Over the last 70 years, the form and functioning of federalism has constantly evolved. Yet, fiscal federal policymaking has stagnated. It has kept pace neither with the changing politics nor with the economics of the federal set-up.
The mandate given to the 15th Finance Commission is yet another example of this policy stagnation. Even though the institutional landscape of Indian federalism has been changed for good—Planning Commission, the extra-constitutional intruder, wound up and the first genuinely federal institution, the goods and services tax (GST) Council created—the terms of reference (TOR) of the 15th Finance Commission are disappointingly routine and ritualistic. Indeed, the TOR are also dangerously regressive and inimical to federalism.
A serious inadequacy in the TOR is in not recognizing the way in which the GST regime has, and will, change the face of fiscal federalism in India. The fundamental change in tax regime has neither appropriately informed the TOR of the 15th Finance Commission nor adequately taken cognizance of its implication on the role of the 15th Finance Commission. It has been factored in as if it is a mere change in the indirect tax collection mechanism.
The manner in which the Union and the states have pooled their tax sovereignty to create a new indirect tax regime ought to have been the cornerstone of the TOR. Indeed, this would have helped the 15th Finance Commission build on the emerging federal compact of cooperative federalism in sync with the new political economy of India defined by the rise to dominance of the states.
Far from this, some of the TOR given to the 15th Finance Commission are inimical to and potentially dangerous for the existing fiscal federal system. Consider this:
Para 4, sub para 6 of the TOR asks the Commission to have regard to: “The impact on the fiscal situation of the Union Government of substantially enhanced tax devolution to States following recommendations of the 14th Finance Commission coupled with the continuing imperative of the national development program including New India – 2022;”
This is a value judgment based on a half truth which is masquerading as a TOR. By putting in such a leading and loaded term of reference, institutional propriety has been seriously compromised.
The hike to 42% in the devolution to states by the 14th FC was part of a package; the expenditure underwriting done by the centre was correspondingly to be reduced.
This was done not only to ensure that the system of vertical transfers is neater, focusing on the revenue sharing. The idea, an operationally significant one, was to give states greater expenditure flexibility by reducing the funding of centrally sponsored schemes. It is important to note that in the scheme of 14th FC, the aggregate flow of resources was more or less calibrated to remain at the earlier level of 61 odd percent.
It is quite possible that the centre has not been able to cut down the expenditure underwriting as suggested by the 14th FC. Indeed, the centre’s view that its finances have been stretched may well be valid. But then it should be a part of the centre’s memorandum to the Commission, not the TOR of the Commission.
The institution of the FC platform cannot be used by the central government to fight its inter-ministerial turf wars.
And what is the “New India 2022”? Is it a constitutional obligation for which resources have to be earmarked? To the extent that the TOR refer to defence, or internal security, it is acceptable as these are constitutionally assigned areas. But the same cannot be said about a programme or a scheme.
The Constitution is very clear on the charge of revenues collected: the first charge on taxes collected is devolution, not centre’s expenditure, including its statutory commitments. This move of asking FC to have regard for schemes is fraught with dangerous implications and consequences.
The same mindset reveals itself in the TOR on performance-based transfers. This amounts to making statutory transfers conditional transfers. Whatever the FC devolves to the states is theirs by right and cannot be linked to performance or behaviour. It is instructive to look at the conditions in the TOR: “control or lack of it in incurring expenditure on populist measures”. Who decides what is populist? If a state replaces various welfare schemes by a Universal Basic Income programme, it can be branded as populist. If a 33% interest subvention is given to borrowers, as has been done by J&K, after devastating floods followed by eight months of civil strife, is it populism or pragmatism? And why should this not apply to centrally sponsored schemes? Or for that matter why doesn’t it apply to government of India (GoI) itself?
As if this weren’t enough, the TOR enjoin to factor in any “conditions that GoI may impose on the States while providing consent under Article 293(3) of the Constitution.” These types of open- ended TOR can easily turn the emerging cooperative federalism to coercive federalism.
At another level, the institutional representations in the form of members of the Commission have not been re-jigged in light of the new institutional structure.
It was a well thought out practice that the member of the Planning Commission (normally in-charge of the Financial Resources division) was an ex-officio member of the FC. This was done to ensure coordination between the plan expenditure handled by the Planning Commission and the non-plan expenditure dealt with by the FC.
Now, not only has the plan and non-plan distinction been replaced by revenue and capex budget, NITI Aayog has no mandate to decide on the capex budget of the states.
As such, in the new set-up, for meaningful institutional coordination, a member ought to have been co-opted from the GST Council rather than the NITI Aayog.
The 15th FC has to be very careful and mindful of the fact that it should not get into conflict with or tread on the turf of another statutory body, the GST Council.
Even though both are statutory bodies, in the warrant of precedence of institution, if there can be one, the GST Council must rank higher because it has elected representatives from the centre and the states.
It needs to be understood that the size of the revenue kitty, which 15th Finance Commission devolves, is now being determined by the GST Council. Any decision on the rate bands, for instance, by the GST Council will have huge implications on the vertical distribution of revenues between the states and the centre to be decided by the 15th Finance Commission.
In order to prevent a constitutional impasse, if not a crisis, it is only proper that the GST Council should be represented in the 15th Finance Commission. So that those who decided the size of the divisible and those who distribute the divisible pool know each other’s minds. The Council and the Commission have to be on the same page.
Finally, the TOR do not seem to have recognized that with GST, the entire criteria of horizontal distribution i.e across states will need to be reviewed.
The existing criteria have evolved in a production-based tax system. Now, 15th Finance Commission will have to redo these for a consumption- based tax system. The change from production to consumption will make a significant difference to inter se distribution as well as need, nature and distribution of equalizing grants. A number of things including the pecking order of states are bound to see major reordering and recalibration.
Indeed, the approach of “gap-filling” through Article 275 transfers or the “deficit grants” may have to be redesigned in light of the compensation law brought in by the GST Council.
The erstwhile non-plan revenue deficit will now be estimated by states as a pre-devolution revenue deficit based on their own tax growth. With share in central taxes, this gap for states will be covered in part or whole. If a post devolution revenue deficit persists, will the 15th Finance Commission align the gap grants with the compensation? Remember these grants are fixed in absolute terms as a number.
To conclude, the changes that have taken place require the 15th Finance Commission to think afresh methodologically, conceptually as well as operationally. And the TOR must facilitate them to do so.