I. Introduction

The Sixteenth Finance Commission will be constituted in the current fiscal year. The Commission will have to assess the impact of the challenges arising due to the global economic uncertainty caused by the war, Covid-induced fiscal shocks and various other macroeconomic instabilities. The Commission will need to quantify the impact of shock and uncertainty to make a realistic forecast of economic growth and revenues and expenditures of the Union and States.  Though this time, the scale of economic uncertainty is unprecedented, past Commissions that faced similar situations were the Thirteenth and the Fifteenth Finance Commissions.

II. Global Macroeconomic Uncertainty and Policy Considerations

We start this note with the following observation made by the FC-XIII (2009) about the macroeconomic uncertainty and its likely impact on the Commission’s assessment of fiscal situation of the Union and States due to the global financial crisis:

“The Indian economy has faced several exogenous shocks in the past years. First, sharp increases in commodity prices have impacted public finances by raising the cost of financing fuel and fertiliser subsidies. Second, the global financial crisis has led to a slowdown in Gross Domestic Product (GDP) growth, impacting the revenue base and necessitating significant incremental counter-recessionary public expenditure.”

FC-XV (2020) observed that the pandemic had complicated fiscal management at the Union and state levels. The FC argued that there is a need for fiscal stimulus. But a robust expansionary fiscal policy to counteract the economic fallout of the pandemic will require an equally credible exit plan with a committed path of fiscal consolidation. (para 3.16)

On rising fiscal imbalance in the context of the Covid pandemic, the FC-XV developed alternative paths of fiscal consolidation for the Union government. Given the revenue uncertainty, fiscal shock and rising expenditure need due to Covid, the FC-XV considered three scenarios for its debt-deficit projections for the Union government. The Commission also proposed allowing additional unconditional borrowing space for states in the first two years of the award period to compensate for loss in tax revenues. (Para 1.41).

Earlier, in light of the global financial crisis, the fiscal deficit target was also relaxed by the Union Government temporarily to 3.5 % of GSDP in 2008-09 and to 4 % of GSDP in 2009-10. The FC-XIII also had formulated a fiscal consolidation strategy which targeted revenue deficit, fiscal deficit and debt to GDP ratio for the period from 2010-11 to 2014-15. The majority of the states had amended their FRBM Acts between 2010-11 and 2011-12 in order to comply with the fiscal consolidation path suggested by the FC-XIII targeting revenue deficit, fiscal deficit and debt. The FC-XIII recommended both Union and States to eliminate the revenue deficit by 2014-15.

In the wake of the pandemic the FC-XV was of the view that there would be uncertainties in GDP growth during 2020-21 and 2021-22. From 2022-23 onwards, it assumed expansion in economic activity for the remaining four years of its award period. Accordingly, the Commission assumed a year-wise differentiated growth path. The FC-XIII had also assumed a differentiated growth path of GDP for the purpose of fiscal assessments.

III. Fiscal Assessment and Forecast

In this section, based on the approaches adopted by the previous Finance Commissions, evolving global macroeconomic uncertainty and the review of the fiscal stance to deal with the pandemic by the Union and State governments, we highlight key issues that may be relevant for the Sixteenth Finance Commission:

(a) Normalisation of the Base year

The choice of the base year for the projection and assessment of revenue and expenditure needs of both the Union and States should be normalised by eliminating shocks and fiscal responses. The estimate of the base year needs to factor in the global macroeconomic uncertainties, fiscal shocks due to Covid and the emerging global macroeconomic scenarios, and their impact on the fiscal balance of the States and the Union.  It is appropriate that the Terms of References of the FC-XVI need not specify a base year for projection. It should be left to the FC-XVI to take an appropriate base year after discussions with the Union, States and considering other relevant factors including new data that would emerge for the fiscal year 2023-24, 2024-25(RE) and 2025-26 (BE).

(b) Policy Changes and Comparability of Data

Important policy changes were introduced to deal with Covid. Changes in the fiscal operation including re-introduction of the on-lending programme to the States have made data on deficits and expenditure non-comparable. A comparable data set across states and over time needs to be developed. Revenue side data also need to be adjusted for GST compensation and Covid fiscal stimulus.

(c) Assumption about Growth

A realistic growth assumption is critical for predicable availability of resources to both the Union and States. The Commission would require to evolve a mechanism to arrive at an estimate of growth for the period from 2026-27 to 2030-31 taking into consideration economic uncertainty, growth and fiscal prudence.

IV.  Framework for Fiscal Sustainability

Given the sharp rise in public debt, fiscal restructuring for sustainable fiscal recovery is becoming a critical issue. Rebalancing of the fiscal adjustment path, a conditional mechanism of reduction of revenue deficit and a rethinking of the fiscal rule without limiting fiscal autonomy would be critical for growth and macroeconomic stability. Given that the Covid pandemic has resulted in significant fiscal shocks to both the Union and States, this has created a post Covid new-normal in terms of deficit and debt. Any fiscal restructuring needs to take into consideration this new-normal, create a symmetric credible and implementable fiscal restructuring plan for the Union and States.

V. Welfare Schemes Vs Freebies

In the recent past, the country has witnessed much discussion on various welfare measures by State governments by terming them ‘freebies’. There have been attempts to create an impression that the States are fiscally profligate. But the reality is quite different. There is a need to have a right balance of issues when it comes to fiscal intervention in a multilevel government system. There is also a need for a right mix of transfers and subsidies for various externality considerations. Given this, the Finance Commission should not be mandated to suggest what States should do when it comes to redistributive fiscal interventions. This is more so when there are fiscal responsibility legislations in all the States and they are taking steps for fiscal consolidation.

VI. Off-Budget Borrowing and Fiscal Responsibility

It is also to be noted that a part of the off-budget borrowings has come under the gross fiscal deficit targets of States. Off-budget borrowings are part of the public sector borrowing requirements and not the borrowing requirement of the state governments. The same logic applies to the Union government also. Thus, merger of the budget and off-budget borrowing, without appropriate upward revision of the deficit target has the potential to reduce the fiscal space. There has to be a symmetric treatment of off-budget operation of the Union and States and the TOR should consider this aspect of fiscal management.

VII. Restructuring of Centrally Sponsored Schemes

Past Finance Commissions had suggested measures to restructure centrally sponsored schemes and their rationalisation. Significant progress also has been made in this regard. From 200 plus Centrally sponsored schemes, the number of CSS has now reduced to 28. However, the complexity of management of CSS has three critical dimensions:

1. The fiscal implications of the closure of CSS on state finances, especially when due to several reasons, personnel employed continue to remain on the pay-roll of the state government
2. Since most CSS are co-financed by the Union and States, greater role of States in design, flexibility and implementation needs to be done and the Sixteenth FC may be asked to suggest a framework.
3. An expenditure council with respect to management of CSS with symmetric power of Union and States in design and implementation of schemes can be considered.

References

Chakraborty, Pinaki and Manish Gupta (2021): “Analysing FC-XV Recommendations: Stability, Continuity and Change”, NIPFP Working Paper