16th Finance Commission

16th Finance Commission

News: The Sixteenth Finance Commission is due to be set up shortly.

What is Finance Commission?
• The Finance Commission is constituted by the President under Article 280 of the Constitution, mainly to give its recommendations on distribution of tax revenues between the Union and the States (Vertical devolution) and amongst the States themselves (Horizontal devolution).

What has been the role of FC over the years in ensuring Fiscal Federalism?
• Introducing tax devolution as a major component of vertical transfers, gradually increasing the states’ share from 29.5% to 42% over time.
• Implementing performance-based incentives for states to promote fiscal discipline, population control, forest conservation, power sector reforms, and other crucial initiatives.
• Establishing disaster relief funds for states and local bodies to enhance their preparedness and response capabilities for natural calamities. For
example, Disaster relief funds for ensuring precautionary measures before disasters.
• Introducing grants for specific sectors like health, education, justice delivery, disaster management and statistical systems, addressing critical gaps and needs in these areas. For example, Grants given in case of upgradation of PHC’s, building new hospitals etc.
• Introducing grants for local bodies to improve their fiscal autonomy.

What are challenges faced by FC?
• FC is not a continuous body. Its functioning stops after submitting its report. Their validity is for 5 years.
• Some states have disagreed upon Terms of reference as provided under 15th FC. For example, southern states were apprehensive on use of 2011 census as against 1971 census as they feared they would receive fewer tax devolution.
• At times, recommendations of FC are not considered by both state and union governments as they have other priorities.
• Reforms suggested by FC are difficult for states to comply with due to resource constraints. All the states have their own limitations.
• The 15th FC proposed performance-based grants. However, this requires the establishment of clear and efficient performance metrics, which can be challenging.

What are the challenges before 16th FC?
• The 16th FC must ascertain the consequences of Pandemic on fiscal consolidation and performance of the states.
• For example, the combined government debt-GDP ratio had also shot up close to 90% at the end of 2020- 21.
• The decisions made by the GST council can impact on the revenue projections and calculations undertaken by Finance Commissions when distributing fiscal resources.

Which areas should the 16th FC focus on?

Cess and Surcharges
• The effective share of States in the Center’s gross tax revenues (GTR) declined from nearly 35% to approximately 31%. This decline was primarily attributed to a significant increase in the share of nonshareable cesses and surcharges in the Center’s GTR.

Horizontal Distribution
• Historically, Finance Commissions have struggled to determine how much a state’s deficit is due to its fiscal incapacity and how much is due to fiscal irresponsibility.
• Every horizontal distribution formula has been criticized as being inefficient or unfair or both.
• The concept of horizontal distribution inherently involves wealthier States providing compensation to poorer States. Ensuring this process doesn’t exacerbate the divide between the rich and poor states presents a challenge for the government when defining the terms of reference for the Finance Commission.

Per capita income criteria
• Per capita income is one of the criteria which determines share of a state’s share in divisible pool of taxes.
• Per capita income is the distance of a State’s per capita income from a benchmark. It is usually determined by the average per capita income of the top three States.
• This criterion ensures relatively larger shares for relatively lower income States. At present, it has the highest weight of 45%.
• Many of the richer States want a lower weight for this criterion. But it is essential to consider the requirements of the lower-income States. These States will have a greater contribution to India’s ‘demographic dividend’ in the future.

Freebies
• Ideally, the FRBM act should have kept a check on populist spending of the states but it has failed to do so. In such events, the 16th FC must lay down strict guidelines on spending of freebies to protect long term fiscal sustainability.

Equalisation Principle
• It is essential to give priority to equalising the provision of education and health services in the overall framework of resource transfers.
• Resource allocation to individual States could be guided by the equalisation principle, by utilising a limited number of criteria such as population, area, and distance.

Way Forward
• The FC should be strict about States maintaining fiscal deficit within limits. It should provide carrots to States maintaining fiscal deficit. For example - including fiscal performance as a criterion in horizontal distribution
• The FC while laying strict guidelines must also ensure that its recommendations are simple and practical to implement.
• The 16th Finance Commission should lay down guidelines for when cesses and surcharges might be levied. It should suggest a formula to cap the amount that can be raised.
• Set up a loan council as recommended by the Twelfth Finance Commission - This independent body should oversee the loan magnitudes and profiles of the central and State governments.