16th Finance Commission- A few reflections

[Views are personal.]

1. Terms of reference

Hon`ble President of India, on 31st December 2023, constituted 16th Central Finance Commission (XVI-FC). Contrary to previous central finance commissions, XVI-FC's terms of reference is crisp and sticks to Constitutional provisions. As per the Gazette notification dated 31st December 2023, the XVI-FC is required to provide recommendations to the following matters, namely:

? i.???? The Commission shall make recommendations as to the following matters, namely: — (i) The distribution between the Union and the States of the net proceeds of taxes which are to be, or may be, divided between them under Chapter I, Part XII of the Constitution and the allocation between the States of the respective shares of such proceeds;

?ii.???? The principles which should govern the grants-in-aid of the revenues of the States out of the Consolidated Fund of India and the sums to be paid to the States by way of grants-in-aid of their revenues under article 275 of the Constitution for the purposes other than those specified in the provisos to clause (1) of that article; and

iii.???? The measures needed to augment the Consolidated Fund of a State to supplement the resources of the Panchayats and Municipalities in the State on the basis of the recommendations made by the Finance Commission of the State.

Further, the Commission may review the present arrangements on financing Disaster Management initiatives, with reference to the funds constituted under the Disaster Management Act, 2005 (53 of 2005), and make appropriate recommendations thereon.

In every Central Finance Commission, some of the critical aspects examined are (i) vertical devolution, (ii) horizontal devolution. Former involves determining appropriate distribution of fiscal resources between Government of India and States and UTs and later entails determining criteria for distributing across states.

2. Vertical Devolution:

How much of financial resources should be shared between Government of India, and States and UTs?

Over the successive central finance commissions, transferrable resources to states have expanded. As shown in exhibit below, overtime, State’s share in net proceeds of income tax increased from 55 per cent in first finance commission to 85 per cent in nineth finance commission. Similarly, in case of Union Excise duties, the number of commodities and portion of ‘total collections’ to be shared with states expanded overtime. Further, 11th Finance Commission onwards, divisible pool expanded from only income tax and union excise duties to all shareable union taxes of which key were addition of ‘Service tax’ and ‘Custom duties’.

As per the last Central Finance Commission (i.e. 15th ), 41 per cent of divisible pool or the shareable union taxes/duties need to be parted with States.

However, there are apprehensions that divisible pool itself has not grown as much as it would have, given the presence of cesses and surcharges which are outside of shareable pool of resources.         

Constitutional provisions only require ‘net proceeds of taxes’ to be shared with States. Cesses and surcharges are levied for specific purpose. For example, in 2024-25 interim budget, Government of India has budgeted for nearly INR 83,000 crore of ‘Health and Education Cess’ levied on corporate tax and personal income tax. Overtime, the share of cesses and surcharges has grown considerably (Figure 1). In 2014-15, Cesses and Surcharges was 7.2 per cent of gross tax revenues of Government of India which increased to 8.9 per cent in 2019-20 and 12 per cent in 2024-25 BE[1]. This has limited the shareable pool of resources to States. Many of the purposes for which cesses are levied comes under either in the state list or concurrent list and hence make states important stakeholder in concerned financial resources.

Figure 1: Cesses and Surcharges (excluding GST compensation cess)? as per cent of Total tax Revenue, INR Crores

[1] This excludes GST compensation cess. Since it is designed to finance transfers to states and fiscal support provided by Government of India for GST transition, it does not reduce resource transfers to that extent.

Successive recommendations of Central Finance Commissions to move up shareable resources to States has been partially offset by cesses and surcharges growth. Therefore, on an overall basis, the percentage of tax transfers to gross tax revenues has not improved much. In 2005-06, devolution of taxes to states was 25.4 per cent of gross tax revenues of Government of India which increased to only 30.5 per cent in 2023-24 BE. On the other hand, total transfers to states (both tax and grants but excluding loans) as per cent of gross revenues of Government of India has moved substantially reflecting preference towards grants as route of fiscal transfers. Gross Transfers excluding loans was 38.5 per cent in 2006-07 and went up to nearly 50 per cent in 2023-24 BE.

Figure 2: Gross Transfers as per cent of Gross Revenues of GOI

Since cesses and surcharges have eroded divisible pool, compensating states would require enhancement of share of states in divisible pool. A scenario is created in Table 1 assuming cesses and surcharges as per cent of gross tax revenues remain constant at 2014-15 levels (pre-15th FC levels) at 7.21 per cent of gross tax revenues. Under this scenario, adjusted cess and surcharges would be INR 2.76 lakh crore in 2024-25 BE than INR 4.56 lakh crore (excluding GST compensation cess), i.e. nearly INR 1.8 lakh crore difference. This increases the imputed divisible pool to INR 35.4 lakh crore and state’s share in central taxes to INR 14.5 lakh crore. In order to ensure tax devolution of INR 14.5 lakh crore with existing divisible pool, state’s share in divisible pool would need to go upto 43.2 per cent from 41 per cent at present.

Table 1: Vertical devolution-Compensating for erosion of divisible pool

3. Horizontal Devolution:

Next pertinent question is how should shareable resources be distributed among states.

In the past, central finance commissions have balanced equity, efficiency, cost of delivery considerations, need and fiscal disability. Population, area, forest area, share of SC/ST in total population, fiscal capacity distance, tax effort, fiscal discipline are some of the criteria used to determine which states gets how much share in total shareable tax pool.        

In 15th FC, population, demographic change, area, forest cover, income distance, and tax effort was considered as criteria for horizontal allocation.

It is expected that population, income distance, area would remain key, balancing equity and efficiency. Given the changing socio-economic landscape and expected challenges in the future following aspects could be worth looking at:        

1.????? In light of India’s NDC commitments and transition towards clean energy, different states may be impacted differently both fiscally, socially and economically. For example, (i) mineral dependent states such as Odisha, Jharkhand have high dependency on minerals for respective economies’ growth, (ii) Mineral revenues possess significant share in state’s non-tax revenues and also important driver for manufacturing sector growth, (iii) Climate transition would also lead to a majority of assets be stranded and could cause fiscal risk in the future, and last (iv) these economies have grown centered around key natural assets (minerals) which has benefited all other states too and there would be a need to provide appropriate fiscal support for ‘Just Transition’.

2.????? There should be due recognition of structural disadvantages that difference states face relative to other states, hence need to be supported to build requisite capability.

A structural constraints index could be created which appropriately account for factors such as geography (size of coastline which gives few advantages to be better connected with Rest of the World or natural attractions which are important drivers for growth in upcoming sectors such as Tourism), forest cover (captured previously), share of SC/ST population, climate vulnerability etc.        

4. Past performance

It is also important to also understand how states have fared based on transfers in the past so as to determine what further needs to be improved in inter-governmental fiscal transfers landscape.

A potential question could be "Is there a relationship between gross transfers from the centre and economic performance of states?" It could be expected that state with recourse to more central transfers should have made productive investments and hence improved growth potential.        

Figure 3 shows the relationship between per-capita cumulative gross transfers (taxes and grants) and improvement in per-capita GSDP between the period 2001-02 to 2021-22. First, high-income states, expectedly, have received lower gross transfers on per-capita basis than low-income states.

The relationship between size of central transfers on per-capita basis and growth (proxied by increase in per-capita GSDP) is not strong enough.         

High-income states have managed to improve per-capita GSDP even with lesser transfer of resources from the centre on per-capita basis. There could be multiple interpretations:

1.????? High-income states may have relative inherent advantages which attract high-value economic activity, and private investment etc. For example, higher income implies presence of higher spending consumer segment thus allows companies to produce and sell premium products/services which attracts investment.

2.????? High-income states may have better fiscal space to invest in creation of productive assets (like infrastructure which is key attraction for private investors) both in terms of recourse to higher revenue base and also relatively lower welfare spending requirements. Greater fiscal space also allows states to be able to offer lucrative incentives to private investors without jeopardizing other spending needs.

3.????? High-income states relative to low-incomes states has better infrastructure built due to investments in the preceding decades, thus remain more preferred destination for investment or high-incomes states posses other structural advantages such as access to foreign markets (long coastline) or access to growth centres (like Haryana bordering Delhi from three sides).

This, however, also indicate that low-income states given the stage of development may require more fiscal support from the centre on per-capita basis to compensate for various structural or non-structural advantages that high-income states posses like geography, infrastructure built based on historical investments.        

Figure 3: Relationship between per-capita cumulative gross transfers and no. of times increase in per capita GSDP at current prices between 2001-02 to 2021-22

But does transfer of more resources to low-income states completes the story? In Figure 4, state’s spending on capital outlay over the period 2001-02 to 2021-22 per INR 100 of gross transfers from centre is depicted.

High-income states such as Gujarat, Haryana, Karnataka, Maharashtra, Tamil Nadu have also managed to spend more on creation of productive assets for every INR 100 shared by Government of India (grants and share in central taxes).         

This is intensifying the per-capita GSDP gap among high-income states and low-income states on a sustained basis which Central Finance Commission are striving to address through its limited reach.

Figure 4: State's spending on capital outlay in relation to transfers from the centre

This could mean institutional capability improvement needs in low-income states which might entail (i) ability to effectively prioritize resource allocation, (ii) enhancement of fiscal space through curtailment of committed expenditure, rationalizing debt servicing cost, bringing efficiencies in procurement, own revenue mobilization, (iii) building further capability in low-income states in terms of ability to design, cost, execute, monitor and evaluate infrastructure projects.

Enhancement of resource envelope among low-income states would need to be supported by institutional capacity development, mainstreaming data driven policy making and fostering relevant private sector partnerships to let stakeholders do what they are best at.