Issues before 16th Finance Commission

Context: Government is scheduled to constitute the 16th Finance Commission towards the end of this year. This article looks at the issues that the next finance commission needs to handle.

About Finance Commission

Finance Commission is a constitutional body (Article 280) at the expiration of every fifth year or at such earlier the President considers necessary by order.

Finance Commission consists of a Chairman and four other members to be appointed by the President.

Parliament may by law determine qualifications for appointment as members of Finance Commission. 

It is entrusted with the responsibility of recommending transfer of 

  • Distribution between Union and States of net proceeds of taxes to be divided between them.
  • Principles which should govern grants-in-aid of the revenue of States out of Consolidated Fund of India
  • Measures needed to augment Consolidated Fund of State to supplement resources of Panchayats and ULBs.
  • Any other matter referred to the Commission by the President. 

Finance Commission (Miscellaneous Provisions) Act, 1951

Chairman of Finance Commission shall be selected from among persons who have had experience in public affairs and four other members shall be elected from among persons who:

  • Qualified or are or have been judges of High Court.
  • Have special knowledge of finances and accounts of Government.
  • Have wide experience in financial matters and in administration
  • Have special knowledge of economics.

15th Finance Commission

The 15th Finance Commission has come out for special report on federal fiscal transfers for the period 2020-21. The report for the rest of the period 2021 to 2026 will be spelt in a different report.

Vertical Devolution (Between Centre and States)

1. For the year 2020-21, 15th FC recommended the same vertical devolution as was recommended by 14th FC. However, considering that the State of Jammu & Kashmir has been broken into two UTs of J&K and UT of Ladakh. Thus, the aggregate share of States was reduced by 1 % point to 41% of the divisible pool. (14th FC recommended States to have 42% of the divisible pool).

Horizontal Devolution (Sharing of Resources within States)

Aims of Horizontal Devolution are:

  • Considerations of fiscal need, equity and incentivising performance. 
  • Addressing fiscal disabilities and fiscal discipline
  • Enable States to provide basic public goods and services with equivalent tax effort
  • Filling up vertical fiscal gap of the States
  • Providing horizontal equity (higher share to poorer regions)
  • Equalising fiscal capacities of States (revenue equalisation)
  • Providing for cost differentials in States for basic public service (expenditure equalisation)
  • Ensure that States have enough incentives to mobilise own revenue and spend them appropriately in an efficient manner. 

Salient Features of 15th Finance Commission Recommendation:

  • 15th FC uses population data from 2011 census. Earlier FCs have used population data of 1971. 
  • Forest and ecology criteria is for rewarding for ecological services provided by the State’s forest cover to the country as a whole and overcoming disabilities arising from areas dedicated to dense forests. (Share of dense forest for each state in the aggregate dense forest of all the States).
  • Income distance: This criteria makes the devolution formula more equalising and progressive and provides higher devolution to States with lower per capita income. Income distance is computed by taking a three year average of per capita GSDP of all States and measuring the taking the distance from the State having highest per capita GSDP.
  • To incentivise States which have controlled population growth, Demographic Performance criteriahas been introduced by 15th FC. It uses a measure of Total Fertility Rate data for all States. This criterion has been computed by using the reciprocal of TFR of each State, scaled by the population data of Census 1971. States which have achieved lower TFR will be scored higher on demographic performance whereas States with higher TFR will be scored lower. 
  • Tax Effort: This criteria was used by 10th, 11th FC, 12th FC however, not used by 13th and 14th FC. The inclusion of this criteria by 15th FC will reward States with higher tax collection efficiency and encourage all States to be  more tax efficient.

Formula suggested by 15th Finance Commission for Horizontal Devolution

CriteriaWeight (15th Finance Commission)
Population (2011)15%
Forest and Ecology10%
Income Distance45%
Demographic Performance12.5%
Tax Effort (New criteria introduced by 15th FC, not used by 14th FC)2.5%

Formula suggested by 14th FC

Population (1971)17.5%
Population (2011)10%
Forest Cover7.5%
Income distance50%

Structural Issues with Finance Commission

  • Appointment of Members: Members of Finance Commission are unilaterally appointed by the Centre with no say from the states. States contend that this makes Finance Commission biased towards Centre. Ideally, the membership of Finance Commission should be appointed with the consent of both Centre or States or some members by Centre and some by States.
  • Terms of Reference: Terms of Reference of Finance Commission are fixed by the Centre. Over the years, apart from constitutional mandate of making recommendations for vertical and horizontal distribution between Centre & States, Central Government gives some additional considerations and parameters. States feel that these additional considerations are often loaded in the favour of Centre. There is a demand from the States that the TOR of Finance Commissions should be fixed jointly by Centre and States. A Forum like GST Council or Inter-State Council can be explored for this.
  • Temporary Nature of Finance Commission: Increasing geopolitical challenges and flux in economic circumstances often makes the 5-yearly award of Finance Commissions not sustainable to operate. This was very evident in case of the Covid-19 pandemic. There has been a demand to make Finance Commission a permanent body which can tweak it’s award to suit the varying economic context. 
  • Based on past data:  The 5 yearly award of Finance Commission is based on past revenue trends and not on forward indicators. However, for maintaining sustainable fiscal situation, future performance matters more.

Other Issues

  1. Issue of cesses and surcharges:
  • The revenue collected by centre as cess and surcharge do not form the part of divisible pool of central taxes. There has been steep increase in the share of cess and surcharge from 12.8% during 2015-16 to about 18.5% during 2023-24. 
  • The impact of increasing reliance on cess and surcharges has reduced states effective share in Centre’s Gross Tax Revenue. Thus, during 2020-21 to 2023-24, the effective share of States in Centre’s gross tax revenue has averaged 31%, which is significantly lower than 35% during 2015-16 to 2019-20. The increase in cesses is particularly visible in the case of cess on Petroleum products.
  • Centre has sharply reduced corporate income tax rate which has impacted the divisible pool of Gross Tax Revenue with States.
  1. Horizontal devolution formula: Currently, the horizontal devolution among states gives highest weightage to income distance (45%). Income distance measures distance of a State’s per capita income from a benchmark (usually average per capita income of top three States). This results in relatively higher share for lower income states. Richer states have argued against such high weightage to income distance however this results in progressiveness in devolution and equity in developmental outcomes for poorer states. The poorer states also house most of India’s demographic dividend. 
  1. Debt levels: Debt-GDP ratio combined for central and state governments peaked at around 90% in 2020-21 with Centre accounting for 58.7% and States accounting for 31%. However, Fiscal Responsibility & Budget Management Act mandates debt-GDP ratio of 40% for Central Government and 20% for State Governments. In view of the large departure of Central and State government debts with the prescribed norms, these norms need to be revisited. 
  1. Revenue Deficit Grants: All Finance Commissions have provided revenue deficit grants to states in need of assistance under Article 275 of the Constitution. The revenue deficit grants accounts for gap in revenue accounts for the States post devolution. However, many States feel that the gap filling approach through revenue deficit disincentivises prudential expenditure and taxation measures by states. However, the demand of equity and handicap faced by mountain states necessitates these grants. However, weightage should also involve education and health outcome gaps between states to came developmental outcomes uniform across states.
  1. Finance Commission and GST Council: GST Council has been constituted as a constitutional body and takes important decisions regarding administration of GST. The GST Council and Finance Commission often deal with issues of revenue and this can result in conflict between them.
  1. Transfer to Local bodies: State’s often fail to constitute State Finance Commissions and implement them. Finance Commission should incentivise states to form State Finance Commission. Often the grants given by Finance Commission are with conditions for example implementing certain schemes etc.  

Way Forward:

  • Consultation with states: The membership and terms of reference of Finance Commissions should be fixed in a consultative manner between Centre and States utilising forums such as Inter-State Council and GST Council.
  • Data collection: The focus should be capacity building and data collection and processing in the Finance Commission Division in the Ministry of Finance and develop forward looking indicators by future Finance Commissions.
  • Managing cess & surcharge:  Finance Commission should recommend a limit on the amount of cess & surcharge the centre could levy up to maximum 10% of overall gross tax revenue. If the centre breaches this limit the shareable pool of revenues to states should increase.
  • Independent Fiscal Council: It is a permanent agency with statutory mandate to assess publicly and independently government’s fiscal policies, plans and performance against macro-economic objectives related to the long-term sustainability of public finances. 
  • Revenue Deficit Grants: In place of a gap filling approach to revenue deficit grants and normative principle that balances handicaps faced by states and also takes care of not incentivising inadequate revenue effort or excessive expenditures.
  • Formula of devolution: Apart from income distance, outcome gaps in health and education should be also given due weightage for equity in developmental outcomes. 

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