By G.R. Reddy

The Sixteenth Finance Commission (FC-XVI) was constituted on December 31 2023 with Dr. Arvind Panagariya as the Chairman.

The Terms of Reference of the Commission (ToR) this time are limited to those mandated in Article 280 of the Constitution and, therefore, much shorter than those of the previous Commissions. These are (i) how much of the Centre’s tax revenue should devolve to the States (vertical sharing), (ii) determining the share of each State in the divisible pool of Central taxes (horizontal distribution), (iii) recommending grants-in-aid to States which need assistance and( iv) recommending measures to augment the Consolidated Fund of a State to supplement the resources of Panchayats and Municipalities in the State.

Though under Article 280(2) (c) of the Constitution, any other matter can be referred to the Commission by the President in the interests of sound finance, the only additional matter included in the ToR this time is reviewing the present arrangements on financing disaster management initiatives and make appropriate recommendations.

These ToR are in sharp contrast to those of the previous Commissions, particularly those of the Fifteenth Finance Commission (FC-XV), which became highly controversial. The controversial ToR of FC-XV  were, (i) whether revenue deficit grants should be at all provided to States , (ii) whether a separate mechanism for funding of defence and internal security ought to be set up, and, if so, how such a mechanism could be operationalized and (iii) proposing measurable performance indicators in as many as nine areas including progress made in achieving the flagship schemes of Government of India.

Considerations that the Finance Commission shall take into account while making its recommendations have not been listed out in the ToR of FC-XVI, departing from past practice. In a press conference after the ToR were approved by the Union Cabinet in November 2023, T V Somanathan, Union Finance Secretary, clarified that they are shorter than recent Commissions but all-encompassing, offering greater leeway to stakeholders so that their inputs can be taken into account. He clarified that the ToR have been prepared after consultation with States.

 

The appointment of a Finance Commission is an important event and its recommendations have far-reaching impact not only on the finances of the Union and the States but also on shaping the future of fiscal federalism in the country.

A number of changes of far- reaching importance have taken place in Indian fiscal federalism in recent years. Without being bound by any consideration or by too many additional matters, this Commission has more leeway than  previous ones in taking into account the impact of recent developments and the growing trust deficit between the Union and the States, and recommend measures to preserve the spirit of the Constitutional provisions governing fiscal federalism. The FC-XVI  can suggest an action plan to realize the objective of promoting cooperative federalism and making States equal partners in progress to realize the growth potential of the country.

Issues before the FC-XVI 

1. Maintaining the Sanctity of Tax Devolution-Cesses and Surcharges

What are the issues which should engage the attention of the new Finance Commission? The first and foremost is maintaining the sanctity of tax devolution. Though the scope for raising the present share of States, standing at 41 per cent of divisible pool of Central taxes, is rather limited because of the committed liabilities of the Centre, arresting its dilution should be a major issue.

Tax devolution as percentage of gross tax revenue was only 28.2 per cent in 2011-12 and 29.4 per cent in 2020-21 as compared with the recommended shares of 32 and 41 per cent, respectively. The States’ share in Central taxes is only 31 per cent at present though the recommended share is 41 per cent. The divergence between the recommended devolution and actual devolution had increased from less than 4 per cent in 2011-12 to 10 per cent in 2020-21 because of the indiscriminate recourse by the Centre to the levy of cesses and surcharges.

Under the Constitution, proceeds of cesses and surcharges are not shareable with States. The share of cesses and surcharges in the gross tax revenue of the Centre increased from 10.4 per cent in 2011-12 to 20.1 per cent in 2020-21, belying the expectation that after the introduction of GST, most of the cesses will be subsumed under it. As a result, the share of tax devolution in the gross tax revenue of the Centre has been much lower than the recommended tax devolution. Under the Constitution, the Centre’s tax revenue, net of cost of collection, is shareable with States. The cost of collections is no more than 1 to 2 per cent of tax revenue. Even after discounting for the cost of collection, actual tax devolution falls short of the recommended share significantly.  Thus, higher tax devolution recommended by the Fourteenth Finance Commission (FC-XIV) has been more than neutralized by the higher recourse to the levy of cesses and surcharges as a source of funding Central and Centrally sponsored schemes.

Commission after Commission has observed that cesses and surcharges are meant to be levied sparingly to meet a specific requirement and for a specified period of time. Despite numerous advisories by the Finance Commissions that these may be capped at a certain level. the Centre’s reliance on their levy has been increasing over the years.  The Vidhi Centre for Legal Policy in a Study sponsored by the FC-XV observed that cesses and surcharges have become an almost permanent feature of India’s tax regime. The purposes for which cesses and surcharges are levied are wide ranging and open ended. A worrisome feature is that cesses are being levied for purposes which are included in the State List. In addition, there is no transparency in the utilisation of proceeds of cesses. The Sixteenth Commission needs to fix this irritant in Union-Centre relations on a permanent basis.

2. Centrally Sponsored Schemes Eroding the Autonomy of States

Related to the problem of cesses and surcharges is the issue of proliferation of Centrally sponsored schemes (CSS), most of which are only partly funded by the Centre. Many of these schemes operate in the subjects listed in the State List.  Though numerous committees appointed by the Government of India recommended restricting the CSS to areas of national importance, all that has been done so far is grouping them under 28 broad umbrella heads without any effective reduction in their number. Bibek Debroy observed that, “Clearly, a figure of 28 is misleading. Counted properly, the number of CSSs depends partly on how one defines a CSS. But the number will be close to 200.” (“Restructuring of centrally sponsored schemes cannot be done without consultation with states”. Financial Express, September 12, 2019)

A decision was taken by the Union Government to review the on-going CSS at an interval of every five years and make them co-terminus with the award period of the Finance Commissions. The existing CSS basket should have expired by March 31, 2020, co-terminus with the recommendations of the FC-XIV. But no such review has been done so far by the Union. Furthermore, the Sub-Committee of Chief Ministers appointed by the NITI Aayog, which submitted its report in 2015, recommended, inter alia, reducing the number of schemes to areas of national importance and to introduce optional schemes to address the problem of the “one-size-fits-all” nature of CSS. Though these were accepted by the Union, there has been no effective implementation of these recommendations despite the lapse of over eight years.

Grants under CSS have consistently been exceeding the FC transfers excluding tax devolution.  For instance, the FC grants in 2015-16 amounted to Rs.84,579 crore while CSS transfers to States were more than double at Rs.1,75,736 crore.  In 2022-23, CSS transfers at Rs.3,46,992 crore exceeded the FC grants by over 100 per cent.   Too many CSS with their one size fits all design and thinly distributed allocations have considerably diluted their benefits.

. Under the Constitution, the Finance Commission is envisaged as the main channel of grants to States.  The CSS grants are dispensed under Article 282 of the Constitution. On a request made by the Ninth Finance Commission, eminent jurist N. A. Palkhivala had opined that, ”Article 282 is not intended to enable the Union to make such grants as fall properly under Article 275. Article 282 embodies merely a residual provision which enables the Union or a State to make any grant for any public purpose, irrespective of the question whether the purpose is one over which the grantor has legislative competence”.

In view of the genuine grievances of States regarding the increasing number of CSS eroding their autonomy, there is an urgent need that the FC-XVI addresses this issue in the interests of promoting cooperative federalism.  Resolving the issues relating to cesses, surcharges and CSS will automatically result in reducing the Centre’s expenditure on State subjects.  The FC-XIV observed that that the revenue expenditure by the Centre on the subjects in the State List increased from an average of 14 per cent to 20 per cent and on subjects in the Concurrent List from an average of 13 per cent to 17 per cent between 2002-05 and 2005-11.

3. Freebies

Another important issue that needs to be addressed by the FC-XVI relates to the growing ‘freebie’ culture by the States and the Union, and a few States reverting to the old pension system threatening the fiscal stability of the country. The salary revision by the Centre and a large number of States which is due in 2026 will also exert stress on the finances. Not all subsidies are freebies. The Finance Commission may hold consultations with all the stakeholders to arrive at a consensus and devise a mechanism to restrict freebies, which are not in the nature of subsidies and not welfare promoting. The Commission may also consider putting in place an incentive/disincentive linked package for this purpose.

4. Fiscal Consolidation Roadmap

The amendments to the FRBM Act in 2018 mandated the Centre to take appropriate steps to bring down its debt to no more than 40 per cent of GDP by March 31, 2024, and to limit its fiscal deficit to 3 percent of GDP by March 31, 2021. These targets are unlikely to be achieved in the short run. The Covid induced economic downturn partially explains the slippages.  Though States have been adhering to fiscal deficit and revenue deficit targets at the aggregate level, there are wide variations across the States. In addition, following the impact of Covid and additional borrowing limits allowed by the Centre, States’ fiscal position has exhibited some deterioration. The recent initiatives by the Centre in bringing off-budget borrowings into its books of accounts and treating the off-budget borrowings as a State’s borrowing if they are serviced from the budgetary resources of that State, are in the right direction. The mechanism for fiscal consolidation has to be strengthened further. The Finance Commissions have been playing a stellar role in recommending glide paths for reduction of debt levels, fiscal and revenue deficits. The FC-XII recommended debt relief linked to reduction in revenue deficit and made debt relief conditional on States enacting fiscal responsibility legislations.   FC-XVI has a major responsibility to strengthen the fiscal consolidation, explore the possibility of putting in place an incentive compatible fiscal prudence and make escape clauses much tougher.

5. Balancing Equity and Efficiency

A major problem before any Finance Commission is balancing equity and efficiency. Despite the Finance Commission transfers becoming more and more progressive, there has been widening of income inequalities across States. In this context, the issue of a North-South divide has come to the fore. The share of southern States in tax devolution had come down from 23.3 per cent from the Second Finance Commission Period (1957-62) to 22.1 per cent in the period covered by the Ninth Commission (19990-95) and further to 15.8 percent in the award period of FC-XV (2021-26). While redistribution of resources from richer to poorer States is common in all federations, the question is to what extent such a steep redistribution is desirable without disincentivizing the richer Sates.

There is a feeling among the performing States that they are being discriminated in the dispensation of Finance Commissions as their per capita incomes are higher than those of backward States.  While incentivizing performing States, the constraints of backward States cannot be overlooked. But the higher transfers should not create a sense of complacency among these States. Then there is looming delimitation that is due in 2026, which will result in a reduction in parliamentary seats of the southern States. For performing States which have moderate growths of population, this is a double whammy.

Even in the States with higher per capita incomes, there are large intra-State differences and backward pockets. These need to be addressed.  It is desirable that any change in the tax devolution criteria is gradual to ensure that there is no major cut in the funds flow to the performing States. Therefore, FC-XVI may consider recommending  a special levy of a surcharge of 5 per cent on income and corporate taxes   and allocate the proceeds exclusively to  States on the basis of origin. (Under the Constitution, income tax is in the Union List and States cannot levy a surcharge on the incomes originating in their jurisdictions).The levy of such a surcharge will result in healthy competitive federalism among States in developing infrastructure and attracting private investments and thus improving taxable income base.  Balancing the interests of performing States and backward States is a major challenge before any Finance Commission.

6. Addressing the Lower Absorptive Capacity of Backward States

While focusing on equity in the transfers to backward Stats, not much attention has been paid so far to the   lack of absorptive capacity of these States because of a number of factors. Despite the Finance Commissions and Planning Commission (till it was replaced by NITI Aayog in March 2015) transfers being very progressive, income inequalities have been widening across the States. This is mainly because of the lack of capacity of the backward States to utilize the available resources optimally. Many backward states like Bihar, Chhattisgarh, Jharkhand, etc., have been maintaining surpluses on their revenue accounts and their fiscal deficits are also found to be lower than the  permissible levels. This indicates that most of the backward States have not been fully utilizing the market borrowings allocated to them by the Centre.

Considering these constraints, there is an imperative that NITI Aayog is assigned the role of handholding them and improve their absorptive capacity. For this purpose, the Centre may create a Special Fund for the development of backward States and place it at the disposal of NITI Aayog for funding projects considered appropriate. This will provide teeth to NITI Aayog which so far remained as a mere think tank.

7. Royalties on Major Minerals and Auctioning of Mineral Blocks by the Centre

Under the Mines and Minerals (Development and Regulation )Act (MMDR), 1957, the Central Government is empowered to enhance or reduce the rate at which royalty shall be payable in respect of any major mineral not more than once during any period of three years. The rates of royalty were last revised in September 2014. The royalties are collected and retained by States. The Centre had started auctioning mines through an amendment of MMDR Act in 2015 on the grounds of reforming the coal sector, unlocking value for the economy and to address shortage of coal for the power sector.  Taxation of mineral rights is included under item 50 of the State List in the Constitution. However, this is subject to the regulation of mines and mineral development by the Union, subject to any law passed by the Parliament to be expedient in the public interest.

In a reply to a Parliament question, Union Minister of Coal, Mines and Parliamentary Affairs indicated that so far, 330 mineral blocks have been auctioned and that out of these many are yet to be operationalised.  He contended that the royalty accrual to States has more than tripled between 2017-18 and 2021-22 and therefore, there is no proposal to revise the royalty rates on major minerals.  Non-revision of royalty rates since 2014 has deprived mineral bearing States that are mostly backward of a buoyant source of revenue. In 2021-22, total royalty on major minerals amounted to Rs. 38,840.54 crore. Out of this, the share of three States, namely, Chhattisgarh, Jharkhand and Odisha accounted for 76.2 per cent. The issue here is why the backward States should be deprived of revenue in the national interest. The FC-XVI may consider recommending immediate revision of royalty rates with indexation from 2014. It may be relevant in this context to note that the Centre Government has amended the MMDR Act, 1957 through the MMDR Amendment Act, 2023, whereby 24 critical and strategic minerals have been inserted in Part D to the Schedule-I of the MMDR Act, 1957 which have been identified as critical and strategic minerals for the country. Further, the amended Act has also empowered the Central Government to auction blocks of these minerals. The Government of India has launched the first tranche of auction of these minerals on November 29, 2023 for 20 blocks of critical and strategic minerals.

8. Grants to Local Bodies

Under the Constitution, one of the mandates of the Finance Commission is to recommend measures needed to augment the Consolidated Fund of a State to supplement the resources of Panchayats and Municipalities on the basis of the recommendations made by the Finance Commission of the State. Despite advisories by successive Finance Commissions, most States have been indifferent to the constitution of the State Finance Commissions in a timely manner, making the periods covered by them coterminous with those of the Central Finance Commissions. The FC-XV had recommended termination of Central Finance Commission grants to local bodies   if the States fail to constitute the Finance Commissions and place action taken reports on their recommendations in the State Legislatures by March 31, 2024. There is a need to make the States fall in line.

To make decentralisation yield the desired results, there is an imperative to make their revenues buoyant both by transfers and own revenue generation. The procedure followed by the FC-XIII in making the transfers buoyant may be of relevance here. The Commission had recommended that local bodies be transferred a percentage of the divisible pool of taxes (over and above the share of the States), after converting this share to grant-in-aid under Article 275. It recommended that the volume of the divisible pool for the previous year (t-1) be used as a basis for computing the grant eligibility of local bodies for a particular year(t).

 

9. Own Resource Mobilisation by Local Bodies

The FC-XVI may consider recommending that the present ceiling Rs.2,500 on the levy of profession tax by a local body under Article 276 may be amended or even omitted to provide more leeway to local bodies. The Commission may also consider advising State Finance Commissions to identify sources of raising additional resources by local bodies. For instance, the  Supreme Court while disposing of Civil Appeal No.9458-63/2003 filed by Rajkot Municipal Corporation ordered that the Union of India and its departments shall not pay any property tax but liable to pay service charges calculated at the rate of 75 per cent, 50 per cent or 33.33 per cent depending upon utilisation of full or partial or no services. The Supreme Court ordered that for this purpose, agreements shall be entered into by the Union of India represented by the department concerned with the respective local body. Many local bodies are not following this.

 

10. Conditional Vs Unconditional Grants

 

One more issue that the FC-XVI may consider is whether grants should be predominantly tied or untied. Of late, Finance Commissions have been recommending grants linked to performance. Experience shows that releases of conditional grants has been rather poor because of the stiff conditions imposed by the Union Ministries in addition to those stipulated by the Finance Commissions. For instance, for availing grants for sanitation recommended by FC-XV, each State Government and the Urban Authority concerned shall sign a tripartite memorandum of understanding (MoU) with the Ministry of Housing and Urban Affairs containing the baseline levels and annual targets for achieving targets for water supply, water conservation and solid waste management and sustaining outcomes for the Swatch Bharat Mission. In many cases, non-fulfilment of just one of the many conditions could result in the entire grant being denied. Therefore, the FC-XVI may consider the issue of conditional grants and impose only those which are easy to implement and monitor with sufficient flexibility to utilize them to suit the local conditions.

11. States’ Growing Expenditure Commitments

The Centre has entered into agreements with multilateral agencies in the areas of sustainable development goals and environmental protection.  These agreements entail costs on the part of the States. These commitments need to be built into the assessment of the Finance Commission.

12. Monetization of Central PSU Lands

. State Governments had assigned lands to Central Government at no cost or very low cost for setting up of public sector undertakings. Many of these have terminated their operations and the lands under their ownership are being monetized by the Centre without sharing the proceeds with the States. This is totally unfair as the lands were assigned for a specific purpose. The FC-XVI may consider the issue of sharing the proceeds of land monetization with States.

13. Revenue Reforms

The ratio of States’ own tax revenue to GDP has been stagnating in the range of 6 to 7 per cent and the ratio of non-tax revenue to GSDP is no more than 1 per cent. Most recent estimates indicate that the buoyancy of  States’ own tax revenue has more than halved from 0.72 towards the end of the last decade to 0.32 in the last three years        (Economic & Political Weekly editorial, ‘The Sixteenth Finance Commission’, December 23, 2023) Though the Centre’s tax-GDP ratio improved to 11.7 per cent in 2021-22, it is still marginally lower than the ratio of 11.89 per cent achieved in 2007-08. Though, there is scope for increase tax revenues by States, it has become limited with the GST subsuming a number of buoyant State taxes like VAT. Thus, it is the major responsibility of the Centre to improve its tax-GDP ratio.  In the normative estimates of the Centre’s revenue,  expansion of the tax base and the scope for raising resources needs to be built in. This is important as States are dependent on the Centre for funding 42 per cent of their revenue expenditure and their entire capital expenditure.

14. Expenditure Reforms and Rationalisation

There is immense scope for rationalisation of expenditure both at the Centre and State levels. There is lack of review of  on-going schemes both by the Centre and States. Schemes initiated many years ago are being continued without any review. As indicated earlier, the Centre seems to have gone back on is commitments to review the CSSs at an interval of every five years and make them coterminous with the award period of the Finance Commissions. Similarly, many ongoing schemes of States have no sunset provisions. As a result, budget provisions are still being made though many of them have become totally redundant. A few States are having more 800 schemes, some of which were initiated more than 40 years ago.

Such practices have resulted in spreading scarce resources too thinly diluting the outcomes.

Similarly, there are offices both at the Centre and State levels which have become totally irrelevant today. For instance, many States have office of State Gazetteer, which is a legacy of the British rule. Such offices can be found in each department of the government. Alternatively, some of the offices can be merged.  Another major problem is of spreading resources too thinly. To cut down the gestation period of capital works, the FRBM Acts of many States stipulate that the total value of sanctioned works including spillover works by any department in a financial year shall not exceed three times of the budget estimates for the corresponding head of account for that year. In addition, the total cost of works to be executed in that year including spillover works shall not exceed one and a half times the budget estimate for the corresponding head of account for that year. These stipulations are breached with impunity. As a result, many new projects are being taken up, starving funds for ongoing projects with consequent time and cost overruns.  The FC-XVI may look into these issues to ensure optimum outcomes from public expenditure. As recommended by the FC-XIV, a transition to accrual-based budgeting by both the Centre and States in stages needs to be reiterated.

 

15. Finance Commissions’ Recommendations to be Treated as an Award and Package

. Deviating from the established tradition of treating the recommendations relating to fiscal transfers to States as an Award, the Centre has not accepted the recommendations of FC-XV relating to sector-specific and State-specific grants. This is totally unprecedented undermining a Commission set up under the Constitution. The FC-XVI may consider making it clear that their recommendations are in the nature of a package and an award. As indicated earlier, it may not be desirable to review the recommendations of previous Commissions, particularly those relating to the share of States in tax devolution. The higher devolution to States was only meant to change the composition of transfers in favour of untied transfers.

Even without being constrained by too many additional subjects and considerations, the FC-XVI has a challenging task to perform.

(January 29, 2024)

(I would like to thank Dr. Y.V. Reddy, Dr. Mahendra Dev and Dr. Rammanohar Reddy for their comments.)