Key recommendations in the first report (2020-21 period) include:
Devolution of taxes to states
- The share of states in the centre’s taxes is recommended to be decreased from 42% during the 2015-20 period to 41% for 2020-21.
- The 1% decrease is to provide for the newly formed union territories of Jammu and Kashmir, and Ladakh from the resources of the central government.
- The individual shares of states from the divisible pool of central taxes are provided in table in the annexure.
Why need devolution formula?
- The Finance Commission is required to recommend the distribution of the net proceeds of taxes of the Union between the Union and the States (commonly referred to as vertical devolution), and the allocation between the States of the respective shares of such proceeds (commonly known as horizontal devolution).
- The FC determines the States’ aggregate share in the divisible pool and its horizontal devolution among the States.
- The basic objective of a horizontal devolution is to enable the States to provide basic public goods and services with equivalent tax effort. Achieving this may entail:
- filling up the vertical fiscal gap of the States;
- providing horizontal equity (by providing higher share to poorer regions);
- equalizing the fiscal capacities of States (revenue equalization);
- providing for cost differentials in States for basic public service (expenditure equalization); and
- ensuring that the States have enough incentives to mobilise own revenue and spend them appropriately in an efficient manner.
Various criteria used
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Income distance: Income distance is the distance of the state’s income from the state with the highest income. The income of a state has been computed as average per capita GSDP during the three-year period between 2015-16 and 2017-18. States with lower per capita income would be given a higher share to maintain equity among states.
New criteria ‘Demographic performance’: The Terms of Reference (ToR) of the Commission required it to use the population data of 2011 while making recommendations. Accordingly, the Commission used only 2011 population data for its recommendations.
The Demographic Performance criterion has been introduced to reward efforts made by states in controlling their population. It will be computed by using the reciprocal of the total fertility ratio of each state, scaled by 1971 population data. States with a lower fertility ratio will be scored higher on this criterion. The total fertility ratio in a specific year is defined as the total number of children that would be born to each woman if she were to live to the end of her child-bearing years and give birth to children in alignment with the prevailing age-specific fertility rates.
Forest and ecology: This criterion has been arrived at by calculating the share of dense forest of each state in the aggregate dense forest of all the states.
Tax effort: This criterion has been used to reward states with higher tax collection efficiency. It has been computed as the ratio of the average per capita own tax revenue and the average per capita state GDP during the three-year period between 2014-15 and 2016-17.
In 2020-21, the following grants will be provided to states:
(i) Revenue deficit grants,
(ii) Grants to local bodies, and
(iii) Disaster management grants
The Commission has also proposed a framework for sector-specific and performance-based grants. State-specific grants will be provided in the final report.
Revenue deficit grants:
- In 2020-21, 14 states are estimated to have an aggregate revenue deficit of Rs 74,340 crore post-devolution.
- The Commission recommended revenue deficit grants for these states.
- In case of three states, the sum of devolution and revenue deficit grants is estimated to decline in 2020-21 as compared to 2019-20.
- These states are Karnataka, Mizoram, and Telangana.
- Sector-specific grants for the following sectors will be provided in the final report: (i) nutrition, (ii) health, (iii) pre-primary education, (iv) judiciary, (v) rural connectivity, (vi) railways, (vii) police training, and (viii) housing
Guidelines for performance-based grants include: (i) implementation of agricultural reforms, (ii) development of aspirational districts and blocks, (iii) power sector reforms, (iv) enhancing trade including exports, (v) incentives for education, and (vi) promotion of domestic and international tourism. The grant amount will be provided in the final report.
Grants to local bodies:
- The total grants to local bodies for 2020-21 has been fixed at Rs 90,000 crore, of which Rs 60,750 crore is recommended for rural local bodies (67.5%) and Rs 29,250 crore for urban local bodies (32.5%).
- This allocation is 4.31% of the divisible pool. This is an increase over the grants for local bodies in 2019-20, which amounted to 3.54% of the divisible pool.
- The grants will be divided between states based on population and area in the ratio 90:10. The grants will be made available to all three tiers of Panchayat- village, block, and district.
Disaster risk management:
- The Commission recommended setting up National and State Disaster Management Funds (NDMF and SDMF) for the promotion of local-level mitigation activities.
- The Commission has recommended retaining the existing cost-sharing patterns between the centre and states to fund the SDMF (new) and the SDRF (existing).
- The cost-sharing pattern between centre and states is (i) 75:25 for all states, and (ii) 90:10 for north-eastern and Himalayan states.
Recommendations on fiscal roadmap
Fiscal deficit and debt levels:
- The Commission noted that recommending a credible fiscal and debt trajectory roadmap remains problematic due to uncertainty around the economy.
- It recommended that both central and state governments should focus on debt consolidation and complies with the fiscal deficit and debt levels as per their respective Fiscal Responsibility and Budget Management (FRBM) Acts.
- The Commission observed that financing capital expenditure through off-budget borrowings detracts from compliance with the FRBM Act.
- It recommended that both the central and state governments should make full disclosure of extra-budgetary borrowings.
- The outstanding extra-budgetary liabilities should be clearly identified and eliminated in a time-bound manner.
Statutory framework for public financial management:
The Commission recommended forming an expert group to draft legislation to provide for a statutory framework for sound public financial management system. It observed that an overarching legal fiscal framework is required which will provide for budgeting, accounting, and audit standards to be followed at all levels of government.
- In 2018-19, the tax revenue of state governments and central government together stood at around 17.5% of GDP.
- The Commission noted that tax revenue is far below the estimated tax capacity of the country. Further, India’s tax capacity has largely remained unchanged since the early 1990s.
- In contrast, tax revenue has been rising in other emerging markets.
- The Commission recommended: (i) broadening the tax base, (ii) streamlining tax rates, (iii) and increasing capacity and expertise of tax administration in all tiers of the government
- The Commission highlighted some challenges with the implementation of the Goods and Services Tax (GST).
- These include: (i) large shortfall in collections as compared to original forecast, (ii) high volatility in collections, (iii) accumulation of large integrated GST credit, (iv) glitches in invoice and input tax matching, and (v) delay in refunds.
- The Commission observed that the continuing dependence of states on compensation from the central government for making up for the shortfall in revenue is a concern.
- It suggested that the structural implications of GST for low consumption states need to be considered.
Financing of security-related expenditure:
- The ToR of the Commission required it to examine whether a separate funding mechanism for defence and internal security should be set up and if so, how it can be operationalised.
- In this regard, the Commission intends to constitute an expert group comprising representatives of the Ministries of Defence, Home Affairs, and Finance.
- The Commission noted that the Ministry of Defence proposed following measures for this purpose:
(i) setting up of a non-lapsable fund, (ii) levy of a cess, (iii) monetisation of surplus land and other assets, (iv) tax-free defence bonds, and (v) utilising proceeds of disinvestment of defence public sector undertakings.
Challenges before 15th FC
Even as the work of the Commission was in a fairly advanced stage, designed towards submitting the report by the stipulated date, there were new developments which impacted the recommendations of the XV-FC.
First was the enactment of the Jammu and Kashmir Reorganization Act, 2019, leading to the creation of two new UTs. The FC needs to closely examine how best the needs of the UT of J&K can be addressed keeping in view all relevant factors.
Second, the global scenario is unpredictable and experiencing a synchronised slowdown. After successive downward revisions, the IMF forecast global growth for 2019 at 3 per cent, which is the lowest since the global financial crisis of 2008-09, with further downside risk.
Third, like many other countries, India too is going through a period of economic sluggishness. The growth in real GDP is expected to slow down from 7.2 per cent in 2017-18 to around 6 per cent estimated for 2019-20.
Fourth, weak revenue collections, driven by slowing activity as well as teething problems in implementing some of the newly introduced structural reforms, have elevated the fiscal risks. With real economic growth at a seven-year low, combined with relatively low inflation, growth has been weak in nominal terms as well, leading to a weak tax base.
- The population parameter used by the Commission has been criticised by the governments of the southern states.
- The previous FC used both the 1971 and the 2011 populations to calculate the states’ shares, giving greater weight to the 1971 population (17.5%) as compared to the 2011 population (10%).
- The use of 2011 population figures has resulted in states with larger populations like UP and Bihar getting larger shares, while smaller states with lower fertility rates have lost out.
- The combined population of the Bihar, Uttar Pradesh, Madhya Pradesh, Rajasthan and Jharkhand is 47.8 crore.
- This is over 39.48% of India’s total population and is spread over 32.4% of the country’s area, as per the 2011 Census.
- On the other hand, the southern states of Tamil Nadu, Kerala, Karnataka and undivided Andhra Pradesh are home to only 20.75% of the population living in 19.34% of the area, with a 13.89% share of the taxes.
- This means that the terms decided by the Commission are loaded against the more progressive (and prosperous) southern states.