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Fiscal Roadmap

Like the previous Commission, it has also recommended the setting up of an independent Fiscal Council, which is a must for bringing the much-needed transparency and credibility to our budget numbers, but which, like the previous FC‘s recommendation, is again likely to be ignored


The adulation for the 2021- 22 budget and exaltation of the stock market somewhat eclipsed the recommendations of the 15th Finance Commission (FFC), whose report was laid on the table of Parliament along with the budget. Aptly named “Finance Commission in Covid Times”, it gives largesse to the populous and poor Hindi-heartland states which share 42.85 per cent of India’s population (2011 census), by giving them 48.57 per cent of the divisible pool of Union taxes for 2021-26, while the five southern states ~ Tamil Nadu, Karnataka, Kerala, Andhra Pradesh and Telangana ~ with a population share of 21.32 per cent might get a little disappointed with only 15.8 per cent of the sharable taxes. Vertical share of the states remains at 41 per cent of the net proceeds of divisible pool of taxes, practically the same as the 42 per cent recommended by the previous Commission, except that 1 per cent has now been set aside for J&K which no longer is a state.Originally slated to give recommendations for 2020-25, the FFC’s tenure was extended by one year in November 2019, after the bifurcation of Jammu and Kashmir in August 2019. It therefore gave an interim report in February 2021 for the year 2020-21 to enable devolution of taxes and grants for this fiscal. The devolution formula of its interim report remains unchanged even in the final report. This was the first Finance Commission of the post- Planning Commission era and after the abolition of the distinction between plan and non-plan expenditure.

It was also the first Commission after the launch of GST in July 2017 that took away the states’ powers of taxation save in a few areas, and conferred those powers upon another consultative Constitutional body, the GST Council. The Terms of Reference (ToR) of the Commission were wide-ranging and unique in many respects, like changing the population criteria from 1971 to 2011, which upset most states outside the Hindi heartland as it placed them at a disadvantage for successfully containing their population growth. It also attracted much criticism for being seen as an encroachment upon the states’ powers. Finally, division of J&K into the UTs of J and K and Ladakh also generated some complex issues the Commission needed to negotiate. However, it tried its best to strike a balance between all these thorny issues, though in the process it might have sacrificed its objectivity at times. As per article 280(3) of the Constitution, the primary task of an FC is to make recommendations for the horizontal and vertical sharing of the net proceeds of taxes in the divisible pool between the Union and the States and determine the principles for Central grants-in-aid to the states, besides recommending measures to supplement resources of Local Bodies. Finance Commissions’ recommendations broadly follow the three principles of equity, equalisation and efficiency.

While the equity principle is reflected in parameters like population and area of a state, the equalisation principle is reflected in parameters related to distance of per capita income (income distance) or fiscal capacity of a state from the highest one so that disadvantaged states with low income or capacity get more funds than the prosperous states. The efficiency criteria is reflected in parameters like tax effort, fiscal discipline, etc.

For the horizontal inter-se transfers among the states, the 15th FC has assigned 45 per cent weightage to ‘income distance’, 15 per cent each to the ‘2011 population’ and the ‘area’ of the state, 12.5 per cent to ‘demographic performance’ and 2.5 per cent to ‘tax effort’. Ten per cent weightage has been allotted to ‘forest and ecology’, an environment parameter introduced for the first time by the 14th FC. However, the actual shares are influenced by population in many ways which results not only in the rather skewed shares of the states as mentioned earlier, but also produces other anomalies.For example, multiplying the tax effort, defined in terms of the ratio of average per capita tax to average state income (GSDP), by the 2011 population resulted in Bihar’s share in terms of tax effort exceeding that of all other states except Uttar Pradesh and Maharashtra, which may not be the true reflection of its relative tax effort. Similarly, scaling demographic performance, defined as the inverse of fertility ratio, by the 1971 population, resulted in Uttar Pradesh’s share in terms of this parameter exceeding that of all other states; even Bihar’s share of 5.513 per cent in terms of demographic performance looks quite respectable compared to, say, Gujrat’s 5.043 per cent even though the fertility ratios are vastly different (2.9 and 2.0). The inverse of fertility ratio alone captures the demographic performance adequately, multiplying this with population distorts the picture.

FFC’s recommendation for reducing off-budget borrowings and for ensuring the stability of direct tax rates and thresholds has already been implemented in the 2021-22 budget. However, another important recommendation was ignored ~ at least for the time being ~ on the rationalisation of the structure of GST by merging the 12 per cent and 18 per cent slabs and converging into a three-rate structure ~ a merit rate, a standard rate and a demerit rate of around 28-30 per cent. Healthcare also left much to be desired ~ with grants of Rs 1.07 lakh crore, about 0.1 per cent of the GDP, over the award period being unlikely to achieve the target of 2.5 per cent of GDP by 2025 ~ given our current low expenditure on health (0.96 per cent of GDP in 2018-19; 0.29 per cent by the states and 0.67 per cent by the Centre).Regarding the Centrally Sponsored Schemes (CCS), the Commission noted that fifteen of the thirty umbrella CSS account for about 90 per cent of the total allocation, many of which include too many schemes too small to create any impact. But except suggesting a re-evaluation of the need to continue such schemes, it did nothing to curtail their numbers. To augment the revenue of states, the Commission has suggested indexing the professional tax, which is levied by 21 states at the 1988 rate with a ceiling of only Rs 2,500 on income from professions etc., for the accumulated inflation since then, which will immediately raise the ceiling to Rs 18,000. There may not be many takers for this, given the disruptions caused by the pandemic which forced the Centre and many states to freeze or curtail wages of employees.

For the Local Bodies the Commission has recommended a grant of Rs. 4.36 lakh crore for the period 2021-26 which will be distributed among the states with a weightage of 90 per cent for population and 10 per cent for area. Of these, 54 per cent will be earmarked for Panchayat Raj Institutions, 28 per cent for urban local bodies and 16 per cent (Rs 70,051 crore) for fixing the critical gaps in the healthcare systems at the primary level through local governments. But the real issue here is the effective transfer of powers to the local bodies; while functions have been transferred, the same cannot be said about the functionaries and funds.

For defence and internal security needs, the Commission has proposed a dedicated nonlapsable “Modernisation Fund for Defence and Internal Security” (MFDIS), in the Public Account of India to bridge the gap between projected capital requirements and budgetary allocations for modernisation of defence and state police state forces. Apart from the Centre’s budgetary allocations, the MFDIS is to be funded by disinvestment proceeds of defence public sector undertakings, proceeds from the monetisation of surplus defence land and arrears of states for use of defence land. For the period 2021-26, the indicative size of fund would be Rs. 2.38 lakh crore, which again is unlikely to be achieved given our recent experiences with monetisation of assets.For the states as well as for the Union, the FFC has also recommended a fiscal roadmap for deficits and borrowing. While for the states, it has suggested a gradual reduction in the limit for net borrowing from 4 to 3 per cent of GSDP over the period 2021-26, for the Union the target suggested is 4 per cent of GDP by 2025-26. These targets also look ambitious at this juncture, given the severe disruptions from which the economy is recovering at a slow pace.The FFC has also recognised the need for restructuring of the FRBM Acts of the Union and the States and recommended its examination by a “High-powered Inter-Governmental Group”. To help reinforce self-discipline on the fiscal front and better pricing of loans raised by the states from the market, it has suggested introduction of a system of credit rating of the states based on their financial position. This is unlikely to be acceptable to the weaker states as their cost of borrowing will increase substantially. Like the previous Commission, it has also recommended the setting up of an independent Fiscal Council, which is a must for bringing the much-needed transparency and credibility to our budget numbers, but which, like the previous FC’s recommendation, is again likely to be ignored. Politicians are unlikely to give up their absolute control over finances which, in fact, give them all their powers.