Hindustan Times (Jalandhar)

16th finance commission: Neutral arbiter with unique opportunit­y

The President of India constitute­d the 16th Finance Commission under Article 280 (1) of the Constituti­on to make recommenda­tions on the distributi­on of net tax proceeds between the Union and the states, the allocation between the states of respective shares of such proceeds, grants-in-aid to the states, and measures needed to supplement the resources of the local bodies during the award period. Upon the central government’s acceptance, the commission’s recommenda­tions would cover a period of five years starting April 1, 2026. As part of the process of preparing its recommenda­tions, the commission carries out consultati­ons with the states and has already visited Himachal Pradesh and Punjab to hold these consultati­ons with the state government­s and other stakeholde­rs.

The debates of the constituen­t assembly related to the finance commission reveal that our founding fathers intended to have a neutral arbiter every five years to distribute the resources between the Union and the states. This role is crucial as it modulates any imbalances that may have developed vis-à-vis the resources available and the expenditur­e responsibi­lities of the Centre and the states.

Introduce transparen­cy

Primarily, the finance commission (FC) has two responsibi­lities: To suggest the distributi­on of net tax proceeds between the Centre and the states (vertical devolution) and the inter-se distributi­on between the states (horizontal devolution). Initially, the Constituti­on provided for the sharing of only two central taxes with states, namely income tax and Union excise duties; it was after the 80th amendment of the Constituti­on in 2000 (on the recommenda­tions of the 10th FC) that the divisible pool became net proceeds of all taxes.

Over the years, most of the states have been clamouring for a share of the resources (cesses, surcharges and fees) that have been collected by the Centre, which are outside the divisible pool. Most of them, such as the spectrum fees or some cesses and surcharges, couldn’t even have been envisaged at the time of drafting the Constituti­on. Thus, the position on the issue of sharing of net proceeds of taxes certainly deserves a relook. For greater transparen­cy and accountabi­lity, perhaps all sovereign levies should be shareable. Cesses and surcharges are essentiall­y taxes.

As for horizontal devolution, successive finance commission­s have designed their awards to promote equity and balanced regional developmen­t by allocating a greater share to states with limited resources. The allocation of these transfers has been based mainly on factors such as state size, population, and per capita income. Till the 8th FC, an overwhelmi­ng weightage of 80-90% was granted on the basis of the state’s population, and the balance of 10-20% was granted to tax collection efforts. Subsequent FCs have introduced elements of equity through the introducti­on of income/poverty criteria. The horizontal devolution formula has evolved to comprise three broad groups of elements: Need, equity and efficiency.

Over the years, this formula has become more complex and convoluted, with many elements in the formula incentivis­ing non-performanc­e. Seventy-five years of focused support to the states that lagged at the time of Independen­ce is a long period for catch up. Perhaps, such ‘cross-subsidisat­ion’ over an undefined period needs a review, since it takes away any incentive for performanc­e by state government­s. The 16th FC has an opportunit­y to redefine the horizontal devolution formula to make it simple and fair, perhaps reverting to the old formula that gives weightage only to population (need), per capita income (equity), and tax collection effort (efficiency). All other factors are relevant at best for non-FC transfers that involve the central sector and centrally sponsored schemes.

Eliminate moral hazard

Another issue with Finance Commission recommenda­tions is the moral hazard involved with its award of revenue deficit grants. This has certainly not encouraged fiscal discipline and consolidat­ion by the states. Reserve Bank of India data reveals that most of the states that have received revenue deficit grants have failed to achieve fiscal consolidat­ion and continue to run significan­t revenue deficits. This is a serious moral hazard with a debilitati­ng impact on the states’ fiscal and the economy. Also, the lack of consistenc­y in the formula for horizontal devolution and its revision every five years by each new FC contribute­s to creating a perverse incentive for states to stray from the projected fiscal consolidat­ion path that they presented to the previous FC.

The 16th FC could consider incentivis­ing performanc­e and fiscal discipline by suggesting a two-part formula for horizontal devolution with a fixed and a variable component. The fixed part (say 75% of the state’s share) can be an agreed formula, based on the state’s tax collection and its share of national GDP that should ideally remain constant beyond the five-year limit of recommenda­tions of the FC so that the state government­s can plan their resources around this assured devolution. This would bring time consistenc­y and enhance fiscal discipline. The balance 25% can be a variable component based on performanc­e achieved in terms of the agreed fiscal consolidat­ion path. The unclaimed or unawarded part of this 25% pool could actually be awarded to states displaying enhanced fiscal discipline at the expense of the poor performers, i.e. to bring an element of competitio­n for fiscal discipline among states.

Build this institutio­n

A weak link in this otherwise robust system of federal fiscal governance is the absence of an institutio­n that acts as a bridge between successive FCs, is the repository of institutio­nal memory and expertise, and is also responsibl­e for overseeing the performanc­e of states while releasing the variable component to the states of their share of taxes as suggested above. Over the decades, the finance commission has built its credibilit­y as a neutral arbiter, which is autonomous, independen­t, profession­al and a non-political forum. It would thus be in the fitness of things if there was a lean and efficient permanent secretaria­t.

This set-up would expand during the first two years of report writing, and for the next three years of its period, it would oversee the implementa­tion while handing over the baton to the next FC. Perhaps, while the chairperso­n and the secretary could be appointed for five years for this purpose, the members could be appointed for the two-year report writing tenure. This institutio­nal set-up would help the Centre and the states maintain fiscal discipline, leading to enhanced growth.

Importantl­y, this reform would not need any constituti­onal amendment.

The 16th FC has a unique opportunit­y to simplify things, introduce transparen­cy, eliminate moral hazard, and build an institutio­n. We hope it seizes this opportunit­y.

OVER THE DECADES, THE FINANCE COMMISSION HAS BUILT ITS CREDIBILIT­Y AS A NEUTRAL ARBITER, WHICH IS AUTONOMOUS, INDEPENDEN­T, PROFESSION­AL AND A NON-POLITICAL FORUM. IT WOULD THUS BE IN THE FITNESS OF THINGS IF THERE WAS A LEAN AND EFFICIENT PERMANENT SECRETARIA­T.