Devil in the devolution detail

Over the next five years, states will likely get less money and more conditions from the Centre

Article 280 of the Constitution requires the appointment of the Finance Commission by the President of India every five years to resolve the imbalances arising from the assignment of revenue powers and expenditure responsibilities. The basic tasks of the Finance Commission are to recommend (i) distribution of the net proceeds of the Union taxes and their allocation between different states; (ii) principles governing the grants-in-aid to the states from the Consolidated Fund of India; (iii) measures to augment the consolidated funds of the states to supplement the resources of local bodies based on the recommendation of State Finance Commissions; and (iv) any other matter in the interest of sound finance.

The Fifteenth Finance Commission (FFC) submitted its final report for the period covering 2021-22 to 2025-26 on November 9, 2020, titled Finance Commission in COVID Times: Report for 2021-26. As required under Article 281, the government has tabled the report in the Parliament along with the explanatory memorandum covering the action taken by it on the report while presenting the Union Budget for 2021-22 on February 1.

The Terms of Reference (ToR) issued to the FFC had evoked a lot of criticism for a number of reasons. The directive to use population figures of 2011 in its calculations as against the 1971 population stipulated to the earlier Commissions was criticised by states which had reduced the fertility rates as penalising them for their better governance performance. The suggestion to avoid giving revenue deficit grants was criticised as interfering with the Commission’s approach and methodology. The stipulation of measurable, performance-based incentives, including those relating to the “control or lack of it in incurring expenditure on populist measures,” was criticised as pushing the Commission to adopt asymmetric treatment between the Union and the states.

The ToR also nudged the Commission to reduce the share of the states in the divisible pool by asking it to take into account the substantially enhanced devolution by the 14th Finance Commission along with the increasing commitment of the Union government on New India 2022.

Finally, the additional ToR asking the Commission to examine whether a separate fund for defence and internal security should be created was apprehended as an attempt to pre-empt funds to reduce the divisible pool.

Revenue-sharing in pandemic times

To its credit, the Commission has steered clear of these controversies. Like in the case of the first report for 2020-21, the Commission has recommended the states’ share at 41% in the divisible pool. The factors determining the horizontal shares of the states, too, are the same as in the Interim Report, with a 15% weightage for population and area, 10% for forest cover, 45% for income distance, 12.5% for demographic performance and 2.5% for fiscal effort. Unfortunately, even as the formula remains the same, the shares of the states in the gross tax revenues of the Centre have been going down as the Centre has been garnering funds from all discretionary changes in the tax structure through cesses and surcharges, which are not included in the divisible pool. And unlike the previous Commissions, the FFC is silent on this practice.

The FFC has continued with the practice of recommending revenue deficit grants and recommended Rs 2,94,514 crore for the five-year period, with phased reduction over the period in the amount of grants and number of eligible states. States with large post-devolution deficits have been given time to tighten the belt. The recommendations relating to disaster management, too, are on expected lines. A total of Rs 1,60,153 crore has been recommended for the disaster management fund, of which the Central share is Rs 1,22,601 crore -- to be distributed to the states on the basis of past expenditures, area, population and hazard and vulnerability index.

Grants for local bodies

The Commission’s recommendations on local body grants involve a number of conditions. Of the total of Rs 4,36,361 crore recommended to the local bodies for the period 2021-26, Rs 70,051 crore has been earmarked for strengthening primary health centres, Rs 8,000 crore for incubation of new cities, and Rs 450 crore for shared municipal services. Of the remaining, the shares of rural and urban local bodies are fixed at Rs 2,36,805 crore and Rs 1,21,055 crore respectively, and these are distributed to the states according to population and area in the ratio 90:10.

The rural grants to be given to all the three tiers are based on the recommendations of State Finance Commissions or the band recommended by the FFC, which are 70-80% to village panchayats, 10-25% to block panchayats and 5-15% to district panchayats. Of the total Rs 1,21,055 crore grants to urban local bodies, Rs 38,196 crore has been earmarked for 50 cities with a million-plus population. One-third of this is to be given for achieving ambient air quality, and two-thirds for achieving service level benchmarks in drinking water supply, rainwater harvesting, water recharging, solid waste management and sanitation. Of Rs 82,859 crore grant meant for smaller urban local bodies, 40% is to be given as untied grants and the remaining 60% earmarked for drinking water, rainwater harvesting, solid waste management and sanitation.

However, there are entry conditions for availing local body grants, which are: (i) states should set up State Finance Commissions, act upon their recommendations and lay the explanatory memorandum on the action taken in the state legislature before March 2024; (ii) both provisional and audited accounts should be placed in public domain, and (iii) fixation of minimum floor for property tax rates in tandem with the growth rate of the state’s GSDP.

There are some concerns on conditional and performance-linked grants to local bodies. According to Article 280 (3) (b) and (c), the Commission is supposed to play only a supplemental role, and the main responsibility for transfers lies with the state government. Furthermore, the states will have to fulfil the entry conditions and ensure performance of the local bodies to get the grants. Will they have the incentive to do so?

Fiscal Consolidation Roadmap

Recommendations on the fiscal consolidation roadmap by the FFC were keenly awaited. Starting from the deficit of 6% of GDP in 2021-22, FFC has recommended a glide path to contain the deficit at 4% in 2025-26. This is supposed to reduce the debt-GDP ratio from 62.9% in 2021-22 to 56.6% in the terminal year.

For the states, the fiscal deficit is supposed to be reduced from 3.3% in 2021-22 to 2.8% in 2025-26, and debt-GSDP ratio from 31% in 2021-22 to 30.5% in 2025-26. States have also been allowed to borrow 4% of their GSDP in 2021-22 to overcome fiscal constraints and an additional 0.5% conditional on reforms in the power sector.

While the government has accepted the debt ceiling for the states recommended by the Commission, it has stated that the fiscal roadmap for the Centre will be examined separately. In fact, the Budget speech set the fiscal deficit target at 4.5% instead of the 4% recommended by the Commission.

Defence and sectoral funds

The Commission has recommended the constitution of a dedicated non-lapsable fund for defence and internal security to bridge the gap between projected budgetary requirements and budget allocation. The fund will access resources from (a) the Consolidated Fund of India; (d) disinvestment proceeds from defence public sector enterprises; (c) proceeds from monetisation of surplus defence land; and (d) receipts from defence land to be transferred to the state governments and for public projects in future. The government has accepted the recommendation in principle and stated that the modalities of creating the fund and sourcing funds will be examined in due course.

The FFC has also recommended sector-specific grants to health, school education, higher education, agriculture, maintenance of PMGSY roads, aspirational districts and blocks, judiciary, and statistics, amounting to Rs 1,20,087 crore. The Commission has also recommended state-specific grants of Rs 49,599 crore. However, the government has not accepted these recommendations, and has only said that due consideration will be given to them in formulating and implementing existing centrally-sponsored schemes.

On the whole, this is an important report that has come at an important juncture. Now, the states will have to work around these recommendations for the next five years.

(The writer was Member, Fourteenth Finance Commission, and former Director, NIPFP, New Delhi. He is also the Chief Economic Adviser, Brickwork Ratings)