Higher tax-gdp is a must for financing security and development

The final report of the Fifteenth Finance Commission maintains continuity in some areas, while making some major changes in others. The report was greatly anticipated — with some concern in many quarters — because the terms of reference provided to the Commission went further in straining federal norms than in previous iterations. The Commission has faithfully considered these fresh terms of reference, and in some cases minimised their impact. The most controversial such change in the reference was the instruction to shift from the 1971 Census to the 2011 Census when it came to determining allocations to the states. On the one hand, this might be considered a necessary updating of the formula, given the vast demographic changes in India since 1971. On the other hand, some states — in the south, in particular — objected, as they saw it as penalising those states that had successfully controlled their population growth in the period since 1971.

The Commission has indeed used the 2011 Census as a base, but it has also upped the proportion in the formula used to apportion taxes among the states devoted to “performance”. This has been done precisely to address the concerns raised by the southern states; the Commission in its official press release states that “while the Census 2011 population data better represents the present need of states, to be fair to, as well as reward, the states which have done better on the demographic front, [the Commission] has assigned a 12.5 per cent weight to the demographic performance criterion”. Overall, the Commission retained the vertical devolution percentage at 41 per cent of the divisible pool of taxes as it had been previously (net of the amount being given to the erstwhile state of Jammu and Kashmir). But this conceals at least one major change — the reduction in the total transfer.

The Terms of Reference indicated that the Commission should deliberate on whether a “separate mechanism for funding of defence and internal security ought to be set up”. The Commission has duly recommended such a mechanism. It uses as justification “the extant strategic requirements for national defence in the global context” — though it is unclear why these requirements are suddenly more urgent than they have been at any point in the past. In order to meet defence capital spending requirements, it has essentially reduced its grant component by 1 per cent. How much additional money does this work out to for the Union government? The Commission says: “Based on our assessment of the gross revenue receipts of the Union government for the entire award period of 2021-22 to 202526, in nominal terms, this dispensation may leave ~1.53 lakh crore (~1.53 trillion) with the Union government.”

While it is certainly true that defence spending needs to be increased, this should be part of the normal budgeting process of the Ministry of Finance and not done through the Finance Commission. If the defence budget is at historic lows, this is because the government has not been able to improve revenue collection over the years. As a consequence, the Commission has penalised the primary engines of development spending in India: The state governments. This is not a lasting solution and the government needs to focus on improving tax collection as a percentage of gross domestic product to fulfil its obligations.