Agenda for 15th Finance Commission

There are news reports that the government is actively in the process of forming the Fifteenth Finance Commission( 15th FC). The task before this FC will be challenging, considering the structural changes the economy has undergone in recent times. With the arrival of the goods and services tax (GST) with all its shortcomings, the major overhaul of the financial sector now on the anvil, the obvious realisation that there is need to infuse massive doses of investment in infrastructure, business as usual is a thing of the past.

Financial relations between the central and provincial governments have been the subject of discussion for very long, even in the constituent assembly and in earlier. The thinking at that time was primarily dominated by the Congress, but even then there were differences of opinion. B R Ambedkar had said, “I confess I have a partiality for a unitary form of government. I think India needs it.” K Santhanam, on the other hand, was apprehensive of the Centre ”taking over everything”. The Expert Committee on Financial Provisions of the Constitution, headed by N C Sarkar, opined that central expenditure requirements would remain comparatively stable while the requirements of the states would be limitless. This committee recommended transfer of 60 per cent of income and corporate taxes to the states, an advice that was not accepted, and the formation of “a neutral expert authority” every five years to periodically review Centre-state financial relations, which led to Article 280 and the FC.

The entry of Planning Commission (PC) made the the role of the FC more complicated. The First FC took the view that demands for funds arising out of planning were outside its purview. The Third FC attempted to flex its muscles vis -a-vis the PC, but was not successful. FCs, by and large, confined themselves thereafter to non-Plan, non-developmental expenditure. Over the years, the Congressled political structure underwent complete transformation. Non- Congress political parties grew in number and in strength. Regional parties and splinter parties mushroomed in different states. The unitary form of financial management, characterised principally by the proliferation of centrally-sponsored schemes (CSS), came under increasing stress, with the National Development Council even recommending in 1969 that the quantum of central assistance through CSS should be restricted to not more than one sixth of central assistance for state plans.

In many ways, the 14th FC marked a watershed in the evolution of Centre-state finances. There was a “compositional shift in transfers”; from grants and tied central assistance to a significant leap in devolution of taxes from 32 to 42 per cent. The FC took into account Plan Revenue expenditures while assessing the revenue position of states and gave Revenue Deficit Grants to 11 states. It changed the parameters for horizontal devolution between states, bringing in forest cover and 2011 population as new factors, changing weights for 1971 population and fiscal capacity criteria, and eliminating the fiscal discipline factor. It gave no sector specific or state-specific grants. It suggested institutional mechanisms for ex ante assessment of fiscal policy implications of Budget proposals through a Fiscal Council, which was also recommended by the N K Singh Committee. The overall impact of the 14th FC was positive for all states but the intention, as stated by the FC, was not an aggregate shift of resources for which there was no fiscal space but a compositional shift. This was achieved through the reduction in central shares of CSS and abolition of a few schemes as recommended by a sub-group of Chief Ministers formed by the NITI Aayog. In the end, some states gained and some lost.

The 15th FC will be formed in the context of a massive change in the indirect tax structure brought about by the arrival of the GST. The GST is an unknown quantity that could complicate both vertical and horizontal devolution. Prima facie, it would appear that the Centre stands to lose as Central GST is lower than the erstwhile excise duty, and service tax has to be equally shared with states. But the assumption is that the GST tax base would increase significantly bringing in higher aggregate revenue. The GST network would also feed information into the income tax network thus raising the volume of direct tax revenue. Horizontal devolution, too, has undergone change. The focus has shifted from states of origin to states of destination. The Integrated GST (IGST), which supplants the Central Sales Tax (CST) of the past , will now go to destination states. The problem of devolution becomes even more complicated by the fact that the effective rate of GST is not clear with its multiple rates of tax and presently uncertain tax base. Perhaps calculations made by different states of revenue neutral rates during the GST calculations may provide some data. The foundations of the GST are, however, shaky at present, changes are being made frequently and there is general unease about the multiplicity of rates and the effectiveness of its platform.

The state of the economy, the changes taking place in the financial sector and the need for more public investment in the context of public debt needs consideration by the next FC. The last two FCs and the N K Singh Committee, had gone into the issue of fiscal deficit at some length. All three seemed to arrive at an ideal fiscal deficit rate of 3 per cent (of the GDP) presently and both provided for some flexibility — the 14th FC on the basis of performance, the N K Singh Committee on the basis of need to adjust to cyclical factors. While the 13th FC recommended a public debt-to-GDP ratio of 68 per cent, Centre and states combined, the N K Singh Committee recommended 60 per cent. It would be desirable for the next Finance Commission to delve a little deeper into the cyclical factors.

When the economy is in trouble, and investment and saving rates are low, flexibility in fiscal deficit rates to accommodate more public investment becomes necessary. This will raise the GDP, the denominator in the equation, leading (in the short term) to automatic adjustment of the ratio. The last FC itself pointed out that while the ratio rose as a consequence of the stimulus package and Pay Commission outflows to 3 per cent in 2009-10, it came down to 1.9 per cent in 2012-13.

Overall, the next FC has its task cut out.