As a constitutional body, the Finance Commission should impartially assess the fiscal position and expenditure requirements of both the Centre and states while finalising its report.
The terms of reference of the 15th Finance Commission have been a source of immense controversy. Southern states have in particular argued that using the 2011 Census data puts them at a disadvantage as they have fared better on family planning. The Commission has sought to assuage their concerns in its interim report by decreasing the population weight from 17.5 per cent to 15 per cent, and providing a counter-balance by assigning a weight of 12.5 per cent for their demographic performance. However, the interim report has left some uncomfortable issues unanswered, which will need to be resolved in its final report.
First, under the current arrangement, states were supposed to be compensated for any shortfall in their GST collections for a five-year period. While there is little clarity over the Centre’s obligation to compensate states if collections from the compensation cess fall short of what is needed to compensate states for their shortfall in revenue, the five-year compensation period ends in 2022. With GST collections falling short of expectations, states have demanded that the compensation period be extended. However, there is no clear indication either on its continuation after 2022, or whether it will be distributed to states, and if so to what extent. This ambiguity poses a grave risk to state finances, impacting both stability and predictability of their budgets. It also makes the job of the commission to project states’ revenue for the balance period difficult, affecting its ability to make a fair assessment of their requirements. Second, in its interim report, the Commission has proposed performance-based incentives for states in six areas, some of which such as agriculture and power distribution fall on the state list. While this is not a new proposal — the 13th Finance Commission had provided states incentives for reducing infant mortality — how will this be funded? Will the Commission, while keeping overall transfers to states at the existing level, reduce tax devolution to states, thereby creating fiscal space for providing these incentives?
Third, the creation of a separate mechanism for funding defence and internal security, if carved out of gross tax revenues, will further reduce the divisible tax pool that is shared with states. A cash-strapped Centre will undoubtedly welcome any proposal that provides it with greater fiscal space. But state finances are equally under pressure. As a constitutional body, the Finance Commission should impartially assess the fiscal position and expenditure requirements of both the Centre and states while finalising its report.