Fourteenth Finance Commission Y Venugopal Reddy Finance Commission - Concepts and definitions Tax Devolution One of the core tasks of a Finance Commission as stipulated in Article 280 (3) (a) of the Constitution is to make recommendations regarding the distribution between the Union and the states of the net proceeds of taxes. This is the most important task of any Finance Commission, as the share of states in the net proceeds of Union taxes is the predominant channel of resource transfer from the Centre to states. Divisible Pool The divisible pool is that portion of gross tax revenue which is distributed between the Centre and the States. The divisible pool consists of all taxes, except surcharges and cess levied for specific purpose, net of collection charges. Cntd.

Fiscal capacity/Income distance The income distance criterion was first used by Twelfth FC, measured by per capita GSDP as a proxy for the distance between states in tax capacity. When so proxied, the procedure implicitly applies a single average tax-toGSDP ratio to determine fiscal capacity distance between states. The Thirteenth FC changed the formula slightly and recommended the use of separate averages for measuring tax capacity, one for general category states (GCS) and another for special category states (SCS).

Fiscal discipline Fiscal discipline as a criterion for tax devolution was used by Eleventh and Twelfth FC to provide an incentive to states managing their finances prudently. The criterion was continued in the Thirteenth FC as well without any change. The index of fiscal discipline is arrived at by comparing improvements in the ratio of own revenue receipts of a state to its total revenue expenditure relative to the corresponding average across all states. Special Category States (SCS) and General Category States (GCS) • The concept of a special category state was first introduced in 1969 when the Fifth Finance Commission sought to provide certain disadvantaged states with preferential treatment in the form of central assistance and tax breaks. Initially three states Assam, Nagaland and Jammu & Kashmir were granted special status but since then eight more have been included (Arunachal Pradesh, Himachal Pradesh, Manipur, Meghalaya, Mizoram, Sikkim, Tripura and Uttarakhand). All other states barring these are treated as General Category States. • The rationale for special status is that these states, because of inherent features, have a low resource base and cannot mobilize resources for development. Some of the features required for special status are: (i) hilly and difficult terrain; (ii) low population density or sizeable share of tribal population; (iii) strategic location along borders with neighbouring countries; (iv) economic and infrastructural backwardness; and (v) non-viable nature of state finances. Finance Commission & It’s Mandate • The Finance Commission is a Constitutional body formulated under Article 280 of the Indian Constitution. It is constituted every five years by the President of India to review the state of finances of the Union and the States and suggest measures for maintaining a stable and sustainable fiscal environment. The core mandate of the finance commission relates to: • (a) proceeds of taxes to be divided between union and the states, usually referred to as the “vertical balance;” • (b) the allocation of distribution of taxes among the states, usually referred to as the horizontal balance; • (c) the principles which should govern the grants-in-aid to states by the finance commission, which are over and above the devolution of taxes as per a formula; and • (d) measures to augment the consolidated fund of a state to supplement the transfer of resources to panchayats and municipalities, based on the recommendations of the respective state finance commissions, usually referred to as finance commission grants to local bodies. The Fourteenth Finance Commission(FFC) was appointed on 2ndJanuary, 2013under the chairmanship of Dr. Y. V. Reddy. The core mandate of the FFC remained broadly no different from the previous commissions but exhibited two striking aspects: 1. First, as in some though not all previous finance commissions, there was no specific mention of the treatment of gross budgetary support to the plan as a committed liability of the union government. The ToR also did not bind the FFC to look at only non-plan revenue expenditure of the states. The absence of such a reference created an opening to the FFC, if it so desired, to dispense with the distinction between plan and nonplan. Unlike many of its predecessors, the FFC was emboldened to pursue this idea. 2. Second, in the past, the ToR required the commissions to take the base of population fi gures of 1971 in all cases where population was a factor. Our ToR indicated that, in addition, we may also take into account the demographic changes that have taken place since 1971. The FFC took advantage of this opening to take into account both the 1971 population and 2011 population, while reluctantly giving higher weight to the 1971 population. •Thethe assessment Context of finances of the union and states, as well as the projections, took account of the prevailing environment relevant to the FFC’s work. • The FFC took cognisance of the changing balances and the new realities of the macroeconomic management and made an effort to place the prevailing fiscal situation and the evolving relationship between the union and the states in the broader context as well. • Finance commissions adopts a comprehensive approach to holistically deliver it’s tasks: First, a demonstrably symmetric view of the union finances, state finances and their fi scal relations was attempted. Second, an integrated view of revenue expenditure with no distinction between plan and non- plan, and a comprehensive view of revenue and capital expenditures, including public debt were attempted. Third, the special responsibilities of the union in macroeconomic management and its relationship with the global economy had to be explicitly recognised. Fourth, a comprehensive view of the transfer from the union to the states, both within and outside the recommendations of the finance commission, was necessary to address the fundamental issues relating to the constitutional assignment, plans and centrally- sponsored schemes (CSS). Fifth, the predominant role of the states, in particular, the state finance commissions, in empowering local bodies had to be re cognised. • Finally, the FFC examined the issue of separate treatment of the special category states. Review of Fiscal Positions • The fiscal position of all states taken together has shown significant improvement during the review period, both in terms of quantity and quality. In fact, many states had not fully utilised the fiscal space available to them to incur capital expenditure within the fiscal targets prescribed by the Thirteenth Finance Commission. • the record of fiscal management by states as a whole reinforced the soundness of recommendations of the Twelfth and Thirteenth Finance Commissions relating to fiscal responsibility. The FFC recognised that the process of fiscal consolidation in the union should ideally be accompanied by prudent fiscal expansion at the level of states.

Intergovernmental Transfers • within the overall fiscal trend in the country, there has been a greater expansion in the fiscal activity of the union than of the states. In particular, the transfers from the union to the states have increased substantially. • Moreover, overall transfers, namely, Finance Commission transfers and other transfers put together, far exceeded the indicative ceiling prescribed by the previous commissions. Within the transfers, discretionary components had increased in the review period, undermining the role of the finance commissions. • FFC concluded that the burden of fiscal consolidation rests heavily on the union government, in view of the initial conditions and its importance. In such a situation, the FFC concluded that it was not possible to increase the level of aggregate transfers from the • union to the states. The focus, therefore, was to concentrate on the composition and the quality of the aggregate transfers from the union to the states. Union Finances

• the FFC followed the practice of assessment of union fi nances that was done by earlier fi nance commissions, but, in addition, the FFC considered the magnitudes, legitimacy and appropriateness of union transfers to states outside the mechanism of the fi nance commissions, keeping in view the Constitutional provisions. A major challenge in this regard was the enacted legal commitment and expenditures on ongoing schemes that fell under the Concurrent List and were being funded by both the union and the states. Several internal exercises on these matters were undertaken to obtain insights relevant to the assessment of respective needs of the union and states.

State Finances In regard to assessment of the own tax revenues of states, the FFC considered aggregate own tax revenue as a single category, following the methodology adopted by the preceding three finance commissions. In making the projections, a two-step methodology was followed. The first step involved reassessment of the base year 2014–15. The second step involved application of normative growth rates for the projections. For states with an above average tax–GSDP ratio, the assumed own tax buoyancy was 1.05 implying a moderate increase, and for others, a higher buoyancy of 1.5 till it reaches the target tax–GSDP ratio. This resulted in an improvement in the terminal year. The assessment of own non-tax revenues was made in terms of major items of non-tax revenue separately for each state, consistent with past practice. The FFC also did not consider any proposal for debt-restructuring on the ground that it would be a good practice for governments to honour their debt obligations. The FFC also accepted the pension expenditure for the base year provided by the states and assessed this expenditure in a manner that refl ects true pension liabilities for the assessment period.

The FFC also attempted to address the goal of equalisation of expenditures across the states in terms of per capita expenditures. It made an additional expenditure provision in assessment of needs of states which required such a provision to ensure that in the fi nal year of the FFC projections every state reached at least 80% of all state average per capita revenue expenditure (excluding interest payment and pension and CSS transfers). MAJOR RECOMMENDATIONS OF FFC

1. The FFC has radically enhanced the share of the states in the central divisible pool from the current 32 percent to 42 per cent which is the biggest ever increase in vertical tax devolution.The last two Finance Commissions viz. Twelfth (period 2005- 10) and Thirteenth (period 2010- 15) had recommended a state share of 30.5 per cent (increase of 1 percent) and 32 per cent (increase of 1.5 percent), respectively in the central divisible pool.

2. The FFC has also proposed a new horizontal formula for the distribution of the states’ share in divisible pool among the states. There are changes both in the variables included/excluded as well as the weights assigned to them. Relative to the Thirteenth Finance Commission, the FFC has incorporated two new variables: 2011 population and forest cover; and excluded the fiscal discipline variable. 3. Several other types of transfers have been proposed including grants to rural and urban local bodies, a performance grant along with grants for disaster relief and revenue deficit. These transfers total to approximately 5.3 lakh crore for the period 2015-20.

4. The FFC has not made any recommendation concerning sector specific-grants unlike the Thirteenth Finance Commission. IMPLICATIONS OF FFC RECOMMENDATIONS FOR FISCAL FEDERALISM: A WAY AHEAD • All states stand to gain from FFC transfers in absolute terms. However, to assess the distributional effects, the increases should be scaled by population, Net State Domestic Product (NSDP) at current market price , or by states’ own tax revenue receipts. • The FFC recommendations are expected to add substantial spending capacity to states’ budgets. The additional spending capacity can better be measure by scaling the benefits either by NSDP at current market price or by states’ own tax revenue. • In terms of the impact based on NSDP, the benefits of FFC transfers are highest for Chhattisgarh, Bihar and Jharkhand among the GCS and for states like Arunachal Pradesh, Mizoram and Jammu & Kashmir among the SCS. While in terms of states’ own tax revenues, the largest gains accrue to GCS of Bihar, Jharkhand and Chhattisgarh and SCS of Arunachal Pradesh, Mizoram and Nagaland. • The FFC transfers have more favorable impact on the states (only among the GCS) which are relatively less developed which is an indication that the FFC transfers are progressive i.e. states with lower per capita NSDP receive on average much larger transfers per capita. • The correlation between per capita NSDP and FFC is transfer per capita is - 0.72. This indicates that the FFC recommendations do go in the direction of equalizing the income and fiscal disparities between the major states. However, FFC transfers are less progressive compared to the transfers of Thirteenth Finance Commission (TFC). • The significant impact due to increase in the divisible pool is on states like Uttar Pradesh, Bihar, Madhya Pradesh, West Bengal and Andhra Pradesh (United) while states like Arunachal Pradesh, Chhattisgarh, Madhya Pradesh, Karnataka and Jharkhand are the major gainers due to a change in the horizontal devolution formula which now gives greater weight to a state’s forest cover.