Center – State Financial Relations and Finance Commission towards Co – Operative federalism

07 Feb 2024 Center – State Financial Relations and Finance Commission towards Co – Operative federalism

Source – The Hindu and PIB.

General Studies – Development of Indian Economy, Indian Constitution and Polity, Government Policies and Central Intervention, Co-operative-Federalism, Financial Transfers, Centre-State Financial Relations, Finance Commission, Populism.

Why in the News ?

• Recently the Central Government has appointed renowned economist and former Vice Chairman of NITI Aayog Arvind Panagariya as the Chairman of the Sixteenth Finance Commission to recommend the method of revenue sharing between the Center and the States for a period of five years. Which is a constitutional body appointed by the President of India to give suggestions on Centre-State financial relations.
• Arvind Panagariya is a professor and renowned economist at Columbia University and served as the first vice-chairman of the NITI Aayog, which replaced the Planning Commission of India, from 2015 to 2017.
• While presenting the Interim Budget 2024-25 in February 2024, India’s Union Finance Minister Nirmala Sitharaman said that – “The central government cannot do anything in the matter of tax devolution to the states, it is completely based on the recommendations of the Finance Commission. Because in India the transfer of direct taxes to the states takes place on the recommendation of the Finance Commission.”
• The Finance Minister said this in response to a supplementary question by Congress leader Adhir Ranjan Choudhary during the Question Hour in the Lok Sabha.
• India’s Union Finance Minister Nirmala Sitharaman told the House that – “100 percent of the State Goods and Services Tax (SGST) goes to the states. The Central Government cannot do anything in the matter of tax transfer to some states, as it is entirely based on the recommendations of the Finance Commission. The Center has neither any authority nor any role in this matter.”
• India’s Union Finance Minister Nirmala Sitharaman said that – “I do not have the right to change whether I like a state or not as per my wish and choice. The recommendations of the Finance Commission are implemented without any fear or favour. The tax devolution system in India is working well.”
• Answering the question of Adhir Ranjan Chaudhary, the Finance Minister said that the Commission makes its recommendations after consulting various stakeholders.
• India’s Union Finance Minister Nirmala Sitharaman told the House that – “Goods and Services Tax (GST), especially State Goods and Services Tax (SGST), is also transferred 100 percent to the states. “Integrated Goods and Services Tax (IGST) is collected because it involves huge inter-state payments.”
• Adhir Ranjan Choudhary had alleged that the central government has done injustice in cutting tax transfers to Karnataka, Kerala, Tamil Nadu, Bihar, West Bengal and other non-BJP ruled states. The central government’s moves towards total financial transfer to the states are weakening cooperative federalism.
• The share of states in central taxes was recommended to be 41% for the period 2021-26, which was the same as for 2020-21. This is lower than the 42% share recommended by the 14th Finance Commission for 2015-20.
• Even after the recommendations of the Fourteenth Finance Commission, since the beginning of 2015-16, the Central Government has been reducing financial transfers to the states. It is noteworthy that the Fourteenth Finance Commission has recommended devolution of 42% of the central tax revenue to the states, which is an increase of 10 percentage points from the recommendation of the 13th Finance Commission. The Fifteenth Finance Commission retained this recommendation of 41%, except for the transfer to Jammu and Kashmir (J&K) and Ladakh, which were reclassified as Union Territories. If we include the shares of Jammu and Kashmir and Ladakh then it should be 42%. The central government not only reduced financial transfers to the states but also increased its total revenue to increase its discretionary expenditure. Discretionary expenditure of the central government is not being carried through the budgets of the states, and hence, it affects different states in different ways.

Provision for recommending tax revenue under Centre – State relations in India :

• The Finance Commission of India recommends the states’ share in the net tax revenue of the central government. The difference between gross and net tax revenue includes collection costs, tax revenue assigned to Union Territories, and cesses and surcharges. Although the Fourteenth and Fifteenth Finance Commissions had recommended states’ share of 42% and 41% respectively in net tax revenue, the share of gross tax revenue was only 35% in 2015–16 and 30% in 2023–24. While the gross tax revenue of the central government increased from ₹14.6 lakh crore in 2015-16 to ₹33.6 lakh crore in 2023-24. States’ share in central tax revenue increased from ₹5.1 lakh crore to ₹10.2 lakh crore.

Structure of Finance Commission :

• The Finance Commission in India is a constitutional body constituted by the President of India under Article 280 of the Indian Constitution.
• The Finance Commission consists of a Chairman and four other members who are appointed by the President.
• The Finance Commission of India is the constitutional body responsible for making recommendations to the President on various matters relating to the distribution of tax revenue between the Center and the States as well as grants-in-aid to the States.
• In India, the Finance Commission is constituted by the President of India every five years or even earlier as he deems necessary.

Qualifications required for selection of Chairman and Members of the Finance Commission of India :

The Chairman of the Finance Commission is selected from among persons having experience in public affairs. Four other members are selected from among them. Who have the following qualifications –

1. He must be, or is serving, or is qualified to be selected as a judge of a High Court.
2. He should have knowledge of government finance or accounts. Or
3. He has experience in administration and financial expertise; Or
4. He has special knowledge of economics and all its approaches.

Importance of fiscal federalism :

• The 122nd constitutional amendment to the Constitution of India in 2016 and the subsequent introduction of the GST regime in 2017 have reshaped India’s fiscal landscape. This shift has replaced production-based taxation with a consumption-oriented approach. This shift highlights the importance of reevaluating fiscal federalism by addressing the formation of the 16th Finance Commission, tax-sharing principles and regional balance in taxation.
• Fiscal federalism refers to the division of financial responsibilities and available resources among different levels of government within a federal or decentralized system.
• Fiscal federalism involves the principles and mechanisms by which different levels of government generate, collect, share and spend revenues, particularly at the national (central) and subnational (state or regional) levels.
• As a federal republic, India operates with a multi-tier system of governance, and fiscal federalism is an essential aspect of this system.

Potential challenges for the 16th Finance Commission :

• Efficient tax collection: Given the joint collection of taxes by the Union and the States under GST, variation in the cost of tax collection (ranging from 7 to 10 per cent) has emerged as a challenge. There is an urgent need to solve this.
• Revisiting tax-sharing principles: The 16th Finance Commission faces the challenge of re-examining and redesigning tax-sharing principles due to the shift from production-based to consumption-based taxation under the GST regime .
• Redesigning the criteria for apportioning and distributing taxes: The Finance Commission of India should address the challenge of redesigning the criteria for distributing the divisible pool among the states to ensure equitable distribution of tax revenues and grants. .
• Necessity to review the compensation scheme: The need, feasibility and desirability of the GST compensation scheme should be reviewed by the Commission in view of the performance of GST revenue in the last six years.
• Institutional relationship between the GST Council and the Finance Commission: Establishing a formal institutional relationship between the GST Council and the Finance Commission presents a challenge in the emerging federal financial structure. Which needs an institutional solution.
• Changes in the GST regime: The introduction of the Goods and Services Tax (GST) regime represents a significant change in India’s taxation system. The transition from a production-based tax system to a consumption-based tax system requires a reassessment of fiscal federalism to align with this new tax paradigm.
• Equitable Resource Allocation: To ensure fair distribution of resources among the states, it is imperative to re-think the norms of resource allocation. The revaluation should consider the principles of fiscal federalism and the specific needs of each state within the GST framework.
• Need for efficiency and transparency in revenue collection: An updated fiscal federalism framework can increase efficiency and transparency in revenue collection, sharing and utilization. This can help streamline fiscal processes and reduce inefficiencies.
• Adapting to realities: India’s economic landscape is dynamic with emerging challenges and opportunities. A comprehensive reassessment allows fiscal policies to adapt to these changes, ensuring that they remain relevant and effective.
• Ensuring fiscal sustainability: To ensure fiscal sustainability, a reassessment should assess the long-term fiscal health of both the central government and state governments. It can recommend measures to manage fiscal deficit and public debt responsibly.
• Conflict of interest of stakeholders: The GST Council’s decisions on tax rates may impact the Finance Commission’s revenue-sharing calculations.
• Viability of Finance Commission recommendations: The central government in India often adopts the Finance Commission’s suggestions on tax devolution and fiscal targets, while sometimes other inappropriate recommendations may be ignored.

Result of Populism in India :

• Increasing debt on states Fiscal imbalance: The average debt-to-GDP ratio of Indian states has increased from 22.2% to 34.5% between 2014 and 2022. In which a sharp increase in its levels has been seen in populist states like Andhra Pradesh and Tamil Nadu.
• Revenue shortfall: And higher deficit: The combined fiscal deficit of Indian states reached 4.1% of GDP in 2021-22, led by populist spending on free electricity, loan waivers and social welfare schemes. Due to which the tax revenue in India could not keep pace with the expenses included in the populist schemes. As a result, many states became dependent on the central government’s ‘bailout’ to fill this gap or became overly dependent on borrowing from it, which led to worrying consequences.
• Investment decline due to price controls and protectionist measures : Foreign direct investment (FDI) inflows into India declined by 10% in 2022, which some analysts said was a result of uncertainty created by populist policies like price controls and protectionist measures.
• Lack of employment generation : India’s unemployment rate remained above 7% despite increased government expenditure in 2023, indicating that populist policies did not lead to significant employment creation.
• Affecting supply chains and consumer welfare : Price controls in sectors like agriculture discourage production and create shortages, which disrupts supply chains and affects consumer welfare.
• Increase in Corruption: and Erosion of Governance : India’s ranking in Transparency International’s Corruption Perception Index has fallen from 80 in 2014 to 85 in 2022, indicating populist rhetoric that weakens institutional checks and balances. This is consistent with the increase.
• Lack of transparency in governance : The Public Affairs Index, which measures transparency in government decision-making, shows a decline in transparency in governance in many states of India with strong populist leaders.

Some major populist policies adopted by the states :

Reversion to Old Pension Scheme (OPS) :

• The decision of some states of India to leave the New Pension Scheme (NPS) launched by the Government of India in 2004 and return to the Old Pension Scheme (OPS) is worrying from the fiscal deficit point of view.
• In the old pension scheme, the government’s liabilities towards employees’ pension are for an indefinite period, which is in sharp contrast to the new pension scheme where the liability is limited to the length of service of the employees.
• An internal study conducted by the Reserve Bank of India shows that OPS will result in 4.5 times more liability than NPS, leading to an additional burden of 0.9% on GDP by 2060.
• This step of Indian states is being considered as an obstacle to development, compromising the interests of future generations and regressive for the development of the country.

Increasing fiscal deficit of states due to subsidies :

• In many states of India, there is a deficit situation in the state due to subsidies given under populist schemes like free electricity. Which is worrying from the fiscal deficit point of view.
• The average expenditure of states on subsidies provided by states is 0.87% of their Gross State Domestic Product (GSDP), while some states are spending much higher amounts on subsidies. Due to which the situation of fiscal deficit persists in those states. Like in Punjab it is 2.35% while in Rajasthan it is 1.92%.

Conclusion / Solution :

• Finance commissions in India play an important role in determining financial transfers between the central and state governments. However, implementation of their recommendations often falls short of expectations due to various challenges and limitations. Critically analyzing the past experiences of Finance Commissions, it becomes clear that a more pragmatic approach is required to align expectations with actual outcomes.
• At a time when federal trust in Centre-state relations is at its weakest and has become deeply politicized, it will be interesting to see how Arvind Panagariya and his team proceed with the difficult task ahead of them.
• Amidst India’s latent fiscal crisis and weak federalism, the 16th Finance Commission faces a difficult task.
• If a state chooses the path of populism and borrows without financing, it must suffer the consequences. A state’s populism should be financed by its own taxpayers, not by others. RBI suggests that fiscal transfers should be linked to reforms and fiscal accountability.
• There is an urgent need to identify and find solutions to the existing tax devolution anomalies by engaging in broad consultation with relevant stakeholders, including state governments, economists and experts, to gather diverse perspectives and insights so that the interest of any state or other stakeholders is not affected. Don’t be.
• The Finance Commission can play a role in creating public awareness about the consequences of populist measures. The Finance Commission can contribute to an informed public discussion by highlighting the strain that freebies have on finances and the long-term impact on economic growth where there will be pressure on political parties to adopt responsible fiscal policies.
• The Finance Commission can contribute to a more cooperative approach to financial administration by promoting cooperative federalism and encouraging open discussion on fiscal matters.
• The Finance Commission may regularly review the financial health of the states and also make periodic recommendations based on the emerging economic scenario. This will allow flexibility to respond to challenges posed to India’s growing economy (such as the impact of external factors such as the COVID-19 pandemic).
• The Finance Commission of India can act as a mediator and facilitator in promoting mutual dialogue between the Center and the States to build consensus.
• The Finance Commission can encourage responsible fiscal management by emphasizing fiscal consolidation and measuring the tax effort of states. This could act as a preventive measure for states resorting to populism without considering their fiscal capacity.
• In India, the 15th Finance Commission had given only 2.5% weightage to fiscal efficiency measured by tax effort (Own Tax to GSDP ratio). This can be reviewed by the 16th Finance Commission.

Practice Questions for Preliminary Exam :

Q.1. Consider the following statements regarding the Finance Commission of India.

1. The Finance Commission in India is a constitutional body constituted by the President of India under Article 280 of the Indian Constitution.
2. The Finance Commission consists of a Chairman and six other members who are appointed by the Prime Minister of India.
3. The Finance Commission of India recommends the states’ share in the net tax revenue of the central government.
4. Former Chairman of NITI Aayog Arvind Panagariya has been appointed Chairman of the Sixteenth Finance Commission.

Which of the above statement / statements is / are correct?

(A). Only 1, 2 and 3

(B). Only 1 and 3.

(C). Only 2 and 4

(D). Only 2, 3 and 4.

Answer – (B)

Practice Questions for Main Exam:

Q.1. Outline the structure and functions of the Finance Commission of India and discuss how the policies of populism in India affect India’s fiscal deficit, cooperative federalism and Center – State relations ?

Akhilesh Kumar Shrivastava

Qualified Preliminary and Main Examination ( Written ) and Shortlisted for Personality Test (INTERVIEW)  three times Of UPSC CIVIL SERVICES EXAMINATION in the year of 2017, 2018 and 2020. Shortlisted for Personality Test (INTERVIEW) of 64th and 67th BPSC CIVIL SERVICES EXAMINATION.

M. A  M. Phil and Ph. D From (SLL & CS) JAWAHARLAL NEHRU UNIVERSITY, NEW DELHI.