The appointment of the 16th Finance Commission (FC) is expected shortly. The global and domestic challenges are different now as compared to 2017 when the 15th Commission was set up. The 16th Commission will have to take into account the Covid-19-induced fiscal shocks and global macroeconomic uncertainty including geopolitical challenges: The combined (Centre and states) deficit and debt were 10% and 89% respectively in 2022-23.
The Finance Commission determines the vertical shares – how much of the Centre’s tax revenue should be given away to states
The Finance Commission determines the vertical shares – how much of the Centre’s tax revenue should be given away to states – and horizontal shares – how to distribute that among states. The 14th Commission had raised the shares of states from 32% to 42% of the divisible pool of Union taxes while the 15th Commission recommended 41% when the number of states was reduced to 28. It looks like there is no scope for increasing this share as there are fiscal imbalances for the Centre with a 6.5% fiscal deficit and 58% debt in 2022-23.
However, the 16th Finance Commission should look into the issue of cesses and surcharges, which increased from around 10% of gross tax revenue (GTR) in 2011-12 to 20% in 2019-20. In fact, the ratio of states in the Centre’s GTR declined from 36.6% in 2018-19 to 30.2% in 2022-23. Rangarajan and Srivastava had suggested an upper limit of 10% GTR for cesses and surcharges. The Commission could recommend this. The share of states in Union taxes can be raised if it exceeds 10%. In other words, vertical share can be made dynamic depending on the share of cesses and surcharges.
The horizontal distribution formula of the Finance Commission is an important instrument for tackling inequalities across states. In one of his articles on inter-state inequalities, former RBI governor YV Reddy indicated that barring the Finance Commission, no other public institution focuses on the inequalities among states. Even the earlier Planning Commission’s per capita outlays were higher for richer states. Centrally sponsored schemes required matching contributions by the states. The terms and conditions of domestic market borrowings and external borrowings would tend to favour the richer states. Bank credit remained regressive as industry and business concentrated in developed states. Central tax concessions also tend to be regressive. The disparities across states have been widening when we consider comparable data on per capita gross state domestic product (GSDP) from the 12th Finance Commission to the 15th FC– the coefficient of variation across states increased from 0.46 to 0.67. The disparities in per capita GSDP are the highest for the data given in the report of the 15th Commission. Therefore, the 16th Commission has to consider these widening disparities in income at the state level.
The horizontal distribution across states is based on indicators such as population, area, per capita income and incentive-related indicators like demographic change and forest cover. Per capita income distance is the most important indicator for tackling income disparities across states. The weightage of income distance in the 15th Commission was 45%. The important idea behind income distance is that fiscal capacity differences among states shall not be a hindrance to a citizen getting basic services such as health, education, water and sanitation.
Comparable data in the Finance Commission reports shows that ranks of low per capita income states such as Bihar, Jharkhand, Uttar Pradesh, Madhya Pradesh and Assam remained more or less the same in the last two decades. The ratio of minimum GSDP per capita (that of Bihar) and maximum GSDP per capita (which, after excluding Goa, refers to either Punjab or Haryana) decreased from 23.3% in the triennial average 1999-2002 to 17.7% in the triennial average 2016-2019. A recent report of NITI Ayog on multidimensional poverty shows that Bihar has the highest poverty ratio (33.76%) followed by Jharkhand (28.81), UP (22.93), Assam (19.35%) and MP (20.63) as compared to the all India poverty ratio of 15%.
In this context, the recommendations of the 16th Commission would be significant in reducing inequalities, particularly of income. The horizontal distribution is a highly politically sensitive issue. Rightly, the high-performing southern states complain that their share has declined over time and that they are being penalised for better performance in income, population stabilisation and human development. One suggestion is not to tinker with the horizontal distribution formula for tax devolution. Grants can be provided to the less developed states. But experience shows that tax devolution, which is 80% of the transfers, was progressive while the grants (20% of total transfers) were less progressive. Therefore, grants have to be more progressive to help the low per-capita income states. In general, the Finance Commission has to be more sensitive to the equity principle in both tax devolution and grants as this is the only institution that addresses inter-state inequalities.
Other issues to be considered by the 16th Finance Commission are: More incentives to tackle the climate crisis, a relook at the revenue deficit grants, transfer of funds to local bodies, freebies by both the Centre and states, and revamping of centrally sponsored schemes (CSS). In the case of CSS, states may be involved in designing the schemes with more flexibility. There should be some cap on the freebies as percentage of revenue expenditure. Recommendations on freebies should apply to both the Centre and states. There are also suggestions to set up an independent fiscal council to provide a debt and fiscal sustainability analysis based on fiscal rules.
To conclude, India aspires to achieve the status of a developed nation by 2047 with inclusive development. The role of states is equally or more important in achieving these goals. States spend 60% of the total government expenditure; 70% of education and health spending; two-thirds of capital expenditure; and 79% of government employees are employed by the states. The recommendations of the 16th Finance Commission will be significant in reducing inter-state inequalities.
S Mahendra Dev is distinguished professor, ICFAI, Hyderabad and former director and vice-chancellor, IGIDR, Mumbai. The views expressed are personal
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