Fiscal federalism, efficiency versus equity concerns, Pg6

Key Highlights:

• The 16th Finance Commission (FC-16), chaired by Arvind Panagariya, submitted its report covering the period 2026-31.
• It retained the vertical devolution of central taxes to states at 41%.
• The Commission fundamentally re-engineered the structure of fiscal transfers, particularly grants-in-aid.
• FC-16 recommended grants-in-aid totaling ₹9.47 lakh crore, a reduction from ₹10.1 lakh crore under the 15th Finance Commission, with their share in total transfers more than halving.
• It eliminated Revenue Deficit Grants (RDGs), sector-specific, and state-specific grants, restricting grants-in-aid to local bodies and disaster management.

Detailed Insights:

• The Finance Commission is a constitutional body established under Article 280 to mediate fiscal asymmetry between the Union and States.
• Grants-in-aid, provided under Article 275, were conceived as instruments of equalisation to support states with special needs where formula-based tax devolution falls short.
• The FC-16's approach marks a shift from need-based equalisation to compliance-based incentivisation, prioritizing efficiency and performance over equity.
• The Commission's decision to remove RDGs is based on concerns about moral hazard, assuming states should manage finances without gap-filling transfers.
• This aggregate view, however, masks deep inter-state disparities, potentially disadvantaging fiscally stressed states.
• The FC-16's stance on RDGs contrasts with its treatment of cesses and surcharges, which are not shared with states and contribute to vertical imbalance.
• The report proposes a "grand bargain" for the Centre to gradually merge cesses into the divisible pool in exchange for states accepting a lower devolution share.
• The horizontal devolution formula was also altered, reducing the weight for income distance and introducing a 10% weight for contribution to GDP.
• This shift, combined with the removal of RDGs, could disproportionately affect disadvantaged states, including those in the North-East and West Bengal.
• The FC-16 emphasizes fiscal discipline, recommending a cap on state fiscal deficit at 3% of GSDP and the discontinuation of off-budget borrowings.

Key Concepts Involved:

• Finance Commission: A constitutional body under Article 280 that recommends the distribution of financial resources between the Union and State Governments.
• Fiscal Federalism: The division of financial powers and responsibilities between different levels of government in a federal system.
• Grants-in-aid: Financial assistance provided by the Union government to states, primarily under Article 275, to address revenue deficits or specific developmental needs.
• Revenue Deficit Grants (RDGs): Grants provided to states to cover the gap between their revenue receipts and revenue expenditure after tax devolution.
• Cesses and Surcharges: Additional taxes levied by the Union government for specific purposes or on higher income groups, which are not part of the divisible pool shared with states.