Finance Commission dips into states’ share for Centre’s expenditure, makes system more discretionary

In the fireworks of the Union budget, little attention has been paid to the recommendation of the Fifteenth Finance Commission (XVFC). The report was laid before the Parliament and the finance minister announced the acceptance of its recommendation of retaining the share of states in central taxes at 42 per cent. She also stated that on its recommendation revenue deficit grants of Rs 1.18 lakh crore to the states have been provided for in the budget.

To its credit, by retaining the existing share of states in taxes, the XVFC has been principled and pragmatic. It has done so despite serious prodding by the Centre (through the terms of reference) to revise it downwards. Having said that, though, there is much more to a finance commission report than the vertical distribution.

Some of the recommendations, and even the obiter dicta, have far-reaching implications on government finances, both of the Centre and the states. Which is why it is strange that in an otherwise trendsetting transparent budget, the recommendations of the XVFC have been obfuscated. Sample this from the budget documents: “Keeping in view the extant strategic requirements for national defence in a global context, XVFC has, in its approach, recalibrated the relative shares of the Union and the states in gross revenues receipts.”

As it turns out, “recalibration” is actually a 1 per cent reduction in the grants to states, which enables the Union to set aside resources for special funding on defence. The states have been made to pay Rs 7,000 crore to “bridge [the] Centre’s gap between projected budgetary requirements and budget allocation for defence and internal security defence” — an expenditure that the Centre is obliged to fund.

For the first time, a finance commission has carved out resources meant for distributable statutory grants and dipped into the states’ revenue share, as against the tax share, in order to finance the Centre’s exclusive expenditure obligation. What has been done is not in line with the system envisaged in the Constitution. The Constitution is very clear on the charge of revenues collected: The first charge on taxes collected is devolution and statutory commitments, not the Centre’s expenditure.

While the amount is just about 0.5 per cent of the total transfers of Rs 14 lakh crore to the states, it is really the thin edge of the wedge that will eventually put the fiscal federal system under systemic strain.

In operational terms, too, this move is a significant departure. So far, the Centre has been used to pre-empting resources from the kitty to be distributed among the states but only to finance expenditures in areas earmarked for states. This was done through the centrally-sponsored schemes, but at least the states’ money was being used in the states, even if on a discretionary rather than a criteria basis. Now, with this move of earmarking and financing of funds for sectors, it is the states’ money that is being used to finance the Centre’s expenditure. This is certainly not cooperative federalism.

If anything, it is heading towards partisan federalism. Consider the issue of horizontal distribution. The criteria used by successive finance commissions for devolving taxes across states have always been linked to need — based on equity, tempered by efficiency. The XVFC has moved the balance sharply: From 92.5 per cent of funds to a state being devolved based on need and equity, the XVFC has reduced these two components to 75 per cent. The remaining 25 per cent are to be devolved on considerations of efficiency and performance. This is the lowest weightage for equity, making the XVFC transfers potentially the least progressive ever.

Apart from these issues arising from what the XVFC has done, there are equally severe problems arising out of what it has not done. While the report is comprehensive in diagnosing and understanding the issues, it has made no effort to prescribe solutions. Far from it, it has not even made any serious effort to review the existing scheme of transfers in light of the changed federal landscape. For instance, the existing criteria have evolved in, and for, a production-based tax system. The XVFC should have reformulated the distributional criteria for a consumption-based tax system. The structural change from production to consumption will make a significant difference to inter se distribution as well as the need, nature and distribution of equalising grants.

Instead, what does the report offer? It merely notes: “Such structural issues may be required to be identified and readjustment may be done to minimise the fiscal and economic impact of GST.” Who is to identify these structural issues? And who is to make the readjustment? The only institution that is constitutionally empowered to do it and ideally positioned to take a technically correct and operationally practical view is the Finance Commission. By rolling the can down the road, the XVFC has abdicated its responsibility.

This is the same manner in which the revenue deficit grants have been carried forward. Ideally, the “gap-filling” approach should have been redesigned in light of the compensation law providing a minimum-guaranteed revenue of 14 per cent to every state. The result of not doing so is that the total grants, statutory and non-statutory, account for almost 55 per cent of the total transfers — up from less than 50 per cent in recent years. The share of tax devolution in aggregate transfers has dropped to 45 per cent, making the system more discretionary.

To conclude, the XVFC’s substantive award is status quoist, its design is regressive even though its obiter dicta is reformist. In not being aligned with the new landscape of federalism, it is like a red herring prospectus, which contains most of the information pertaining to the operations, but does not address the key issues.

The writer is the former finance minister of Jammu and Kashmir

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