Fiscal Devolution challenge before Finance Commission

Context: Recently, Tamil Nadu has hosted the Sixteenth Finance Commission to hold discussion with  various stakeholders in the state on the issues concerning fiscal devolution. In this context, let us assess the critical fiscal challenges facing India and suggestions to address the skewness in the relationship between the States and the Union. 

Financial relations between Union and States:

• Articles 268 to Article 293 in Part XII of the Indian Constitution deal with Centre-state financial relations.
• Article 268: Taxes levied by Centre but collected and appropriated by States. E.g., Stamp duties
• The 101st Constitution amendment provides for GST taxation law, establishing the GST Council under Article 279A of the Indian Constitution.
• Grants-in-aid to States: Statutory grant under Article 275 and discretionary grant under Article 282 of Indian Constitution.

Present formula for Fiscal Devolution:

• As per the 15th Finance Commission (2021-25), the states should be given 41% of the divisible tax pool. (Vertical devolution). 
• Within that 41%, the Finance Commission uses a horizontal criteria that determines the amount of funds going to different States. The formula is based on income, population, the area, forests and ecology, demographic performance, etc. 

Issues with the Finance Commission's Revenue Sharing Model:

1. Weightage of Population and Area combined has increased: 

• Weight for population in the devolution formula was 10% under the 11th Finance Commission (2000-05). It has increased to 15% under the 15th Finance Commission based on 2011 census.
• The weight given to the area has also doubled from 7.5% under the 11th Finance Commission to 15% under the 14th Finance Commission. 
• This tilts the scales in favour of states with large areas and large populations. Southern states have opposed this move as they argue that they are being penalised for controlling their fertility rates.

2. Income Distance: 

• Income distance is calculated by deducting the GSDP per capita of a state from the GSDP per capita of the state which scores the highest on this metric. 
• It has the highest weightage under the horizontal devolution formula. This is based on the principle of federalism which requires the wealthier states to share their excess revenue with not so wealthier states for overall development of the nation. 
• This has benefitted the North Indian states disproportionately.

3. Demographic Performance: 

• This criterion was introduced by 15^th Finance Commission to cater to the demands of the South Indian states who have performed well to control population explosion in their states.
• However, the formula for calculating the weight for demographic performance inverses the TFR and multiplies it by the population in 1971. This results in higher weight once again going to more populous states.

4. Tax and Fiscal Efforts: 

• The Fifteenth Finance Commission introduced a 2.5% weight for States which improve their tax and fiscal performance. But the weight for fiscal discipline was much higher at 17.5% under the Thirteenth Finance Commission. 

5. Shrinking Devolution: 

• Though the Finance Commission enhanced states’ share in the divisible pool of taxes, it did not result in concomitant increase in the actual devolution. 
• This is because, over the last few years, Central government has reduced the tax rates and increased the cess and surcharges which are not mandated to be shared with the states.
  • Cess and surcharges are part of central taxes but not part of the divisible tax pool and do not have to be shared with States. 
  • E.g.,: Share of cess and surcharge as a percentage of Gross Tax revenue of Center has increased sharply from 2.3% in 1980-81 to 15% in 2019-20.

6. Gaps between Declared Objectives and Outcomes: 

• While the Fifteenth Finance Commission awarded the vertical share of the divisible pool to the States as 41%, the effective devolution to States in the first four years of the award period amounted to only 33.16% of the Union’s gross tax revenue. 

7. Ceiling on the States’ Borrowing: 

• The Union Budget has kept 3.5% of GSDP as their borrowing limit for FY24 and it restricted borrowing power of the states. (As per article 293, states cannot raise loans without the consent of the union if there is any outstanding loan made by the state government with a guarantee given by the Centre.)

8. Restrictions on Off-budget Borrowings: 

• The Union Government had noticed in FY22 that such off-budget borrowings would be considered as borrowings made by the state. This reduced the capacity of states to increase their borrowings without violating fiscal deficit targets. 

9. Loss of Taxation Rights under GST Mechanism: 

• With the advent of GST, the states lost their rights to increase tax revenues by changing the tax rates on sale of many goods and services. (GST rates and slabs are decided by the GST Council with 3/4^th majority vote).

Way Forward:

• Giving taxation autonomy to states with sound fiscal performance or states which are more disaster prone like Kerala.
• 50% devolution of the gross central taxes, allowing States greater fiscal autonomy in funding and implementing locally relevant schemes. (Demand of Tamil Nadu)
• Including states in deciding the terms of consideration of the Finance Commission, similar to the GST council, a more formal arrangement for the participation of States in the constitution and the working of the FC should be considered.
• Weightage of demographic performance can be raised to 15 to 20 per cent. 
• Weightage given to income distance must be reduced, as that may help southern states with a higher per capita income.  
• Weightage for efficiency criteria in the horizontal devolution should be increased.
• Rationalising the share of cess and surcharges in the gross tax revenue of Centre.