The Next Finance Commission will have a Tough Task, The Hindu Editorial Analysis

The Hindu Editorial Analysis: The Editorial Analysis of The Hindu Newspaper Editorial Articles aimed at simplifying various concepts relevant to the UPSC and other State PSC Exams. The Editorial Analysis helps in expanding the knowledge base as well as framing better quality mains answers. Today’s Hindu Editorial Analysis of ‘The Next Finance Commission will have a Tough Task’ discusses various aspects of fiscal federalism and role and challenges faced by Finance Commission of India in promoting Fiscal Federalism in India.

The Next Finance Commission will have a Tough Task

In the coming months, the government plans to establish a Finance Commission to determine the allocation of the Centre’s tax revenue to the States, both in terms of vertical sharing (how much is given to each State) and horizontal sharing (the formula for distribution among States).

Significance of Finance Commission

During the pre-reform era, the recommendations of the Finance Commission were not as crucial since the Centre had alternative methods to compensate States or show favoritism, such as through plan financing and investments in public sector undertakings (PSUs). However, following the reforms, PSU investments have declined, and the Planning Commission was abolished in 2014. As a result, the Finance Commission now holds significant responsibility and wields considerable influence as the primary architect of India’s fiscal federalism.

Issues with Horizontal Distribution

Currently, the Centre allocates 41% of its tax pool to the States. While States may demand an increase in this proportion, it may be challenging to accommodate such demands due to the Centre’s own expenditure needs and borrowing limitations. As a result, much of the debate will focus on the horizontal distribution formula.

Previous Finance Commission on Horizontal Distribution

During the appointment of the previous Finance Commission in 2017, there was controversy surrounding its terms of reference. It was asked to consider the 2011 population figures, deviating from the previous practice of using the 1971 population numbers. This change was seen by some States, particularly those with successful population control measures like the southern States, as a penalty for their efforts.

• A similar conflict arises in relation to revenue deficit grants awarded by the Finance Commission to States that remain in deficit even after tax devolution.
• While these grants aim to ensure a minimum level of service provision across all States, they can also create a disincentive for States to raise their own revenues.

Allocation for Fiscal Deficit

Historically, Finance Commissions have struggled to determine the extent to which a State’s deficit is due to fiscal incapacity versus fiscal irresponsibility. They have attempted to balance the distribution formula to support deficit-ridden States without penalizing responsible ones, but this has proven mathematically impossible as providing more to one State means giving less to another. Consequently, every distribution formula has faced criticism for being inefficient or unfair.

North-South Gap

These divisions among States have deepened in recent years, spanning political, economic, and fiscal dimensions. There is a perception of a north-south divide in politics, with the BJP primarily prevailing in northern States and opposition parties governing the southern States.

• Additionally, southern States tend to outperform others in infrastructure, private investment, social indicators, and the rule of law, contributing to a widening north-south gap.
• Ultimately, the challenge for the government lies in defining the terms of reference for the Finance Commission, ensuring that richer States compensate poorer ones without exacerbating the divide.
• The Finance Commission itself will need to deliver on these terms of reference, navigating the complexities of horizontal distribution.

Issue with Cesses and surcharges

The upcoming Finance Commission has an important role in considering the expenditure needs and revenue earning capacity of both the Centre and the States. In this regard, there are two significant issues that the Commission should address.

• Firstly, the increasing reliance of the Centre on cesses and surcharges instead of raising taxes has become a matter of concern.
• According to a white paper released by the Tamil Nadu government, the proportion of cesses and surcharges in the Centre’s total tax revenue has nearly doubled from 10.4% in 2011-12 to 20.2% in 2019-20.

Impact of excessive Cesses and surcharges

This practice creates a perverse incentive. If the Centre chooses to raise taxes, it must share 41 paise with the States.

• However, by implementing a surcharge, the Centre retains the entire additional revenue.
• When the Constitution was amended in 2000 to allocate a share of the Centre’s tax pool to the States, it was understood that cesses and surcharges would be used sparingly, rather than as a routine practice.
• This breach of understanding has left States feeling deprived of their rightful share of national tax revenue.
• The next Finance Commission should establish guidelines for the appropriate circumstances in which cesses and surcharges can be levied.
• Additionally, the Commission should propose a formula to limit the amount that can be raised through these measures.

Restraining Freebies to Promote Fiscal Prudence

The Finance Commission should also address the issue of government spending on what is commonly referred to as “freebies.” It is important to note that all political parties have been guilty of such spending, to varying degrees, so assigning blame would not be productive.

• In a country where millions of households struggle to meet their basic needs, it may seem heartless to argue against safety nets for the poor. However, precisely because India is a poor country, we need to exercise caution when it comes to freebies.
• Although the Fiscal Responsibility and Budget Management (FRBM) Act was intended to act as a check on populist spending, governments have found ways to raise debt without it being transparently reflected in the budget.
• Defining freebies in an unambiguous manner is challenging, and any attempt to regulate such spending will likely be met with resistance, as it may be seen as encroaching on the autonomy of elected governments.
• Nonetheless, in the interest of long-term fiscal sustainability, the next Finance Commission should take a bold stance and establish guidelines on spending related to freebies.

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