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The Finance Commission doesn’t rock the federal boat

Members of the 15th Finance Commission present their report to president Ram Nath Kovind. The FC’s recommendation to set up disaster mitigation funds at both Union and state levels is timely. So far, only disaster relief funds have been constituted.Premium
Members of the 15th Finance Commission present their report to president Ram Nath Kovind. The FC’s recommendation to set up disaster mitigation funds at both Union and state levels is timely. So far, only disaster relief funds have been constituted.

  • The Finance Commission has largely maintained status quo in Centre-state ties. What could be the flashpoints?
  • New flashpoints have opened up in local body funding, with the commission exceeding its mandate by imposing certain conditions to keep the funding tap open

BENGALURU : The four-volume report of the Fifteenth Finance Commission (FFC)—titled “Finance Commission in Covid Times"—is rich in analysis. The Commission must be credited for undertaking a challenging task of making recommendations at a time when both global and domestic environment is unclear and uncertain due to the pandemic.

With both Union and state governments under acute fiscal stress thanks to severe contraction in revenues and large increases in expenditures required to save lives and livelihoods and revive the economy, providing forward guidance on fiscal matters for five years is challenging. As the Commission claims , “... the report seeks to achieve responsible, efficient, equitable, and inclusive growth for India amid an unparalleled global and domestic macro-economic backdrop".

On the whole, states’ concerns about issues like the non-lapsable defence fund and a proposed tax devolution arrangement based on more recent population figures have been put to rest for now through a mix of compromise and conservatism in approach. However, new flashpoints have opened up in local body funding, with the commission exceeding its mandate by imposing certain conditions to keep the funding tap open.

This FC ‘s report not only allays the fears about the transfer system that many states had when the terms of reference was given, but also provides useful analysis. Of course, it remains to be seen how well the projections made will stand the test of time and whether the recommendations will ensure the finances of the Union and states will be on an even keel.

In many ways, the report features continuity and change. There were apprehensions that the Commission could reduce the states’ share in tax devolution—in fact, in its first report, it had stated that it would recommend sector-specific and performance-based grants in the final report.

Vocal for local
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Vocal for local

However, the Commission has continued with 41% share in the divisible pool of taxes to the states, which is identical to the recommendation of the Fourteenth Finance Commission after adjusting for the share of Jammu & Kashmir, which has now become a union territory.

The factors determining the horizontal shares of the states too are the same as in the interim report, with population and area receiving the weight of 15%; 10% for forest cover; 45% for income; 12.5% for demographic performance; and 2.5% for tax and fiscal effort. Not surprisingly, there are only marginal changes in the relative shares of the states from the shares in the first report.

The Commission has also continued with the practice of recommending revenue deficit grants even though there were doubts as the terms of reference (TOR) had asked the Commission to “... examine whether revenue deficit grants be provided at all". The total amount of grants recommended for the five-year period works out to 2.94 trillion.

However, in keeping with its interim recommendation that the states should, over time, eliminate their post devolution gaps, there is a phased reduction in revenue deficit grants from 1.18 trillion in the first year to 13,705 crore in the final year of recommendation. The number of states eligible for these grants is reduced from 17 to 6. The phased reduction provides the states with time to make suitable adjustments in their fiscal management.

The recommendations relating to disaster management too are on expected lines. The recommendation to set up disaster mitigation funds at both Union and state levels is timely and important. So far, only disaster relief funds have been constituted. A total of 1.6 trillion has been recommended for the disaster management fund, of which the Central share is 1.22 trillion to be distributed to the states on the basis of past expenditures, area, population and hazard index.

Local bodies

On local bodies, the commission has recommended a grant of 4.36 trillion for 2021-26 to be distributed among the states on the basis of population and area in the ratio 90:10. The share of rural local bodies comes to 2.36 trillion and that of urban local bodies at 1.21 trillion. In addition, there’s 70,051 crore of health grants; 8,000 crore for incubation of new cities; and 450 crore for facilitating shared municipal services.

Availing the grants by local bodies, however, requires the states to fulfil some entry-level conditions. These include setting up of State Finance Commissions, acting upon their recommendations and laying the explanatory memorandum as to the action taken report before the state legislature on or before March 2024. Also, both provisional and audited accounts should be placed in the public domain and there should be a minimum floor for property tax rates in tandem with the growth rate of the state’s own GSDP.

Furthermore, the Commission has recommended that 60% of the grants to rural local bodies and for urban local bodies in non-million-plus cities should be tied to strengthening of two basic services —sanitation and drinking water. For million-plus cities, the entire grant is performance-linked through the million-plus Cities Challenge Fund.

This conditional and performance-linked grants to local bodies raises questions on whether the Commission has gone beyond its mandate.

The TOR of the Commission is only to recommend “measures to augment consolidated funds of the states to supplement the resources of local bodies based on the recommendations of the State Finance Commission". The main role is supposed to be played by the state government and the Commission is supposed to play only a supplemental role. The responsibility for the local bodies is assigned to the states entirely under Entry 5 of the state list in the seventh schedule of the Constitution

It is the responsibility of the governor to appoint the State Finance Commission and cause the report to be placed in the State legislature. If he/she does not, can we deny the resources to local bodies?

Moreover, all the suggested reforms have to be undertaken by the state governments, including auditing of the local bodies’ accounts. Failure to comply with the conditions will not deny the states any funds—it is the local bodies that will lose. The only way to force the reluctant states is public opinion.

Hopefully, good sense will prevail, and the reforms will be carried out, and the local bodies will not have to suffer for the failure of the states. In any case, this recommendation has been accepted by the government.

Then, the Finance Commission, as it had stated in the interim report, has recommended sector-specific grants to health, school education, higher education, agriculture, maintenance of PMGSY roads, aspirational districts and blocks, judiciary and statistics. The total amount of grants recommended to these sectors amounts to 1.2 trillion. Similarly, the Commission has recommended state-specific grants of 49,599 crore.

However, the government has, in the explanatory memorandum, stated that it will implement the existing centrally-sponsored schemes and has not accepted the recommendation.

Defence fund

There was considerable apprehension when an additional TOR was issued to the Commission to examine the possibility of creating a non-lapsable modernisation fund for defence since this may have resulted in lower tax devolution.

The Commission has recommended the constitution of a dedicated non-lapsable fund—a modernisation fund for defence and internal security to bridge the gap between projected budgetary requirements and budget allocation. The proceeds of the fund are to be utilised for capital investment for modernisation of defence services, capital investment for central police forces and modernisation of state police forces as projected by MHA, and a small component as welfare fund for soldiers and paramilitary personnel.

The fund shall have the standard notified rules for its administration, public reporting and an audit by the CAG. The fund will access resources from four sources—contribution from the consolidated fund of India; disinvestment proceeds from defence public sector enterprises; proceeds from monetisation of surplus defence land; and receipts from defence land to be transferred to the state governments and for public projects in future.

The government has accepted the recommendation in principle and stated that the modalities of creating the fund and sourcing funds will be examined .

Deficit levels

Considering the fiscal problems created by the pandemic, the issue of one of the most important subjects on which the recommendations were keenly awaited was on the recommendations on appropriate levels of debt and deficit levels to the Union and state governments.

The pandemic has rendered the fiscal deficit and debt targets completely irrelevant and economic revival requires the government to sharply increase expenditures without bothering about deficit and debt in the immediate context.

However, as the economy recovers, it is important to return to the path of fiscal rectitude. In this context, the Commission has assumed that the fiscal deficit of the Union government for 2020-21 would be 7.4% of GDP. Starting from the deficit of 6% of GDP in 2021-22, it has laid down the path to contain the deficit at 4% in 2025-26. Correspondingly, starting with the debt-GDP ratio of 62.9% in 2021-22, the consolidation path leads to containing it at 56.6% in the terminal year.

For the states, the fiscal deficit is supposed to be reduced from 3.3% in 2021-22 to 2.8% in 2025-26 and marginally reduce the debt-GDP ratio from 31% in 2021-22 to 30.5% in 2025-16. The states have also been allowed to borrow 4% of their GSDP in 2021-22 to overcome fiscal constraints and an additional 0.5% conditional on the reforms in the power sector.

The government has, in principle, accepted the debt ceilings for the states recommended by the Commission. However, in regard to the fiscal roadmap for the Centre and amendments to FRBM Act, it has stated that the matter will be examined separately.

As a point of fact, assumption about the deficit in the starting year taken for the Centre itself is an underestimate in the Finance Commission’s exercise. As against the estimate of 7.4% of GDP taken by the Commission, the revised estimate shown in the budget is 9.5% and the Budget Estimate for 2021-22 is 6.8% as against 6% taken by the Commission. For the terminal year, the Finance Commission has put the ceiling at 4% of GDP, but in the budget speech the Finance Minister has pegged it at 4.5%.

There is also a recommendation by the Commission that an independent Fiscal Council, an advisory body with powers to access records required from the Union as well as the states should be appointed to ensure better compliance and to act as a repository of fiscal data. The government has not stated its position on this recommendation.

M Govinda Rao was member, Fourteenth Finance Commission and former director, NIPFP. These are his personal views.

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