Calibrating finances

The Report of the 16th Finance Commission (FC) containing recommendations on the devolution of Central taxes and grants to states was tabled in Parliament on Budget day. Not many changes were expected from the FC, which mostly continues on predictable lines. The last time a major change was introduced in the scheme of fiscal transfers was by the 14th FC (2015-20), which increased the share of states by 10 per cent to 42 per cent of the net proceeds of all taxes in the divisible pool comprising all central taxes sans cesses and surcharge, with consequent reduction in grants.

Vertical devolution by both the 15th and 16th FCs have practically remained unchanged since then at 41 per cent, the remaining 1 per cent accounting for J&K which was then a state but now is an UT whose share goes to the Union government. As regards horizontal devolution that determines the inter-se share of individual states, the FC divides the resources based on the three principles of equity, equalisation and efficiency. The last two FCs added a fourth: environment. But efficiency always takes a back seat, and all FCs preferred equalisation over efficiency ~ the 14th FC completely ignored it, while the 15th FC gave tax effort, a measure of fiscal efficiency, a meagre 2.5 per cent weight in determining the shares of individual states.

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To the credit of the 16th FC, it brought back the focus on efficiency, while the preference for equalisation remains. The 15th FC caused a lot of resentment for southern states, which lost their shares when the government changed the population base in the terms of reference for the 15th FC from 1971 to 2011, for determining the states’ shares in devolution. Population has always been an important parameter used by all FCs along with area, which addresses equity. Southern states, and some others as well, have stabilised their population and achieved a total fertility rate (TFR) much below the replacement level of 2.1, and they rightly felt they were being penalised for attaining this, while the shares of the Hindi-belt states went up.

The 16th FC has, for the first time, introduced a new efficiency parameter, replacing the earlier tax effort, in the form of a state’s contribution to the national GDP, assigning 10 per cent weightage to it. However, these contributions would show wide variation across states, especially at the top and bottom ends, which would cause huge differences in devolutions to the obvious disadvantage of poorer states. To moderate these differences, the FC modified this parameter by defining a state’s share as the ratio of the square root of its GSDP to the sum of the square roots of GSDPs of all states, which would moderate the shares of the higher income states.

However, even in this tampered form, it would benefit the southern states and compensate them for their loss of population share. Other criteria in the formula for horizontal devolution remain more or less the same, with some redefinitions and adjustments in weights assigned to respective parameters to make the transfer formula seem more rational than the 15th FC’s. While the weightage on a state’s share of the 2011 population has increased from 15 per cent recommended by the 15th FC to 17.5 per cent, the weightage on the share of a state’s area has decreased from 15 to 10 per cent now.

Weightage of the equalizing parameter, income distance, i.e. the distance of per capita income of a state from the average of the three highest per capita income states has been reduced marginally from 45 to 42.5 per cent and outweighs any other parameter by a huge margin. The 16th FC has also expanded the definition of the lone parameter on ecology and environment, i.e. forest cover. The earlier FCs considered only the medium and dense forest covers with higher canopy densities; the 16th FC has now included open forests with a lesser canopy density of 10-40 per cent to determine the total forest cover. Additionally, it has also rewarded states for increasing their shares of forest areas between 2015 and 2023.

The share of a state is now calculated by assigning 80 per cent weightage to its share in the national forest cover and 20 per cent weightage to its share in this increase. Thus calculated, this share is then given an overall 10 per cent weightage in the horizontal devolution formula, the same as earlier. Demographic performance, introduced by the 15th FC to compensate the southern states for their loss due to the change of the population base, was defined by the inverse of TFR. But the 15th FC scaled it up by the 1971 population, which benefited the Hindi belt states unduly, which was an aberration.

The 16th FC has rejected the concept of using the inverse of Total Fertility Rate as a performance indicator, arguing instead that the states which have stabilised their populations ~ like the southern states and also others ~ are now staring at the prospect of ageing populations without enough workers to support them which will affect their future growth, and hence felt that the reward for lower population through TFR needed to be phased out. Thus, it has redefined demographic performance as the inverse of population growth rates between 1971 and 2011 and reduced the weightage to this parameter from 12.5 to 10 per cent. The net result of these changes introduced in the devolution formula is that save Tamil Nadu, all other southern states would now receive a larger share of the devolution, as would Maharashtra, Gujarat, Haryana and Punjab.

All Hindi belt states except Jharkhand would see their shares in the total devolution go down and so would be the case with West Bengal, Odisha, and all north eastern states except Assam and Mizoram. But for both groups, the changes would only be marginal. As regards grants, the 16th FC has provided no grants other than grants for local bodies, abandoning the practice adopted by earlier FCs to compensate states for their post-devolution revenue deficits and other sector-specific grants and state-specific grants given to some states. It expects the states to balance their revenue accounts by bringing more fiscal discipline and mobilizing more resources. As regards local bodies, it had provided total grants of Rs 7.91 lakh crore for the rural and urban local bodies (60 per cent to RLBs and 40 per cent to ULBs), much higher than Rs 4.36 crore provided by the 15th FC.

A part of these grants ~ 20 per cent ~ is linked to the performance of ULBs and RLBs in improving their revenues and the constitution of State FCs by the states. For disaster management, an issue that was flagged to it, it recommended a total amount of Rs 2 lakh crore at the state level and Rs 79,000 crore at the national level, to be financed by the states (NEH states 10 per cent and others 25 per cent) and the rest by the Centre. The FC has strongly advocated against the use of off-budget borrowings practised by several states, urging them to reform their power sector by privatising DISCOMs and to close their loss-making PSUs. It has red-flagged the issue of fiscally unsustainable subsidies ~ especially the unconditional cash transfers (UCT) or freebies, which are claiming increasing shares of states’ revenue expenditure (RE) and pushing many states’ revenue accounts deep into the red.

UCTs for all states have multiplied unchecked from Rs 73,000 crore in FY19 to over Rs 4 lakh crore in FY26, growing at an alarming rate of almost 29 per cent annually. States are increasingly resorting to such electoral gimmicks, and the number of states spending over 10 per cent of RE on UCTs has gone up from only one (Telangana) in FY19 to nine by FY26, led by Chhattisgarh, Telangana, Andhra Pradesh, West Bengal, Karnataka and Madhya Pradesh; all these states except Telangana and Madhya Pradesh, had deficits in their revenue accounts in FY24. Majority of the states are financing their UCTs by either borrowing or cutting capital outlay, compromising growth. But perhaps realising its own limitations, the 16th FC only made some general recommendations for states to control their UCTs. The recommendation of setting up an independent Fiscal Council to bring in greater discipline in public finances made by the previous FCs is also singularly absent in its report

(The writer is a commentator, author and academic. Opinions expressed are personal)