022. Primary healthcare expenditure should be two-thirds of the total health expenditure by 2022. All India Medical and Health Service should be established.
FUNDING OF DEFENCE AND INTERNAL SECURITY:
- A dedicated non-lapsable fund called the Modernisation Fund for Defence and Internal Security (MFDIS) will be constituted. It will have a contribution from the consolidated fund of India and disinvestment proceeds from defence undertakings etc.
CENTRALLY-SPONSORED SCHEMES (CSS)
- Develop mechanisms to phase out CSS that has outlived its utility or has insignificant outlays. Third-party audit of CSS should be done in a time-bound manner.
ANALYSIS OF THE RECOMMENDATIONS
CONTINUITY IN FISCAL FEDERALISM
- The commission has continued the enhanced devolution of taxes to states as started by the XIVth FC (42%). The 1% reduction is due to J and K becoming a UT which enhanced the fiscal load of the union government.
BALANCING NORTH-SOUTH DIVIDE
- Along with the use of population data of 2011 which catered to the resource needs of northern states, the commission also assuaged the concerns of southern states by incentivising demographic performance.
REVENUE DEFICIT GRANTS TO STATES
- One of the terms of reference of the commission was whether revenue deficit grants be provided to the states. But the commission has not made these grants conditional on any factors. It has also recommended that 70% of these grants are to be disbursed during the current and next financial year owing to the management of the pandemic.
PROVISION OF ADDITIONAL GRANTS
- Sector and state-specific grants in areas like administration, education, water etc can not only improve the resource position of the states but also encourage them to implement vital reforms.
FISCAL CONSOLIDATION
- The commission has advocated an overhauling of the FRBM acts both at the central and state level. The emphasis on a Fiscal Council could bring fiscal accountability to public finances. Also, the extended timelines for meeting Fiscal Deficit and public debt targets can provide fiscal space to the governments in Covid times.
REFORMS IN THE TAX FRONT
- Rationalizations of GST slabs, measures to boost stamp duty, computerization of property registration along the criteria of tax and fiscal efforts can improve tax revenues.
LOCAL BODY FINANCES
- The commission has recommended grants for all the tiers of PRIs and made them conditional (except health) on executing various reforms in their functioning. For instance, the timely constitution of the state finance commission and adopting a streamlined accounting system etc will improve their functioning.
ADDRESSING FISCAL CONCERNS OF SECURITY
- The non-lapsable fund for defence and internal security will address the resource needs of these sectors on a sustainable basis. The commission has allayed the concerns of states as there is no mandatory contribution from the states to this fund.
CRITICISM OF THE RECOMMENDATIONS
DECLINE IN STATES’ KITTY
- Share of 10 states has declined relative to that of the 14th finance commission. The total tax devolution to the states for the period 2021 2022 will be lower than what they got during 2017-2018.
DOMINANCE OF CONDITIONAL GRANTS
- The government has not yet accepted the recommendation pertaining to sector and state-specific grants. Moreover, the FC has increased the share of conditional grants sharply. As a result, 57% of the grants accepted by the govt are conditional relative to 17% by the previous commission
IMPACT ON DEMOCRATIC AND FISCAL DECENTRALISATION.
- 84% of the grants to the local bodies are conditional. These conditions include setting up and implementing the recommendations of SFCs failing which the local bodies will be deprived of the grants. Secondly,60% of the grants are tied to water and sanitation which are the pet schemes of the centre that affects local priorities and needs.
VIOLATION OF CONSTITUTIONAL SPIRIT
- Internal security and defence are the centre’s responsibilities. The setting up of a fund for this purpose means the revenue share of the states will be reduced. The constitution does not envisage a situation where the FC earmark funds for the centre’s obligation.
PARTISAN FEDERALISM
- States’ devolution is linked to its tax performance while the centre’s tendency to forego tax revenues through a sharp reduction in corporate tax and others is left untouched. This shows a bias towards the centre on the part of the commission.
OUTDATED CRITERIA FOR DEVOLUTION
- The criteria used by the commission has been evolved during a production centred tax system. But post GST the system has changed into a consumption centred tax regime. The failure of the commission to look into this aspect has significant implications for fiscal positions of the states.
BORROWING CAPACITY OF STATES
- The states have demanded more borrowing space especially in the context of a depleted fiscal base due to Covid 19. But the commission has recommended only .5% additional borrowing subject to reforms taken by states. This is less than a 1% additional borrowing window provided after the covid crisis.
A COMPARISON BETWEEN 14TH AND 15TH FINANCE COMMISSION
Item – 14th Fc – 15th Fc
Criteria
Devolution – 42% – 41%
Sector Specific Grants – Discontinued – Recommended
Defence Funds – Not Part Of To Rs. – Provided
Share Of Conditional Grants – 17% – 57%
Grants To Local Bodies – Only To Gram Panchayat – All Tiers Of PRIs
Fiscal Council – Recommended – Recommended
FRBM – Amend FRBM, or replace it with Debt Ceiling and Fiscal Responsibility legislation. – A New FRBM Framework Recommended
Fiscal road map for the Union – Fiscal deficit target 3% from 2016-17 through the entire award period. – Fiscal deficit target of 4% in 2025-2026.
CRITERIA – 14th FC 2015-20 – 15th FC 2020-21 – 15th FC 2021-26
Income Distance – 50.0 – 45.0 – 45.0
Area – 15.0 – 15.0 – 15.0
Population (1971) – 17.5 – –
Population (2011) – 10.0 – 15.0 – 15.0
Demographic Performance – 12.5 – 12.5
Forest Cover – 7.5 – –
Forest and Ecology – 10.0 – 10.0
Tax and fiscal efforts – 2.5 – 2.5
Total – 100 – 100 – 100
FOR A NEW NORMAL IN FISCAL FEDERALISM IN INDIA: FINANCE COMMISSION AND BEYOND
COLLABORATIVE FEDERALISM
- The Finance commission’s terms of reference should be finalised after effective consultation with the states so that the commission is seen to be “Union Finance Commission” rather than “Central Finance Commission”.
MONITORING THE IMPLEMENTATION OF THE AWARD
- States often complain that timely release of funds as per the recommendations of the commission are not followed. Thus a mechanism, like a midterm review by an independent body must be put in place to ensure that the accepted recommendations are adhered to by the centre in letter and spirit.
FAIR VERTICAL DEVOLUTION
- The union’s decision to cut the corporate taxes in 19-20 led to a reduction of around 150000 crores of tax revenue. This has resulted in the states losing 65000 crores as their share of devolution. While the centre has options to generate revenues from many other sources, states do not have such luxury. Thus, due to the union’s tax policies states fair share should not suffer.
BALANCING THE USE OF CESSES AND SURCHARGES
- The share of cesses and surcharges as part of the Gross tax revenue of the Union has reached about 20% by 2021. The revenue realized from them does not form a part of a divisible pool thereby need not be shared with states. The progressive increase in their share and the reduction in the share of taxes in the divisible pool result in subversion of the Finance commission’s recommendations.
RESOURCE SHARING WITH STATES
- The centre can share a portion of proceeds from disinvestment, spectrum sales etc with states in the spirit of cooperative federalism. This is also suggested by MM Puncchi Commission on centre-state relations in 2011.
STATES’ ROLE IN RESOURCE AUGMENTATION
- The constitutional mandate of “Equalisation levy (revenue deficit) to the states in a way made the states complacent in fiscal management. The states must take effective measures to reduce wasteful expenditure and improve their public financial management.
FEDERALISM WITHIN STATES
- The states must treat their Local Bodies in a similar way they are treated by the centre. It means the federal division of financial resources must be extended to local governments. For this, state finance commissions must be set up and their recommendations need to be accepted in a time-bound manner.
THE CONCLUSION: The finance commission is the most significant instrument in transforming political federalism into fiscal federalism. The resource requirements of the Union has risen in the context of its enhanced responsibilities and a depleting treasury in the midst of a pandemic while the mismatch between states’ demands and revenue has worsened. In such a challenging scenario, the commission has done a commendable job in addressing most of the concerns of the constituent parts of Indian polity although it has missed an opportunity in revamping the devolution ecosystem in the backdrop of a GST regime.
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