16th finance commission faces an uphill challenge
The 16th FC faces challenges in navigating the difficult fiscal environment of Indian federalism, with tense relationships between the Union and some states
The 16th finance commission (FC) is set to be appointed later this year, and will have the challenging task of navigating the prevailing difficult fiscal environment of Indian federalism. Article 280 (3) of the Constitution lists the basic tasks of FC. These include the distribution of taxes from the divisible pool between the Union and the states, and the allocation of the states’ share to individual states; the principles governing the grants to be given to the states from the consolidated fund of India, and measures to augment the consolidated funds of the states to supplement the resources of panchayats and urban local bodies, among others. Other aspects that FC looks into are recommendations on disaster relief, reviewing deficit and debt levels of the Union and states and suggestions on a fiscal consolidation road map.
The 16th FC has a formidable task. The relationships between the Union and some states are very acrimonious and the competition for fiscal resources is acute. Besides the general elections in 2024, assembly polls are slated in a number of states later this year, when competing promises of freebies, subsidies, transfers, and guarantees are only likely to mount, making the fiscal situation more precarious.
The pandemic severely strained the finances of the Union and states and made the competition for resources more intense. The Union government’s strategy of mobilising additional resources through special excise on diesel and motor spirit, and increasing cesses and surcharges in the aftermath of the 14th FC’s recommendations have also become contentious.
Against this backdrop, two aspects need attention. The first is the financial health of both the Union and state governments. The pandemic pushed the aggregate fiscal deficit and public debt to 13.3% and 89.6% of the Gross Domestic Product (GDP) respectively in 2020-21. As the economy recovered, the deficit and debt ratios receded to 8.9% and 85.1%, respectively, but the targets of limiting the aggregate debt to GDP ratio at 60% — decided before the pandemic — no longer looks feasible, at least in the short and medium term.
At the Union level, the ratio of fiscal deficit to GDP rose to 9.2% in 2020-21 before receding to 6.9% the next year. The debt-to-GDP ratio rose to 61.5% in the pandemic year before falling to 57.1% in 2022-23. The fiscal consolidation plan was briefly jettisoned by the Union government, and states were given relaxation in their borrowing limit — from 3% of GSDP to 4% without conditions, and up to 5% with some reform conditions. These relaxations resulted in the slippage in the gross fiscal deficit at the state level to 4.1% of GDP — higher than the 3% limit in 2020-21 — before recovering strongly at 2.8%, largely by compressing capital expenditures.
But the deficit and debt levels in some states — revised estimates for 2022-23 showed that the deficit and debt as percentages of GSDP stood at 5.2% and 50% in Punjab, 5.1% and 38.1% in Kerala, 4% and 37.2% in Rajasthan and 4% and 38.6% in West Bengal, respectively — have risen sharply to unsustainable levels.
Second, macroeconomic stabilisation is predominantly a Union function, and the states have no incentive to contain their deficits and debts, except to look after interest burdens and see that it doesn’t crowd out social and infrastructure expenditures. Since the states are required to seek the Centre’s permission to borrow as long as they are indebted to the former, some states curb capital expenditures and resort to off-budget borrowings through their enterprises.
A third factor is also important. One of the questions before the 15th FC was whether revenue-deficit grants — which are given to states to make up for the shortfall between projected and actual revenue collections — should be continued. The committee, in response, worked out projections for the revenue growth and expenditure growth for individual states so that, no major state was eligible to get such grants in the terminal year of its recommendation. But some fiscally stressed states slipped. They failed to undertake reforms to align their growth of revenues and expenditures to contain the deficit, hence their debt situation was driven to unsustainable levels. Furthermore, FC assumed that the Goods and Services Tax compensation will continue for the period of its award; as this was discontinued in July 2022, the situation in some states became precarious.
The 16th FC will have to deal with these imbalances. Making recommendations for tax sharing and grants in a fiscally stressed and politically surcharged environment will require the commission to tread the path with utmost care. In addition, incentivising the states, particularly the fiscally stressed ones, for prudent fiscal behaviour would be a major challenge.
The related issue is framing the next-generation fiscal rules. 15th FC recommended the setting up of an inter-governmental group to define and achieve fiscal sustainability and design a new framework and implementation schedule. This was not done. The new commission will do well to take stock of the impact of various reform incentives, including those on local governments, to strategise further reforms.
M Govinda Rao is former director NIPFP, and member, 14th FC. The views expressed are personal
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