Finance Commission – Concepts and definitions
Tax Devolution
One of the core tasks of a Finance Commission as stipulated in Article 280 (3) (a) of the Constitution is to make recommendations regarding the distribution between the Union and the states of the net proceeds of taxes. This is the most important task of any Finance Commission, as the share of states in the net proceeds of Union taxes is the predominant channel of resource transfer from the Centre to states.
Divisible Pool
The divisible pool is that portion of gross tax revenue which is distributed between the Centre and the States. The divisible pool consists of all taxes, except surcharges and cess levied for specific purpose, net of collection charges.
Prior to the enactment of the Constitution (Eightieth Amendment) Act, 2000, the sharing of the Union tax revenues with the states was in accordance with the provisions of articles 270 and 272, as they stood then. The eightieth amendment of the Constitution altered the pattern of sharing of Union taxes in a fundamental way. Under this amendment, article 272 was dropped and article 270 was substantially changed.
The new article 270 provides for sharing of all the taxes and duties referred to in the Union list, except the taxes and duties referred to in articles 268 and 269, respectively, and surcharges on taxes and duties referred to in article 271 and any cess levied for specific purposes.
Grants-in-aid
Horizontal imbalances are addressed by the Finance Commission through the system of tax devolution and grants- in-aid, the former instrument used more predominantly. Under Article 275 of the Constitution, Finance Commissions are mandated to recommend the principles as well as the quantum of grants to those States which are in need of assistance and that different sums may be fixed for different States. Thus one of the pre-requisites for grants is the assessment of the needs of the States.
The First Commission had laid down five broad principles for determining the eligibility of a State for grants.
- Budget of a State was the starting point for examination of a need.
- Efforts made by States to realize the potential
- Grants should help in equalizing the standards of basic services across States.
- Any special burden or obligations of national concern, though within the State’s sphere, should also be taken into account.
- Grants might be given to further any beneficent service of national interest to less advanced States.
Grants recommended by the Finance Commissions are predominantly in the nature of general purpose grants meeting the difference between the assessed expenditure on the non-plan revenue account of each State and the projected revenue including the share of a State in Central taxes. These are often referred to as ‘gap filling grants‘. Over the years, the scope of grants to States was extended further to cover special problems.
Following the seventy-third and seventy-fourth amendments to the Constitution, Finance Commissions were charged with the additional responsibility of recommending measures to augment the Consolidated Fund of a State to supplement the resources of local bodies. This has resulted in further expansion in the scope of Finance Commission grants. The Tenth Commission was the first Commission to have recommended grants for rural and urban local bodies. Thus, over the years, there has been considerable extension in the scope of grants-in-aid.
Fiscal capacity/Income distance
The income distance criterion was first used by Twelfth FC, measured by per capita GSDP as a proxy for the distance between states in tax capacity. When so proxied, the procedure implicitly applies a single average tax-to-GSDP ratio to determine fiscal capacity distance between states.
The Thirteenth FC changed the formula slightly and recommended the use of separate averages for measuring tax capacity, one for general category states (GCS) and another for special category states (SCS).
Fiscal discipline
Fiscal discipline as a criterion for tax devolution was used by Eleventh and Twelfth FC to provide an incentive to states managing their finances prudently. The criterion was continued in the Thirteenth FC as well without any change.
The index of fiscal discipline is arrived at by comparing improvements in the ratio of own revenue receipts of a state to its total revenue expenditure relative to the corresponding average across all states.
Fourteenth Finance Comission
The Fourteenth Finance Commission (FFC) was appointed on 2nd January, 2013 under the chairmanship of Dr. Y. V. Reddy. In addition to the primary objectives mentioned above, the terms of reference for the commission sought suggestions regarding the principles which would govern the quantum and distribution of grants-in-aid (non- plan grants to states), the measures, if needed, to augment State government finances to supplement the resources of local government and to review the state of the finances, deficit and debt conditions at different levels of government.
MAJOR RECOMMENDATIONS OF FFC
Some of the major recommendationsare as follows;
- The FFC has radically enhanced the share of the states in the central divisible pool from the current 32 percent to 42 per cent which is the biggest ever increase in vertical tax devolution.
- Twelfth (period 2005- 10) had recommended a state share of 30.5 per cent (increase of 1 percent) in the central divisible pool.
- Thirteenth (period 2010-15) had recommended a state share of 32 per cent (increase of 1.5 percent), respectively in the central divisible pool.
- The FFC has also proposed a new horizontal formula for the distribution of the states’ share in divisible pool among the states. There are changes both in the variables included/excluded as well as the weights assigned to them. Relative to the Thirteenth Finance Commission, the FFC has incorporated two new variables: 2011 population and forest cover; and excluded the fiscal discipline variable .
- Several other types of transfers have been proposed including grants to rural and urban local bodies, a performance grant along with grants for disaster relief and revenue deficit. These transfers total to approximately 5.3 lakh crore for the period 2015-20.
- The FFC has not made any recommendation concerning sector specific-grants unlike the Thirteenth Finance Commission.
Special Category States (SCS) and General Category States (GCS)
The concept of a special category state was first introduced in 1969 when the Fifth Finance Commission sought to provide certain disadvantaged states with preferential treatment in the form of central assistance and tax breaks. Initially three states Assam, Nagaland and Jammu & Kashmir were granted special status but since then eight more (now total 11 states) have been included (Arunachal Pradesh, Himachal Pradesh, Manipur, Meghalaya, Mizoram, Sikkim, Tripura and Uttarakhand). All other states barring these are treated as General Category States.
The rationale for special status is that these states, because of inherent features, have a low resource base and cannot mobilize resources for development.
Some of the features required for special status are:
- Hilly and difficult terrain;
- Low population density or sizeable share of tribal population;
- Strategic location along borders with neighbouring countries;
- Economic and infrastructural backwardness;
- Non-viable nature of state finances.
IMPLICATIONS OF FFC RECOMMENDATIONS FOR FISCAL FEDERALISM: A WAY AHEAD
Based on its recommendations and projections, the FFC has assessed and quantified the implications for the revenues of states.
The total increase in FFC transfers in FY 2015-16 from FY 2014-15 is estimated to be about 2 lakh crores (both from tax devolution and FFC grants).
Several points are worth noting.
1. All states stand to gain from FFC transfers in absolute terms.
However, to assess the distributional effects, the increases should be scaled by population, Net State Domestic Product (NSDP) at current market price4, or by states’ own tax revenue receipts.
- The biggest gainers in absolute terms
- GCS : Uttar Pradesh, West Bengal , Madhya Pradesh while
- SCS : Jammu & Kashmir, Himachal Pradesh , Assam.
- The major gainers in per capita terms
- GCS : Kerala, Chhattisgarh and Madhya Pradesh for and
- SCS : Arunachal Pradesh, Mizoram and Sikkim for.
2. The FFC recommendations are expected to add substantial spending capacity to states’ budgets. The additional spending capacity can better be measure by scaling the benefits either by NSDP at current market price or by states’ own tax revenue.
- In terms of the impact based on NSDP, the benefits of FFC transfers are highest for :
- GCS : Chhattisgarh, Bihar , Jharkhand
- SCS : Arunachal Pradesh, Mizoram , Jammu Kashmir
- While in terms of states’ own tax revenues, the largest gains accrue to
- GCS : Bihar, Jharkhand , Chhattisgarh
- SCS : Arunachal Pradesh, Mizoram , Nagaland.
3. The FFC transfers have more favorable impact on the states (only among the GCS) which are relatively less developed which is an indication that the FFC transfers are progressive i.e. states with lower per capita NSDP receive on average much larger transfers per capita. FFC recommendations do go in the direction of equalizing the income and fiscal disparities between the major states. However, FFC transfers are less progressive compared to the transfers of Thirteenth Finance Commission (TFC).
4. A final interesting finding relates to the decomposition of the resource transfers through tax devolution due to the increase in the divisible pool per se and due to the change in the horizontal devolution formula itself.
- Impact due to increase in the divisible pool is on states like Uttar Pradesh, Bihar, Madhya Pradesh, West Bengal and AndhraPradesh (United)
- Major gainers due to a change in the horizontal devolution formula which now gives greater weight to a state’s forest cover are Arunachal Pradesh, Chhattisgarh, Madhya Pradesh, Karnataka and Jharkhand.
BALANCING FISCAL AUTONOMY AND FISCAL SPACE
FFC recommendations provided more fiscal autonomy and this is ensured by increasing share of states from 32 to 42 per cent of divisible pool.
There is concern that fiscal consolidation path of the Centre would be adversely affected. However, to ensure that the Centre’s fiscal space is secured, the suggestion is that there will be commensurate reductions in the Central Assistance to States (CAS) known as “plan transfers.”
One immediately noteworthy fact is that CAS transfers per capita are only mildly progressive. This is a consequence of plan transfers moving away from being Gadgil formula-based to being more discretionary in the last few years. Greater central discretion evidently reduced progressivity. A corollary is that implementing the FFC recommendations would increase progressivity.
Balancing the enhanced fiscal autonomy of the states with preserving fiscal space of the Centre entails reduction in CAS transfers. But there are many ways of doing the latter from the totally discretionary to formula-based.
If net surplus to the states, i.e. the difference between increase in FFC transfers less the reduction in CAS transfers is taken into consideration, we get following results:
1. All the GCS gain from FFC transfers net of CAS reduction.
2. The top three gainers in absolute terms under
- GCS : Uttar Pradesh, West Bengal and Madhya Pradesh
- SCS : Jammu & Kashmir, Himachal Pradesh and Arunachal Pradesh.
3. The surplus/ shortfall in per capita terms. The major gainers are
- GCS : Goa, Kerala , Chhattisgarh
- SCS : Arunachal Pradesh, Mizoram , Himachal Pradesh
4. The surplus/shortfall as per cent of NSDP at current market price, the states which add up maximum fiscal resources are
- GCS : Chhattisgarh, Jharkhand , Bihar
- SCS : Arunachal Pradesh, Mizoram , Jammu & Kashmir.
5. The surplus is going to add significant amount to the states revenue.
- There are nine states among the GCS which are expected to get more than 25 per cent of their own tax revenue
This also suggests that states can maintain the same level of spending on the programs financed by the CAS especially the legally-backed schemes, and still have additional resources to finance their own new programs. If they do not want to accept Centrally Sponsored Schemes, all the increase in FFC transfers is new, unencumbered money.
CONCLUSION
FFC has made far-reaching changes in tax devolution that will move the country toward greater fiscal federalism, conferring more fiscal autonomy on the states. This will be enhanced by the FFC-induced imperative of having to reduce the scale of other central transfers to the states. In other words, states will now have greater autonomy on the revenue and expenditure fronts. The numbers also suggest that this renewed impulse toward fiscal federalism need not be to the detriment of the center’s fiscal capacity. A collateral benefit of moving from CAS to FFC transfers is that overall progressivity will improve.
There will be transitional costs entailed by the reduction in CAS transfers. But the scope for dislocation has been minimized because the extra FFC resources will flow precisely to the states that have the largest CAS- financed schemes.
In sum, the far-reaching recommendations of the FFC, along with the creation of the NITI Aayog, will further the Government’s vision of cooperative and competitive federalism.
The necessary, indeed vital, encompassing of cities and other local bodies within the embrace of cooperative and competitive federalism is the next policy challenge.
abhijeetgautam 