Shanmugam Ias Academy

Context:

This article discusses the potential challenges that might arise in front of the next Finance Commission.

Introduction:

The government will appoint the next Finance Commission in the coming months, tasked with determining the distribution of tax revenue between the central government and the states.
This involves deciding the vertical share (how much goes to the states) and the horizontal sharing formula (how it is divided among the states).
Before economic reforms, the Finance Commission’s recommendations were less significant since the Union government had alternative methods to compensate states and exercise favouritism.
However, with the changes implemented, such as the decline in fresh public sector undertaking investments and the dissolution of the Planning Commission, the Finance Commission now plays a much more pivotal role in India’s fiscal federalism as the primary architect of the system.

Issues faced by 15th FC:

The appointment of the previous Finance Commission sparked controversy due to its mandate to consider the 2011 population figures instead of 1971 figures when determining a State’s expenditure.
States that had successfully controlled population growth, particularly in the southern region, opposed this change, considering it a “penalty for good performance.”
A similar conflict arises regarding revenue deficit grants awarded by the Finance Commission to States experiencing deficits even after tax devolution.

Potential Challenges for Next Finance Commission:

Finance Commissions have historically struggled to distinguish between a State’s deficit resulting from fiscal incapacity versus fiscal irresponsibility.
The Union government currently allocates 41% of its tax pool to the States. However, due to the Union’s expenditure needs and borrowing constraints, there will be less room to further increase the allocation.
Every horizontal distribution formula has faced criticism for being inefficient or unfair, or both.
Historically, Finance Commissions have attempted to adjust the distribution formula to support deficit-ridden States without penalizing responsible ones.
Divisions among States have deepened in recent years along political, economic, and fiscal lines.
The fundamental nature of horizontal distribution entails wealthier States compensating poorer States. The challenge lies in ensuring that this process does not further deepen the divide.
Various indicators suggest that southern States excel in terms of infrastructure, private investment, social development, and the rule of law, creating a growing gap between the North and the South.
Finding a balance between richer and poorer States through horizontal distribution will be a significant challenge for the government and the Finance Commission.

Way Forward:

The Finance Commission’s terms of reference mandate considering the expenditure needs and revenue capacity of both the Centre and the States.
To address specific concerns, the upcoming Finance Commission should utilize this authority in two key areas.
It should establish guidelines for the appropriate use of cesses and surcharges, as well as propose a formula to limit the amount that can be raised through them.
A white paper released by the Tamil Nadu government highlighted that the proportion of cesses and surcharges in the Centre’s total tax revenue nearly doubled from 10.4% in 2011-12 to 20.2% in 2019-20.
By addressing this issue, the Finance Commission can ensure that cesses and surcharges are utilized judiciously and in line with the original intent of revenue sharing between the Centre and the States.
It would also prevent the Centre from excessively benefiting from these levies at the expense of the States, fostering a stronger sense of fiscal balance and cooperation.
The Finance Commission should prioritize the issue of government spending on what is commonly referred to as “freebies.”
The upcoming Finance Commission should take decisive action in the interest of long-term fiscal sustainability and establish guidelines for freebie spending.

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