Finance Commission – Issues related to devolution of resources

Finance Commission – Issues related to devolution of resources

Private: Fifteenth Finance Commission Recommendations For Local Government Funds

The Fifteenth Finance Commission has raised the vertical devolution recommended to local governments to 4.23% with a reasonably estimated amount of ₹4,36,361 crore. Compared with the Fourteenth Finance Commission there is a 52% increase in the vertical share.

Evolution

  • Post–Independence Period: After the Constitution came into force, Article 40 made a mention of panchayats and Article 246 empowers the state legislature to legislate with respect to any subject relating to local self-government.
  • However, this inclusion of panchayats into the Constitution was not unanimously agreed upon by the then decision-makers, with the major opposition having come from the framer of the Constitution himself i.e. B.R.Ambedkar.
  • What is a village but a sink of localism, a den of ignorance, narrow-mindedness and communalism
  • It was after much discussion among the supporters and opponents of the village panchayat that the panchayats finally got a place for themselves in the Constitution as Article 40 of the Directive Principles of State Policy.
  • Since the Directive Principles are not binding principles, the result was the absence of a uniform structure of these bodies throughout the country.
  • After independence, as a development initiative, India had implemented the Community Development Programmes (CDP) on the eve of Gandhi Jayanti, the 2nd October, 1952 under the major influence of the Etawah Project undertaken by the American expert, Albert Mayer.
  • It encompassed almost all activities of rural development which were to be implemented with the help of village panchayats along with the participation of people.
  • In 1953, the National Extension Service was also introduced as a prologue to CDP. But the programme did not yield much result.
  • There were various reasons for the failure of CDP like bureaucracy and excessive politics, lack of people participation, lack of trained and qualified staff, and lack of local bodies interest in implementing the CDP especially the village panchayats.
  • In 1957, the National Development Council constituted a committee headed by Balwant Rai Mehta to look into the working of community development programme.
  • The team observed that the major reason for the failure of the CDP was the lack of people’s participation.
  • The committee suggested a three-tier PRIs, namely, Grama Panchayats (GPs) at the village level, Panchayat Samiti (PSs) at the block level, and Zilla Parishad (ZPs) at the district level.
  • As a result of this scheme of democratic decentralization was launched in Rajasthan on October 2, 1959.
  • In Andhra Pradesh, the scheme was introduced on 1st November, 1959. The necessary legislation had also been passed and implemented in Assam, Gujarat, Karnataka, Madhya Pradesh, Maharashtra, Orissa, and Punjab etc.
  • The appointment of the Ashok Mehta Committee in 1977 did bring new thinking in the concepts and practice of the Panchayat Raj.
  • The committee recommended a two-tier Panchayat Raj institutional structure consisting of Zilla Parishad and Mandal Panchayat.
  • In order to use planning expertise and to secure administrative support, the district was suggested as the first point of decentralization below the state level.
  • Based on its recommendation, some of the states like Karnataka incorporated them effectively.
  • In subsequent years in order to revive and give a new lease of life to the panchayats, the Government of India had appointed various committees.
  • The most important among them are the Hanumantha Rao Committee (1983), G.V.K. Rao Committee (1985), L.M.Singhvi Committee (1986) and the Sarkaria Commission on Centre-State relations (1988), P.K. Thungan Committee (1989) and Harlal Singh Kharra Committee (1990).
  • The G.V.K. Rao Committee (1985) recommended making the “district” as the basic unit of planning and also holding regular elections while the L.M.Singhvi committee recommended providing more financial resources and constitutional status to the panchayats to strengthen them.
  • The Amendment phase began with the 64th Amendment Bill (1989) which was introduced by Rajiv Gandhi seeking to strengthen the PRIs but the Bill was not passed in the Rajya Sabha.
  • The Constitution (74th Amendment) Bill (a combined bill for the PRIs and municipalities) was introduced in 1990, but was never taken up for discussion.
  • It was during the Prime Ministership of P.V.Narasimha Rao that a comprehensive amendment was introduced in the form of the Constitution 72nd Amendment Bill in September 1991.
  • 73rd and 74th Constitutional Amendments were passed by Parliament in December, 1992. Through these amendments local self-governance was introduced in rural and urban India.
  • The Acts came into force as the Constitution (73rd Amendment) Act, 1992 on April 24, 1993 and the Constitution (74th Amendment) Act, 1992 on June 1, 1993.

Salient Features of the Constitution 73rd and 74th Amendments

  • These amendments added two new parts to the Constitution, namely, added Part IX titled “The Panchayats” (added by 73rd Amendment) and Part IXA titled “The Municipalities” (added by 74th Amendment).
  • Basic units of democratic system-Gram Sabhas (villages) and Ward Committees (Municipalities) comprising all the adult members registered as voters.
  • Three-tier system of panchayats at village, intermediate block/taluk/mandal and district levels except in States with population is below 20 lakhs (Article 243B).
  • Seats at all levels to be filled by direct elections Article 243C (2).
  • Seats reserved for Scheduled Castes (SCs) and Scheduled Tribes (STs) and the chairpersons of the Panchayats at all levels also shall be reserved for SCs and STs in proportion to their population.
  • One-third of the total number of seats to be reserved for women.
  • One third of the seats reserved for SCs and STs also reserved for women.
  • One-third offices of chairpersons at all levels reserved for women (Article 243D).
  • Uniform five year term and elections to constitute new bodies to be completed before the expiry of the term.
  • In the event of dissolution, elections compulsorily within six months (Article 243E).
  • Independent Election Commission in each State for superintendence, direction and control of the electoral rolls (Article 243K).
  • Panchayats to prepare plans for economic development and social justice in respect of subjects as devolved by law to the various levels of Panchayats including the subjects as illustrated in Eleventh Schedule (Article 243G).
  • 74th Amendment provides for a District Planning Committee to consolidate the plans prepared by Panchayats and Municipalities (Article 243ZD).
  • Budgetary allocation from State Governments, share of revenue of certain taxes, collection and retention of the revenue it raises, Central Government programmes and grants, Union Finance Commission grants (Article 243H).
  • Establish a Finance Commission in each State to determine the principles on the basis of which adequate financial resources would be ensured for panchayats and municipalities (Article 243I).
  • The Eleventh Scheduled of the Constitution places as many as 29 functions within the purview of the Panchayati Raj bodies.
  • The following areas have been exempted from the operation of the Act because of the socio-cultural and administrative considerations:
    • Scheduled areas listed under the V Schedule in the states of Andhra Pradesh, Bihar, Gujarat, Himachal Pradesh, Madhya Pradesh, Maharashtra, Orissa and Rajasthan.
    • The states of Nagaland, Meghalaya and Mizoram.
    • The hill areas of district of Darjeeling in the state of West Bengal for which Darjeeling Gorkha Hill Council exists.
  • In conformity with provisions in the Constitution Amendment Act, an Act called the Provisions of Panchayats (Extension to the Scheduled Areas) Act, 1996 passed by the Government of India.

Evaluating the Panchayati Raj Institutions at 28

  • PRIs has witnessed simultaneously a remarkable success and a staggering failure in the journey of 28 years depending on the goalposts against which they are evaluated.
  • While the PRI has succeeded in creating another layer of government and political representation at the grass-roots level, it has failed to provide better governance.
  • There are about 250,000 PRIs and urban local bodies, and over three million elected local government representatives.
  • The 73rd and 74th Amendments required that no less than one-third of the total seats in local bodies should be reserved for women. At 1.4 million, India has the most women in elected positions. Seats and sarpanch/pradhan positions were also reserved for SC/ST candidates.
  • Research using PRIs has shown that having female political representation in local governments makes women more likely to come forward and report crimes.
    • In districts with female sarpanchs, significantly greater investments are made in drinking water, public goods.
  • Moreover, the states have also provided the statutory safeguards for many devolution provisions, which have considerably empowered local governments.
  • Successive (central) Finance Commissions have, so substantially, increased fund allocations for local bodies and also the grants have been increased.
  • 15th Finance Commission is also considering to further increase the allocations for local governments to match the international standards.

Issues

  • The grey area is the lack of adequate funds. There is a need to enlarge the domain of panchayats to be able to raise their own funds.
  • The interference of area MPs and MLAs in the functioning of panchayats also adversely affected their performance.
  • The 73rd amendment only mandated the creation of local self-governing bodies, and left the decision to delegate powers, functions, and finances to the state legislatures, therein lies the failure of PRIs.
  • The transfer of various governance functions—like the provision of education, health, sanitation, and water was not mandated. Instead the amendment listed the functions that could be transferred, and left it to the state legislature to actually devolve functions.
    • There has been very little devolution of authority and functions in the last 26 years.
  • Because these functions were never devolved, state executive authorities have proliferated to carry out these functions. The most common example is the terrible state water boards.
  • The major failure of the Amendment is the lack of finances for PRIs. Local governments can either raise their own revenue through local taxes or receive intergovernmental transfers.
  • The power to tax, even for subjects falling within the purview of PRIs, has to be specifically authorized by the state legislature. The 73rd Amendment let this be a choice open to the state legislatures—a choice that most states have not exercised.
  • A second avenue of revenue generation is intergovernmental transfers, where state governments devolve a certain percentage of their revenue to PRIs. The constitutional amendment created provisions for State Finance Commissions to recommend the revenue share between state and local governments. However, these are merely recommendations and the state governments are not bound by them.
  • Though finance commissions, at every level, have advocated for greater devolution of funds, there has been little action by states to devolve funds.
  • PRIs are reluctant to take on projects that require any meaningful financial outlay, and are often unable to solve even the most basic local governance needs.
  • PRIs also suffer from structural deficiencies i.e. no secretarial support and lower levels of technical knowledge which restricted the aggregation of bottom up planning .
  • There is a presence of adhocism i.e. lack of clear setting of agenda in gram sabha, gram samiti meetings and no proper structure.
  • Though women and SC/STs has got representation in PRIs through reservation mandated by 73rd amendment but there is a presence of Panch-Pati and Proxy representation in case of women and SC/STs representatives respectively.
  • Accountability arrangements remain very weak even after 26 years of PRIs constitutional arrangement.
  • The issue of ambiguity in the division of functions and funds has allowed concentration of powers with the states and thereby restraining the elective representatives who are more aware and sensitive to the ground level issues to take control.

Suggestions

  • Genuine fiscal federalism i.e. fiscal autonomy accompanied by fiscal responsibility can provide a long term solution without this PRIs will only be an expensive failure.
  • 6th report of 2nd ARC, ‘Local Governance- An inspiring journey into the future’’, had recommended that there should be a clear-cut demarcation of functions of each tier of the government.
  • States should adopt the concept of ‘activity mapping’, wherein each state clearly delineates the responsibilities and roles for the different tiers of the government in respect to the subjects listed in the Schedule XI.
  • The subjects should divided and assigned to the different tiers on the basis of accountability to the public.
  • States like Karnataka and Kerala have taken some steps in this direction but overall progress has been highly uneven.
  • There is need for bottom up planning especially at the district level, based on grassroots inputs received from Gram Sabha.
  • Karnataka has created a separate bureaucratic cadre for Panchayats to get away from the practice of deputation of officials who often overpowered the elected representatives.
    • Such practices needs to be replicated in other states for strengthening the true character of local self governance.
  • The center also needs to financially incentivize states to encourage effective devolution to the panchayats in functions, finances, and functionaries.
  • Training should be provided to local representatives to develop expertise so that they contribute more in planning and implementation of policies and programmes.
  • To solve the problem of proxy representation social empowerment must precede the political empowerment.
  • Recently states like Rajasthan and Haryana have set certain minimum qualification standards for Panchayat elections. Such necessary eligibility can help in improving effectiveness of governance mechanism.
  • These standards should apply for MLAs and MPs also and in this direction government should speeden up efforts for universal education.
  • There should be clear mechanisms to ensure that States comply with the constitutional provisions, particularly in the appointment and implementation of the recommendations of the State Finance Commissions (SFCs).

Way Forward

  • The need of the hour is to bring about a holistic change in the lives of beneficiaries among the villagers by uplifting their socioeconomic and health status through effective linkages through community, governmental and other developmental agencies.
  • Government should take remedial action in the interest of democracy, social inclusion and cooperative federalism.
  • People’s demands for the sustainable decentralisation and advocacy should focus on a decentralisation agenda. The framework needs to be evolved to accommodate the demand for decentralisation.
  • It is important to have clarity in the assignment of functions and the local governments should have clear and independent sources of finance.

 

Finance Commission – Issues related to devolution of resources

Still no recognition of the third tier

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Not much

Mains level : Paper 2- Critique of the Fifteenth Finance Commission recommendations with regard to local government

The article highlights the issues with the Fifteenth Finance Commission recommendations with regard to the third tier of the local governments.

Significance of Finance Commission recommendations for local government

  • The primary task of the Union Finance Commission is to rectify the vertical and horizontal imbalances in resources and expenditure responsibilities between Union and States including the third tier of local governments.
  • Part IX and Part IX-A were incorporated into the Constitution by the 73rd and 74th Constitutional Amendment.
  • Part IX and Part IX-A mandate the Union Finance Commission to supplement the resources of panchayats and municipalities on the basis of the recommendations of the State Finance Commission.
  • Now, nearly 2.5 lakh local governments and over 3.4 million elected representatives form the real democratic base of the Indian federal polity.

Increase in vertical devolution

  • The Fifteenth Finance Commission has raised the vertical devolution recommended to local governments to 4.23% with a reasonably estimated amount of ₹4,36,361 crore.
  • Compared with the Fourteenth Finance Commission there is a 52% increase in the vertical share.
  • Even if we deduct the grant of ₹70,051 crore earmarked for improving primary health centres, the share is still an all-time high of 4.19%.
  • All the Commissions since the Eleventh Commission have tied specific items of expenditure to local grants and the Fifteenth Finance Commission has raised this share to 60% and linked them to drinking water, rainwater harvesting, sanitation and other national priorities in the spirit of cooperative federalism.

Reduction in performance-based  grants

  • The Fifteenth Finance Commission has reduced the performance-based grant to just ₹8,000 crore — and that too for building new cities, leaving out the Panchayati Raj Institutions (PRIs) altogether.
  • The performance-linked grants were introduced by the Thirteenth Finance Commission and covered a wide range of reforms.
  • The transformative potential in designing performance-linked conditionalities for improving the quality of decentralised governance in the context of indifferent states is missed.

Encouraging standardisation of accounting system

  • An important recommendation of the Fifteenth Finance Commission is the entry-level criterion to avail the union local grant (except health grant) by local governments.
  • For panchayats, the condition is the online submission of annual accounts for the previous year and audited accounts for the year before.
  • For urban local governments, two more conditions are specified: fixation of the minimum floor for property tax and improvement in its collection.
  •  It is not clear why gram panchayats are left out from this.
  • Although Finance Commissions, from the Eleventh to the Fourteenth, have recommended measures to standardise the accounting system and update the auditing of accounts, the progress made has been halting.
  • Therefore, the entry-level criteria of the Fifteenth Finance Commission are timely.

Missed opportunity to ensure minimum public services

  • The Fifteenth Finance Commission failed to carry policy choices forward systematically.
  • Articles 243G, 243W and 243ZD read along with the functional decentralisation of basic services like drinking water, public health care, etc., mandated in the Eleventh and Twelfth schedules demand better public services and delivery of ‘economic development and social justice’ at the local level.
  • A good opportunity to ensure comparable minimum public services to every citizen irrespective of her choice of residential location has not been taken forward in an integrated manner.

Missing equalisation principle for the local government

  • The Fifteenth Finance Commission claims that it seeks to achieve the “desirable objective of evenly balancing the union and the states”.
  • It is not clear why there is no recognition of the third tier in this balancing act.
  • It may be relevant to recall that the Alma-Ata declaration of the World Health Organization (1978) which outlined an integrated, local government-centric approach with a simultaneous focus on access to water, sanitation, shelter and the like.
  • There is no integrated approach in the recommendations of the Fifteenth Finance Commission about the local governments (in contrast to the recommendations of the Thirteenth Finance Commission).
  • Although the Fifteenth Finance Commission stresses the need to implement the equalisation principle, it is virtually silent when it comes to the local governments.

Equity and efficiency sidelined

  • The Fifteenth Finance Commission employed population (2011 Census) with 90% and area 10% weightage for determining the distribution of grant to States for local governments.
  • The same criteria were followed by the Fourteenth Finance Commission.
  • While this ensures continuity, equity and efficiency criteria are sidelined.
  • Abandoning tax effort criterion incentivises dependency, inefficiency and non-accountability.

Consider the question “Discuss the various aspects of the Fifteenth Finance Commission’s recommendations with regard to local governments.”

Conclusion

In sum, if decentralisation is meant to empower local people, the primary task is to fiscally empower local governments to deliver territorial equity. We are far from this goal.

Finance Commission – Issues related to devolution of resources

Fifteenth Finance Commission has increased proportion of grants conditional on reforms

Note4Students

From UPSC perspective, the following things are important :

Prelims level : State Finance Commission

Mains level : Paper 2- Conditional grants to incentivise the states for reforms

The article highlights the crucial recommendations made by the 15th Finance Commission and also explains the importance of conditions for grants from the Centre to push the state for reforms.

Crucial recommendations by 15th Finance Commission

  • The Fifteenth Finance Commission’s report for the period 2021-22 to 2025-26 outlines some crucial recommendations for state governments.
  • These recommendations cover tax devolution, grants from the Centre, and the guidelines for the borrowings that they are permitted to incur over the medium-term.
  • The commission has recommended that 41 per cent of the government’s divisible pool of taxes be transferred to state governments.

Horizontal devolution formula

  • The horizontal devolution formula specifies each state’s share in the overall pie.
  • The 15th FC was required to use the states’ population as per the 2011 Census — a highly contentious change.
  • It has also introduced a demographic performance criterion.
  • Additionally, it has also introduced a new criterion –tax effort.
  • Tax effort is measured by the ratio of the three-year average of per-capita own tax revenues and per-capita gross state domestic product (GSDP).
  • The net result of the change in criteria is that the share of 10 states in the divisible pool has declined.
  • Karnataka is the biggest loser, while Maharashtra is the biggest gainer.

Grants from the Centre conditioned on reforms in states

  • Another major set of the commission’s recommendations pertain to grants from the Centre.
  • In a major shift, the 15th FC has sharply increased the proportion of grants whose receipt is conditional on specified reforms being undertaken.
  • 57 per cent of the 15th FC-recommended grants accepted so far by the GoI are conditional, relative to just 17 per cent for the 14th FC (including J&K).

What are the conditions

1) Setting up of State Finance Commission (SFC) and applicability of SFC’s recommendations for 5 years only

  • Constitution requires state governments to set up State Finance Commissions (SFC).
  • The 15th FC has asserted that the mandate of any given SFC is intended to be applicable only for five years.
  • It revealed that only 15 states have set up their fifth or sixth SFCs, whereas several states have not moved beyond their second or third SFC.
  • Accordingly, a staggering 84 per cent of the Rs 4.4 trillion grants for local bodies recommended by the 15th FC are conditional on the states setting up SFCs for the coming five-year period, and acting on their recommendations by March 2024.

2) Availability of online accounts

  • Another entry-level condition for availing grants by rural and urban local bodies pertains to the timely availability of their accounts online from 2021-22 onwards.

3) Notiflying floor rate for property tax

  • For the receipt of grants by the urban bodies, states are required to notify a floor rate for property tax by 2021-22, and demonstrate consistent year-wise improvement from 2022-23 onwards.
  • This will complement the conditions set previously by SEBI for ULBs to become eligible to raise municipal bonds.

Changes in limit on net borrowings of state governments

  • The commission has recommended that the normal limit for net borrowings of state governments be fixed at 4 per cent of GSDP in 2021-22.
  • This will ease to 3.5 per cent by 2022-23, thereafter reverting to the erstwhile 3 per cent limit till 2025-26.
  • The additional borrowing space of 0.5 per cent of GSDP for states is conditional on the completion of power sector reforms.

Prospect of huge gaps in states’ revenue in the future

  • The states’ fiscal arithmetic will alter in 2022-23 with the GST compensation set to cease at the end of June 2022 as things stand today.
  • The ensuing drop in grants, combined with the tapering of the front-loaded revenue deficit grants is likely to leave a big gap in some states’ revenues.

Consider the question “What are the conditions laid down by the 15th Finance Commission on the states for the central grants? How these conditions could benefit the states?”

Conclusion

The question is whether this revenue gaps will force the states to move on both the power sector reforms, which have proven challenging in the past, and the municipal reforms, so that their resource availability may be enhanced.

Finance Commission – Issues related to devolution of resources

15th Finance Commission could catalyse accountability, effective governance at grassroots

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Not much

Mains level : Paper 2- Catalysing accountability and creative governance in local government

The article explains the innovative approach adopted by the Fifteenth Finance Commission in devolution of funds.

Steep hike in grants

  • Local governments are the closest to the people at the grassroots level. 
  • They provide critical civic amenities such as roads, water and sanitation, and primary education and health.
  • With this in view, the Fifteenth Finance Commission (FFC) has recommended grants of Rs 4,36,361 crore from the Union government to local governments for 2021-26.
  • This is an increase of 52 per cent over the corresponding grant of Rs 2,87,436 crore by its predecessor for 2015-20.

Innovation in recommendations

1) Scaling of capacities in municipalities

  • The Commission has recommended Rs 8,000 crore as performance-based grants for incubation of new cities and Rs 450 crore for shared municipal services.
  • This is designed to foster innovations in urban governance to transform our cities with speed and scale.
  • There is an urgent need for synergistically combined area-based development to spur economic growth and job creation, and decongesting through the development of satellite townships.
  • Separately, the massive scaling of capacities in municipalities, particularly the 4,000-odd smaller ones, cannot be done by building capacities in each one of them, but through institutional and technological innovations, without compromising their autonomy.
  • The shared municipal services model, with mobile internet, maps, platform thinking, and outsourced services all taken together, can help us fast-track the creation of municipal capacities at scale.
  • This is one of the innovations in the FFC recommendations.

2) Allocation covers all three tiers of panchayats

  • Of grants for all local governments with 90 per cent weightage on population and 10 per cent on area remains unchanged from the Fourteenth Finance Commission.
  • For panchayats, the FFC allocations cover all the three tiers — village, block, and district — as well as the Excluded Areas in a state exempted from the purview of Part IX and Part IX-A of the Constitution.
  • Funds to all three can improve functional coordination and facilitate the creation of assets collectively across smaller jurisdictions.
  • This is the second new aspect of the FFC recommendations.

3) Focus on metropolitan governance

  • The FFC calls for a focus on urban agglomerations (UAs) that include urban local bodies, census towns and outgrowths.
  • In 2011, out of the total urban population of 377 million, 61 per cent lived in UAs.
  • The FFC has emphasised the need to focus on the complex challenges of air quality, drinking water supply, sanitation, and solid waste management in the million-plus UAs and cities.
  • Thus, for 2021-26, there is a Million-plus Challenge Fund of Rs 38,196 crore that can be accessed by million-plus cities only through adequate improvements in their air quality and meeting service level benchmarks for drinking water supply, sanitation, and solid waste management.
  • This focus on metropolitan governance through substantive but 100 per cent outcome-based grants is the third innovation.
  • For ULBs other than the million-plus category, the total grants are Rs 82,859 crore.
  • The grants to local governments, both urban (less than a million category) and rural, contain a mix of basic, tied as well as performance grants.

4) Entry-level conditions

  • The efficiency, smooth functioning and accountability of local bodies have been plagued by:
  • (i) lack of readily accessible and timely audited accounts,
  • (ii) absence of timely recommendations of State Finance Commissions and suitable actions thereon,
  • (iii) inadequate mobilisation of property tax revenues (especially in ULBs).
  • Finance Commissions in the past have drawn pointed attention to these issues, but with limited success.
  • These entry-level conditions for availing any grants and their applicability to all local governments is the fourth innovation.

Consider the question “Examine the innovative approach adopted by the Fifteenth Finance Commission for the devolution of funds to panchayats and municipal bodies.”

Conclusion

Hopefully, over the next five years, through a partnership among the Union, states, and local governments, in the spirit of cooperative federalism, these recommendations and innovations will catalyse progress in the accountability and effectiveness of local governments in India.

 

Finance Commission – Issues related to devolution of resources

In difficult times, Fifteenth Finance Commission rose to the challenge

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Finance Commission

Mains level : Paper 2- Recommendations of Fifteenth Finance Commission

The article analyses the various recommendations of the Fifteenth Finance Commission and their impact.

Unique challenges

  • Many new and unique demands were placed on the 15th Finance Commission.
  • The major challenge being addressing the issue of the 2011 population census evoking a sharp response from the southern states.
  • Other issues include the non-lapsable defence fund and the use of certain parameters for performance incentives.
  • The Commission was also required to perform the task of assessing and projecting the fiscal roadmap for the Union and state amid an uncertain domestic environment due to shortfall in the GST collection, further accentuated in the year 2020 by the global pandemic.

Key recommendations

The Commission, in its final report, recommended vertical devolution at 41 per cent, adjusting 1 per cent for the erstwhile state of Jammu and Kashmir.

1) Horizontal distribution

  • For horizontal distribution, the commission has tried to harmonise the principles of expenditure needs, equity and performance.
  • This is achieved by the introduction of efficiency criteria of tax and fiscal efforts and by assigning 12.5 per cent weight to demographic performance.
  • Consideration of demographic performance will help in resolving the demographic debate and incentivising states in moving towards the replacement rate of population growth.

2) Principles governing grant-in-aid

  • Grants are important as they are more directly targeted and equalise the standards of basic social services to some extent.
  • The Commission has recommended a total grant of Rs 10,33,062 crore during 2021-26.
  • Grant is broadly characterised into: (a) revenue deficit grants (b) grants for local governments (c) grants for disaster management (d) sector-specific grants and (e) state-specific grants.
  • Many of these grants are linked with performance-based criteria, thereby promoting principles of transparency, accountability, and leading to better monitoring of expenditures.
  • However, the Commission was asked to examine whether revenue deficit grants should be provided at all to the states.
  • Some states stressed that revenue deficit grants have serious disincentives for tax efforts and prudence in expenditure and, hence, these should be discontinued.
  • Fiscally stressed states of Kerala, West Bengal and Punjab are regular recipients of these grants due to high debt legacy.

3) Conditional grants to local bodies

  • This Commission’s grant for local government is different from that of its predecessors for the set of entry-level conditions:
  • (a) Constitution of State Finance Commissions.
  • (b) Timely auditing and online availability of accounts for rural local bodies coupled with
  • (c) Notifying consistent growth rate for property tax revenue for urban local bodies.
  • Secondly, the recommendations are in alignment with the national programmes of Swachch Bharat Mission and Jal Jeewan Mission.

4) Incubation of new cities and urban grants

  • It is for the first time that a Finance Commission has recommended Rs 8,000 crore to states for incubation of new cities, granting Rs 1,000 crore each for eight new cities.
  • The focus of urban grants for million-plus cities is improvement in air quality and meeting the service level benchmark of solid waste management and sanitation.

5) Grants for health and setting up of disaster mitigation fund

  • The commission recommended channelising the health grant of Rs 70,051 crore through local bodies, addressing the gaps in primary health infrastructure.
  • The Commission’s recommendation for setting up the state and national level Disaster Risk Mitigation Fund (SDRMF), in line with the provisions of the Disaster Management Act, is both well-timed and necessary.
  • For the first time, the Finance Commission has introduced a 10-25 per cent graded cost-sharing basis by the states for the NDRF and NDMF which has not been appreciated by the states.

6) Non-lapsable fund for defence

  • The Commission has recommended setting up of a dedicated non-lapsable fund, the Modernisation Fund for Defence and Internal Security (MFDIS).
  • Objective of the fund is to bridge the gap between projected budgetary requirements and budget allocation for defence and internal security and to provide greater predictability for enabling critical defence capital expenditure.
  • The fund will have four specific sources: (a) Transfers from the Consolidated Fund of India, (b) disinvestment proceeds of DPSEs, (c) proceeds from the monetisation of surplus defence land and (d) proceeds of receipts from defence land likely to be transferred to state governments and for public projects in the future.
  • The total indicative size of the proposed MFDIS over the period 2021-26 is Rs 2,38,354 crore.
  • The Union government has accepted this recommendation in principle.

Consider the question “Examine the various principles on which the Fifteenth Finance Commission based the horizontal distribution of states share.”

Conclusion

The report starts with the famous quote of Mahatma Gandhi: “The future depends on what we do in the present”. It would be interesting to see the impact of these overarching and revolutionary recommendations in the times ahead.

Finance Commission – Issues related to devolution of resources

Finance Commission dips into states’ share for Centre’s expenditure

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Finance Commission and its recommendations

Mains level : Paper 2- Fifteenth Finance Commission report and federalism

The article analyses the recommendations of fifteenth Finance Commission and their implications for the federalism in India.

Major recommendations accepted by the government

  • Report of the fifteenth Finance Commission (XVFC) was laid before the Parliament.
  • The finance minister announced the acceptance of its recommendation of retaining the share of states in central taxes at 42 per cent.
  • She also stated that on its recommendation revenue deficit grants of Rs 1.18 lakh crore to the states have been provided for in the budget.
  • Some of the recommendations, however, have far-reaching implications on government finances, both of the Centre and the states.
  • Keeping in view the extant strategic requirements for national defence in a global context, XVFC has, in its approach, recalibrated the relative shares of the Union and the states in gross revenues receipts.

Issues with the recalibration for national defence

  • Recalibration enables the Union to set aside resources for special funding on defence.
  • The states have been made to pay Rs 7,000 crore to bridge [the] Centre’s gap between projected budgetary requirements and budget allocation for defence and internal security defence.
  • But this is an expenditure that the Centre is obliged to fund.
  • For the first time, a finance commission has carved out resources meant for distributable statutory grants and dipped into the states’ revenue share, as against the tax share, in order to finance the Centre’s exclusive expenditure obligation.
  • What has been done is not in line with the system envisaged in the Constitution.
  • This move will eventually put the fiscal federal system under systemic strain.
  • In operational terms, too, this move is a significant departure.
  • So far, the Centre has been used to pre-empting resources from the kitty to be distributed among the states but only to finance expenditures in areas earmarked for states.
  • This was done through the centrally-sponsored schemes, but at least the states’ money was being used in the states, even if on a discretionary rather than a criteria basis.
  • Now, with this move of earmarking and financing of funds for sectors, it is the states’ money that is being used to finance the Centre’s expenditure.
  • This is certainly not cooperative federalism.

Changes in horizontal distribution: More weightage to efficiency and performance

  • In horizontal distribution, the criteria used by successive finance commissions for devolving taxes across states have always been linked to need — based on equity, tempered by efficiency.
  • From 92.5 per cent of funds to a state being devolved based on need and equity, the XVFC has reduced these two components to 75 per cent.
  • The remaining 25 per cent are to be devolved on considerations of efficiency and performance.
  • This is the lowest weightage for equity, making the XVFC transfers potentially the least progressive ever.

Structural changes not taken into account

  • The Finance Commission has not even made any serious effort to review the existing scheme of transfers in light of the changed federal landscape.
  • The existing criteria for the devolution have evolved in, and for, a production-based tax system.
  • The XVFC should have reformulated the distributional criteria for a consumption-based tax system [GST].
  • The structural change from production to consumption will make a significant difference to distribution as well as the need, nature and distribution of equalising grants.
  • This is the same manner in which the revenue deficit grants have been carried forward.
  • Ideally, the “gap-filling” approach should have been redesigned in light of the compensation law providing a minimum-guaranteed revenue of 14 per cent to every state.

Consider the question “For the first time, a finance commission has carved out resources meant for distributable statutory grants and dipped into the states’ revenue share, as against the tax share, in order to finance the Centre’s exclusive expenditure obligation. What are the issues with this move?”

Conclusion

The Fifteenth Finance Commission report is not aligned with the new landscape of federalism and does not address the key issues.

Finance Commission – Issues related to devolution of resources

Municipal finance reform through Finance Commission recommendations

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Finance Commission

Mains level : Paper 2- Transformation of financial governance of municipalities

Transforming the financial governance of India’s municipalities

  • Interim report of the Fifteenth Finance Commission of India (XV FC) indicates that it could fundamentally transform the financial governance of India’s municipalities.
  • Final report for FY 2021-22 to FY 2025-26 is expected to be tabled along with the forthcoming Budget 2021-22.
  • Building on the track record of previous finance commissions, the XV FC Commission has significantly raised the bar on financial governance of India’s municipalities in the interim report in at least four specific ways.

4 Provisions in the interim report

1) Increase in the outlay for municipalities

  •  It has set aside Rs 29,000 crore for FY 2020-21 and indicated the intent to raise the share of municipalities in the total grants’ of local bodies including panchayats gradually over the medium term, from the existing 30 per cent to 40 per cent.
  • This could result in the outlay over five years being in the range of Rs 1,50,000-Rs 2,00,000 crore compared to Rs 87,000 crore during the XIV FC period.

2) Ensuring financial accountability through conditions

  • Two very important entry conditions have been set for any municipality in India to receive FC grants:
  • 1) Publication of audited annual accounts.
  • 2) Notification of floor rates for property tax.
  • These two entry conditions lay strong foundations for financial accountability of municipalities and own revenue enhancement respectively.
  • Similarly, the Atmanirbhar Bharat Abhiyan links Rs 50,000 crore of additional borrowing limits for states to reforms in property taxes and user charges for water and sanitation.
  • There is also a thrust on municipal bonds and municipal finance reform conditions under AMRUT.

3) Distinguishing between million-plus urban agglomerations, and other cities

  • The XV FC has adopted an approach of distinguishing between million-plus urban agglomerations, and other cities.
  • This is well-founded, based on the pattern of urbanisation in India, where 53 million-plus urban agglomerations comprising 250-plus municipalities account for approximately 44 per cent of the total urban population.
  • The remaining 4,250-plus municipalities comprise 56 per cent of the total urban population.
  • Of the remaining 56 per cent, there is a “long tail” of approximately 3,900 municipalities with 33 per cent of the total urban population.
  • The XV FC has now provided for 100 per cent outcome-based funding of approximately Rs 9,000 crore to 50 million-plus urban agglomerations (excluding Union Territories) with specific emphasis on air quality, water supply and sanitation and basic grants to the rest of the cities, with 50 per cent of the end-use tied to water supply and sanitation.
  • For the first time, there is also an acknowledgement of the metropolitan area as a unified theatre of action to solve complex challenges of air quality, water and sanitation, with implicit emphasis on inter-agency coordination.

4) Common digital platform for municipal accounts

  • The report recommends a common digital platform for municipal accounts, a consolidated view of municipal finances and sectoral outlays at the state level, and digital footprint of individual transactions at source, the FC has broken new ground and demonstrated farsightedness.

Role of the state governments

  • The ultimate responsibility for municipal finance reforms remains with state governments.
  • Constitutional bodies such as the finance commission can, at best, prepare the ground and provide incentives and disincentives.
  • We need municipal legislation to reflect progressive and enabling financial governance of our cities through five reform agendas:
  • 1) Fiscal decentralisation including strengthening state finance commissions.
  • 2) Revenue optimisation to enhance own revenues.
  • 3) Fiscal responsibility and budget management to accelerate municipal borrowings.
  • 4) Institutional capacities towards an adequately skilled workforce.
  • 5) Transparency and citizen participation (for democratic accountability at the neighbourhood level).
  • The first step needs to be predictable fiscal transfers from state governments to municipalities and other civic agencies on a formula-based approach as against the present practice of ad hoc, discretionary grants.
  • State finance commissions would need to emulate the XV FC and its predecessors, and emerge as credible institutions.
  • State governments need to ensure that state finance commissions are constituted on time, resourced right, and their recommendations taken seriously.

Consider the questions “Financial governance of our cities faces several challenges. Discuss the reforms that could transform the financial governance of municipalities”

Conclusion

The state government must act on these reform agenda and ensure the transformation of financial governance of their municipalities.

Finance Commission – Issues related to devolution of resources

N.K. Singh calls for a fresh look at the Seventh Schedule

Note4Students

From UPSC perspective, the following things are important :

Prelims level : 7th Schedule

Mains level : Federalism issue raised by the Agricultural Bills

Fifteenth Finance Commission chairman N.K. Singh has called for a fresh look at the Constitution’s Seventh Schedule, which forms the basis for allocating subjects to the Centre and States.

Try this PYQ:

Q.Which of the following provisions of the Constitution of India have a bearing on Education?

  1. Directive Principles of State Policy
  2. Rural and Urban Local Bodies
  3. Fifth Schedule
  4. Sixth Schedule
  5. Seventh Schedule

Select the correct answer using the codes given below:

(a) 1 and 2 only

(b) 3, 4 and 5 only

(c) 1, 2 and 5 only

(d) 1, 2, 3 4 and 5

Why such calls by Mr NKS?

  • Singh said these issues needed urgent consideration to reinforce trust in fiscal federalism.
  • He urged a review of both the Seventh Schedule and Article 282 of the Constitution so as to give more flexibility to States in implementing centrally sponsored schemes.
  • Many have argued that the trust between various forms of government is waning.
  • Since the farmers’ agitation, these are seen through the prism of suspicion and mistrust.

Q. The federal organisation of powers under the Constitution’s Seventh Schedule needs review. In light of this, examine the problems faced by the distribution and suggest the challenge the review would face.

What is the Seventh Schedule?

  • This Schedule of the Indian Constitution deals with the division of powers between the Union government and State governments.
  • It defines and specifies the allocation of powers and functions between Union & States. It contains three lists; i.e. 1) Union List, 2) State List and 3) Concurrent List.

The Union List

  • It is a list of 98 (Originally 97) numbered items as provided in the Seventh Schedule.
  • The Union Government or Parliament of India has exclusive power to legislate on matters relating to these items.

The State List

  • It is a list of 59 (Originally 66) items.
  • The respective state governments have exclusive power to legislate on matters relating to these items.

The Concurrent List

  • There are 52 (Originally 47) items currently in the list.
  • This includes items which are under the joint domain of the Union as well as the respective States.

Finance Commission – Issues related to devolution of resources

15th Finance Commission submits report to President

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Finance Commission

Mains level : Mandate of the Finance Commission

The 15th Finance Commission, chaired by NK Singh, on Monday submitted its final report for 2021-22 to 2025-26 to the President.

Try this PYQ:

With reference to the Finance Commission of India, which of the following statements is correct?

(a) It encourages the inflow of foreign capital for infrastructure development

(b) It facilitates the proper distribution of finances among the Public Sector Undertakings

(c) It ensures transparency in financial administration

(d) None of the statements (a), (b) and (c) given above is correct in this context

Key recommendations that would feature in its final report:

  • A separate defence and national security: The viability of creating a separate defence and national security fund as suggested by the Centre.
    • States would keenly await these recommendations as it may translate into a lower share of funds for them.
  • GST compensation dues to States: The panel is also expected to factor in unpaid GST compensation dues to States for this year, while working out State’s revenue flow calculations for the years beyond 2022.

Formula that decides a State’s share:

Weight in 15th FC Parameters Weight in 14th FC
15 (2011 Census) Population 27.5 (17.5 – 1972, 10 – 2011 Census)
15 Area 15
10 Forest and Ecology 7.5
45 Income Distance 50
12.5 Demographic Performance
2.5 Tax Effort

What is the Finance Commission?

  • The Finance Commission (FC) was established by the President of India in 1951 under Article 280 of the Indian Constitution.
  • It was formed to define the financial relations between the central government of India and the individual state governments.
  • The Finance Commission (Miscellaneous Provisions) Act, 1951 additionally defines the terms of qualification, appointment and disqualification, the term, eligibility and powers of the Finance Commission.
  • As per the Constitution, the FC is appointed every five years and consists of a chairman and four other members.
  • Since the institution of the First FC, stark changes in the macroeconomic situation of the Indian economy have led to major changes in the FC’s recommendations over the years.

Constitutional Provisions

Several provisions to bridge the fiscal gap between the Centre and the States were already enshrined in the Constitution of India, including Article 268, which facilitates levy of duties by the Centre but equips the States to collect and retain the same.

Article 280 of the Indian Constitution defines the scope of the commission:

  1. The President will constitute a finance commission within two years from the commencement of the Constitution and thereafter at the end of every fifth year or earlier, as the deemed necessary by him/her, which shall include a chairman and four other members.
  2. Parliament may by law determine the requisite qualifications for appointment as members of the commission and the procedure of selection.
  3. The commission is constituted to make recommendations to the president about the distribution of the net proceeds of taxes between the Union and States and also the allocation of the same among the States themselves. It is also under the ambit of the finance commission to define the financial relations between the Union and the States. They also deal with the devolution of unplanned revenue resources.

Why need the Finance Commission?

  • As a federal nation, India suffers from both vertical and horizontal fiscal imbalances.
  • Vertical imbalances between the central and state governments result from states incurring expenditures disproportionate to their sources of revenue, in the process of fulfilling their responsibilities.
  • However, states are better able to gauge the needs and concerns of their inhabitants and therefore more efficient at addressing them.
  • Horizontal imbalances among state governments result from differing historical backgrounds or resource endowments and can widen over time.
  • The first FC was established in 1951 by Dr B.R. Ambedkar, the then-incumbent law minister, to address these imbalances.

Important functions

  • Distribution of net proceeds of taxes between Center and the States, to be divided as per their respective contributions to the taxes.
  • Determine factors governing Grants-in-Aid to the states and the magnitude of the same.
  • To make recommendations to the president as to the measures needed to augment the Fund of a State to supplement the resources of the panchayats and municipalities in the state on the basis of the recommendations made by the finance commission of the state.
  • Any other matter related to it by the president in the interest of sound finance.

Members of the Finance Commission

  • The Finance Commission (Miscellaneous Provisions) Act, 1951 was passed to give a structured format to the finance commission and to bring it to par with world standards.
  • It laid down rules for the qualification and disqualification of members of the commission, and for their appointment, term, eligibility and powers.
  • The Chairman of a finance commission is selected from people with experience of public affairs. The other four members are selected from people who:
  1. Are, or have been, or are qualified, as judges of a high court,
  2. Have knowledge of government finances or accounts, or
  3. Have had experience in administration and financial expertise; or
  4. Have special knowledge of economics

Finance Commission – Issues related to devolution of resources

Fifteenth Finance Commission

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Finance Commission

Mains level : Finance Commission, Its evolving role in fiscal federalism

Three years after it was constituted, the Fifteenth Finance Commission has finalised its report for fund devolution from the Centre to States for the five years from 2021-22 to 2025-26.

Fifteenth Finance Commission

  • The Fifteenth Finance Commission (XV FC) was constituted on November 27, 2017.
  • It was constituted against the backdrop of the abolition of the Planning Commission and the distinction between Plan and non-Plan expenditure, and introduction of the Goods and Services Tax (GST).

 What is the Finance Commission?

  • The FC was established by the President of India in 1951 under Article 280 of the Indian Constitution.
  • It was formed to define the financial relations between the central government of India and the individual state governments.
  • The Finance Commission (Miscellaneous Provisions) Act, 1951 additionally defines the terms of qualification, appointment and disqualification, the term, eligibility and powers of the Finance Commission.
  • As per the Constitution, the FC is appointed every five years and consists of a chairman and four other members.
  • Since the institution of the First FC, stark changes in the macroeconomic situation of the Indian economy have led to major changes in the FC’s recommendations over the years.

Why in news now?

  • That report of the XV FC had pared the States’ share of the divisible tax pool from 42%, as recommended by the Fourteenth Finance Commission, to 41%, citing the creation of the UT of Jammu and Kashmir and Ladakh.
  • The Commission had then said that some of the key recommendations it was required to make would feature in its final report, including the viability of creating a separate defence and national security fund.
  • The panel is also expected to factor in unpaid GST compensation dues to States for this year while working out States’ revenue flow calculations for the years beyond 2022.

Must read:

[Burning Issue] 15th Finance Commission and its recommendations (Part I)

Finance Commission – Issues related to devolution of resources

India needs a Fiscal Council

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Idea of fiscal council

Mains level : Paper 2- Fiscal Council

The newscard highlights the need of bipartisan, independent Fiscal Council to report and analyse FRBM discrepancies by the Government.

Try this question for mains:
Q.Fiscal Council is an important institution needed to complement the rule-based fiscal policy. Discuss.

What is a Fiscal Council?

  • A Fiscal Council is an independent fiscal institution (IFI) with a mandate to promote stable and sustainable public finances.
  • They aim to provide nonpartisan oversight of fiscal performance and/or advice and guidance — from either a positive or normative perspective — on key aspects of fiscal policy.
  • These institutions assist in calibrating sustainable fiscal policy by making an objective and scientific analysis.

Voices for a Fiscal Council

  • The 13th Finance Commission recommended that a committee be appointed by the Ministry of Finance which should eventually transform itself into a Fiscal Council.
  • The FC expected it to conduct an annual independent public review of FRBM compliance, including a review of the fiscal impact of policy decisions.
  • The FRBM Review Committee too made a similar recommendation underlining the need for an independent review by the Finance Ministry appointing the Council.

Why need a fiscal council?

(1)Burgeoning deficits

  • For the current year, even without any additional fiscal stimulus, the deficit is estimated at about 7% of GDP as against 3.5% estimated in the Budget due to a sharp decline in revenues.
  • The consolidated deficit of the Union and States could be as high as 12% of GDP and the overall debt could go up to 85%.
  • Thus it is necessary that the government must return to a credible fiscal consolidation path once the crisis gets over.

(2)Transparency issues

  • Besides large deficits and debt, there are questions of comprehensiveness, transparency and accountability in the Budgets.
  • The practice of repeated postponement of targets, timely non-settlement of bill payments and off Budget financing to show lower deficits has been common.
  • The report of the CAG of India in 2018 has highlighted various advances done to keep the liabilities hidden.

Fiscal Council can be a game changer. How?

  • First, an unbiased report to Parliament helps to raise the level of debate and brings in greater transparency and accountability.
  • Secondly, costing of various policies and programmes can help to promote transparency over the political cycle to discourage populist shifts in fiscal policy and improve accountability.
  • Third, scientific estimates of the cost of programmes and assessment of forecasts could help in raising public awareness about their fiscal implications and make people understand the nature of budgetary constraint.
  • Finally, the Council will work as a conscience keeper in monitoring rule-based policies, and in raising awareness and the level of debate within and outside Parliament.

Issues meddling between

  • The problem is that a Council created by the Finance Ministry and reporting to it can hardly be expected to be independent.

Diverse role to play ahead

  • According to the IMF, there were 36 countries with IFIs in 2014 and more have been established since.
  • While most of the IFIs are in advanced countries, emerging economies too have also shown growing interest in them.
  • Although their common agenda has been to function as watchdogs, there is considerable diversity in their structure and functions.
  • Over the years, monitoring compliance with fiscal rules and costing policies and programmes have become major tasks of these councils.

Way forward

  • When the markets fail, governments have to intervene.
  • Whenever governments seem obstructed, it is here that we need systems and institutions to ensure checks and balances.
  • In that respect, a Fiscal Council is an important institution needed to complement the rule-based fiscal policy.

Conclusion

  • Of course, it is not a ‘silver bullet’; if there is no political will, the institution would be less effective, and if there is political will, there is no need for such an institution.
  • That is also true of the FRBM Act. While we cannot state that the FRBM Act has been an unqualified success, it has also not been an abject failure either.

Finance Commission – Issues related to devolution of resources

NPA issue in India:Complete analysis

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Finance commission and related constitutional provisions

Mains level : Implication in federal relation; scope for reforms

The Financial Stability Report (FSR) released by RBI recently has once again underlined the vulnerability of the Indian public sector banks (PSBs). They have been under a severe balance sheet crisis even before the pandemic, and the crisis created by the pandemic, and the moratorium offered, will explode when the chickens come to roost.

Current banking scenario in India

According to the FSR

  • The gross non-performing assets would go up from 11.3% in March 2020 to 15.2% in March 2021, and to 16.3% under a very severe stress scenario. 
  • The CRAR is estimated to deteriorate from 14.6% in March to 13.3% in the baseline scenario, and to 11.8% under a very severe stress scenario. 
  • The volume of recapitalisation required is humongous.

What is a Non-Performing Asset (NPA)?

  • You may note that for a bank, the loans given by the bank is considered as its assets. So if the principle or the interest or both the components of a loan is not being serviced to the lender (bank), then it would be considered as a Non-Performing Asset (NPA).
  • Any asset which stops giving returns to its investors for a specified period of time is known as Non-Performing Asset (NPA).
  • Generally, that specified period of time is 90 days in most of the countries and across the various lending institutions. However, it is not a thumb rule and it may vary with the terms and conditions agreed upon by the financial institution and the borrower.

Reasons for rise in NPA in India

  • Historical factors -Between early 2000’s and 2008 Indian economy were in the boom phase. During this period Banks especially Public sector banks lent extensively to corporate. However, the profits of most of the corporate dwindled due to slowdown in the global economy, the ban in mining projects, and delay in environmental related permits affecting power, iron and steel sector, volatility in prices of raw material and the shortage in availability of. This has affected their ability to pay back loans and is the most important reason behind increase in NPA of public sector banks.
  • Relaxed lending norms : One of the main reasons of rising NPA is the relaxed lending norms especially for corporate honchos when their financial status and credit rating is not analyzed properly. Also, to face competition banks are hugely selling unsecured loans which attributes to the level of NPAs.
  • Lack of contigency planning: Banks did not conducted adequate contingency planning, especially for mitigating project risk. They did not factor eventualities like failure of gas projects to ensure supply of gas or failure of land acquisition process for highways.
  • Restructuring of loan facility was extended to companies that were facing larger problems of over-leverage& inadequate profitability. This problem was more in the Public sector banks.
  • Unforseen economic shocks like Demonetization and Covid 19

What is the impact of NPAs?

  • Lenders suffer a lowering of profit margins.
  • Stress in banking sector causes less money available to fund other projects, therefore, negative impact on the larger national economy.
  • Higher interest rates by the banks to maintain the profit margin.
  • Redirecting funds from the good projects to the bad ones.
  • As investments got stuck, it may result in it may result in unemployment.
  • In the case of public sector banks, the bad health of banks means a bad return for a shareholder which means that the government of India gets less money as a dividend. Therefore it may impact easy deployment of money for social and infrastructure development and results in social and political cost.
  • Investors do not get rightful returns.
  • Balance sheet syndrome of Indian characteristics that is both the banks and the corporate sector have stressed balance sheet and causes halting of the investment-led development process.
  • NPAs related cases add more pressure to already pending cases with the judiciary.

What are the various steps taken to tackle NPAs?

1.Corporate Debt Restructuring – 2005

It is for reducing the burden of the debts on the company by decreasing the rates paid and increasing the time the company has to pay the obligation back.

2.5:25 rule – 2014

  • Also known as, Flexible Structuring of Long Term Project Loans to Infrastructure and Core Industries.
  • It was proposed to maintain the cash flow of such companies since the project timeline is long and they do not get the money back into their books for a long time, therefore, the requirement of loans at every 5-7 years and thus refinancing for long term projects.

3.Joint Lenders Forum – 2014

  • It was created by the inclusion of all PSBs whose loans have become stressed. It is present so as to avoid loans to the same individual or company from different banks.
  • It is formulated to prevent instances where one person takes a loan from one bank to give a loan of the other bank.

4.Mission Indradhanush – 2015

The Indradhanush framework for transforming the PSBs represents the most comprehensive reform effort undertaken since banking nationalization in the year 1970 to revamp the Public Sector Banks (PSBs) and improve their overall performance by ABCDEFG.

  • A-Appointments: Based upon global best practices and as per the guidelines in the companies act, separate post of Chairman and Managing Director and the CEO will get the designation of MD & CEO and there would be another person who would be appointed as non-Executive Chairman of PSBs.
  • B-Bank Board Bureau: The BBB will be a body of eminent professionals and officials, which will replace the Appointments Board for the appointment of Whole-time Directors as well as non-Executive Chairman of PSBs
  • C-Capitalization: As per finance ministry, the capital requirement of extra capital for the next four years up to FY 2019 is likely to be about Rs.1,80,000 crore out of which 70000 crores will be provided by the GOI and the rest PSBs will have to raise from the market.
Financial Year Total Amount
FY15-16 25,000 Crore
FY16-17 25,000 Crore
FY17-18 10,000 Crore
FY18-19 10,000 Crore
Total 70,000 Crore
  • D-DEstressing: PSBs and strengthening risk control measures and NPAs disclosure.
  • E-Employment: GOI has said there will be no interference from Government and Banks are encouraged to take independent decisions keeping in mind the commercial the organizational interests.
  • F-Framework of Accountability: New KPI(key performance indicators) which would be linked with performance and also the consideration of ESOPs for top management PSBs.
  • G-Governance Reforms: For Example, Gyan Sangam, a conclave of PSBs and financial institutions. Bank board Bureau for transparent and meritorious appointments in PSBs.

5.Strategic debt restructuring (SDR) – 2015

  • Under this scheme banks who have given loans to a corporate borrower gets the right to convert the complete or part of their loans into equity shares in the loan taken company. Its basic purpose is to ensure that more stake of promoters in reviving stressed accounts and providing banks with enhanced capabilities for initiating a change of ownership in appropriate cases.

6.Asset Quality Review – 2015

  • Classify stressed assets and provision for them so as to secure the future of the banks and further early identification of the assets and prevent them from becoming stressed by appropriate action.

7.Sustainable structuring of stressed assets (S4A) – 2016

  • It has been formulated as an optional framework for the resolution of largely stressed accounts. 
  • It involves the determination of sustainable debt level for a stressed borrower and bifurcation of the outstanding debt into sustainable debt and equity/quasi-equity instruments which are expected to provide upside to the lenders when the borrower turns around.

8.Insolvency and Bankruptcy code Act-2016

  • It has been formulated to tackle the Chakravyuha Challenge (Economic Survey) of the exit problem in India.
  • The aim of this law is to promote entrepreneurship, availability of credit, and balance the interests of all stakeholders by consolidating and amending the laws relating to reorganization and insolvency resolution of corporate persons, partnership firms and individuals in a time-bound manner and for maximization of value of assets of such persons and matters connected therewith or incidental thereto.

9.Pubic ARC vs. Private ARC – 2017

  • This debate is recently in the news which is about the idea of a Public Asset Reconstruction Companies (ARC) fully funded and administered by the government as mooted by this year’s Economic Survey Vs. the private ARC as advocated by the deputy governor of RBI Mr. Viral Acharya.
  • Economic survey calls it as PARA (Public Asset Rehabilitation Agency) and the recommendation is based on a similar agency being used during the East Asian crisis of 1997 which was a success.

10.Bad Banks – 2017

  • Economic survey 16-17, also talks about the formation of a bad bank which will take all the stressed loans and it will tackle it according to flexible rules and mechanism. It will ease the balance sheet of PSBs giving them the space to fund new projects and continue the funding of development projects.

11.Prompt corrective action

  • PCA is a framework under which banks with weak financial metrics are put under watch by the RBI.
  • The RBI introduced the PCA framework in 2002 as a structured early-intervention mechanism for banks that become undercapitalised due to poor asset quality, or vulnerable due to loss of profitability.
  • It aims to check the problem of Non-Performing Assets (NPAs) in the Indian banking sector.

12.RBI’s revised stressed asset resolution norms

  • The RBI in June 2019 released a revised set of norms on stressed asset resolution which are substantially less stringent from the previous one.

About the February 2018 RBI circular

  • Through a notification issued on Feb 12, 2018 the RBI laid down a revised framework for the resolution of stressed assets, which replaced all its earlier instructions on the subject.
  • Banks were required to immediately start working on a resolution plan for accounts over Rs 2,000 crore, which was to be finalised within 180 days.
  • In the case of non-implementation, lenders were required to file an insolvency application.
  • RBI termed it necessary to substitute the existing guidelines with a harmonized and simplified generic framework for resolution of stressed assets.
  • Also, banks have to recognise loans as non-performing even if the repayment was delayed by just one day.
  • Not adhering to the timelines in the circular would attract stringent supervisory and enforcement actions.

What did the revised framework replace?

  • The circular went into effect on the same day that it was issued, and all existing schemes for stressed asset resolution were withdrawn with immediate effect.
  • The circular was ostensibly intended to stop the “evergreening” of bad loans the practice of banks providing fresh loans to enable timely repayment by borrowers on existing loans.
  • The RBI warned banks that not adhering to the timelines laid down in the circular, or attempting to evergreen stressed accounts, would attract stringent supervisory and enforcement actions.

New circular of the RBI

  • The new framework gives lenders a breather from the one-day default rule whereby they had to draw up a resolution plan (RP) for implementation within 180 days of the first default.
  • It gives lenders (scheduled commercial banks, all-India financial institutions and small finance banks) 30 days to review the borrower account on default.
  • During this review period, lenders may decide on the resolution strategy, including the nature of the RP and the approach for its implementation.
  • Lenders may also choose to initiate legal proceedings for insolvency or recovery.
  • The new circular is also applicable to small finance banks and systemically important non-deposit taking non-banking financial companies (NBFCs) and deposit-taking NBFCs.
  • In cases where the RP is to be implemented, all lenders have to enter into an intercreditor agreement (ICA)for the resolution of stressed assets during the review period to provide for ground rules for finalisation and implementation of the RP in respect of borrowers with credit facilities from more than one lender.
  • Under the ICA, any decision agreed to by the lenders representing 75 per cent of total outstanding credit facilities by value and 60 per cent by number will be binding upon all the lenders. In particular, the RPs will provide for payment which will not be less than the liquidation value due to the dissenting lenders.
  • In cases where the aggregate exposure of a borrower to lenders (scheduled commercial banks, all-India financial institutions and small finance banks) is ₹2,000 crore and above, the RP has to be implemented within 180 days from the end of the review period, and the reference date has been set as June 7, 2019.
  • In the case of borrowers in the ₹1,500 crore and above but less than ₹2,000 crore category, January 1, 2020 has been set as the reference date for implementing the RP. In the less than ₹1,500 crore category, the RBI will announce the reference date in due course.

 What if the Resolution Plan is delayed?

  • There is a disincentive for banks if they delay implementing a viable resolution plan.
  • In case the plan is not implemented within 180 days from the end of the review period, banks have to make additional provision of 20% and another 15% if the plan is not implemented within 365 days from the start of the review period.
  • The additional provisions would be reversed if resolution is pursued under Insolvency and Bankruptcy Code (IBC).

Further reforms needed

  • Banks have to accept losses on loans (or ‘haircuts’).
  • They should be able to do so without any fear of harassment by the investigative agencies.
  • The Indian Banks’ Association has set up a six-member panel to oversee resolution plans of lead lenders. To expedite resolution, more such panels may be required.
  • An alternative is to set up a Loan Resolution Authority, if necessary through an Act of Parliament.
  • Also, the government must infuse at one go whatever additional capital is needed to recapitalise banks — providing such capital in multiple instalments is not helpful
  • The quality of lending by PSB must be improved in future so that the same problem does not arise again.
  • To provide Public sector banks with greater autonomy the shareholding of the government can be reduced to less than 50 percent or 33 percent.
  • A second requirement is that public sector banks should become board-managed institutions, with the board responsible for all appointments, including that of the chief executive officer (CEO). If the shares of the government are actually transferred to a holding company, then decisions regarding appointments could be taken by the board of the new company on the recommendation of the board of the bank.
  • The objective of creating a genuinely commercial environment in which public sector banks can function and managements are made accountable can only be achieved if the government is willing to step back from exercising direct control. 

Finance Commission – Issues related to devolution of resources

[pib] 15th Finance Commission submits report on Agricultural Exports

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Finance Commission

Mains level : Finance Commission, Its evolving role in fiscal federalism

The High-Level Group on Agricultural Exports set up by the Fifteenth Finance Commission has submitted its report to the Commission.

Try this PYQ from CSP 2019

Q.In India, which of the following reviews the independent regulators in sectors like telecommunications, insurance, electricity, etc.?

  1. Ad Hoc Committees set up by the Parliament
  2. Parliamentary Department Related Standing Committees
  3. Finance Commission
  4. Financial Sector Legislative Reforms Commission
  5. NITI Aayog

Select the correct answer using the code given below.

(a) 1 and 2

(b) 1, 3 and 4

(c) 3, 4 and 5

(d) 2 and 5

Why focus on Agri-exports?

  • India’s agricultural export has the potential to grow from USD 40 billion to USD 70 billion in a few years.
  • The estimated investment in agricultural export could be in the tune to USD 8-10 billion across inputs, infrastructure, and processing and demand enablers.
  • Additional exports are likely to create an estimated 7-10 million jobs.
  • It will lead to higher farm productivity and farmer income.

Highlights of the report

(A) The HLEG has made its recommendations, major among which are:

  • Focus on 22 crop value chains – demand-driven approach.
  • Solve Value Chain Clusters (VCC) holistically with a focus on value addition.
  • Create a State-led export plan with participation from stakeholders.
  • Private Sector should play an anchor role.
  • The centre should be an enabler.
  • The robust institutional mechanism to fund and support implementation.

(B) State-led Agri Exports

The Group has recommended a State-led Export Plan –  a business plan for a crop value chain cluster. It will lay out the opportunity, initiatives and investment required to meet the desired value chain export aspiration.

The Group has also said that for its success, the following factors needed to be considered:-

  • Plans should be collaboratively prepared with private sector players and Commodity Boards.
  • Leveraging of state plan guide and value chain deep dives.
  • The private sector should play an anchor role in driving outcomes and execution.
  • The centre should enable state-led plans.
  • Institutional governance should be promoted across the state and centre.
  • Funding through the convergence of existing schemes, Finance Commission allocation and private sector investment.

Back2Basics: Finance Commission (FC)

  • The FC is a constitutionally mandated body that decides, among other things, the sharing of taxes between the Centre and the states.
  • Article 280 (1) requires the President to constitute, “within two years from the commencement of this Constitution.
  • And thereafter constitute FC at the expiration of every fifth year or at such earlier time as the President considers necessary.
  • An FC “which shall consist of a Chairman and four other members”.

Divisible Pool of Taxes

  • Under Article 280(3) (a) the FC must make recommendations to the President “as the distribution between the Union and the States of the net proceeds of taxes which are to be, or maybe, divided between them under this Chapter and the allocation between the States of the respective shares of such proceeds”.
  • Accordingly, the FC determines a formula for tax-sharing between the states, which is a weighted sum of the states’ population, area, forest cover, tax capacity, tax effort and demographic performance, with the weights expressed in percentages.
  • This crucial role of the Commission makes it instrumental in the implementation of fiscal federalism.

Finance Commission – Issues related to devolution of resources

For the sake of sound fiscal federalism

Note4Students

From UPSC perspective, the following things are important :

Prelims level : FRBM Act

Mains level : Paper 2- Issue of devolution to state under the recommendations of 14th finance commission.

Faultlines in the Centre-State fiscal relations have widened due to Covid. This article examines how States are not getting what they should as per the 14th Finance Commission report.

Centre-state tussle

  • The tussle for the rights of States has been focused on Article 356.
  • Partial behaviour by the Governors, regional party governments were politically destabilised.
  • Little was done to implement the report of  Justice R.S. Sarkaria Commission on Centre-State relations.
  • The new faultline in the Centre-State relation could be over the way report of 14th Finance Commission is being implemented.
  • This began well before COVID-19, but the pandemic and its economic disruption have brought things to an edge.

Issues over the implementation of 14th Finance Commission report

  • The 14th Finance Commission report in 2015 promised devolution of more finances to the States.
  • As part of the process, States would have new responsibilities, especially in the social sector.
  •  The Goods and Services Tax (GST) regime was also justified as a grand bargain that would eventually leave all States better off.
  • In reality, tax devolution to States has been consistently below 14th Finance Commission projections.
  • One reason for this has been the economic slowdown, and lower-than-expected GST collections.
  • The shortfall in GST collection for 2018-2019 was 22% when compared to projections.
  • Payments to the States have been delayed as well.
  • There is a ₹6.84 lakh crore gap between what the 14th Finance Commission promised to States and what they have received.
  • States undertook programmes and projects spending 46% more than the Central Government; today the figure is 64%.
  • Despite spending less than the states the Centre’s fiscal deficit exceeds the consolidated State deficit by 14%.

Need to revisit the FRBM provisions

  • Due to pandemic, the fiscal deficit for States, collectively, is inevitably going to breach the projection of 2.04%.
  • As per provisions of the Fiscal Responsibility and Budget Management (FRBM) Act, the GSDP can actually accommodate a fiscal deficit of 3%.
  • Now, post-pandemic, this limit will be crossed.
  • The FRBM has an “escape clause” that allows for a one-time relaxation of the fiscal deficit threshold upto 0.5% in a time of exigency.
  • The escape clause has been utilised by the Centre but it has proven woefully insufficient in addressing the current crisis.
  • Fiscal policymakers and technocrats agree that the rigidity of the FRBM has to be revisited.
  • It should allow for greater flexibility and consultation as to when and how the “escape clause” can be applied.
  • The Centre has gone in for subjective interpretation, imposing conditions that are outside the scope of the FRBM.

Consider the question “Fiscal tensions have emerged as  a new front in the Centre-State relations. Suggest the steps the Centre should take to address it.”

Conclusion

Centre government needs to be more considerate of the financial woes of the State and try to deliver on the recommendations of the 14th Finance Commission report.

Finance Commission – Issues related to devolution of resources

Need for fiscal decentralisation

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Finance Commission and its role

Mains level : Paper 2- Fiscal decentralisation.

Covid pandemic has turned the fiscal health of states from bad to worse. This article highlights the role of the Finance Commission as a neutral arbiter in the Centre-state relation in achieving the delicate balance. It has highlighted certain issues that the commission has to consider when it submits its report. So, what are those issues? Read to know…

Disruption in fiscal consolidation and impact on Centre-state relations

  • Due to COVID, there is a  collapse in general government revenues and the consequent rise in the deficit levels.
  • It has disrupted the glide path of fiscal consolidation.
  • But it has also deepened the faultlines in Centre-state fiscal relations. 
  • The Centre is trying to claw back the fiscal space ceded to the states and assert its dominance over the country’s fiscal architecture.
  • This coupled with the fiscal constraints exposed by the pandemic have made it harder to maintain the delicate balance needed to manage the contesting claims of the Centre and the states

Why the 15th Finance Commission report is critical for decentralisation

  • It will be ironic if the ongoing health crisis that has ended up exposing the limitations of a centralised approach, ends up reversing the trend towards fiscal decentralisation.
  • The Commission’s report will be critical on two counts:
  • First, it will determine how India’s fiscal architecture is reshaped.
  • Second, how Centre-state relations are reset as the country attempts to recover from the COVID-19 shock.

1. Will the burden of reducing debt/gdp  fall equally on Centre and state?

  • The glide path of fiscal consolidation laid out by the FRBM review committee had envisaged bringing down general government debt to 60 per cent of GDP by 2022.
  • This is unlikely to materialise now.
  • Factoring in the additional borrowings, the debt-to-GDP ratio may well be over 80 per cent this year.
  • Thus the fiscal consolidation roadmap will have to be reworked.
  •  As per its terms of reference, the Finance Commission will lay out the new path to be followed by both Centre and states.
  • But the question is: Will the burden of debt reduction fall equally upon the Centre and states?
  • Or will the Commission allow the Centre to have greater leeway when it comes to fiscal consolidation?

2. Will the conditional extension of borrowing limit be formalised?

  •  Recently, the Centre eased the states’ budget constraint, allowing them to borrow more this year.
  • But this extra borrowing was conditional upon states implementing reforms in line with the Centre’s priorities.
  • Despite protests, most states are likely to comply with the conditions, to varying degrees.
  • But the issue is: As the hit from the ongoing crisis spreads over multiple years, state governments may want to maintain their expansionary fiscal stance next year as well.
  • Then, will the Finance Commission, in line with its terms of reference, go along with the Centre’s stance and recommend imposing conditions on additional borrowing and formalise this arrangement?
  • It is difficult to see such an arrangement being rolled back once formalised.

3. GST compensation cess

  • The GST council, in which the Centre effectively has a veto, is yet to clearly spell out its views on the extension of the compensation cess to offset states losses beyond the five-year period.
  • The Commission will have to weigh in on this too.
  • At this time the Centre is struggling to fulfil its promise of assuring states their GST revenues.
  • In such situation, will the Commission argue in favour of extending the compensation period, as states desire, but, perhaps, lowering the assured 14 per cent growth in compensation and linking it to nominal GDP growth?
  • As GST revenue accounts for a significant share of states’ income, how this plays out will also have a bearing on their ability to bring down their debt levels.

4. Issue of tax devolution

  • In some sense, accepting the recommendations of the 14th Finance Commission was a fait accompli.
  • The terms of reference of the 15th Finance Commission points to the present government’s desire to claw back the fiscal space offered to the states.
  • But is clawing back fiscal space now a prudent approach?
  • A cash-strapped Centre will surely welcome greater say over the diminished resources.
  • And there a strong argument for the Centre to have far greater fiscal space than it currently enjoys.
  • This is partly because the fiscal multiplier of central government capital spending is greater than that by the states.
  • But also the nature of politics may well push in that direction.
  • Centralisation of political power may well lead to demands for centralisation of resources.
  • However, surely fiscal space can be created by a review of the Centre’s own spending programme.

Need to relook at the Centre’s expenditure priorities

  • Over the past decades, there has been a substantial increase in the Centre’s spending on items on the state and concurrent list.
  •  This shift has occurred even as grants by the Centre to states exceed the former’s revenue deficit.
  • This, as some have pointed out, effectively means that the Centre is borrowing to transfer to states.
  • Surely, a relook at the Centre’s expenditure priorities would create greater fiscal space for it.

What the Finance Commission can do?

  • Any attempt to shift the uneasy balance in favour of the Centre will strengthen the argument that this government’s talk of cooperative federalism serves as a useful mask to hide its centralising tendencies.
  • As a neutral arbiter of Centre-state relations, the Finance Commission should seek to maintain the delicate balance in deciding on contesting claims.
  • This may well require giveaways especially if states are to be incentivised to push through legislation on items on the state and concurrent list.
  • The fiscal stress at various levels of the government necessitates a realistic assessment of the country’s macro-economic situation, the preparation of a medium-term roadmap, as well as careful calibration of the framework that governs Centre-state relations.
  • At this critical juncture, the Finance Commission should present the broad contours of the roadmap.
  • Though it could request for another year’s extension to present its full five-year report citing the prevailing uncertainty.

Consider the question “COVID pandemic has put the States in the dire fiscal position. What we need is more of the fiscal decentralisation now.” In light of this, along with other factors, elaborate on the role 15th Finance Commission could play in this regard.

Conclusion

Finance Commission has to play an important role in achieving the delicate balance in the conflicting domain of finance by addressing the concerns of both the players.

Finance Commission – Issues related to devolution of resources

Needed, greater decentralisation of power

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Federal system.

Mains level : Paper 2-Why it is said that there is a paradox in the federal system of India? Covid-19 has highlighted the need for decentralisation in India.

Context

Even as States have taken up positions of leadership in the pandemic response, federal limitations are becoming hurdles.

State governments at the position of leadership

  • In the fight against the pandemic, one of the striking features of governance has been the signal role played by State Chief Ministers across India.
  • Proactive measures: Even before the Union government invoked the Disaster Management Act, 2005, many State governments triggered the Epidemic Diseases Act, 1897, and installed a series of measures to combat what was then an oncoming onslaught of COVID-19.
  • These actions have not always been perfect. Some of them have even disproportionately trenched upon basic civil liberties.
  • But, by and large, they have been tailored to the reality faced on the ground by the respective governments.
  • Policies to address local concerns: States such as Maharashtra, Kerala, Tamil Nadu, Rajasthan, and Karnataka have shaped their policies to address their direct, local concerns.
  • They have communicated these decisions to the public with clarity and consideration, helping, in the process, to lay out a broad framework for the nation.
  • Not just the laboratories of democracy: In doing so, they have acted not merely as “laboratories of democracy”, to paraphrase the former U.S. Supreme Court Justice Louis Brandeis, but also as founts of reasoned authority.

Federal arrangements placing limitations on the states

  • Equally, though, as much as State governments have taken up positions of leadership, they have repeatedly found themselves throttled by the limitations of the extant federal arrangement.
  • The Centre for Policy Research has pointed out at least three specific limitations.
  • Funds and structuring own package: The inability of States to access funds and thereby structure their own welfare packages.
  • Curbs imposed by PFMS: The curbs imposed by a public finance management system (PFMS) that is mired in officialdom.
  • This has prevented States from easily and swiftly making payments for the purchase of health-care apparatus such as ventilators and personal protective equipment.
  • Disruption of supply chains: Three, the colossal disruption of supply chains not only of essential goods and services but also of other systems of production and distribution, which has placed States in a position of grave economic uncertainty.
  • Need to decentralise: As these limitations demonstrate an urgent need to decentralise administration, where States — and local bodies acting through such governments — are allowed greater managerial freedom.
  • Under such a model, the Union government will command less but coordinate more.

Indian federalism-two distinct levels

  • There are varying accounts of what Indian federalism truly demands.
  • Two levels: What is manifest from a reading of the Constitution is that it creates two distinct levels of government: one at the Centre and the other at each of the States.
  • The Seventh Schedule to the Constitution divides responsibilities between these two layers.
  • The Union government is tasked with matters of national importance, such as foreign affairs, defence, and airways.
  • But the responsibilities vested with the States are no less important. Issues concerning public health and sanitation, agriculture, public order, and police, among other things, have each been assigned to State governments.
  • In these domains, the States’ power is plenary.
  • This federal architecture is fortified by a bicameral Parliament.
  • Significantly, this bicameralism is not achieved through a simple demarcation of two separate houses, but through a creation of two distinct chambers that choose their members differently-
  • A House of the People [Lok Sabha] comprising directly elected representatives and a Council of States [Rajya Sabha] comprising members elected by the legislatures of the States.

Financial autonomy of the states

  • Ensuring financial autonomy: In formulating this scheme of equal partnership, the framers were also conscious of a need to make States financially autonomous.
  • No overlap: To that end, when they divided the power to tax between the two layers of government they took care to ensure that the authority of the Union and the States did not overlap.
  • Therefore, while the Centre, for example, was accorded the power to tax all income other than agricultural income and to levy indirect taxes in the form of customs and excise duties, the sole power to tax the sale of goods and the entry of goods into a State was vested in the State governments.
  • The underlying rationale was simple: States had to be guaranteed fiscal dominion to enable them to mould their policies according to the needs of their people.

History of paradox in federal system of India

  • Despite this plainly drawn arrangement, the history of our constitutional practice has been something of a paradox.
  • It is invariably at the level of the States that real development has fructified.
  • But the Union has repeatedly displayed a desire to treat States, as the Supreme Court said in R. Bommai v. Union of India, as mere “appendages of the Centre”.
  • Time and again, efforts have been made to centralise financial and administrative power, to take away from the States their ability to act independently and freely.
  • Following five examples demonstrated that the point made here.

1 Matters of finance-what was expected in theory did not realise

  • Consider the widely hailed decision to accept the 14th Finance Commission’s recommendation for an increase in the share of the States in total tax revenues from 32% to 42%.
  • While, in theory, this ought to have enabled the States to significantly increase their own spending, in reality, as a paper authored by Amar Nath H.K. and Alka Singh of the National Institute of Public Finance and Policy suggests, this has not happened.
  • What went wrong? Gains made by the States, as the paper underlines, have been entirely offset by a simultaneous decline in share of grants and by a concomitant increase in the States’ own contribution towards expenditures on centrally sponsored schemes.

2. Goods and Service Tax

  • The decline in the sovereignty of the states: Notably, the creation of a Goods and Services Tax regime, which far from achieving its core purpose of uniformity has rendered nugatory the internal sovereignty vested in the States.
  • By striking at the Constitution’s federal edifice, it has made the very survival of the States dependent on the grace of the Union.
  • The tension today is so palpable that a number of the States are reported to have written to the Union Finance Ministry.
  • More than four months’ worth of Goods and Services Tax compensation to the States — reportedly totalling about a sum of ₹40,000 crore — remains unreleased.

3. Passing a bill as a money bill

  • The Union government’s centralising instinct, though, has not been restricted to matters of finance.
  • It has also introduced a slew of legislation as money bills, in a bid to bypass the Rajya Sabha’s sanction, even though these laws scarcely fit the constitutional definition.

4. Role of the Governors

  • Similarly, the role of the Governors has been weaponised to consolidate political power.

5. Article 370

  • But perhaps most egregious among the moves made is the gutting of Article 370 and the division of Jammu and Kashmir into two Union Territories.
  • It was done without securing consent from the State Legislative Assembly.

Conclusion

Perhaps a crisis of the kind that COVID-19 has wrought will show us that India needs greater decentralisation of power; that administration through a single central executive unit is unsuited to its diverse and heterogeneous polity. We cannot continue to regard the intricate niceties of our federal structure as a nettlesome trifle. In seeing it thus, we are reducing the promise of Article 1 of the Constitution, of an India that is a Union of States, to an illusory dream.

Finance Commission – Issues related to devolution of resources

Why has Kerala sought a relaxation of FRBM rules?

Note4Students

From UPSC perspective, the following things are important :

Prelims level : FRBM Act

Mains level : Read the attached story

Kerala CM has urged the Centre to provide Kerala with flexibility under the Fiscal Responsibility and Budget Management (FRBM) Act so as to ensure that the State’s finances are not adversely impacted.

FRBM Act

  • The FRBM is an act of the parliament that set targets for the Government of India to establish financial discipline, improve the management of public funds, strengthen fiscal prudence and reduce its fiscal deficits.
  • It was first introduced in the parliament of India in the year 2000 by Vajpayee Government for providing legal backing to the fiscal discipline to be institutionalized in the country.
  • Subsequently, the FRBM Act was passed in the year 2003.

Features of the FRBM Act

  • It was mandated by the act that the following must be placed along with the Budget documents annually in the Parliament:
  1. Macroeconomic Framework Statement
  2. Medium Term Fiscal Policy Statement and
  3. Fiscal Policy Strategy Statement

Fiscal Indicators

It was proposed that the four fiscal indicators be projected in the medium-term fiscal policy statement viz.

  1. Revenue deficit as a percentage of GDP,
  2. Fiscal deficit as a percentage of GDP,
  3. Tax revenue as a percentage of GDP and
  4. Total outstanding liabilities as a percentage of GDP

Why is Kerala seeking flexibility under the FRBM?

  • Kerala was one of the earliest States to announce an economic package of ₹20,000 crore to mitigate the impact on livelihoods and overall economic activity.
  • Kerala’s current fiscal position means that it can borrow about ₹25,000 crore during the financial year 2020-21.
  • However the State government is understandably concerned that the stringent borrowing cap under the fiscal responsibility laws should not constrain its borrowing and spending ability over the remaining 11 months.
  • This is a crucial period when the state would have to meet other expenditure for routine affairs related to the running of the State’s socio-economic programmes as well as the post pandemic recovery.

How does a relaxation of the FRBM work?

  • The law does contain what is commonly referred to as an ‘escape clause’.
  • Under Section 4(2) of the Act, the Centre can exceed the annual fiscal deficit target citing grounds that include national security, war, national calamity, collapse of agriculture, structural reforms and decline in real output growth of a quarter by at least three percentage points below the average of the previous four quarters.
  • The ongoing pandemic could be considered as a national calamity.
  • This would allow both the Union government and States including Kerala to undertake the much-needed increases in expenditure to meet the extraordinary circumstances.

When have the FRBM norms been relaxed in the past?

  • There have been several instances of the FRBM goals being reset.
  • But the most significant FRBM deviation happened in 2008-09, in the wake of the global financial crisis, when the Centre resorted to a focused fiscal stimulus: tax relief to boost demand and increased expenditure on public projects.
  • This was aimed to create employment and public assets, to counter the fallout of the global slowdown.
  • This led to the fiscal deficit climbing to 6.2%, from a budgeted goal of 2.7%.
  • Simultaneously, the deficit goals for the States too were relaxed to 3.5% of GSDP for 2008-09 and 4% of GSDP for fiscal 2009-10.

Finance Commission – Issues related to devolution of resources

Private: Interim report of the 15th Finance Commission (FC)

What is the news: The interim report of the 15th Finance Commission (FC) has been tabled in Parliament this budget session.

Terms of Reference of XV-FC

XV-FC is mandated to give recommendations regarding

  • The distribution between the Union and the States of the net proceeds of taxes which are to be divided between them.
  • The allocation between the States of the respective shares of such proceeds.
  • The principles which should govern the grants in aid of the revenues of the States out of the Consolidated Fund of India.
  • The measures needed to augment the Consolidated Fund of a State to supplement the resources of the Panchayats and Municipalities in the State based on the recommendations made by the Finance Commission of the State.

The Commission shall review the current fiscal status of the Union and the States, and recommend a fiscal consolidation roadmap. The Commission may also examine whether revenue deficit grants be provided at all.

While making the recommendations, the XV-FC may consider

  • Resources of Central and State governments and their potential and fiscal capacity.
  • Demand on the resources of respective governments.
  • Impact of the enhanced devolution following 14th FC on the fiscal situation.
  • Impact of GST and compensation for the losses in revenues for 5 years.

The Commission may consider proposing performance-based incentives to the States based on

  • Efforts made in expansion and deepening of tax net under GST.
  • Efforts and progress made in moving towards the replacement rate of population growth.
  • Achievements in the implementation of flagship schemes of Government of India, disaster-resilient infrastructure, and sustainable development goals.
  • Progress made in increasing capital expenditure, eliminating losses of the power sector, and improving the quality of such expenditure in generating future income streams.
  • Progress made in increasing tax/non-tax revenues.
  • Promoting savings by the adoption of Direct Benefit Transfers and Public Finance Management System.
  • Promoting digital economy and removing layers between the government and the beneficiaries.
  • Progress made in promoting ease of doing business and promoting labour-intensive growth.
  • Provision of grants in aid to local bodies for basic services and implementation of a performance grant system in improving the delivery of services.
  • Control or lack of it in incurring expenditure on populist measures.
  • Progress made in sanitation, solid waste management and bringing in a behavioural change to end open defecation.

The Commission shall use the population data of 2011 while making its recommendations.

The Commission may review the present arrangements on financing Disaster Management initiatives regarding the funds constituted under the Disaster Management Act, 2005.

Recommendations of the 15th Finance Commission

The 15th Finance Commission proposed recommendations for both vertical and horizontal devolution.

Vertical Devolution

  • 41% of the divisible pool to be devolved to the States in the year 2020-21.
  • FC-XIV which had recommended 42%, had a view that tax devolution should be the primary route of transfer of resources to States as they are a more objective form of transfer of resources as compared to other forms.
  • The XV-FC also agrees with this view but reduced the States’ share to 41% because of the re-organization of the State of Jammu & Kashmir into UTs of Ladakh and Jammu & Kashmir through the Jammu & Kashmir Re-organization Act, 2019.
  • UTs are the responsibilities of the Union and their demands have to be met from the Union Government’s resources.

Horizontal Devolution

  • Horizontal devolution is done primarily to enable the States to provide basic public goods and services with equivalent tax effort.
  • The various criteria to be considered for horizontal devolution are classified into three broad groups as follows.
  • Need-based criteriaPopulation, area and forest & ecology form the need-based criteria. This is needed to address the fiscal gap of States existing due to the structural mismatch between the States’ resources and their expenditure liabilities.
  • Equity-based criterionIncome distance forms the equity-based criterion to ensure fiscal equalization given the large differences in the resource base available and status of development within the country.
  • Performance-based criteriaDemographic performance and tax effort are part of the performance-based criteria that is framed to reward and incentivize States to perform better, in terms of utilization of resources available to them.

Table 1 Horizontal Devolution Criteria

Criteria 14th FC 15th FC
Income Distance 50.0 45.0
Population of 1971 17.5
Population of 2011 10.0 15.0
Area 15.0 15.0
Forest Cover 7.5
Forest & Ecology 10.0
Demographic Performance 12.5
Tax Effort 2.5
Total 100 100
  • Population: Only 2011 Census numbers are used as per the ToR. Population criterion is assigned a weight of only 15 per cent as some of the other criteria will also be scaled by it.
  • Area: A moderate weight of 15 per cent for the area criterion is assigned larger area incurs some additional administrative costs but it may not lead to a proportional increase in the cost of providing services.
  • Forest and Ecology: This criterion is for the ecological services being provided by a State’s forest cover to the country as a whole and is arrived at by calculating the share of the dense forest of each State in the aggregate dense forest of all the States. A weight of 10 per cent is assigned for the forest and ecology criterion.
  • Income Distance: Distance of per capita income is the criteria used to make the devolution formula more equalizing and progressive, and provides higher devolution to States with lower per capita income and lower own tax capacity. The XV-FC retained the income distance criterion with a weight of 45 per cent.
  • Demographic Performance: An abrupt change from 1971 Census data to 2011 Census data should not unfairly penalize some States which have performed well on population control. Hence, the commission recommended introducing a new performance-based criterion to reward States who have performed well on the demography front. This criterion of demographic performance is computed by using the reciprocal of TFR of each State, scaled by the population data of Census 1971. States which have achieved lower TFR will be scored higher and vice versa. This criterion is assigned a weight of 12.5 per cent.
  • Tax Effort: The inclusion of tax effort as a performance-based criterion will reward the States with higher tax collection efficiency and encourage all States to be more tax efficient. It is computed by taking the ratio of the average of per capita own tax revenue of a State over three years and its per capita GSDP and scaling this ratio by the population of the State. Total weight of 2.5 per cent has been assigned to this criterion.
  • Uttar Pradesh and Bihar have received the largest devolutions for 2020-21 while Karnataka and Kerala saw the largest decreases in the share of the divisible pool.

Grants in Aid

  • Revenue Deficit Grants: 14 states are estimated to face a revenue deficit post-devolution.
  • The Commission has recommended revenue deficit grants worth Rs 74,341 crore to these 14 states.
  • Furthermore, the three states of Karnataka, Mizoram, and Telangana received special grants to make up the shortfall between untied transfers received by these States in the form of tax devolution plus revenue deficit grant in 2020-21 vis-a-vis the corresponding amount in 2019-20.
  • Sectoral Grants: The XV-FC is considering recommending sectoral grants for nutrition, health, pre-primary education, judiciary, rural connectivity, railways, statistics and police training, and housing during its tenure.
  • Of these, grants for nutrition, to augment the efforts of the States towards reducing and ultimately eliminating malnutrition, is specifically recommended even in 2020-21.
  • Performance-based Incentives: Six broad areas are identified to provide performance-based incentives to States.

1. Implementation of Agriculture Reforms

2. Development of Aspirational Districts and Aspirational Blocks

3. Power Sector Reforms

4. Enhancing Trade including Exports

5. Incentives for Education

6. Promotion of Domestic and International Tourism

Empowering Local Bodies

Some significant changes made by XV-FC compared to previous Finance Commissions:

  • To recommend grants to all tiers of the Panchayati Raj to enable pooling of resources to create durable community assets and improve their functional viability.
  • To give grants to the Fifth and Sixth Schedule areas and Cantonment Boards.
  • To provide for tied grants in the critical sectors of sanitation and drinking water to ensure additional funds to the local bodies over and above the funds allocated for these purposes under the centrally sponsored schemes (CSS), Swachh Bharat and Jal Jeevan Missions.
  • To account for increasing urbanization the share of urban local bodies in Finance Commission grants to local bodies should be gradually increased to 40 per cent over the medium term.
  • Since larger cities will tend to grow faster with the agglomeration effect, the fifty Million-Plus cities in the country need differentiated treatment, with special emphasis on meeting the challenges of bad ambient air quality, groundwater depletion and sanitation.

Grants to Local Bodies:

  • The Commission has recommended a total of Rs 90,000 crore for grants to the local bodies in 2020-21.
  • This amounts to 4.31% of the divisible pool.
  • These grants will be made available to all three tiers of Panchayat- village, block, and district.
  • The inter-se distribution of grants for local bodies among the States may be based on population and area in the ratio of 90:10.
  • For 2020-21, the proportion of grants between rural and urban local bodies recommended by the XV-FC is in the ratio of 67.5:32.5.
  • For all urban bodies, the distribution of grants for 2020-21 is based on population.

Disaster Risk Management

  • To promote local-level mitigation activities, mitigation funds shall be set up at both national and state levels in the form of NDMF and State Disaster Mitigation Funds (SDMF), following the Disaster Management Act.
  • The Commission recommended the creation of funds for disaster mitigation along with disaster response, which will now together be called as National Disaster Risk Management Fund (NDRMF) and State Disaster Risk Management Funds (SDRMF).
  • Recommended grants for the State Disaster Risk Management Fund is Rs 28,983 crore. Out of this, the share of SDRF shall be 80 per cent and the share of SDMF 20 per cent. The allocation for the National Disaster Risk Management Fund is Rs 12,390 crore.
  • Allocations for NDRF / SDRF will be further sub-divided into
    • Response and Relief – 40 per cent
    • Recovery and Reconstruction – 30 per cent
    • Capacity Building – 10 per cent

What is the Finance Commission?

  • Article 280 of the Constitution of India provides for a quasi-judicial body, the Finance Commission.
  • It is constituted by the President of India every fifth year or at such earlier time as he considers necessary.
  • The recommendations made by the Finance Commission are only advisory in nature and hence, not binding on the government.
  • The 15th Finance commission makes recommendations for the period of 2020-2025 (5 years).

Finance Commission – Issues related to devolution of resources

Private: Recommendations of the 15th Finance Commission

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Finance Commission

Mains level : Recommendations of the Finance Commissions

The Fifteenth Finance Commission (FC) has considered the 2011 population along with forest cover, tax effort, area of the state, and “demographic performance” to arrive at the states’ share in the divisible pool of taxes.

Quick recap: Finance Commission (FC)

  • The FC is a constitutionally mandated body that decides, among other things, the sharing of taxes between the Centre and the states.
  • Article 280 (1) requires the President to constitute, “within two years from the commencement of this Constitution.
  • And thereafter constitute FC at the expiration of every fifth year or at such earlier time as the President considers necessary.
  • An FC “which shall consist of a Chairman and four other members”.

Divisible Pool of Taxes

  • Under Article 280(3) (a) the FC must make recommendations to the President “as the distribution between the Union and the States of the net proceeds of taxes which are to be, or may be, divided between them under this Chapter and the allocation between the States of the respective shares of such proceeds”.
  • Accordingly, the FC determines a formula for tax-sharing between the states, which is a weighted sum of the states’ population, area, forest cover, tax capacity, tax effort and demographic performance, with the weights expressed in percentages.
  • This crucial role of the Commission makes it instrumental in the implementation of fiscal federalism.

Major recommendations of 15th FC

  • The report of the 15th FC, along with an Action Taken Report, was tabled in Parliament on Saturday.
  • The Commission has reduced the vertical devolution — the share of tax revenues that the Centre shares with the states — from 42% to 41%.
  • The 1 per cent decrease in the vertical devolution is roughly equal to the share of the erstwhile state of J&K, which would have been 0.85% as per the formula described by the Commission.
  • The Commission has said that it intends to set up an expert group to initiate a non-lapsable fund for defence expenditure.
  • The terms of reference of the Commission included considering the Centre’s demand for funds for defence and national security.
  • It may do so by creating a separate fund from the gross tax revenue before computing the divisible pool — which means that states would get a smaller share of the taxes.

 

The new parameter: 2011 census Population

  • As had been widely anticipated, shares of the southern states, except Tamil Nadu, have fallen — with Karnataka losing the most.
  • 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%).

Why 2011 census was used?

  • The 15th FC has reasoned that the terms of reference leave it with no choice but to use the 2011 population; it has also argued that in the interest of fiscal equalization, it is necessary to use the latest Census figures.
  • 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.

Various criteria used

  • In order to reward population control efforts by states, the Commission developed a criterion for demographic effort — which is essentially the ratio of the state’s population in 1971 to its fertility rate in 2011 — with a weight of 12.5%.
  • The total area of states, the area under forest cover, and “income distance” were also used by the FC to arrive at the tax-sharing formula.
  • Income distance is calculated as the difference between the per capita gross state domestic product (GSDP) of the state from that of the state with the highest per capita GSDP, with states with less income getting a higher share in order to allow them to provide services comparable to those provided by the richer ones.
  • The Commission used the per capita GSDP of Haryana as the reference for calculating the income distance, and gave it a weight of 45%, down from the 50% assigned by the 14th FC.
  • The weight assigned to state area was unchanged at 15%, and that of forest cover was increased from 7.5% to 10%.

Ambiguity over the criterion

  • The effect of the demographic effort in increasing states’ devolution is not clear.
  • Shares of states like Maharashtra, Himachal Pradesh and Punjab, along with Tamil Nadu, all of which have fertility rates below the replacement level, have increased slightly.
  • On the other hand, Andhra Pradesh, Kerala, Karnataka, and West Bengal’s shares have fallen, even though their fertility rates are also low.
  • Incidentally, Karnataka, the biggest loser in this exercise, also had the highest tax-GSDP ratio in 2017-18, as per an RBI report on state finances.
  • Tax effort was also used by the Commission to decide the states’ shares, with a weight of 2.5%.

Finance Commission – Issues related to devolution of resources

Finance Commission

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Finance Commission

Mains level : Finance Commission, Its evolving role in fiscal federalism

  • The report of the Fifteenth Finance Commission, along with an Action Taken Report, was tabled in Parliament.
  • The Commission, headed by N K Singh, had submitted its Report to the President in December 2019.
  • The government had accepted the recommendations of the Commission “in substantial measure a/c to FM.

The Finance Commission and its purpose

  • Article 280 of the Constitution requires that a Finance Commission be constituted to recommend the distribution of the net proceeds of taxes between the Centre and states, and among the states.
  • Much has changed since the First Commission was set up in November 1951 under the Chairmanship of K C Neogy, a former member of the Constituent Assembly and diwan of a princely state.
  • The President has appointed 14 more Commissions since then.

Why need Finance Commission?

  • The framers of the Constitution were seeking to address the vertical imbalance between the taxation powers and expenditure and responsibilities of the federal government and the states, and the horizontal imbalance, or inequality, between states that were at different stages of development.
  • Ensuring inclusiveness is, therefore, a key mandate of the Finance Commission.
  • That means assigning weights to things like population, the fiscal distance between the top ranked states and the others, etc.
  • It is not that the best-performing state will be allocated the highest share — even if delivery execution and governance are better — rather, the effort will be to narrow the development gap between states.

Constitution of the Finance Commission

  • The Finance Commission Rules, 1951, lay down the criteria for being members of the constitutional body.
  • Members:
  1. those having special knowledge of finance and accounts of government with wide knowledge and experience in financial matters and in administration,
  2. or with special knowledge of economics, and
  3. those who have been qualified to be appointed as a judge of a High Court

Notable members

  • In the years following the reforms of the 1990s, Commissions have been headed by reputed economists and administrators — from A M Khusro, who headed the Eleventh Finance Commission, to Chakravarthi Rangarajan, Vijay Kelkar, and Y V Reddy, who were Chairmen of subsequent Commissions.
  • Senior politicians like K Brahmananda Reddy, Y B Chavan and N K P Salve had helmed earlier Commissions.
  • Before N K Singh, an economist and career administrator who subsequently joined politics, the last politician in this role was K C Pant, who then went on to be Deputy Chairman of the Planning Commission.

Changing role of the Finance Commission

  • What has changed dramatically since the 1950s, when the First Commission presented its recommendations on the transfer of resources between the Centre and the states, is the scale of distribution of tax proceeds.
  • From 10% of the total tax receipts of the Centre in 1950, it rose to a record 42% after the recommendations of the Fourteenth FC headed by Y V Reddy — a share that made previous awards look conservative, and sat well with the spirit of cooperative federalism.
  • The Fifteenth FC has recommended that this allocation be reduced by a percentage point to 41% in order to meet the security and special needs of the erstwhile state of Jammu and Kashmir.
  • The other significant change has been in the equation between the central and state governments as a result of the recommendations of the Twelfth FC which reshaped lending by the federal government to states.
  • The Fourteenth Commission recommended the creation of a Fiscal Council; the Thirteenth had set out detailed measures on implementing GST with a grand bargain for states.

Finance Commission – Issues related to devolution of resources

[oped of the day] Over to the states

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Nothing much

Mains level : Role of states in the economic development story

Context

In the World Bank’s Ease of Doing Business index released last month, India ranked 63. It is a jump from its lowly rank of 142 in 2014. 

Challenges remain – with the states:

    • 15th FC ToR – When the government amended the terms of reference asking that allocations for defence and internal security be carved out upfront, states accused Centre’s highhandedness.
    • Land acquisition – government attempted to reform the land acquisition law by tweaking the balance in favour of investors many states objected to this. This happened despite the land being on the concurrent list in the Constitution.

Importance of states in India’s economic management

    • Early federalism – In the early years of our republic, the Centre dominated across all domains — political, economic and administrative — and states acquiesced to this unequal arrangement. 
    • Reaction to dominance – The reaction to central dominance came in the early 1980s when strong regional leaders started agitating against “the hegemony of the Centre”. Leaders like N T Rama Rao built their political careers on an “anti-Centre” platform.
    • Centre yielded – subsequently, the Centre yielded to the states largely in the political space. 
    • Economic policy spaceMuch of the economic policy control stayed with the Centre. It decided public investment and private investment through its industrial and import licensing policies. It left the states on the margins of economic management.

Economic reforms – change in relation: Three trends

    • The arrangement started to change with the onset of reforms from 1991.
    • Three trends have shifted the economic centre of gravity from the Centre to the states.

Trend # 1: Change in the content of the reform agenda

    • 1991 reforms – Centre could push through the reforms of the 1990s without even informing the states because they all pertained to subjects such as industrial licencing, import permits, exchange rate and the financial sector, which were entirely within its domain. 
    • Second-generation reforms – shift the emphasis from product to factor markets like land, labour and taxation, which often need the consent of states.
    • GST – it illustrates the increased clout of the states in driving reforms more than the GST negotiations. There was a clash of interests between the Centre and states, producer and consumer states, large and small states and coastal and inland states. The deal could not be finalised until the Centre guaranteed to fill the revenue gap of states according to an agreed formula.

Trend # 2: Fiscal federalism

    • Revenue – expenditure gap – estimates suggest that the Centre collects about 60% of the combined revenue, but gets to spend only about 40% of the combined expenditure. 
    • States collect 40% of the combined revenue but spend as much as 60% of the combined expenditure.
    • States autonomy – states now enjoy greater autonomy in determining their expenditure. Planning Commission is no more. The states get a larger quantum of central transfers and decide on how to spend that larger quantum.
    • Management of state financesThe RBI in its latest annual report on state finances raised several red flags
      • states’ increasing weakness in raising revenue
      • their unsustainable debt burden
      • the tendency to retrench capital expenditures in order to accommodate fiscal shocks such as farm loan waivers, power sector loans under UDAY and a host of income transfer schemes
    • Impact of state finances – As the RBI pointed out, the quality of expenditure at the state level has a multiplier effect on overall development outcomes.
    • Market response – The market will penalise the mismanagement of public finances. Even if it is the Centre or the states, for an unsustainable debt burden, market penalises.

Trend # 3: Economic federalism

    • Investments – There is states’ growing importance in economic federalism. They play a critical role in creating a conducive investment climate in the country. 
    • Ease of Doing Business – Much of the responsibility for improving the ease of doing business rests not with Delhi but with the states.

Conclusion

    • India’s prospects and aspiration for a $5 trillion economy depend on the Centre and the states working together.
    • If ever there was an opportune moment for a big push on cooperative federalism, it is now.

Finance Commission – Issues related to devolution of resources

[oped of the day] Beyond the mandate

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Nothing much

Mains level : 15th Finance Commission - ToRs - challenges

Context

Recent amendments to the Terms of Reference (ToR) of the 15th Finance Commission (FFC) are examined here. 

Amendments

    • First – requires the FFC to examine “whether a separate mechanism for funding of defence and internal security ought to be set up and how such a mechanism should be operationalised”. 
    • Second – from Section 83 of the Jammu and Kashmir Reorganisation Act 2019. It requires the President to “make a reference to the 15th Finance Commission to include the UT of J&K in its ToR and make an award for the successor UT of Jammu and Kashmir.

A new funding mechanism

    • Separate mechanism – The use of the words “separate mechanism” points to creating a mechanism distinct from the existing one. 
    • Constitutional position 
      • The Constitution requires that estimates relating to voted expenditure in the Annual Financial Statement be submitted in the form of demands for grants to the Lok Sabha.
      • The Government of India submits demands for grants to the Lok Sabha under the defence and home ministries for defence and deployment of armed forces in states.
    • New mechanism – The separate mechanism could be the creation of defence and internal security fund in the public account to which their annual budgetary allocations could be credited and spent over a multi-year time-frame without the threat of lapse. 
    • Already existing model – Such an arrangement already exists for a number of funds in the public account, like the National Disaster Relief Fund.

Challenges with this model

    • The extent of sum – The budget provision for 2019-20 for defence and the police grant of the home ministry is about Rs 5,30,000 crore. 
    • Huge amounts – It will be inappropriate to take away one-fifth of the GoI’s budget allocations into the public account. 
    • Budgetary management – escrowing such a large amount from its resources will constrain the GoI’s budgetary management.
    • Other ministries – similar demands could arise from other critical ministries like infrastructure and health, which will further emasculate budgetary flexibility. 
    • Lax budgeting – it will lead to lazy budgeting by the beneficiary ministries. 
    • Violation of rules – it violates the Government Accounting Rules 1990 (GAR), which allow for creating a fund in the public account only for the implementation of specified schemes of ministries and not for entire budgetary allocations of departments. 
    • Canons of budgeting – it violates the fundamental canons of annual budgeting mandated in the Constitution — providing for lapse of money budgeted but unspent during a year and obtaining Parliament’s approval every year for the Annual Financial Statement.
    • Ambiguity – The use of the words “internal security” creates ambiguity. 
      • Internal security means maintaining public order and peace by tackling internal threats and upholding the law. 
      • Public order and police are part of the state’s responsibility. 
      • Internal security is as much a concern of states as it is of the centre. 
    • Sharing with states – there would be a further challenge if such a fund is created in the GoI’s public account. It will have to decide how it will be shared with states.

J&K amendment

    • The phrase “include UT of JnK in its Terms of Reference” is indeterminate. 
    • No place for states – ToR of the FFC has 15 clauses. In which clause and where should it be included remains a question. The names of no state or UT find a place in any of these 15 clauses.
    • Treat as a state – this amendment requires the FFC to treat the UT of JnK as a state for the purposes of its award. 
    • No awards for UTs – No Finance Commission has ever made an award for any UT. It is not clear how the FFC can now make an award treating the UT of J&K as a state.
    • Competition with other UTs – the claims of the two other UTs with a legislature — Delhi and Puducherry demanding that FCs award a share of the divisible pool to them can’t be ignored.
    • The challenge from states – States argue that the impact of such a provision would increase the number of claimants to the divisible pool and reduce their individual share. 

Conclusion

    • Some state governments have complained about its perceived inequities to the President.
    • These two amendments unnecessarily raise more challenges for the FFC.

Finance Commission – Issues related to devolution of resources

[oped of the day] Firm steps to ease the fiscal federalism tension

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Nothing much

Mains level : Fiscal federalism in India

Context

A “camel’s nose” is a metaphor to describe a situation where one permits a small entry to an outsider into one’s territory, only to be soon pushed out entirely. The fiscal relationship between the Centre and the States is fast turning into a “camel’s nose” syndrome for the States. 

Gaining entry to pushing out

  • Centre gained an entry through the GST into the territory of taxation powers of States.
  • It is now arming itself to elbow the States out entirely of its fiscal powers. 

Federalism

  • India is a union of States. Citizens of every State elect their government independently. 
  • The primary responsibility of such an elected government is efficient governance and accountability to its voters. 
  • An elected government is typically granted the powers to be able to raise revenues through taxation of its citizens and incur appropriate expenditure for their benefit.
  • Over the past five years, democratically elected State governments have been stripped of almost all powers of taxation.
  • There is an attempt to palm off the Centre’s expenditure obligation to the States and there is talk of even limiting expenditure powers of the States.

Lessons from the past : Meal scheme

  • In 1982, the newly elected Chief Minister of Tamil Nadu, MG Ramachandran (MGR) wanted to expand the midday meal programme to all 70 lakh children across 52,000 government schools to improve student enrolment. 
  • This entailed an additional expenditure of ₹150 crore, which the government did not have. 
  • MGR decided to levy an additional sales tax on goods sold in Tamil Nadu to cough up the amount needed. 
  • The programme was then further expanded by successive governments under the DMK. 
  • It catapulted Tamil Nadu’s literacy rate from 54% in 1981 to 83% in 2011. In just three decades, Tamil Nadu was counted as one of India’s most literate States.
  • MGR and other Chief Ministers of Tamil Nadu did not have to rush to New Delhi to make the decision to implement a midday meal programme and impose additional sales taxes to fund it. It was decided and approved in Chennai. 
  • In today’s India, MGR would have had to dash to Delhi and seek approval.

Fiscal federalism – goes against states

  • More than 80% of government’s revenues come from taxes, primarily from income tax (direct tax) and sales taxes (indirect tax). 
  • State governments in India do not have powers to levy income taxes. 
  • With GST, the Centre stuck its nose into the indirect taxes of State governments. States lost their sole powers to levy indirect taxes. 
  • Instead, they depend on a GST Council to determine tax rates and revenues.
  • A democratically elected State government in India can neither levy income tax nor sales tax. Effectively, it’s a representation without taxation.

Extending the intrusion into states’ domain – Defence

  • The Centre is now stretching its arms and legs to capture more. 
  • It has now proposed that there should be a permanent expenditure fund created for defence spending out of the total tax revenue pool. 
  • The Centre keeps 52% of the total tax revenue pool and distributes 48% to all the States and Union Territories. 
  • Instead of using its 52% share to spend on defence, the present government wants to palm off this expenditure to all the States. 
  • This will likely further reduce the tax revenues distributed to States for their own expenditure. 

Expenditure Council

  • There is now talk of constituting an Expenditure Council, similar to the GST Council. 
  • Not only did States lose their taxation powers but with this idea, they will lose its sole spending powers too. 
  • An elected Chief Minister of a State with no discretionary powers to earn or spend for the people of the State can virtually hand over the reins of governance to Delhi. 

Challenges

  • There is huge economic and cultural diversity among the various States. It is a terrible mistake to presume that all of India can be governed from Delhi.
  • Elected State governments and leaders cannot be made dummies without any fiscal powers for long. 
  • This fiscal federalism tension between the Centre and States can erupt into something more dangerous and spread wide.

Way ahead

  • Grant State governments the powers to levy income taxes. In large federal democracies such as the United States, State governments and even local governments have the right to levy income taxes. 
  • State governments should be given powers to raise revenues and incur expenditure in accordance with each State’s needs and priorities.
  • Amend the Constitution to grant States the powers to levy income taxes as they deem fit.

Conclusion

There is a distinction between unity and uniformity. Uniformity is not an essential condition for unity. On the contrary, a celebration of plurality may foster greater unity in a nation such as ours. The days of imperialistic London are over. It is the era of Gandhinagar, Chennai, Lucknow and Kolkata.

Finance Commission – Issues related to devolution of resources

[op-ed snap] Share of the state

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Nothing Much

Mains level : Maintaining Fiscal Federalism

CONTEXT

Last week, the Union cabinet passed an amendment to widen the terms of reference of the 15th Finance Commission.

Background

  • The Commission has now been asked to examine the possibility of setting up a mechanism for funding defence and internal security.
  • As capital spending on defence continues to fall well short of what is required, it is difficult to contest the premise that it needs to be bolstered.
  • But, as the creation of “secure and non-lapsable funds for defence and internal security” may end up reducing the divisible tax pool further, the move could face resistance from states, especially when several of them are arguing for a greater share in tax revenues.
  • While the commission is yet to spell out its views on the subject, this request raises fundamental questions over the spending priorities of different levels of government and the framework that governs Centre-state fiscal relations.
  • The Seventh Schedule of the Indian Constitution specifies the separate as well as concurrent responsibilities of the Centre and state governments, with defence falling in the Union list.
  • The inability of the Centre to ramp up its spending on defence indicates the limited fiscal space available to it.
  • In large part, this is due to an increase in spending on items in the state and concurrent list, and a corresponding decline in spending on items in the Union list.
  • In 2015-16 alone, the Centre spent 16 per cent of its revenue expenditure on items in the state list, and another 16.4 per cent on items in the concurrent list.

Reduced Fiscal space for states –

  • In a federal structure, the Centre must address regional imbalances in the delivery of public services.
  • But the bulk of this spending is routed through sector-specific transfers or centrally sponsored schemes that curb the autonomy of the states in deciding their own expenditure priorities.
  • The added fiscal pressures on the Centre have, in turn, contributed to reduced fiscal space for states.
  • Over the years, the Centre has begun to rely increasingly on taxes collected through cesses and surcharges to meet its expenditure priorities.
  • But revenue from these sources does not form part of the divisible tax pool, it is not shared with states — squeezing them from both ends.

Conclusion

While the compulsions of the political economy have ensured greater central government spending on items in the state and concurrent lists, the current juncture may well be an opportune moment to rethink the spending priorities of different levels of the government. There is a need, particularly, to address legitimate concerns of states about increasing encroachment by the Centre.

Finance Commission – Issues related to devolution of resources

Time to have institutional mechanism like Fiscal Council to enforce rules: NK Singh

Note4students

Mains Paper 2: Polity | Appointment to various Constitutional posts, powers, functions and responsibilities of various Constitutional Bodies

From UPSC perspective, the following things are important:

Prelims level: Fiscal Council

Mains level: Mandate of the finance commission


News

  • Stressing on the need to have uniform rules for fiscal consolidation of States and Centre 15th Finance Commission’s Chairman NK Singh called for institutional mechanism like a ‘Fiscal Council’ to enforce fiscal rules and keep a check on Centre’s fiscal consolidation.

A check over borrowings

  • For state government liabilities, Article 293 (3) provides a constitutional check over borrowings.
  • But there is no such restriction on the Centre.
  • It is time we have an alternative institutional mechanism like Fiscal Council to enforce fiscal rules and keep a check on Centre’s fiscal consolidation.
  • Singh had earlier proposed creation of an autonomous Fiscal Council with representatives from both states and Centre, but the recommendation was not implemented.

Why need Fiscal Council?

  • Various cesses and surcharges are becoming disproportionate proportion of overall divisible revenue.
  • There should be some mechanism to ensure that the basic spirit of the devolution process should not be undercut by clever financial engineering or taking recourse to traditions.
  • There is a need for coordination between the finance commission as well as the GST Council, which he termed as the only federal institution in the country.
  • There’s need for coordination between Finance Commission and GST council.
  • GST Council has no clue of what the Finance Commission is doing and Finance Commission has even lesser clue of what the GST Council is doing.

The municipal example

  • It is very clear that successful economic growth, successful good quality employment depends on agglomerations that work.
  • That in turn is going to depend on whether municipalities have enough revenue.
  • What the municipalities get today in terms of revenue is one per cent of GDP whereas on comparative basis, looking at other emerging market countries, it really ought to be 5 per cent of GDP.

Finance Commission – Issues related to devolution of resources

[op-ed snap] Another look at fiscal transfers

Note4students

Mains Paper 2: Polity | Functions & responsibilities of the Union & the States, issues & challenges pertaining to the federal structure

From UPSC perspective, the following things are important:

Prelims level: State Finance Commission (SFC)

Mains level: Role of finance commissions in fiscal federalism and changes proposed


NEWS

CONTEXT

Concept of federalism

  • Federalism is an old concept.
  • It is well known that the efficiency of a government depends on, among other factors, its structure.
  • In large countries, it has been felt that only a federal structure can efficiently meet the requirements of people from different regions.

The reason behind the existence of the present form of federalism

  • In our country during the independence struggle, provincial autonomy was regarded as an integral part of the freedom movement.
  • However, after Independence, several compulsions, which included defence and internal security, led to a scheme of federalism in which the Centre assumed greater importance.
  • Also in the immediate period following Independence, when the Centre and all States were ruled by the same party and when many of the powerful provincial leaders migrated to the Centre, the process of centralisation gathered further momentum.
  • Economic planning at a nation-wide level helped this centralising process.

What is Fiscal Federalism?

  • Fiscal federalism is the economic counterpart to political federalism.
  • Fiscal federalism is concerned with the assignment on the one hand of functions to different levels of government, and with appropriate fiscal instruments for carrying out these functions on the other.
  • The Central government must provide national public goods that render services to the entire population.
  • A typical example cited is defence.
  • Sub-national governments are expected to provide goods and services whose consumption is limited to their own jurisdictions.

Determinations of Raising of Taxes by different units of government

  • An equally important question in fiscal federalism is the determination of the specific fiscal instruments that would enable the different levels of government to carry out their functions.
  • This is the ‘tax-assignment problem’ .
  • In determining the taxes that are best suited for use at different levels of government, one basic consideration is in relation to the mobility of economic agents, goods and resources.
  • It is generally argued that the de-centralised levels of government should avoid non-benefit taxes and taxes on mobile units.
  • This implies that the Central government should have the responsibility to levy non-benefit taxes and taxes on mobile units or resources.

Problems in assigning different  taxing responsibilities  to different levels of government

  • Different Constitutions interpret differently what is mobile and what is purely a benefit tax.
  • For example, in the United States and Canada, both Federal and State governments have concurrent powers to levy income tax.
  • On the contrary, in India, income tax is levied only by the Central government though shared with the States.
  • Recognising the possibility of imbalance between resources and responsibilities, many countries have a system of inter-governmental transfers.

The provision in Indian Constitution regarding the division of taxes

  • The Indian Constitution lays down the functions as well as taxing powers of the Centre and States.
  • It is against this background that the issues relating to the correction of vertical and horizontal imbalances have been addressed by every Finance Commission, taking into account the prevailing set of circumstances.
  • However, Central transfers to States are not confined to the recommendations of the Finance Commissions.
  • There are other channels such as those through the Planning Commission until recently as well the discretionary grants of the Central government.

Recent changes in the division of tax proceeds

  • The Fourteenth Finance Commission has broken new ground in terms of allocation of resources.
  • One of its major recommendations has been to increase the share of tax devolution to 42% of the divisible pool.
  • This is a substantial increase by almost 10 percentage points.
  • The commission has argued that this does not necessarily affect the overall transfers but only enhances the share of unconditional transfers.
  • Over years, the performance of the Central government is judged not only on the basis of actions taken which fall strictly in its jurisdiction but also on initiatives undertaken in the areas which fall in the Concurrent and even State lists.
  • Today, the Central government is held responsible for everything that happens, including, for example, agrarian distress.
  • The Planning Commission was replaced by the NITI Aayog, which was simply a think-tank with no powers of resource allocation.

Way Forward

  • The Constitution should be amended and the proportion of shareable taxes that should go to the States fixed at the desired level.
  • The shareable tax pool must also include cesses and surcharges as these have sharply increased in recent years.
  • Fixing the ratio at 42% of shareable taxes, including cesses and surcharges, seems appropriate.
  • Another possible route is to follow the practice in the U.S. and Canada: of allowing the States to levy tax on personal income, with some limitations.
  • Also once this power is given to the States, the transfers from the Centre need adjustment.
  • There are issues relating to horizontal distribution. An appropriate balancing of criteria is needed particularly in the context of the rise in unconditional transfers.

Finance Commission – Issues related to devolution of resources

RBI governor bats for permanent status to Finance Commission

Note4students

Mains Paper 2: Polity | Functions & responsibilities of the Union & the States, issues & challenges pertaining to the federal structure

From UPSC perspective, the following things are important:

Prelims level: Finance Commission

Mains level: Read the attached story


News

  • The 15th Finance Commission, constituted in November 2017, will give recommendations for devolution of taxes and other fiscal matters for five fiscal years, commencing April 1, 2020.
  • RBI Governor Shaktikanta Das has said increasingly it is felt that there is a need to give permanent status to the Finance Commission and constitution of State Finance Commissions every five years.

Addressing various challenges

  • According to Das, there is now general agreement in the country about the importance of fiscal consolidation roadmap both at national and sub-national levels.
  • Successive finance commissions have made efforts to address the emerging issues and challenges, but in a democracy like India, the debate goes on.
  • Geopolitical risks have necessitated higher expenditure on defence and internal security.
  • Natural calamities and disasters have called for higher expenditure on relief and rehabilitation.
  • In parallel, aspirations of people and the country as a whole have required that the government spends more on developmental programmes.

Why such move?

  • The Commission can function as a leaner entity in the intervening period till the next Finance Commission is set up in a full-fledged manner.
  • Over past several decades, Finance Commissions have adopted different approaches with regard to principles of tax devolution, grants to be given to states and fiscal consolidation issues.
  • There is a need to ensure broad consistency between Finance Commissions so that there is some degree of certainty in the flow of funds, especially to the states.
  • This has become even more critical in the post GST scenario.

Imbibing Continuity

  • According to Das, finance commissions have over the past several decades adopted different approaches with regard to principles of tax devolution, grants to be given to states and fiscal consolidation issues.
  • In other words, there has to be continuity and change between finance commissions.
  • Increasingly, therefore, it is felt that there is a need to give permanent status to the finance commission.
  • A commission can function lean till the next finance commission is set up in a full-fledged manner.
  • During the intervening period, it can also address issues arising from implementation of the recommendations of the finance commission.

Other recommendations

  • The principle of decentralisation works better when powers and functions are delegated based on which tier of governance is best suited to fulfill that responsibility.
  • The constitution has already provided for delegation of certain functions to the urban and rural local bodies; but it is seen that there is still good distance to traverse when it comes to devolution of funds to these local bodies.
  • It is essential that State Finance Commissions are constituted every five years as per the mandate in Article 243I of the Constitution and arrangements are made for their robust functioning.

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Finance Commission

Finance Commission of India: Powers, Functions and Responsibilities

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