After Reading This Article You Can Solve This UPSC Mains Model Question:
The Finance Commission’s transfer formula has increasingly raised concerns regarding equity, efficiency, and fiscal autonomy of States. Critically examine. 15 Marks (GS-3, Economy)
Context
The recent recommendations of the 16th Finance Commission (FC) have revived debates regarding the balance between equity and efficiency in fiscal transfers between the Centre and States. Although the 16th Finance Commission (FC) has continued to prioritise equalisation, several better-performing States have raised concerns regarding declining devolution shares, fiscal stress, and reduced fiscal autonomy.
Finance Commission and Its Role in Fiscal Federalism
- Constitutional Basis: Under Article 280 of the Indian Constitution, the Finance Commission (FC) is constituted every five years to recommend the distribution of Union tax revenues between the Centre and States and among the States themselves.
- Addressing Fiscal Imbalances: The Finance Commission (FC) addresses two major imbalances: vertical fiscal imbalance, arising from the mismatch between the Centre’s revenue powers and States’ expenditure responsibilities, and horizontal fiscal imbalance, arising from unequal fiscal capacities among States.
- Instrument of Cooperative Federalism: The Finance Commission acts as the primary constitutional mechanism for operationalising cooperative federalism in India through fiscal transfers and resource-sharing arrangements.
- Recommendations of the 16th Finance Commission: The 16th Finance Commission retained the same 41% vertical devolution share recommended by the 15th FC and continued to prioritise equity in horizontal transfers.
Key Concerns Raised by States Before the 16th Finance Commission
1. Exclusion of Cesses and Surcharges from the Divisible Pool
- Cesses and surcharges have exceeded 15% of gross tax revenues yet remain excluded from the divisible pool.
- States demanded these be either included in the pool or capped at 8 to 10%, as this exclusion directly reduces actual devolution received by States.
2. Growing Fiscal Pressures on States
- COVID 19 pandemic caused an extraordinary rise in expenditure and a sharp fall in revenues.
- GST rationalisation from four rates to two principal rates introduced uncertainty in State tax buoyancy.
- Mounting public debt has constrained developmental expenditure across States.
- Centrally Sponsored Schemes have narrowed fiscal autonomy; the restructured MGNREGA now requires States to bear 40% of programme costs.
- These pressures led several States to demand a 50% vertical share instead of the existing 41%.
3. Frequent Changes in Devolution Criteria
- Successive Finance Commissions have frequently altered criteria and weights, making it difficult for States to predict their future shares.
- States called for a reduced weight for the income distance criterion and its adjustment for purchasing power differences to reflect inter State cost of living variations.
4. Steady Decline in Shares of Better Performing States
- The combined share of the four southern States (Andhra Pradesh including Telangana, Karnataka, Kerala and Tamil Nadu) declined from 24.8% (Sixth Finance Commission) to 15.8% (15th Finance Commission).
- In contrast, the share of the four major beneficiary States (Bihar including Jharkhand, Madhya Pradesh including Chhattisgarh, Uttar Pradesh including Uttarakhand and West Bengal) rose from 42.5% to 51%, widening the gap to 35.2 percentage points.
5. Fiscal Transfers Have Not Ensured Convergence in Public Services
- In 2022-23, Bihar spent only Rs. 937 per person on health against Arunachal Pradesh’s Rs. 10,148, a gap of 10.8 times.
- Bihar’s per student spending on elementary education in 2023-24 was Rs. 20,282 against Sikkim’s Rs. 1,30,498.
- These figures establish that unconditional equalisation transfers alone have failed to ensure convergence in public service delivery.
Recommendations of the 16th Finance Commission and Their Significance
- On Vertical Devolution
- The 16th Finance Commission accepted the Centre’s argument that cesses and surcharges cannot be shared because they finance welfare and infrastructure programmes that indirectly benefit States. Accordingly, the 41% vertical share was retained
- On Grants and Fiscal Discipline
- Revenue deficit grants as well as sector specific and State specific grants were abolished by the 16th Finance Commission.
- States were directed to discontinue off budget borrowings, bring all liabilities on to their budgets, and maintain fiscal deficits below 3% of Gross State Domestic Product (GSDP). While these are sound fiscal norms, their immediate implementation is likely to increase short term fiscal stress for several States.
- On Horizontal Devolution Criteria
- Income Distance: Assigned the highest weight of 42.5%, reflecting the Commission’s continued emphasis on equity.
- Population: Assigned a weight of 17.5%.
- Area: Assigned a weight of 10%.
- Forest Cover: Assigned a weight of 10%.
- Demographic Performance: Assigned a weight of 10%, with the criterion modified by replacing the inverse fertility rate with population growth.
- States’ Contribution to National GDP: A new criterion assigned a weight of 10%, replacing the earlier tax effort criterion. However, instead of using actual GSDP shares, a square root transformation was applied, which significantly diluted the advantage of economically larger States.
Impact of the New Formula on State Finances
- Gainers and Losers in Devolution: Under the new formula, 14 States saw a marginal rise in their shares, with Karnataka gaining the most (0.484 percentage points), while Uttar Pradesh and Madhya Pradesh witnessed a reduction in their relative weights.
- Marginal Gains for Southern States: The combined share of southern States rose slightly to 17%, but this remains significantly lower than the historical high of 24.8% seen during the Sixth Finance Commission period.
- Dilution of Performance Advantage: The use of square-root GSDP shares rather than actual GSDP shares has slashed the weighted contribution of States like Maharashtra from 14.23% to 8.31%, depriving them of substantial capital resources.
- Concerns Regarding Political Representation and Delimitation: As parliamentary delimitation approaches, there is a fear that fiscally efficient States with lower populations will lose both political voice and financial resources, further skewing the federal balance in favor of politically influential but economically lagging States.
Way Forward for Building a Balanced, Transparent, and Data-Driven Fiscal Transfer System
- Integrating Cesses into the Divisible Pool: To restore vertical equity, the 16th Finance Commission or future amendments should consider capping cesses and surcharges at 8%-10% of gross tax revenues or including them in the sharable pool.
- Implementing Alternative Devolution Models: Moving toward an equal-weight scheme across all six criteria would provide a more balanced outcome, ensuring that developed States like Tamil Nadu and Maharashtra receive hundreds of billions in additional annual funding.
- Utilizing Data-Driven Weighting Methods: The Commission should adopt sophisticated tools like Principal Component Analysis (PCA) to assign weights based on empirical data rather than arbitrary percentages, ensuring transparency.
- Focusing on Fiscal Outcome Indicators: Future transfers must prioritize fiscal capacity and expenditure efficiency, moving away from non-fiscal indicators that may penalize States for successful population control and economic reforms.
Conclusion
The 16th Finance Commission attempts to bridge the gap between poor and rich States, yet the marginal shift suggests that the efficiency-equity trade-off remains unresolved. For a truly resilient India, the fiscal architecture must evolve to reward economic contribution while ensuring that basic public services are converged across all geographical boundaries.
