Transfer design and emerging outcomes of the 16th Finance Commission

The Sixteenth Finance Commission's transfer framework raises questions on equity and fiscal equalisation as rigid tax devolution and limited grants reshape Centre-state finances

Two core aspects for any scheme of fiscal transfers relate to their vertical and horizontal dimensions. The core vertical determinant of transfers — the share of states in the sharable pool of central taxes — has remained largely unchanged over time. It was, in fact, the Fourteenth Finance Commission (FC14) that sharply raised this share from 32 per cent, as recommended by FC13, to 42 per cent. This increase of 10 percentage points came as a surprise to the central government.

 

This revised share became a rigid number for subsequent Commissions, except for a 1 per cent reduction by FC15 when Jammu & Kashmir was converted into a Union Territory. Thus, the 42 per cent, later 41 per cent, share of states in the sharable pool of central taxes has continued to operate from 2015-16 onwards and this would continue at least up to 2030-31. With devolution continuing as the primary transfer mechanism, and limited assessment of this ratio by subsequent FCs, the share has largely remained unchanged.

 

The Centre’s response has been to discontinue transfers through grants that are to be given to the states under Article 275. With the recommendations of FC16, three channels of grant-based transfers have now been eliminated — namely, revenue-need grants arising out of the provision of Article 275, sector-specific grants, and state-specific ones.

 

Narrow information base for criteria-based devolution: The information base used for the inter-se distribution of transfers to states is now dependent only on the information incorporated in the tax devolution formulae and has become narrow in this sense. The tax devolution formulae by nature tend to be broad-based but cannot capture the informational details that affect the fiscal parameters of states. India’s states are highly differentiated in terms of their size, needs and cost conditions.

 

The information base of tax devolution formulae has certain limitations. In particular, this information is highly dated since there is a requirement of using the available Census population data, which in the present instance is available only for 2011. Since population is a core factor used by FC, the 2011 population data will be nearly 21 years out of date by the final year of the recommendation period of FC16, which is 2030-31. The fiscal capacity of states is captured by data on nominal per capita gross state domestic product (GSDP). For this purpose, the years used by FC16 pertain to 2018-19 to 2023-24, excluding the Covid year of 2020-21. This is centred in 2021-22. This also, therefore, will be dated by nine years by the final year of the FC16 recommendation period.

 

Revenue deficit is a function of tax devolution: The Commission has decided not to undertake any assessment of post-devolution revenue needs of individual states or to give any grant on this basis. These grants have come to be known as revenue-deficit grants. The argument for not undertaking such an assessment exercise or to give any revenue deficit grants as stated by FC16 is that the aggregate revenue deficit of states is only 0.3 per cent of GDP (Para 9.48 of FC16 report.

 

However, this reasoning may be open to debate, as aggregating revenue deficits across states does not reflect the fiscal position of individual states. The Commission’s mandate includes examining the revenue balance position of individual states. A revenue surplus in one state does not directly offset a revenue deficit in another. It is more appropriate to consider the sum of the revenue deficits of the deficit states, which amounted to 0.8 per cent of GDP in 2023-24 — quite a large sum considering the two other grants recommended by the Commission, namely local body and natural calamity grants, together amount to only 0.4 per cent of GDP.

 

However, there is another important consideration. For determining revenue-deficit grants under Article 275, the exercise involves estimating post-devolution revenue deficits and revenue surpluses. If the devolution scheme changes, then the past profile of revenue deficits does not matter. The profile of revenue balance would depend on the devolution scheme that the Commission recommends. In this scheme, the Commission has added an additional criterion based on the share of GSDP of a state in all-state GSDP. This factor may lead to higher surpluses for states that already have revenue surpluses and higher revenue deficits for states that already have revenue deficits, since higher-GSDP states are designed to get higher devolution. This impact needs to be examined. A state-wise examination of the fiscal impact of the FC16 devolution framework could have provided a clearer assessment of the impact of its overall transfer scheme on fiscal equalisation. This change represents a notable departure from earlier frameworks and highlights an area that requires further review to ensure that it does not become a precedent for future FCs. 

 

Tax devolution— losing and gaining states: In the FC16 design of tax devolution, the new criterion of GSDP contribution was given a weighting of 10 per cent, which was accommodated by reducing the weighting of the income distance criterion by 2.5 per cent (reduction in the equalising criterion) and the weighting of area criterion by 5 per cent (a reduction in the criterion reflecting cost disabilities). Further, the tax effort criterion, having a weighting of 2.5 per cent, was dropped. The list of major states that have lost in the FC16 tax devolution scheme compared to that of FC15 are Madhya Pradesh, Arunachal Pradesh, Uttar Pradesh, West Bengal, Meghalaya, Bihar, Odisha, Chhattisgarh, Rajasthan, Manipur, Nagaland, Tripura, Sikkim, and Goa. These are generally either low fiscal capacity states or relatively small states. Undertaking a post-devolution needs assessment may have allowed some states’ losses to be partly addressed, while keeping the gains of other states intact.

The author is chief policy advisor, EY India. Ragini Trehan, senior manager, tax and economic policy group, EY India, also contributed to the article.

The views are personal