Date : 29/07/2023

Relevance – GS Paper 3 – Indian Economy - Fiscal Policies

Keywords – Debt to GDP ratio, Covid-19, Finance Commission, FRBM

Context –

The establishment of the Sixteenth Finance Commission is imminent. The Fifteenth Finance Commission, constituted in November 2017, witnessed critical changes that have had a profound impact on India's fiscal landscape. The outbreak of the COVID-19 pandemic and subsequent geopolitical challenges significantly disrupted the economy. As a result, the combined government debt-GDP ratio surged close to 90% by the end of the fiscal year 2020-21. Moreover, several States have been grappling with large fiscal imbalances, exacerbating the challenges faced by the central government.

Vertical and Horizontal Dimensions:

In an effort to address the fiscal disparities between the central government and States, the Fourteenth Finance Commission had raised the share of States in the divisible pool of central taxes from 32% to 42%. However, this share was later revised to 41% when the number of States in India was reduced to 28. Despite the increased share for States, the Centre managed the situation effectively by withdrawing Planning Commission grants, which were abolished during that period.

Given the Centre's substantial fiscal imbalances, recommending any further increase in the States' share of central taxes may not be justifiable. Additionally, the reliance on non-shareable cesses and surcharges, constituting 18.5% of the Centre's gross tax revenues during 2020-21 to 2023-24 (BE), warrants scrutiny by the Sixteenth Finance Commission. To address this issue, one option is to consider freezing the share of cesses and surcharges at a base number. The Thirteenth Finance Commission had set this share at just 9.6%, and it may be prudent for the Sixteenth Finance Commission to propose a 10% upper limit. If the proportion exceeds 10%, the share of States should be increased accordingly to maintain fiscal balance.

Goods and Services Tax (GST):

One of the key concerns in recent years has been the poor performance of the Goods and Services Tax (GST) and its impact on the divisible pool of taxes. However, there is some respite as GST collections have displayed good buoyancy over the past two years. Despite this, it is essential to continue restructuring the GST to make it a simpler and more efficient tax system.

Determining States' Share in Divisible Pool:

The share of individual States in the Centre's divisible pool is determined by a set of indicators, including population, per capita income, area, and incentive-related factors such as forest cover and demographic change. The per capita income criterion, currently weighted at 45%, has been a subject of contention among richer States. They argue for a reduction in the weight given to this criterion, which previously held an even higher weight.

However, it is crucial to take into consideration the needs of lower-income States. These States are expected to contribute significantly to India's demographic dividend in the future, provided adequate attention is given to their educational and healthcare needs. To strike a balance, the weight of the distance criterion could be frozen at the current level or slightly reduced to 40%, while ensuring upward adjustments in the resources transferred to the poorer States through grants.

Equalization Principle:

Streamlining resource transfers to individual States could be achieved by adopting the equalization principle. This involves using a limited number of criteria such as population, area, and distance, supplemented by suitable grants. The equalization principle aligns with both equity and efficiency and has been successfully employed in federations like Canada and Australia.

Recommendations:

The combined debt-GDP ratio of the central and State governments stood at 89.8% in 2020-21, significantly higher than the Fiscal Responsibility and Budget Management (FRBM) norms of 40% and 20%, respectively. The Centre's fiscal deficit during the same period surged to 9.2% of GDP, with States also facing a considerable fiscal deficit at 4.1%. Given these deviations from the FRBM norms and the reduction of States' debt-GDP target to 20% in the 2018 amendment, it is essential to re-examine the amendment to the Centre's FRBM as recommended by the Fifteenth Finance Commission.

To address the concerns of the Twelfth Finance Commission, considering a target of 28% consistent with an underlying nominal GDP growth of 12% could be explored. However, it is evident that the adjustment required for the central government would be larger than that for State governments. Furthermore, the proliferation of subsidies and the re-introduction of the old pension scheme in some States without clear identification of financing sources pose challenges to fiscal discipline.

To address these concerns, the establishment of a loan council, as recommended by the Twelfth Finance Commission, could be a viable option. This independent body could oversee the magnitudes and profiles of loans taken by both the central and State governments, ensuring fiscal discipline and prudence.

While dealing with subsidies, the Sixteenth Finance Commission should carefully examine non-merit subsidies to determine their justifiability. However, the exclusion of certain subsidies while determining grants may lead to the commission being caught in political crossfire. Nevertheless, the commission must maintain a strict approach toward States exceeding fiscal deficit limits while offering incentives to those adhering to fiscal discipline.

Conclusion:

The Sixteenth Finance Commission faces significant fiscal challenges due to the impact of COVID-19 and geopolitical dynamics. Addressing the fiscal imbalances between the Centre and States requires careful consideration of various factors, including cesses, surcharges, and subsidies. Adopting the equalisation principle and streamlining resource transfers can ensure both equity and efficiency. By re-examining the FRBM norms and considering innovative approaches like a loan council, the commission can propose recommendations that promote fiscal responsibility and sustainable economic growth for India.

Source – The Hindu