15th Finance Commission Report: Challenges And Controversies

The 15th Finance Commission, which submitted its report to the President of India, has had an extended tenure full of challenges and controversies. While recommendations have not been made public yet, the Commission has tackled some tricky questions, with the Covid-19 pandemic adding to its task in the final year.

Reviewing The Higher Tax Devolution To States

The key function of a Finance Commission is to recommend the tax devolution formula or the share of central taxes that all states are entitled for.

The 14th Finance Commission had recommended a 10 percentage point increase in tax devolution to states to 42%. The terms of reference given to the 15th Finance Commission asked that it assess “the impact on the fiscal situation of the Union Government of substantially enhanced tax devolution to States following recommendations of the 14th Finance Commission”.

This led to concerns that the tax devolution to states may be altered.

In its interim report for 2020-21, the commission left the devolution formula mostly unchanged, but adjusted 1 percentage point as proceeds to Jammu & Kashmir and Ladakh after the state was split into two union territories. The remaining 41% was devolved to other states.

The share of devolution can be reduced from 41% so that the centre to increase capital expenditure to revive economic growth, said NR Bhanumurthy, vice chancellor at Bengaluru Dr. BR Ambedkar School of Economics. Emphasis should be on targeting to lower revenue deficit that will help in creating more capital assets, in turn increasing growth, he said.

The Population Question

Soon after its constitution, the commission found itself mired in controversy with southern Indian states complaining their efforts to control population would go against them. This is because the terms of reference of the 15th Finance Commission included using the 2011 census to suggest devolution of taxes to states.

To be sure, its predecessor, 14th Finance Commission had also assigned a 10% weight to the 2011 population while suggesting devolution of taxes to states. This was done to better “capture the demographic changes since 1971”.

The 15th Finance Commission, in its interim report for 2020-21, said that while it had used the 2011 census data, it tried to address concerns of southern states by recommending a new performance-based criteria termed ‘Demographic Performance', which measures the total fertility rate of all states.

Public services need to be provided to the entire population, said M Govinda Rao, a member of 14th Finance Commission, adding that latest data should be used in making such estimates.

Finance Commissions can tinker weightages for different norms to strike the right balance for ensuring better performing states do not lose out much, and at the same time poor states get necessary help, said Bhanumurthy.

New Defence Fund

The 15th Finance Commission's terms of reference were amended after they were first issued to examine if a separate mechanism for funding defence and internal security is possible. This had led to speculation that states will have to contribute to such a fund, in turn leading to a drop in their share of central government's taxes.

If states are made to contribute to such a fund, it would put pressure on transfer to states, said Bhanumurthy. However, this would be balanced through other transfers to states such as grants, he said.

The 15th Finance Commission, in its interim report had said, “There is merit in ensuring a predictable and stable flow of funds for defence and internal security and this will receive appropriate consideration in our final report.”

Rao said a non-lapsable fund can be created by monetising large land holdings and assets of Ministry of Defence, and divesting stake in defence public sector undertakings. This suggestion was also given to the 15th Finance Commission by its economic advisory council.

Focus On Health

The outbreak of Covid-19 outbreak has sharpened the focus on healthcare. Although the 14th Finance Commission had desisted from recommending sector-specific grants for health, education, drinking water and sanitation, the 15th Finance Commission, in its interim report, said India should aspire to spend 2.5% of GDP on healthcare.

The commission had suggested that the Union Health Ministry and state governments undertake preparatory work for setting up medical colleges in district hospitals with over 100 beds. It also recommended developing district hospitals as training sites for allied health professionals so that suitable state-wise grants proposed to be included in its final report final report can be optimally utilised.

With the world's deadliest virus exposing the poor state of India's healthcare system, the emphasis on improving health infrastructure could be a priority for the 15th Finance Commission.

The Broader Fiscal Question

The 14th Finance Commission had suggested lowering the central government's fiscal deficit to 3% of GDP from 2016-17. This, the commission felt, could be achieved because of the possibility of higher growth led by direct and indirect tax reforms such as GST. The commission also sought that the revenue deficit be completely eliminated by 2019-20. States fiscal deficit was targeted at 3% of GSDP.

These targets couldn't be met. The 15th Finance Commission, in its interim report, had said that its difficult to achieve the fiscal deficit target of 3.3% for 2019-20, and the central government has the option to invoke the escape clause in the amended Fiscal Responsibility and Budget Management Act to deviate from the target by 0.5%. The government had accepted this recommendation. Its fiscal deficit in 2019-20 stood at 4.6%.

For the ongoing fiscal, India's fiscal deficit is expected to spiral higher due to a sharp fall in revenues following the Covid-19 pandemic and the lockdown imposed to curb the virus' spread.

The 15th Finance Commission's fiscal deficit recommendations will come against this backdrop.

The commission could look at a target range for the fiscal deficit instead of a number, a measure seen to be in congruity with India's monetary policy, its chairman N.K. Singh had earlier said.

Bhanumurty said the unanticipated risks due to the pandemic are so high that there should be a range as the fiscal deficit target. Fiscal deficit target would then be consistent with flexible inflation targeting framework, he added.

Almost all Finance Commissions have faced difficulty while making projections due to uncertainty during their tenure, said Bhanumurthy. The uncertainty was on account of GST for 14th Finance Commission and the Pay Commission awards for the 12th Finance Commission. Finance Commissions are not immune to shocks, he said. “Had the 15th Finance Commission submitted its report on the original deadline of last year, its projections would now had become redundant,” he added.

Abhijit Sen, a member of 14th Finance Commission, said the current environment makes it difficult to accomplish the basic function of the finance commission which is to make revenue and expenditure calculations for next five years. One year from now, nobody knows where the economy ends up because of the uncertainty due to Covid-19, Sen told BloombergQuint.

“It never happened that a Finance Commissions estimates has hit bull's eye,” said Rao. One way to approach the current situation would be to consider the pre-pandemic situation and make estimates using the nominal growth by negating the disruption caused by Covid-19. This would help in creating a base, he said, adding the recovery process next year onwards will have to be factored in, too.

Another approach, according to Lekha Chakraborty, a professor at National Institute of Public Finance and Policy, would be to assume differential nominal GDP growth for the award period, on year on year basis. Different growth rates would take care of Covid-19 induced uncertainties, she said.