Equity versus efficiency: 16th Finance Commission must take a cue from its predecessor, balance interests

Regardless of the 14th FC raising the states’ share in shareable tax kitty by over 30%, and the 15th FC retaining that, there has been a transfer of fiscal resources from the states to the Centre, and from the performing states to the laggards.

Despite the 15th Finance Commission’s deft handling of its unusual—and unusually challenging—mandate, its soon-to-be-formed successor will have a bigger task at hand. The Centre-state fiscal strains have worsened after the 15th FC award. For sure, the Centre’s commendable “tax effort” has ensured that, despite the pandemic, its gross revenue receipts in FY21-FY24, the first four years of award period, are set to exceed the commission’s estimate by over 20%. However, many states which have marched ahead on socioeconomic/sustainable development are indignant about their share of central resources being reduced to an extent that their further development is constrained. There is understandable heartburn among them on being made to cross-subsidise the “less-performing states,” to an unacceptable extent, in the name of equity.

True, it’s ingrained in the formula for horizontal distribution (apportioning of states’ tax share among them) that richer states compensate poorer ones. But all “performing states” are not necessarily rich, and some have inherent fiscal incapacity that needs to be addressed. Besides, there is also an overwhelming feeling among states in general that, while they have had a 42% share of divisible pool of taxes since the start of 14th FC period (FY16), as against 32% earlier, the pool’s growth itself has been slowed. Since FY20, the Centre raised the cesses and surcharges—the proceeds of which are not to be shared with states—quite sharply, amid questions about the move’s constitutional propriety. Proceeds from cesses and surcharges had risen from less than 9% of the Centre’s gross tax receipts to more than a fifth by FY21. The net effect of this has been a drop in the growth of transfers to states.

In short, regardless of the 14th FC raising the states’ share in shareable tax kitty by over 30%, and the 15th FC retaining that, there has been a transfer of fiscal resources from the states to the Centre, and from the performing states to the laggards. While this is an issue that ought to engage the 16th Commission, the terms of reference to be given to it by the Centre will be the key determinant. An unconventional (and controversial) ToR asked the 15th FC to examine whether revenue deficit grants (RDGs) “be provided at all” to states, and stated that, it “shall use the population data of census 2011 (the long-held practice was to employ 1971 data).” The latter term enraged the states that had attained replacement rate of population growth. The commission, however, tempered the row by not withdrawing the RDGs to compensate states with innate fiscal weakness. Also, while relying on the 2011 population data, it sought to reduce the resultant perverse incentive to states with unbridled population growth, by assigning a 12.5% weight to population control. A semblance of balance was sought to be maintained.

It may buoy up the 16th Commission that the ratio of overall government debt to GDP came down to 81% in FY23. That beat the 15th FC’s forecast that the ratio would linger around 90% in the year, the same level as in the pandemic-hit FY21. But the question is whether the glide path for debt is sustainable, given the loss of economic growth potential. The upcoming commission would do well to encourage tax effort among states, recommend ways to boost Goods and Services Tax revenues, and discourage fiscally irresponsible steps like reverting to unfunded pension schemes, and spending on “freebies.”

This piece was originally published in Financial Express.

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