Finance Commission transfers and equity issue, Pg6

Key Highlights:

• The 16th Finance Commission (FC) retained the vertical devolution share of 41% for States, emphasizing equity in horizontal transfers.
• States raised concerns about cesses and surcharges exceeding 15% of gross tax revenues, suggesting a cap of 8-10%.
• The FC accepted the Centre’s argument against sharing cesses and surcharges and retained the 41% vertical share.
• The FC made modest adjustments to devolution criteria, with income distance receiving a weight of 42.5%.
• Overall devolution shares of 14 States rose marginally, with Karnataka gaining the most (0.484 percentage point increase).
• Alternative weighting schemes suggest different outcomes, potentially increasing shares for Maharashtra, Karnataka, and Tamil Nadu.

Detailed Insights:

• States face mounting fiscal pressures due to the COVID-19 pandemic, GST implementation, and increasing public debt, limiting their fiscal autonomy.
• Frequent changes in devolution criteria make it difficult for States to predict their future shares, leading to calls for a reduced weight for the income-distance criterion.
• The combined shares of major beneficiary States (Bihar, Madhya Pradesh, Uttar Pradesh, West Bengal) have increased, while those of southern States have declined, widening the gap.
• Continued reliance on unconditional equalisation transfers may weaken incentives for revenue mobilisation and fiscal discipline in weaker States.
• The FC abolished revenue-deficit grants and recommended that States discontinue off-budget borrowings and maintain fiscal deficits below 3%.
• The FC introduced States’ contribution to national GDP with a 10% weight, but applied a square-root transformation, reducing the advantage of economically stronger States.
• Alternative weighting schemes, such as assigning a 25% weight to the square root of GDP contribution, could significantly increase shares for stronger States.
• Disparities in public expenditure on basic services persist, indicating that fiscal transfers alone have not ensured convergence in public service delivery.
• Future FCs should place greater emphasis on fiscal capacity and fiscal outcome indicators and adopt more data-driven approaches for assigning weights.

Key Concepts Involved:

• Vertical Devolution: Distribution of tax revenues between the Union (Centre) and the States.
• Horizontal Devolution: Distribution of tax revenues among the States themselves.
• Cesses and Surcharges: Taxes levied by the Union government for specific purposes, not usually shared with States.
• Income Distance: A criterion used by the Finance Commission to measure the economic disparity between States.