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The Fourteenth Finance Commission, due to be set up soon, must be mandated to go beyond the letter of its Constitutional responsibility. Its terms of reference now must include addressing key issues that have emerged in India’s post-liberalized market economy.

As an institution of federalism, the Finance Commission (FC) was set up to redress the vertical imbalance in governmental finances and to ensure horizontal equalization of public services through revenue sharing and fiscal decentralization.

This institutional structure was designed at a time when the Union government was the principal driver of development. In the planned economy with quantitative controls, fiscal policy was geared to finance investment by raising the level of domestic savings, and transfer household savings to public investment. This had a major impact on the operation of the fiscal federal system.

Today, the situation is radically different. It is no longer public investment, but private investment that is driving development, helped by a liberalized domestic and foreign investment regime.

In the market-led growth paradigm, in natural resources—minerals, oil, natural gas, and hydropower—are fast becoming the key revenue drivers of, and major constraints to, growth and its spread across the sub-national economies. This necessitates a change in the design of fiscal federalism.

As such, the fundamental change in the approach FC has be spelt out in its in its terms of reference. The 14th FC must be asked to “design a framework for resource revenue sharing" in addition to the “transactional revenue" sharing that it traditionally does. In other words, fiscal federalism must now be linked to resource federalism in India.

This alternative framework can start with a fair scheme for distribution of resource rents, but must eventually graduate to a more robust and institutionalized system of resource federalism.

In doing so, the FC can also capture the changes needed in a fiscal federal set up to work in an open, but regulated, market economy as against a closed controlled one, the vestiges of which remain in this segment of the economy. For instance, instead of restructuring the minerals sector along market lines, amendments to the Mines and Minerals (Development and Regulation) Act, 1957, have restricted states from exercising powers of state governments, even though minerals are located within their respective boundaries.

Not only that, the Union government also extracts substantial share of revenue directly and indirectly from these resources. At the pre-production stage the Centre collects revenue as forest conservation charges and labour welfare cess; in the production stage in the form of custom duty, excise duty, income tax, and corporate taxes; and in the post-production stage as central tax and export duty.

If this wasn’t enough, the Union government’s undertakings—being the biggest consumers of minerals—are an additional source of revenue for it. The Union government has been milking these minerals cows, through dividend and can encash their embodied value by divesting its stake in them.

The net result is that distribution of revenues emanating from natural resources is effectively 50:50. In other words, the Union government corners half of the revenues generated from natural resources. In some cases, such as iron ore, it has been estimated that share of state taxes (royalty and sales tax) in total revenues is in the range 20% while the Union government’s share (mainly income tax and dividend tax) is 80%. This is because large profits are made by iron ore companies due to increased demand, high prices, and the very low royalty payments they make to states.

In this system, the resource aspect is peripheral if not absent from the scheme of federal transfers. Financial transfers are independent of the financial contribution by a region for the development of its natural resource activities. And the revenue so generated, is generally used for broad social and infrastructure needs. This must change.

One of the criteria for the level of transfers should be the contribution of a region to the development of natural resources. This is especially important going forward, as India is a resource deficit economy and there is a premium on raw materials.

To start with, the FC should be specifically mandated to restructure the royalty system, which is an ad hoc mix of unit-based and ad valorem-based approaches. A move towards a non-discretionary and automatic system of indexed ad valorem rates that moves in line with the price movements in commodity markets needs to be made.

These fiscal federal issues, apart from ignoring resource federalism, are creating systemic political stress that is now threatening the democratic set up. It would be naive to attribute the current political turmoil, for instance, to administrative or political corruption alone. The root of the issues such as “coalgate" originate in the resource conflict between the Centre (and its associates) and states (and their associates).

Haseeb A. Drabu is an economist, and writes on monetary and macroeconomic matters from the perspective of policy and practice. Comments are welcome at haseeb@livemint.com

To read Haseeb A. Drabu’s earlier columns, go to www.livemint.com/methodandmanner

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