Fifteenth Finance Commission has increased proportion of grants conditional on reforms by states

This year’s Union budget was accompanied by the unveiling of the Fifteenth Finance Commission’s report for the period 2021-22 to 2025-26. This report outlines some crucial recommendations for state governments, covering tax devolution, grants from the Centre, and the guidelines for the borrowings that they are permitted to incur over the medium-term.

The commission has recommended that 41 per cent of the government’s divisible pool of taxes be transferred to state governments during its award period of 2021-22 to 2025-26. This vertical tax devolution is in line with the level that the 15th FC had recommended for 2020-21. It only differs from the 14th FC’s recommendation on account of the exclusion of Jammu and Kashmir, which is no longer a state.

In the horizontal devolution formula — which specifies each state’s share in the overall pie — the criteria and weights chosen by the 15th FC differ from those taken by the previous commission. The 15th FC was required to use the states’ population as per the 2011 Census — a highly contentious change. It has also introduced a demographic performance criterion to reward those states which have performed well on demographic management over the last few decades. Additionally, it has also introduced a new criterion (tax effort) measured by the ratio of the three-year average of per-capita own tax revenues and per-capita gross state domestic product (GSDP).

The net result of the change in criteria is that the share of 10 states in the divisible pool has declined during its award period, relative to the previous commission’s period. Karnataka is the biggest loser, while Maharashtra is the biggest gainer.

In absolute terms, central tax devolution to states had peaked at Rs 7.6 trillion in 2018-19. Thereafter, it contracted by around 15 per cent each over the next two years. Mercifully, it is forecasted to expand by 21 per cent in 2021-22 to Rs 6.7 trillion, which appears to be a credible assessment. Nevertheless, this is a tad lower than the 2017-18 levels — a sobering reality that the states must contend with while planning their finances.

Another major set of the commission’s recommendations pertain to grants from the Centre. So far, the Centre has accepted the recommendations for revenue deficit grants, grants for local bodies and disaster management and mitigation, totalling Rs 8.5 trillion over the award period. This is 59 per cent higher than the Rs 5.4 trillion (including J&K) recommended by the 14th FC. However, the government is yet to accept the 15th FC’s recommendations towards state-specific and sector-specific grants (adding up to Rs 1.8 trillion). But in a major shift, the 15th FC has sharply increased the proportion of grants whose receipt is conditional on specified reforms being undertaken. As a result, 57 per cent of the 15th FC-recommended grants accepted so far by the GoI are conditional, relative to just 17 per cent for the 14th FC (including J&K).

In line with the Finance Commissions that are set up at the Union level, the Constitution requires state governments to set up State Finance Commissions (SFC). The 15th FC has asserted that the mandate of any given SFC is intended to be applicable only for five years. It revealed that only 15 states have set up their fifth or sixth SFCs, whereas several states have not moved beyond their second or third SFC. Accordingly, a staggering 84 per cent of the Rs 4.4 trillion grants for local bodies recommended by the 15th FC are conditional on the states setting up SFCs for the coming five-year period, and acting on their recommendations by March 2024.

Another entry-level condition for availing grants by rural and urban local bodies pertains to the timely availability of their accounts online from 2021-22 onwards. Additionally, for receipt of grants by the urban bodies, states are required to notify a floor rate for property tax by 2021-22, and demonstrate consistent year-wise improvement from 2022-23 onwards. We are hopeful that the conditional funds being made available will incentivise states to undertake the associated reforms, and complement the conditions set previously by SEBI for ULBs to become eligible to raise municipal bonds.

The Centre has also accepted the recommendation of providing Rs 2.9 trillion as revenue deficit grants to 17 states during 2021-26. These grants are unconditional — a positive for the recipients. Nearly 70 per cent of these grants are to be disbursed during 2021-22 and 2022-23, which should aid the recipient states in recovering from the damage caused to their tax revenue base by the pandemic.

Further, the commission has recommended that the normal limit for net borrowings of state governments be fixed at 4 per cent of GSDP in 2021-22, in line with the enhanced baseline borrowing limit for the year. This will ease to 3.5 per cent by 2022-23, thereafter reverting to the erstwhile 3 per cent limit till 2025-26. The additional borrowing space of 0.5 per cent of GSDP for states is conditional on the completion of power sector reforms. This is, however, lower than the 1 per cent limit permitted by the Centre for 2020-21 that was linked to a set of four reforms.

The states’ fiscal arithmetic will alter in 2022-23 with the GST compensation set to cease at the end of June 2022 as things stand today. The ensuing drop in grants, combined with the tapering of the front-loaded revenue deficit grants is likely to leave a big gap in some states’ revenues. The question is whether this will force the states to move on both the power sector reforms, which have proven challenging in the past, and the municipal reforms, so that their resource availability may be enhanced.

Roy is group head-corporate sector rating and Nayar is principal economist, ICRA Limited

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