Key challenges facing the Sixteenth Finance Commission

Horizontal imbalance: Challenges of delivering equalization

The well-established principle for resolving horizontal imbalance consistent with equity and efficiency, as practiced by major federal countries, is called fiscal capacity equalization. The underlying idea is that fiscal transfers compensate for a deficiency in fiscal capacity, but not that in tax effort. In India, fiscal capacity equalization is delivered at least partially through the ‘distance criterion’. The distance criterion is supplemented by a number of other devolution criteria. 

The distance criterion involves a re-distribution from states with higher fiscal capacity to lower fiscal capacity. For lower per capita GSDP states, the distances from the benchmark and the relative population size have both increased, accompanied by a lowering of weight attached to the distance criterion. This implies larger redistribution to achieve the same degree of equalization.

After FC14’s recommendations, the GoI has shown reluctance to accept state specific and purpose specific grants that facilitated augmenting the extent of equalization or delivery of other welfare objectives by finer targeting. In this context, either the share of states in tax devolution may be reduced from 42% or 41% of the sharable pool or tax devolution framework should be modified to impart to it greater targeting capacity. There is a need to evolve the next generation of devolution criteria¹.

Fiscal imbalance: Issues of debt and deficit sustainability

The FC16 has not been directly asked to examine the sustainability of debt and fiscal deficit for the GoI and the states. However, FC16 should and can consider this under the provisions of Articles 280 (d) making a reference to ‘interest of sound finance’ and under constitutional articles 292 and 293 dealing with central and state borrowing. Also, FC grants to states ‘in need of assistance’ as per article 275 (1), cannot be normatively determined until there is a normative determination of the interest payments and revenue expenditures of states. Thus, fiscal, vertical, and horizontal imbalances require to be jointly resolved. 

The issue of symmetry in fiscal deficit targets for the GoI and the states is linked to the way vertical transfers from the GoI to states have evolved. Here, it is important to compare the share of GoI in the combined revenue receipts after fiscal transfers with its share in the combined primary expenditures (Chart 3). 

GoI’s share in combined primary expenditures has consistently been higher than its share in combined revenue receipts after transfers. This implies that on a systematic basis, GoI would need a higher share in combined primary deficit (and combined fiscal deficit). The 2018 amendment to the union government’s FRBM Act, however, provides for equal levels of fiscal deficit for the GoI and the states. 

Demographic imbalance: Accounting for state-differentiated profiles

The latest available Census figures in India still pertain to 2011, as the 2021 Census has not been conducted. The Ministry of Health and Family Welfare, however, provides state-wise population projections up to 2036. There are considerable differences in the way the size and age profiles of the state-wise population are expected to evolve. Consequently, the median age of different states also shows varying profiles.

For optimally utilizing the emerging patterns of the age profile of population across states, there is a need for increased allocation for education and health in states with higher young and old age dependency ratios, respectively. For the working age population, both health and educational services need to be equalized across states to avoid migration for seeking better standards for these services.

Environmental imbalance: Need for a more comprehensive coverage

Some aspects of ecological and environmental externalities have been captured through devolution criteria such as the forest criterion under which states with a higher share of forest area in all-India forest area receive higher share in tax devolution as compensation for the loss that they bear on behalf of other states for absorbing CO₂ while bearing the opportunity cost of their area under forests. There are, however, some aspects where environmental costs are heavy and fiscal transfers do not take these into account. One example relates to the extraction of minerals, particularly coal. Pollution hazards and related costs are quite large for mineral rich states, whereas the benefits are shared across the country. Further, these coal and mineral rich states have a relatively larger share of tribal population requiring greater attention on their health and education indicators.