GS Paper II

News Excerpts: 

The 16th Finance Commission is currently facing significant challenges as it proceeds with its deliberations.

More About the News: 

• With the full commission appointed only at the end of January, it has just 19 months until October 2025 to complete its work and submit recommendations, a shorter timeframe than usual. 
• Fortunately, its terms of reference are limited to the core issues mandated by the Constitution, unlike recent commissions which had additional matters to consider under the "any other matters" clause [article 280 (3)(d)]. 
• This focused approach allows the commission to concentrate on essential issues without being diverted by extraneous concerns.

Three Key Challenges among the FC: 

1. Revenue Projections: The reliability of revenue projections, particularly tax revenue, is crucial for determining the volume of tax devolution to states. While macroeconomic projections are always vital for economic policy decisions, they hold particular significance for determining the amount of tax revenue to be devolved to states. 
   1. The formula recommended by the Finance Commission for tax devolution from the divisible pool of central taxes will dictate the flow of revenue to states. If actual central tax revenues exceed projections, it provides fiscal flexibility for both the Center and states. 
   2. Conversely, lower-than-projected tax revenues create fiscal strain for both levels of government. Given the series of economic shocks and uncertainties in recent years, such as the 2008 financial crisis, demonetization in 2016, GST rollout in 2017, and the COVID-19 pandemic, alongside geopolitical events like the Ukraine and Gaza conflicts, complicate the forecasting task. 
   3. The 16th FC must adopt robust methods for making projections, considering the potential impact of external factors such as international commodity market fluctuations. Despite efforts to mitigate uncertainty, large error margins are likely to persist, making reliable forecasting a challenging exercise.
2. Balancing Subsidiarity and Centralisation:  The subsidiarity principle holds that in federal governance systems, decisions are more efficient when the decision-making authority is as close as possible to the constituents affected by the decision, while higher levels of authority should hold a subsidiary role; i.e., authority should only move upward when the issue affects constituents beyond the jurisdiction of lower-level authorities, such as state governments. 
   1. Examples include national security, defense, and macroeconomic stability. Additionally, there's the issue of ensuring equity in providing public services and merit goods like subsidized food across all states under a common national tax jurisdiction. 
   2. The allocation of subjects under the Constitution's 7th schedule to the central list, states' list, and concurrent list generally aligns with these principles of decentralization and centralization. However, there's been criticism that the current subject allocation fails to adequately consider externalities and may need revision. 
   3. While the 16th Finance Commission lacks the authority to alter the 7th schedule, if it chooses to address these issues in its observations, it must proceed cautiously. 
   4. Any reallocation of subjects would be a politically sensitive matter, especially as many states, particularly those governed by non-National Democratic Alliance (NDA) parties, have expressed concerns about the central government encroaching on their constitutional space through centrally-sponsored schemes.
3. Resource Allocation for Local Governments: Ensuring adequate resources for the third tier of government. Local governments provide many of the key services that citizens need, like water supply and sanitation. 
   1. Rapid urbanization has made this particularly urgent for urban local bodies. Subsequently, the 73rd and 74th Constitutional amendments elaborated on this in great detail, but again left it to state legislatures to decide what should be done. There is a direct conflict of interest here between state legislators and those elected to local bodies, which accounts for the continuing weakness of most local governments. 
   2. The 16th FC is tasked with recommending measures to augment state government funds for local governments based on state finance commission recommendations. However, previous FCs have struggled with this mandate, with some states failing to appoint state finance commissions on time or disregarding their recommendations. Designing effective incentives for states to strengthen local governments is key to addressing this challenge.

Other challenges:

Vertical & Horizontal Imbalances: The combined government debt-GDP ratio peaked at 89.8% in 2020-21, with the Centre's debt-GDP ratio at 58.7% and that of states at 31%. In 2020-21, the Centre's fiscal deficit was 9.2% of GDP, while that of the states was 4.1%. Cesses and surcharges constituted around 23% of the Union government's gross tax receipts for 2024-25. The total tax revenue for the years 2022-23 (actual), 2023-24 (revised estimates), and 2024-25 (Budget estimates) of the Union government was 30.5, 34.4, and 38.8 lakh crore respectively.

• Vertical Imbalance: The increase in the States' share of central taxes from 32% to 42% by the Fourteenth Finance Commission was significant. However, subsequent revisions have slightly reduced this share to 41%. The proportion of non-shareable cesses and surcharges in the Centre's gross tax revenues has increased substantially, reaching 18.5% during 2020-21 to 2023-24 (BE) from 12.8% during 2015-16 to 2019-20. The fiscal gap between the Union and states, resulting from greater revenue-raising powers with the Union compared to expenditure responsibilities with states, leads to vertical fiscal imbalance. The increasing reliance on cess and surcharges by the Union, which are not shareable with states, further exacerbates this imbalance. 
• Horizontal Imbalance: Criteria for distributing resources among states include population, per capita income, area, and incentive-related factors. Per capita income, with a weightage of 45%, has been a contentious criterion. Richer states argue for a reduction in its weightage. Adjustments in resource transfers, possibly through grants, may be necessary to address the needs of lower-income states. Finance Commissions aim to correct both vertical and horizontal imbalances. However, there are challenges in implementing fiscal federalism policies, with relatively weaker states facing discrimination. The selection of criteria by Finance Commissions, often based on universal applicability rather than regional disparities, contributes to horizontal imbalance.

Few Suggestions to 16th FC:

• Normalizing Base Year: Given the volatility introduced by shocks and policy responses, establishing a normalized base year for revenue and expenditure projections becomes imperative. The choice of the base year should accommodate global macroeconomic uncertainties, fiscal shocks from COVID-19, and emerging scenarios, allowing flexibility for the Commission to determine the most appropriate base year after consultation with stakeholders.
• Policy Changes and Data Comparability: Significant policy shifts in response to the pandemic, such as fiscal operations adjustments and stimulus measures, have impacted data comparability. To ensure consistency across states and over time, a framework for developing comparable datasets needs to be established. 
• Assumption about Growth: Formulating realistic growth assumptions is crucial for ensuring stable resource availability for both the Union and States. The Commission must devise a mechanism to estimate growth for the forthcoming period, considering economic uncertainty and fiscal prudence.
• Framework for Fiscal Sustainability: With a steep rise in public debt, achieving sustainable fiscal recovery requires a reevaluation of fiscal adjustment paths. The Commission should explore conditional mechanisms for reducing revenue deficits and reassess fiscal rules without compromising fiscal autonomy, taking into account the post-COVID fiscal landscape.
• Welfare Schemes Vs Freebies: Amid debate on state government welfare measures labeled as 'freebies,' the Finance Commission should maintain a balanced perspective on fiscal intervention. Recognizing the nuanced considerations involved in redistributive fiscal interventions, the Commission should refrain from mandating specific actions for states, particularly given existing fiscal responsibility legislations and efforts towards consolidation.
• Off-Budget Borrowing and Fiscal Responsibility: Addressing off-budget borrowings and their impact on fiscal space is essential. The Commission should ensure a symmetric treatment of off-budget operations for both the Union and States, considering their implications on fiscal management.
• Restructuring of Centrally Sponsored Schemes: While progress has been made in streamlining centrally sponsored schemes (CSS), their management remains complex. The Commission should explore frameworks for CSS closure, emphasizing state finances' fiscal implications and enhancing state involvement in scheme design and implementation, potentially through an expenditure council with equitable representation from Union and States.

Conclusion: 

The objective of fiscal federalism should be to promote continuous progress among states, narrowing down disparities. The upcoming Finance Commission (FC16) should address flaws in previous transfers and design a formula that considers the needs of low-income states. Additionally, it should focus on increasing rational transfers under tax devolution rather than expanding discretionary grants-in-aid.