Finance Commission strikes a balance – addresses southern states’ concerns, and equity

Context & The Gist

The 16th Finance Commission’s recommendations are in the news as states prepare for the upcoming delimitation exercise following the Census. This exercise is crucial as it impacts political representation and, consequently, financial resource allocation. The Commission aims to strike a balance between addressing the concerns of southern states regarding declining share in the divisible tax pool and maintaining fiscal discipline. It has retained the existing 41% vertical devolution while adjusting the criteria for horizontal devolution, increasing the weightage given to a state’s contribution to GDP.

Essentially, the Commission is trying to fairly distribute tax revenue between the central government and the states, while also considering each state’s economic performance and population size. This is a complex task, as different states have different needs and priorities.

Key Arguments & Nuances

• Vertical Devolution: The Commission has maintained the 41% share of states in the divisible pool, addressing concerns about a potential reduction in state funding.
• Horizontal Devolution: The criteria for distributing funds *among* states have been revised. The weight assigned to population has been adjusted, and a new criterion – a state’s contribution to GDP – has been added.
• Southern States’ Concerns: The share of southern states in the divisible tax pool had declined in previous Commissions. The 16th FC has increased their share to 17%, partially addressing this concern.
• Fiscal Discipline: The Commission recommends states discontinue off-budget borrowings and cap their fiscal deficit at 3% of GSDP. It also advocates for rationalizing subsidy schemes and introducing “sunset clauses” for non-merit subsidies.
• Privatization & PSU Reforms: The Commission emphasizes the need for privatizing power distribution companies and closing/privatizing loss-making Public Sector Enterprises (PSUs).

UPSC Syllabus Relevance

• Indian Economy: Fiscal Federalism, Finance Commission, Tax Devolution.
• Polity: Centre-State Relations, Constitutional provisions related to Finance.
• Governance: Government policies related to economic development and resource allocation.

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 Union and the States.
• Vertical Devolution: The division of the total tax revenue between the Centre and the States. Currently at 41%.
• Horizontal Devolution: The distribution of the states’ share among themselves.
• GSDP: Gross State Domestic Product – a measure of the economic activity within a state.
• Cesses and Surcharges: Taxes levied by the Centre, but not shared with the states, leading to concerns about reduced state funding.

Mains Critical Analysis

The 16th Finance Commission’s recommendations present a mixed bag of opportunities and challenges. The retention of the 41% devolution ratio provides a degree of fiscal certainty for states, particularly crucial in the context of GST implementation and evolving economic conditions.

Challenges

• Limited Structural Reforms: The Commission stops short of addressing the fundamental issue of cesses and surcharges not being included in the divisible pool. This limits the potential for significantly increasing states’ revenue.
• Implementation of Recommendations: The recommendations regarding fiscal discipline (reducing deficits, rationalizing subsidies, privatization) require strong political will and may face resistance from states.
• Potential for Regional Disparities: While the southern states have seen an increase in their share, other states have experienced a decline. This could exacerbate regional inequalities.

Opportunities

• Incentivizing Economic Performance: The increased weightage given to GDP contribution incentivizes states to focus on economic growth and efficient resource management.
• Fiscal Consolidation: The recommendations for fiscal discipline can help states improve their financial health and reduce their dependence on central transfers.
• Improved Governance: The emphasis on privatization and PSU reforms can lead to greater efficiency and better service delivery.

The core issue revolves around balancing equity and efficiency in fiscal federalism. While the Commission attempts to address the concerns of specific regions, the long-term sustainability of the system depends on addressing structural issues like the increasing reliance on cesses and surcharges and promoting responsible fiscal behavior by both the Centre and the States.

Value Addition

• Punchhi Commission (2010): Recommended inclusion of cesses and surcharges in the divisible pool.
• N.K. Singh Committee (2017): Examined the Fiscal Responsibility and Budget Management (FRBM) Act and recommended a debt target for the general government.
• SC Judgement (2019 - Kerala case): The Supreme Court held that cesses are not taxes and are outside the purview of the divisible pool.

Context & Linkages

This article provides further detail on the 16th Finance Commission’s recommendations, highlighting the retention of the 41% devolution ratio and the revised horizontal devolution formula. It emphasizes the Commission’s cautious approach, avoiding drastic changes that could disrupt the existing fiscal framework. It also points out the continued reliance on Centrally Sponsored Schemes, which limits states’ autonomy.

This article provides crucial context regarding the precarious financial situation of both the Centre and the States in 2026. Rising fiscal deficits and increasing borrowing costs create a challenging environment for the implementation of the Finance Commission’s recommendations. The need for fiscal consolidation and a shift towards sustainable spending priorities is underscored, making the Commission’s recommendations even more critical.

The Way Forward

• Include Cesses & Surcharges: A long-term solution involves including cesses and surcharges in the divisible pool to ensure a more equitable distribution of resources.
• Strengthen GST Compensation Mechanism: Explore mechanisms to provide continued support to states facing revenue shortfalls due to GST implementation.
• Promote Cooperative Federalism: Foster greater collaboration between the Centre and the States on fiscal matters, including revenue mobilization and expenditure planning.
• Incentivize Fiscal Responsibility: Link central transfers to states’ performance on fiscal indicators, encouraging responsible financial management.