Shaping the Sixteenth Finance Commission's Path: Crucial Factors for India's Fiscal Federalism

Shaping the Sixteenth Finance Commission's Path: Crucial Factors for India's Fiscal Federalism

The upcoming Sixteenth Finance Commission (16th FC) holds significant importance as it will determine the distribution of tax revenue between the central government and states and the allocation among states. This comes in the backdrop of critical changes since the constitution of the Fifteenth Finance Commission (15th FC) in 2017, including the impact of GST, the COVID-19 pandemic, and rising geopolitical challenges. The 16th FC's recommendations will play a crucial role as India moves towards becoming the world's third-largest economy.

Distribution of Tax Proceeds and Performance-based Incentives:

The 15th FC focused on a fair distribution of tax proceeds between the center and states, ensuring a balanced fiscal sharing mechanism. Additionally, it emphasized assessing the impact of GST on the economy. Going forward, the 16th FC is expected to continue examining the implications of GST implementation and introduce performance-based incentives for states based on factors such as population control and ease of doing business.

Grants to States and Fiscal Imbalances:

To support the financial needs of states and ensure effective governance, the 15th FC proposed revenue deficit grants, grants to local bodies, and disaster management grants. However, many states currently face significant fiscal imbalances, which the 16th FC will likely address while formulating its recommendations.

Expected Deliberations of the 16th FC:

During the deliberations, states may demand an increase in their share of the divisible pool of central taxes (vertical distribution). However, constraints on the center's borrowing limit and expenditure needs may limit the scope for further increases. Thus, the debate will largely revolve around the horizontal distribution formula (distribution among states).

Cesses and Surcharges:

The 16th FC will scrutinize the heavy reliance on cesses and surcharges, which has led to a decline in the effective share of states in the center's gross tax revenues. One option could be capping the share of cesses and surcharges to prevent their disproportionate growth. The commission may refine the formula based on the latest data.

Divisible Pool and Income Criterion:

The 16th FC is likely to reevaluate the weight given to the per capita income criterion for distributing the divisible pool among states. Richer states have called for a lower weightage, but attention must be paid to the needs of lower-income states, which can contribute significantly to India's demographic dividend if supported in education and healthcare.

Re-examination of the 2018 Amendment to the Centre's FRBM:

The 15th FC recommended reexamining the 2018 amendment to the Fiscal Responsibility and Budget Management (FRBM) norms. The debt-GDP ratios of both the center and states are still considerably above the prescribed norms, necessitating a reassessment by the 16th FC.

Restraint on Freebies and Fiscal Sustainability:

The 16th FC is expected to issue clear guidelines to restrain the proliferation of non-merit subsidies and freebies, as these can strain fiscal sustainability. It may consider setting up an independent loan council to oversee government borrowing, incentivizing states to maintain fiscal discipline while addressing the needs of the poor responsibly.

In recent years, the Finance Commission's role has become paramount in India's fiscal federalism following the abolition of the Planning Commission. With India's ascent towards becoming the world's third-largest economy, the 16th Finance Commission's recommendations carry significant weight. Addressing the challenges of fiscal imbalances, tax distribution, and fiscal sustainability will be critical for ensuring a robust and balanced economic future for the nation.

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