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EDITORIAL ANALYSIS : Charting the path for the Sixteenth Finance Commission



Source: The Hindu

Continuation of article: The next Finance Commission will have a tough task


  • Prelims: Current events of national importance(Federalism, Finance Commission, Cess and Surcharges, NITI Ayog, etc)
  • Mains GS Paper II & III: Functions and responsibilities of the union and the states, issues and challenges pertaining to the federal structure etc



  • The Sixteenth Finance Commission is due to be set up shortly.
  • The combined government debt-GDP ratio had also shot up close to 90% at the end of 2020-21.
    • Many States show large fiscal imbalances




Finance Commission:


The vertical and horizontal dimensions

  • The Fourteenth Finance Commission raised the share of States in the divisible pool of central taxes to 42% from 32%.
    • This was revised to 41% when the number of States in India was reduced to 28.
  • During 2020-21 to 2023-24 (BE): The effective share of States in the Centre’s gross tax revenues (GTR) averaged close to 31%
    • It was significantly lower than the corresponding share of nearly 35% during 2015-16 to 2019-20.
    • The increase in the share of cesses and surcharges to 5(eighteen point five)% of the Centre’s GTR during 2020-21 to 2023-24 (BE) from 12.8(twelve point eight)% during 2015-16 to 2019-20.



  • The heavy reliance on cesses and surcharges requires scrutiny by the Sixteenth Finance Commission.
    • Option: freeze the share of cesses and surcharges to some base number.
    • Under Thirteenth Finance Commission: The share was just 6%.
    • A 10% upper limit of the share of cesses and surcharges as a percentage of Centre’s GTR may be recommended.
    • The share of States must be increased if the proportion crosses 10%.
  • There will be one proportion-42%, if cesses and surcharges exceed 10%, and another share of 41% if they are 10% or below.
    • The formula may be nuanced by the Sixteenth Finance Commission with the help of the latest data.
  • GST collections have maintained good buoyancy in the last two years.
    • GST still needs restructuring to make it a good and simple tax.


The share of individual States in the Centre’s divisible pool of taxes:

  • It is determined by a set of indicators:
    • population
    • per capita income
    • area
    • incentive-related factors
      • forest cover
      • demographic change.
    • In the case of per capita income: It is the distance of a State’s per capita income from a benchmark
      • It is usually kept at the average per capita income of the top three States that is used as a determining factor.
      • The distance criterion implies relatively larger shares for relatively lower income States.
      • At present, it has the highest weight of 45% — it had an even higher weight previously.


Lower Income states:

  • These States are expected to provide a relatively larger share of ‘demographic dividend’ to India in future
    • Attention needs to be paid to the educational and health needs of their populations.
  • It may be useful to freeze the weight to distance criterion at the current level or even reduce it to 40%
    • but some upward adjustment in the resources transferred to the poorer States may be done through grants.


Equalization principle:

  • Equalization of the provision of education and health services should be prioritized in the overall scheme of resource transfers.
  • Instead of using a large number of tax devolution criteria, the transfer of resources to individual States may be guided by the equalization principle
    • using a limited number of criteria such as population, area and distance, supplemented by a suitable scheme of grants.
  • The equalization principle is consistent with both equity and efficiency.
  • It is used in federations such as Canada and Australia.
  • The basic consideration of reflecting needs, costs of providing services, and equity considerations.
    • It can all be reflected through these three criteria, provided there is more fine-tuning.


What are the other Recommendations?

  • The debt-GDP ratio for the combined account of central and State governments had peaked at 8(eighty nine point eight)% in 2020-21
    • Out of which the Centre’s debt-GDP ratio excluding any on-lending to the States amounted to 7(fifty eight point seven)%, and that of States was 31%.
    • While these numbers have begun coming down
    • These are still above the corresponding Fiscal Responsibility and Budget Management (FRBM) norms of 40% and 20%, as in the 2018 amendmen
  • In 2020-21, the Centre’s fiscal deficit had shot up to 2(nine point two)% of GDP and that of States to 4.1(four point one)%.
    • The 2018 amendment to the Centre’s FRBM needs to be re-examined.
    • This was also recommended by the Fifteenth Finance Commission.
  • The Twelfth Finance Commission had recommended a target of 28% consistent with an underlying nominal GDP growth of 12%.
    • The adjustment needed for the central government is larger than that for State governments.
    • Few State governments appear to have relatively larger debt and fiscal deficit numbers relative to their GSDPs.
    • Concerns:
      • Proliferation of subsidies
      • Re-introduction of the old pension scheme in States
    • such subsidies are sought to be financed by raising the fiscal deficit.


Way Forward

  • There may not be a strong case for recommending any further increase in the States’ share of central taxes in view of the Centre’s large fiscal imbalances.
    • A re-examination of the role of non-shareable cesses and surcharges is required.
  • Set up a loan council(recommended by the Twelfth Finance Commission): This independent body should oversee the loan magnitudes and profiles of the central and State governments.
  • The Sixteenth Finance Commission should examine the subject of non-merit subsidies in detail.
    • However, exclusion of ‘unjustified’ subsidies while determining grants may cause the Finance Commission to be caught in political crossfire.
  • The Finance Commission should be strict about States maintaining fiscal deficit within limits.
    • It should provide carrots to States maintaining fiscal deficit
    • for example:
      • including fiscal performance as a criterion in horizontal distribution
      • sticks for those that exceed fiscal deficit limits by suitably acting on the extent of borrowing allowed.



How far do you think cooperation, competition and confrontation have shaped the nature of federation in India ? Cite some recent examples to validate your answer.(UPSC 2020) (200 WORDS, 10 MARKS)