8 minute read 31 Jul 2023
16th finance commission

Why the 16th Finance Commission must prioritize restoration of fiscal balance

D. K. Srivastava
By D. K. Srivastava

EY India Chief Policy Advisor

A noted economist, D.K. Srivastava is an Honorary Professor at Madras School of Economics and Member of the Advisory Council to the 15th Finance Commission.

8 minute read 31 Jul 2023
Related topics Tax COVID-19
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Finance Commissions have handled resource sharing between union and states in a relatively stable manner. 

In brief

  • The 16th Finance Commission (FC16), due to be set up in November 2023, must address issues of vertical, horizontal, and fiscal imbalances.
  • Given the greater dependence on tax devolution as an instrument of transfers, FC16 needs to modify the tax devolution criteria to better target the inter-state distribution of transfers.
  • FC16 may consider the possibility of setting up a ‘Loan Council’ to oversee the debt and fiscal deficit profiles of the central and state governments.

Finance Commission (FC) is a constitutional body that is set up at intervals of five years under normal circumstances. The Presidential order constituting the Commission specifies a Term(s) of Reference (ToR) for the Commission, spelling out the specific tasks that it should take up. These tasks pertain to the constitutional provisions regarding sharing of central taxes with the states in India and the determination of grants under Article 275(1). These ToR also recognize India’s contemporary economic and fiscal realities and specify any particular issue that the Commission should attend to in the context of fiscal federalism. So far, 15 FCs have submitted their recommendations since FY1951. 

Resolving vertical fiscal imbalance

Vertical fiscal imbalance occurs due to the asymmetry in the constitutional scheme of assignment of resources and responsibilities between the central and the state governments. The central government has been assigned a relatively larger share in the collection of tax revenues, while the state governments have relatively larger expenditure responsibilities. 

Table 1 gives the share of states in the divisible pool of central tax revenues. Under Articles 270 and 271, all central taxes have been made sharable with the states except cesses and surcharges. A reading of state memoranda to different FCs indicates their continuous demand for assigning at least 50% of union government’s gross tax revenues (GTR) to them. This has not happened so far. FC14 had raised their share from 32% as recommended by FC13 to 42%, which was revised to 41% by FC15 for 28 states after Jammu and Kashmir was made a union territory. However, the union government neutralized the increase in sharable central taxes by increasing the share of non-sharable cesses and surcharges.

Table 1: Recommended and effective share of states in sharable central revenues (%): FC12 to FC15 (2)

Reducing horizontal fiscal imbalance

Horizontal fiscal imbalances arise from the inter-state differences in tax bases and due to the varied ground conditions of the states vis-à-vis needs and costs of provision of public goods.

Notably, a much larger share of transfers has been earmarked for the states under tax devolution. In terms of the relative importance of the two instruments of transfers namely, tax devolution and grants, the former constitutes a share in the range of 80.6% [FC15(2)] and 91.4% (FC10) considering the period from FC10 to FC15. This implies that the inter-se targeting of transfers would suffer since tax devolution is undertaken through broad-based criteria, whereas grants could be more finely targeted. There is a need for the FCs to introduce modifications in the tax devolution criteria such that better targeting can be achieved in the inter-se distribution of transfers to satisfy the states’ requirements. Some of the state-and sector-specific grants which were used for finer targeting, recommended by FC15, were not accepted by the union government. This is primarily due to GoI’s concerns pertaining to a sharp increase in the states’ share in central taxes by 10% points by FC14.  

It is important that tax devolution criteria and their inter-se weights be determined objectively to better reflect states’ needs and cost disabilities. Table 2 gives the relative weights associated with different criteria used by recent FCs. Recognizing that there is now a greater dependence on tax devolution as an instrument of fiscal transfers, ways need to be found to increase the information content under each of these groups of criteria so that transfers through devolution can be better targeted.

Table 2: Relative weights for different tax devolution criteria: FC12 to FC15

There has been a debate regarding the relative emphasis that needs to be given to criteria reflecting equity vis-à-vis those reflecting efficiency. While some of the less developed states argue in favor of assigning a relatively higher weight to equity considerations, some of the high per capita income states argue for higher weights to efficiency considerations. 

In the literature on fiscal federalism as well as in empirical practice, in many established federal countries, the principle of equalization in fiscal transfers has been considered desirable on account of its compatibility with equity as well as efficiency. Empirically, two approaches have evolved in regard to translating equalization into practice. In the first approach, equalization is limited to fiscal capacity equalization1. In the second approach, this is supplemented by expenditure-side equalization. Canada follows the first approach, while Australia is an example of the second.

Restoring fiscal balance

In 2018, the Fiscal Responsibility and Budget Management Act was amended based on the report from the FRBM Review Committee. There were four key changes brought about by this amendment. First, the target of maintaining a balance or surplus on the revenue account was given up. Second, the fiscal deficit to GDP targets for both central and state governments were kept at 3% each and these were made operational targets. Third, the statutory target was defined in terms of government debt-GDP ratios. Separate limits were defined for the central government at 40% of GDP and 20% for the aggregate of states. Fourth, several countercyclical clauses were provided as part of the Act. In the literature that developed subsequently, certain inconsistencies in the debt and fiscal deficit targets were noted2. Also, the levels of government debt and fiscal deficits rose inordinately in FY21 in response to COVID-19. There is a need for the GoI to re-examine the FRBMA. FC15 had also recommended the setting up of a High-Powered Intergovernmental Group to examine these issues. In particular, three issues need to be addressed. First, the debt and fiscal deficit targets should be made internally consistent. Second, once the new norms are specified, a new glide path can be indicated by the Commission based on its growth projections. Third, the FRBMA needs a more realistic macro stabilization clause to handle the economic slowdowns like the one faced during FY20 and FY21. 

In recent years, there has also been a re-emphasis on provision of non-merit subsidies by some of the state governments. An example of this is the provision of free electricity, which is a private good with limited externalities. Another issue that appears to be gathering momentum pertains to the re-introduction of the old pension scheme in some states without a clear identification of sources of financing the resultant fiscal burdens. FC16 should re-examine these issues given their impact on the fiscal imbalances of central and state governments. The Commission should find methods to penalize states who are not able to keep their fiscal deficit within the FRL norms. One possibility is to set up a ‘Loan Council’, which was recommended by FC12, to oversee the debt and fiscal deficit profiles of the central and state governments. This council may consist of the Chairperson and members representing the Ministry of Finance, Reserve Bank of India, two state governments by rotation, and fiscal experts.

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  • Show article references#Hide article references

    1. Fiscal capacity refers to the revenue raising capacity of a tier of government.
    2. Srivastava, D. K. (2022). The Future of fiscal consolidation in India, Economic and Political Weekly, Issue No. 13, Volume 57, 29-35

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Summary

The 16th Finance Commission must objectively determine the tax devolution criteria and their inter-se weights with an objective of reducing the inter-state disparities in the standards of services. In view of the inordinate rise in fiscal imbalances, the Commission also needs to re-examine union government’s 2018 Fiscal Responsibility and Budget Management Act.  

About this article

D. K. Srivastava
By D. K. Srivastava

EY India Chief Policy Advisor

A noted economist, D.K. Srivastava is an Honorary Professor at Madras School of Economics and Member of the Advisory Council to the 15th Finance Commission.

Related topics Tax COVID-19
Upvote