The 15th Finance Commission led by N.K. Singh held its first meeting this week. The tasks before it are unique in the sense that it has to make its recommendations after the rules of  fiscal federalism have been profoundly reset by the introduction of the goods and services tax (GST). This is the first finance commission that will do its work under the new tax system.

The impact of GST on federal public finances is still not clear. For example, the fact that the new tax, which is a destination levy, will shift the incidence of taxation from production to consumption means that the distribution of indirect taxes between different states could change significantly. The ambiguity about the revenue-neutral GST rate also puts a big question mark on the health of public finances at all levels over the medium term. These issues need to be framed against the larger challenge of increasing the Indian tax to gross domestic product ratio.

Successive finance commissions have increased the proportion of tax revenue that goes to the states—a necessary change given the growing importance of direct taxes as well as the need for higher spending by state governments in local public goods. The First Finance Commission headed by K.C. Neogy had recommended that the states get a tenth of total taxes collected centrally. That share has steadily increased. The 14th Finance Commission headed by Y. V. Reddy recommended that the share of the states should be 42%.

The Constitution empowers the finance commissions to go beyond the core issues of how to divide taxes vertically between New Delhi and the states on the one hand and horizontally between states on the other. Constitutional provisions also allow finance commissions to make broader recommendations in the interests of sound finance, a testimony to the vision of our Constitution makers.

One of the key issues that the 15th Finance Commission will need to deal with is how to incentivise the states to stick to fiscal discipline. The terms of reference of the new commission have suggested linking transfers to a range of parameters, such as efforts made to deepen GST, how quickly a state moves towards the replacement level of fertility, eliminating power sector losses, improving the ease of doing business, adoption of direct benefit transfers and progress in sanitation. These performance parameters are clearly a reflection of the policy preferences of the Narendra Modi government.

One important change—and a tricky political issue—is the decision to use population according to the 2011 census as the base for calculating the expenditure needs of various states. Even the 14th Finance Commission had been explicitly asked to use the 1971 population numbers while deciding the devolution formula. The shift to the latest demographics is necessary since public goods expenditure by the states has to be linked to the number of citizens, but it could also be a sore point for southern states that have been more successful in reducing their rate of population growth.

The Fifteenth Finance Commission is also expected to recommend new fiscal targets for the Union and state governments. It can be assumed that the targets will broadly be similar to what the recent fiscal review committee suggested, especially since it was also headed by N.K. Singh.

A focus on state finances is needed, especially given the recent deterioration in the fiscal parameters of the states. But the finance commission should also not ignore the fiscal health of the Union government, given its importance in the overall macro performance of the Indian economy.

Every finance commission has to do a political balancing act. It needs to give more resources to the states given the growing importance of sub-national governments in the Indian political economy. It also needs to ensure that New Delhi is not fiscally constrained given its role in key national public goods such as defence. Federalism can flourish only when it is accompanied by a strong central agency that credibly enforces the rules for a new political economy equilibrium (which is sometimes mistakenly described as pooled sovereignty, even though Indian states are not sovereign in any rigorous sense of the term).

The three central tasks of the 15th Finance Commission will thus be to strengthen cooperative federalism, frame the incentives needed to shift public spending in the desired direction, and do all this without compromising fiscal stability.

What will be the key challenges for the 15th Finance Commission? Tell us at views@livemint.com

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