15th Finance Commission – A look at the Terms of Reference

Authored By: Shreyas B. T

As the regular practice goes once every 5 years, the President of India has now constituted a new Finance Commission (FC) – the 15th FC for the period 2020-25, and so its Terms of Reference (ToR) has been published as well alongside. (For a recap on the mandate of the FC, its composition etc, the article on the 14th FC can be referred to.)

 ToR for a Finance Commission is a set of areas that the President mandates the FC to formulate its recommendations on. Besides the mention of the core mandated areas like tax devolution formula, grants-in-aid etc, the ToR invariably also has a set of “other” areas on which the President mandates the FC to provide its recommendations in the interests of the sound finance.

Although the FC is predominantly a quasi-judicial body and hence supposedly independent, the FC can arguably be led into certain areas* to suit the Center’s preferences by careful handling of the ToR.

 Some of the key terms of reference for the 15th FC, other than the core items (like tax devolution formula, grants-in-aid etc) are:

  • Usage of 2011 population data in the tax distribution formula
  • Review the need for revenue deficit grants
  • Review the so-called increased tax devolution of the 14th FC
  • Factor in some kind of performance-based ‘incentives’ for States based on:
    • States’ efforts on tax net under GST
    • Efforts in moving towards replacement rate of population growth
    • Implementation of GoI’s flagship schemes
    • Progress in increasing capital expenditure, eliminating losses of power sector
    • Promoting digital economy
    • Ease of doing business
    • Degree of States’ Populist measures (negative measure)
    • Efforts towards improving sanitation, solid waste management and end open defecation

The remainder of this paper aims to dissect some of these key terms of reference in the context and interest of Federalism, State autonomy in key financial matters and revenues at its direct control and disposal. One needs to wait and watch the final set of recommendations by the FC, especially around performance-based incentives and revenue deficit grants.

 Usage of 2011 population data for tax distribution:

Like touched upon in the article on the 14th FC, using the most recent demographic data in determining horizontal tax distribution is very logical. But given the aggressive population control policy adopted across the country since the 70’s, and some of the large States miserably failing in this, using the latest population statistics turns out to be disadvantageous to the relatively smaller yet better performing States on population control.

However, a possible saviour in the ToR of the 15th FC is the mention of incentivising States based on efforts moving towards replacement rate of population growth. It’s a matter of concern though that few of the large, populous north India States are still at very high TFRs contrary to the relatively smaller south India States, leading to unprecedented demographic shift/ migration. The limited pros and mostly cons of this shift is a different topic altogether, albeit extremely important.

 Review the need for revenue deficit grants:

Revenue deficit grants are the additional ‘transfers’ to the States to cover for post-devolution revenue deficits**, if any. In simpler words, these are additional compensation only to those States that would be in deficit even after factoring in the horizontal divisible pool distribution formula.

 So, if this grant need to be stopped, the 15th FC should somehow ensure a more robust horizontal devolution methodology – particularly address the anomalies around large weights assigned to Population (which would directly nudge the expense part higher) and Income Distance (which would directly pull the revenue part lower), due to which an undeservingly large amounts are currently getting diverted to some of the large yet poor performing States.

 Review increased tax devolution by the 14th FC:

It is now well marketed that the Center, by accepting 14th FC’s recommendations has devolved the highest percentage of divisible pool (from 32% to 42%) to the States and hence is pro-Federal.

Although this is true to the extent of providing greater flexibility to the States through increasing tax devolution (for unplan accounts), the plan transfers and grants have almost proportionately reduced – thereby leaving the aggregate transfers only slightly higher (approx. 4% higher) in comparison to the 13th FC.

Given the difference is already not as high as broadly perceived, there is hardly any room for reduction. So this will be yet another area that warrants a close watch, that could potentially decide the amount of flexibility and fiscal autonomy the States would have.

Performance based incentives to States:

While incentivising the States based on performance is surely a welcome measure, given the presence of major anomalies currently in the devolution formula effectively penalising good performance, hopefully these anomalies will be fine-tuned and addressed by the 15th FC.

Moreover, areas like GoI’s flagship schemes, GST etc are predominantly delivered by Central government departments and agencies, it will be highly complicated to quantify State government’s performance and hence the degree of incentives too in such areas. It should also be noted that most of these schemes are arguably anti-Federal in the first place, including measuring the ‘badness’ of a State policy in the context of populism can be very circumstantial, subjective and hence controversial – all the more reasons for these aspects not to be included in the assessment to devolve taxes, instead of striving towards making the States more and more empowered and accountable for it to manage its revenues and expenditures more autonomously.

Conclusion:

The ToR also makes a mention of a New India – 2022. India is an union of States. A prosperous India is possible only when its States do well. States can do well only when we become a truly Federal and a decentralised setup, instead of further centralizing even the resources available at the States’ disposal. The sooner we realize that for India to come first, the States have to first come first, the more practical will be a New India – 2022.

 —

 *One such example being the directive to the 14th FC to take into account the demographic changes that have taken place subsequent to 1971. As described in the article on the 14th FC, it sounds completely logical to base the distribution on the most recent demographic conditions, however by completely ignoring the efforts by States that have done well in population control and thereby not incentivising them, this particular term of reference eventually meted out an unfair deal for better performance.

**As per the 14th FC’s recommendations, 11 States are currently receiving this grant – they are, AP (the split version of the State), Assam, HP, J&K, Kerala, Manipur, Meghalaya, Mizoram, Nagaland, Tripura and West Bengal.

Going by this list of States that have a post-devolution deficit, it can be seen that this situation would arise due to,

  • A low tax effort of a State OR
  • Vertical devolution alone unable to meet the minimum required administrative expenses (mostly for small sized States) OR
  • Both

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