The Finance Commission, appointed every five years, performs a constitutional function of recommending the distribution of the “divisible pool” of Union taxes between the Central and state governments. The challenge is to divide fairly and efficiently. The former requires an impartial assessment of the needs of a state, while the latter ensures that the commission does not end up perversely rewarding backwardness. Efficiency also requires rewarding fiscal prudence. Thus the share is not purely on the basis of tax collection, nor on state GDP, nor on population. It is a judicious mix of all these factors and more. But, as the report of the Thirteenth Finance Commission (TFC) observes, there are three additional challenges: Central revenue now increasingly includes a non-shareable portion (e.g. sale of 3G spectrum, various cesses and surcharges), putting states at a disadvantage; secondly, there is increasing mismatch between fiscal capacity and fiscal needs of various states; and thirdly, with increased urbanisation, the obligations of the third tier of government has been rapidly increasing without any meaningful or automatic devolution to the third tier. Thus, urban and rural local bodies routinely lament the lack of funds, or non-transfers by their respective state finance commissions. One mechanism in past commissions has been to include explicit grants meant for local bodies. A forthright devolution to the third tier is not possible without a Constitutional amendment. But the TFC has, for the first time, augmented grants with an incentive-based devolution that rewards intra-state decentralisation. Thus, those states with an effective devolution to their local bodies will get some extra support. The increased salience of the state of local governments in the life of a citizen is obvious, given that the states’ share constitutes 60 per cent of the combined expenditure of states and the Centre. As such, there are already multiple and sometimes ad hoc avenues for fund flow from the Centre to the states, such as Centrally-sponsored schemes, and even the Pay Commission! The rationality and fairness of the Finance Commission framework is greatly distorted by such other flows.
The report of the TFC provides a clear articulation of the issues and approach followed, and the consideration that it has used in recommending the fiscal transfers. For example, in determining vertical devolution, it explicitly recognises greater fiscal needs of the states and the need to insure them against regional shocks. So, the TFC has increased the states’ share from 30.5 per cent previously to 32 per cent now. Similarly, in determining horizontal devolution, states have been rewarded for efficiency in public management and fiscal discipline. The current shares of most states are within 1 per cent of their means. But there are notable exceptions, wherein the deviation from the mean is more than 3 per cent, which will partly be mitigated by GST. This report will be implemented in the context of a GST rollout, which will contribute significantly to both buoyancy of tax revenues as well as consolidation of a common economic market. In fact, the chairman of the TFC has said elsewhere that he expects GST to add 50 per cent to GDP in present value terms. The task of future commissions will then be much less contentious. Finally, the TFC’s recommendation to impose a ceiling on total government debt is timely.