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15th Finance Commission | Fiscal federalism | UPSC

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Sub Theme:  15th Finance Commission Recommendations- 2nd Report (2021-26)

UPSC Syllabus: GS Paper III – Economic development

The 15th Finance Commission headed by Mr. N.K. Singh has recently submitted its recommendations. Usually, the Finance Commission recommendations are valid for a period of 5 years. However, this time, the 15th Finance Commission recommendations would be valid for a period of 6 years.

Earlier, the 15th Finance Commission had submitted its first set of recommendations which were applicable for the financial year 2020-21. Now, the commission has submitted its second report, whose recommendations will be applicable for the next 5 years i.e. 2021-2026.

In this regard, let us understand the need for setting up of Finance Commission in India and the important recommendations of 15th Finance Commission.

Important recommendations of 15th Finance Commission

Vertical Devolution of Taxes: The share of states in the central taxes for the 2021-26 period is recommended to be 41%, same as that for 2020-21.  This is less than the 42% share recommended by the 14th Finance Commission for 2015-20 period.  The adjustment of 1% is to provide for the newly formed union territories of Jammu and Kashmir, and Ladakh from the resources of the Centre.

Criteria for the Horizontal distribution of taxes among the States:

The criteria for distribution of central taxes among states for 2021-26 period is same as that for 2020-21.

Criteria 14th Finance Commission 15th Finance Commission
Income Distance 50 45
Population (1971 Census) 17.5 Not Considered
Population (2011 census) 10 15
Demographic Performance Not Considered 12.5
Forest Cover 7.5 Not Considered
Forest and Ecology Not Considered 10
Area 15 15
Tax Effort Not considered 2.5
Total 100 100

Analysis of the Criteria used by the 15th Finance Commission:

Income Distance: The Income distance criteria is the difference between per-capita income of a particular state and state with the highest per-capita income. If the income distance is larger, it would mean that a particular state is poorer and hence it would get higher share of taxes. If the income distance is smaller, it would mean that a particular state is richer and hence it would it would get lesser share of taxes.

Population: Earlier, the 15th Finance Commission has asked to explore the possibility of using the Population of 2011 census instead of 1971 census for the devolution of taxes. However, this was opposed by the Southern states. These states have taken substantial efforts to reduce the Population growth rates by undertaking the Family planning programmes since 1970s. So, naturally, if the criteria of 2011 census were to be used, this would lead to loss in the share of their taxes.

Here, the Finance Commission has done a fine balancing between the directions issued by the centre and concerns raised by the Southern states.

It has used the Population of 2011 census and done away with the Population of 1971 census. However, keeping in mind, the concerns raised by the Southern states, it has introduced the new criteria of Demographic performance. The Demographic performance indicator looks at the Fertility rate in a state. If the fertility rate in a particular state is lower, it would mean that such a state has taken substantial efforts to reduce its population growth rate and accordingly it would get a higher share. Since, the fertility rate in the southern states is much lower, the introduction of such an indicator is likely to reduce the impact caused by using the criteria of 2011 census instead of 1971 census.

Forest and ecology: This criteria has been arrived at by calculating the share of dense forest of each state in the aggregate dense forest of all the states.

Tax effort: This criterion has been used to reward states with higher tax collection efficiency.   It has been computed as the ratio of the average per capita own tax revenue and the average per capita state GDP during the three-year period between 2014-15 and 2016-17.

Grants-in-aid

The Terms of Reference of the Finance Commission require it to recommend grants-in-aid to the States.  These grants include: (i) revenue deficit grants, (ii) grants to local bodies, and (iii) disaster management grants.

Revenue Deficit Grants: In spite of the devolution of taxes from Centre, some of the states may not able to fund their revenue expenditure requirements on their own through their Revenue receipts. Hence, in order to meet requirements of such states, the Finance Commission provides for Revenue deficit grants. These grants are usually assigned in order to cover the gap between the Revenue expenditure and Revenue Receipts of the states. The 15th Finance Commission has estimated that 17 states would face revenue deficit post-devolution. To make up for this deficit, the Commission has recommended revenue deficit grants worth Rs 2.9 lakh crores to these 17 states.

Sector Specific Grants: Sector-specific grants of Rs 1.3 lakh crores will be given to states for Health, Education, Agriculture etc.

Grants to local bodies: The total grants to local bodies for 2021-26 has been fixed at Rs 4.36 lakh crore. The grants will be divided between states based on population and area in the ratio 90:10. The grants will be made available to all three tiers of Panchayat- village, block, and district. No grants will be released to local bodies of a state after March 2024 if the state does not constitute State Finance Commission and act upon its recommendations by then.

Fiscal Roadmap

Fiscal deficit and debt levels: The Centre should bring down fiscal deficit to 4% of GDP by 2025-26.  For states, fiscal deficit should be reduced to 3% of GSDP.

The Commission observed that the recommended path for fiscal deficit for the centre and states will result in a reduction of total liabilities of: (i) the centre from 63% of GDP in 2020-21 to 56.% in 2025-26, and (ii) the states on aggregate from 33% of GDP in 2020-21 to 32.5% by 2025-26.

It also recommended forming a high-powered inter-governmental group to: (i) review the Fiscal Responsibility and Budget Management Act (FRBM), (ii) recommend a new FRBM framework for centre as well as states, and oversee its implementation.

Goods and Service Tax

The 15th Finance Commission has highlighted some challenges with the implementation of the Goods and Services Tax (GST).  These include: (i) large shortfall in collections as compared to original forecast, (ii) high volatility in collections, (iii) accumulation of large integrated GST credit, (iv) glitches in invoice and input tax matching, and (v) delay in refunds.  The Commission observed that the continuing dependence of states on compensation from the central government (21 states out of 29 states in 2018-19) for making up for the shortfall in revenue is a concern.

Recommendations:

Address the Inverted Duty Structure: The term ‘Inverted duty Structure’ refers to a situation where the rate of tax on inputs purchased (i.e. GST Rate paid on inputs) is more than the GST rate on finished goods. The inverted duty structure leads to higher input tax credits and hence lower tax collection for the Government.

Revenue Neutrality: A change in tax regime can be said to be revenue neutral if the modified tax is able to realise revenue comparable to the original tax regime. As far as GST is concerned, earlier, general government revenues from the taxes subsumed under GST was around 6.3 per cent in 2016-17. However, collections under GST was around 5.1 per cent of GDP in 2019-20. This clearly shows that post the implementation of GST, the overall indirect tax collections have failed to reach up to the earlier levels.

Correcting the inverted duty structure and problems related to invoice matching in the next two years should progressively help India’s GST to re-establish its revenue neutrality.

Rationalisation of GST rates: The GST was introduced in order to simplify the tax structure and improve the tax compliance. However, the existing GST regime has multiple rates: 0, 0.25, 1, 3, 5, 12,

18 and 28%; Rate structure should be rationalised by merging the rates of 12% and 18%.

Centrally Sponsored Schemes (CSS)

Present Status:  The Union Budget 2020- 21 shows that fifteen of the thirty umbrella CSS account for about 90 per cent of the total allocation under CSS. Many umbrella schemes have, within them, a number of small schemes, some of them with negligible allocations

Recommendations: It is important to gradually stop the funding for those CSS and their subcomponents which have either outlived their utility or have insignificant budgetary outlays not commensurate to a national programme. There should also be a minimum threshold funding size for the approval of a CSS. Below the stipulated threshold, the administrating department should justify the need for the continuity of the scheme. Third-party evaluation of all CSS should be completed within a stipulated timeframe.

Funding of defence and internal security: 

Present Status: Defence expenditure has, over time, been characterised by a higher share of revenue expenditure, huge pension bills and lower capital expenditure with high dependence on import of defence equipment.

Recommendations: A dedicated non-lapsable fund called the Modernisation Fund for Defence and Internal Security (MFDIS) should be constituted under the Public Account for capital expenditure in defence and internal security. The fund will be funded through (a) Transfers from the Consolidated Fund of India (b)  Disinvestment of defence PSUs (c) Monetisation of defence lands.

Public Health

States should increase spending on health to more than 8% of their budget by 2022.  Primary healthcare expenditure should be two-thirds of the total health expenditure by 2022.  Centrally sponsored schemes (CSS) in health should be flexible enough to allow states to adapt and innovate.  Focus of CSS in health should be shifted from inputs to outcome.  All India Medical and Health Service should be established.

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