FINANCE COMMISSION

1. Context

2. Evolution of India's Fiscal Federalism: Pre-Reform vs. Post-Reform

• Finance Commission recommendations held less significance.
• Centre had alternative methods to compensate states and show favoritism.
• Plan financing and PSU investments are used as tools for compensation and favoritism.

• Fresh PSU investments were reduced significantly.
• Planning Commission was abolished in 2014, shifting greater responsibility to the Finance Commission.
• Finance Commission is now the primary architect of India's fiscal federalism.
• Increased responsibility and influence of the Finance Commission in shaping fiscal policies.

3. Challenges in Horizontal Distribution Formula in India's Fiscal Federalism

• Proportion of Tax Pool: Centre currently allocates 41% of its tax pool to the states. States may demand an increase in this proportion. Limited room for a further increase due to the Centre's expenditure needs and borrowing constraints.
• Population Figures: Contentious issue in the previous Finance Commission (2017). Terms of reference mandated the use of 2011 population figures instead of 1971 figures. Southern states, which had successfully stabilized population growth rates, protested this change as a "penalty for good performance".
• Revenue Deficit Grants: Finance Commission awards revenue deficit grants to states in deficit after tax devolution. Intended to ensure a minimum level of service provision. Concerns raised about it becoming a perverse incentive for states to rely on compensation rather than rising revenues independently.
• Balancing Fiscal Incapacity and Irresponsibility: Finance Commissions historically struggled to distinguish between fiscal incapacity and irresponsibility. Attempted to tweak the distribution formula to support deficit states without penalizing responsible states. Criticisms of every formula as inefficient or unfair due to the inherent challenge of giving more to one state without giving less to another.

4. Increasing Cesses and Surcharges

• Centre's reliance on levying cesses and surcharges instead of raising taxes has grown.
• Tamilnadu Government's white paper revealed that the proportion of cesses and surcharges in the Centre's total tax revenue nearly doubled from 10.4% in 2011-12 to 20.2% in 2019-20.
• The Centre benefits from this practice as it can retain the entire revenue raised through surcharges, unlike sharing taxes with states.
• Since the constitutional amendment in the year 2000, understanding has been breached, which intended limited use of cesses and surcharges.
• States perceive this as a denial of their rightful share of national tax revenue.

5. Addressing the Issue:

• The forthcoming Finance Commission should utilize its leverage to address this concern.
• Establish guidelines for reducing routine usage when cesses and surcharges can be levied.
• Propose a formula to cap the amount raised through cesses and surcharges.
• Ensuring a fair and equitable distribution of revenue among the Centre and states.

6. Government spending on Freebies

• Issue of Freebies: Government spending on freebies is a significant concern, with all political parties engaging in it to varying degrees. Blaming specific parties for this practice is unproductive; addressing the issue is the priority.
• Considerations for Poor Country: In a poor country like India, it may seem harsh to argue against safety nets for the poor. However, the country's economic constraints necessitate caution regarding freebies.
• Fiscal Responsibility and Budget Management (FRBM) Act: The FRBM Act was intended to limit populist spending but has been bypassed through creative debt-raising methods. Defining freebies is challenging, and any attempt to regulate them can be seen as infringing on the elected governments' sovereignty.
• Guidelines for Freebie Spending: The forthcoming Finance Commission should take decisive action for long-term fiscal sustainability. Lay down guidelines to regulate spending on freebies, considering the country's financial well-being. Such measures are necessary to ensure restraint and avoid bankruptcy risks.
• Prime Minister's Stance: After the Karnataka election, the Prime Minister expressed concerns about unsustainable guarantees offered by political parties. The Prime Minister should lead by example in state assembly elections, prioritizing good governance over the allure of freebies. This will provide confidence to the Finance Commission to establish mechanisms for restraining freebies and promote responsible governance.

7. Finance Commission

• The Finance Commission is a constitutional body in India that is appointed by the President every five years. Its primary function is to make recommendations on the distribution of financial resources between the central government and the state governments.
• The Commission assesses the needs and requirements of both levels of government and recommends the sharing of tax revenues, grants-in-aid, and other financial resources. The Finance Commission also addresses issues related to fiscal federalism, including the principles governing the distribution of resources, the allocation of grants to states, and measures to improve fiscal management.
• It takes into account various factors such as population, income disparities, tax efforts, infrastructure requirements, and socio-economic indicators while formulating its recommendations.
• The recommendations of the Finance Commission are crucial in ensuring a fair and equitable distribution of resources, promoting balanced regional development, and addressing the financial needs of the states.
• The Commission's reports and recommendations are submitted to the President, who then lays them before both houses of Parliament for consideration and implementation.

Previous year Question