Context & The Gist
The Sixteenth Finance Commission (FC-16) has recently submitted its recommendations, retaining the existing 41% vertical devolution ratio – the share of states in the divisible pool of central taxes. This comes amidst growing concerns about the fiscal space available to states, particularly after the implementation of the Goods and Services Tax (GST). While acknowledging these concerns, the Commission has opted for a cautious approach, making incremental changes to the horizontal devolution formula and stopping short of recommending more significant structural changes to address the imbalance in fiscal federalism.
Key Arguments & Nuances
- Vertical Devolution: The FC-16 maintains the 41% vertical devolution, despite states advocating for a 50% share. This decision reflects a desire for fiscal stability and a reluctance to drastically alter the existing framework.
- Horizontal Devolution: The Commission has shifted from a “tax effort” criterion to a broader “contribution to GDP” measure, increasing its weight to 10% to reward efficient states. This aims to incentivize better governance and economic performance.
- Demographic Factors: The weight given to demographic performance has been reduced, acknowledging that penalizing population growth is no longer appropriate. Conversely, the weight for population size has been slightly increased.
- Cesses and Surcharges: The FC-16 acknowledges the shrinking divisible pool due to the increasing use of cesses and surcharges by the Centre but does not recommend including them in the divisible pool.
- Centrally Sponsored Schemes: A significant portion of the projected increase in transfers to states is through Centrally Sponsored Schemes, reinforcing a model where states primarily implement centrally determined priorities.
UPSC Syllabus Relevance
- Polity: Finance Commission and its constitutional provisions (Article 280).
- Economy: Fiscal Federalism, Centre-State financial relations, GST and its impact on state finances.
- Governance: Issues related to planning, resource allocation, and the role of constitutional bodies.
Prelims Data Bank
- Finance Commission: A constitutional body (Article 280) formed every five years to recommend the principles governing the distribution of tax revenues between the Centre and the States.
- Vertical Devolution: The percentage of divisible taxes that the Centre transfers to the States.
- Horizontal Devolution: The principles governing the distribution of the States’ share among themselves.
- GST (Goods and Services Tax): A comprehensive indirect tax levied on the manufacture, sale and consumption of goods and services across India.
- Centrally Sponsored Schemes: Schemes funded by the central government but implemented by state governments.
Mains Critical Analysis
The FC-16’s recommendations present a mixed bag. While acknowledging the financial strains on states, particularly in the GST regime, the Commission adopts a cautious approach, prioritizing stability over substantial reform.
Challenges
- Limited Structural Change: The recommendations lack the boldness needed to address the fundamental imbalances in fiscal federalism. The continued reliance on Centrally Sponsored Schemes and the non-inclusion of cesses and surcharges in the divisible pool perpetuate a system where states have limited fiscal autonomy.
- Incremental Adjustments: The changes to the horizontal devolution formula, while positive, are incremental and may not significantly alter the distribution of resources.
- Shrinking Divisible Pool: The increasing use of cesses and surcharges by the Centre reduces the size of the divisible pool, limiting the resources available for devolution to states. This undermines the principles of fiscal federalism.
Opportunities
- Rewarding Performance: The increased weight given to “contribution to GDP” incentivizes states to focus on economic growth and efficient governance.
- Acknowledging Demographic Shift: Reducing the weight given to demographic performance reflects a pragmatic understanding of India’s changing demographic profile.
- Cautious Approach: The gradual approach to restructuring horizontal devolution minimizes the risk of abrupt redistributive shocks to states.
The core issue is the need for a more equitable and sustainable fiscal framework that empowers states to address their unique challenges and contribute to India’s overall economic development. The current system, characterized by a shrinking divisible pool and a reliance on centrally determined priorities, hinders this process.
Value Addition
- Previous Finance Commissions: The 15th Finance Commission (2020-2026) had recommended retaining the 41% devolution ratio.
- GST Compensation: The GST Compensation to states ended in June 2022, exacerbating the financial challenges faced by many states.
The Way Forward
- Expand the Divisible Pool: Include cesses and surcharges in the divisible pool to ensure a more equitable distribution of resources.
- Increase Vertical Devolution: Gradually increase the states’ share in the divisible pool to 45% or 50% over the next few Finance Commission cycles.
- Strengthen State Finances: Implement measures to enhance state revenue mobilization and improve fiscal discipline.
- Reduce Reliance on CSS: Streamline Centrally Sponsored Schemes and provide states with greater flexibility in designing and implementing programs.