Abstract
The 15th Union Finance Commission (UFC) report, submitted in India in the middle of a global economic setback due to COVID-19, was a hope for sub-national governments to arrive at a favourable financial devolution mechanism. Even though few recommendations by 15th UFC looks promising, it is difficult to outrightly reject the possibilities of increasing fiscal imbalances. The retention of the proportion of shared tax devolution to states as used during 14th UFC and the use of (a) tax and fiscal effort, (b) 2011 census population figure and (c) total fertility rate as demographic performance, for distribution of shared tax across states may be helpful to reduce fiscal imbalances. However, the decline in the size of shared taxes of states due to (a) shrinking tax collection by the central government during current economic crisis and (b) assignment of additional burdens on states like (i) the contribution of states towards national defence and (ii) internal security, may result in vertical imbalance. There is a possibility of an increase in horizontal imbalance with the rise in the weightage of neutral (need based) criteria and decline in the weight of equity criterion due to the proportionate decline in the shares of poorer state through these two criteria. The fiscal imbalances are to be reduced to a minimum level to enable the country providing a common minimum level of public goods to its people. Since the weight of neutral criteria is implicit in equity and efficiency criteria, an optimum weight adjustment solution as suggested by Mahamallik and Sahu ((2015), Artha Vijnana, 57(4), 301–320) may be helpful to reduce imbalances.
Introduction
The 15th Union Finance Commission (UFC 1 ) submitted its final report 2 on 9 November 2020 to the President of India which was tabled in the Indian parliament on 1 February 2021.This report was submitted at a point of time when both the Central and sub-national (State) governments were encountering with economic instability and uncertainty due to economic lockdown and states were struggling particularly with the delay in the payment of Good and Service Taxes (GST) share from the Central government. 3 During such an economic crisis, the submission of 15th UFC report will naturally bring a ray of hope for the sub-national governments. It is obvious that both the Central and state governments, if not, at least would expect recommendations from 15th UFC in following lines: (a) maximum possible measures to address fiscal imbalances and (b) measures for fiscal strengthening of states. The UFC generally makes suggestions on Centre–state financial devolution. In brief, it was constitutionally assigned to prescribe: (a) formula for vertical and horizontal central shared tax devolution, (b) principle of determining grants and (c) any other matter necessary for sound finance of the country as directed by the President of India (Rao & Chelliah, 1996). 4 All previous commission’s reports, prior to the 15th UFC were more or less recommended in a similar line with little modification in the (a) share of shared taxes for vertical tax devolution (Government of India (GoI), 2020, p. 151) and (b) criteria with their weights for horizontal tax devolution. No attempt has so far been made to come out with an ‘out of box’ solution for a better horizontal and vertical tax devolution structure. Further, no efforts are being undertaken to create space in the recommendation to deal with fiscal uncertainties by states. In other words, meagre structural change is observed either in formula based (shared tax) or conditional 5 (grants) transfer in the recommendations of previous UFCs. Although few credible efforts were made in the recommendations of the 15th UFC 6 to reduce imbalances, the increase in the weightage of neutral (need based) criteria (population, and forest coverage) and the decline in the weightage of equity criterion (income distance method) question the objective of bringing down the imbalances.
Context
Over time, 15 commissions have submitted their reports recommending formulae relating to vertical and horizontal devolution of shared taxes, grant devolution and other matters as directed by the central government. Initially, a proportion of union excise duty and income tax was devolved to states under the umbrella of ‘shared taxes’. Subsequently, except, ‘taxes’ under Article 268 and 269 as well as ‘cess’ and ‘surcharges’ under Article 271, all central taxes were brought under the umbrella of shared taxes. Even though the volume of shared taxes has increased through widening of the domain of shared taxes over successive commissions, vertical imbalance has not declined. In a similar manner, policy paradox arising from methods used for inter-se distribution of shared taxes among states increases horizontal imbalance even after a series of reforms (Mahamallik & Sahu, 2015). 7 In addition, to deal with horizontal and vertical imbalance, different commissions have made recommendations on different directions, as directed by the President of India. The report of 15th UFC is unique in the sense that (a) it holds a special title 8 and (b) has made recommendations for performance-based incentive grants to cover a wide range of activities, besides constitutionally restricted sphere of activity.
Fiscal Imbalances and Recommendations of Union Finance Commissions
Despite remedial measures undertaken by Governments as recommended by UFCs, there has been persisting rise in vertical and horizontal fiscal imbalances in the country (GoI, 2020, p.150; Mahamallik & Sahu, 2015). The revenue share of state in the combined revenue of Centre and state and the expenditure share of state in the combined expenditure of Centre and state were 37.5% and 57.4% respectively during 1980 to 2015 (Mahamallik & Sahu, 2015). The 15th UFC observed the presence of vertical imbalance during 2018–2019 measured in terms of the ratio of revenue and expenditure share of state to their corresponding combinations of centre and state which were 37.3% and 62.4%, respectively (GoI, 2020, p.150). The increase in expenditure share of states leaving the revenue share more or less the same between 1980–2015 (as estimated by Mahamallik and Sahu (2015)) and 2018–2019 (as estimated by GoI (2020)) indicates rising vertical imbalance. Further, vertical fiscal gap in India is larger and increasing at a higher rate than most federations of the Globe 9 (GoI, 2020, p. 28; Rao & Sen, 1996). Rao and Sen (1996) observed the degree of vertical imbalance as 53% in India. However, the degree varies from 20% in Germany to 70% in Indonesia. The vertical imbalance in India during 2018–2019 is estimated as 58.1%, while it varies from 6% in Germany to 82% in Mexico among the OECD countries during same period (GoI, 2020). Mahamallik and Sahu (2015) estimated the horizontal imbalance during 1980–1981 to 2014–2015 to the extent of 23% on an average in India. An inverse relationship exists between degree of fiscal imbalance and capacity to provide minimum level of public goods (Rao & Sen, 1996). A utopian degree of fiscal imbalance (zero degree) is appropriate to enable a country to provide minimum level of public goods. The degree of fiscal imbalances cannot be reduced to zero due to the structural division of resources and responsibility between different levels of government and differences in resource endowment, population composition and level of development within the same level of government. Increase in the degree of imbalances is mainly attributed to policy paradox, which is inbuilt in the methods of horizontal devolution (Mahamallik & Sahu, 2015). Practically, horizontal imbalance influences the vertical imbalance and vice versa. 10 Imbalance in one dimension leads to imbalance in other. Finance commissions of India have been using value judgment 11 for vertical devolution and a set of formula with varying weights for horizontal devolution. Therefore, reduction of horizontal imbalance is the appropriate mechanism to reduce both imbalances.
In order to reduce the horizontal imbalance, neutral, equity and efficiency criteria have been used for the distribution of central shared taxes 12 by successive commissions in India. Population was used as a need-based criterion assigning around 80% to 90% weightage in the distribution of shared tax from 1st to 7th UFC. Subsequently, weight of population was reduced considering population is not directly related to expenditures of all economic activities. As population is inbuilt in the efficiency and equity criteria, reduction in weight of population is meaning-less argument to reduce the impact of population on the distribution of shared taxes. Assignment of significant weightage to population is criticised on the grounds of (a) adversely affecting states that takes measures to control population (Tripathi et al., 2003) and (b) regressivity (Mahamallik & Sahu, 2015).
The outcomes of measures undertaken as per the recommendations of 14th UFC has been criticised by researchers (GoI, 2020, p. 150; Mahamallik & Sahu, 2015; Reddy, 2015) on the ground of rising fiscal imbalances. Although an increase in the weightage of equity criteria (income distance method) leads to progressivity as per the recommendation of the 14th UFC (Bhaskar, 2015), the methods of horizontal tax devolution and revenue deficit grants were condemned for reducing horizontal imbalances on the ground of regressivity (Bhaskar, 2015; Mahamallik & Sahu, 2015) and fiscal indiscipline 13 (Dholakia, 2015; Mahamallik & Sahu, 2015). The increase in the weight of neutral criterion favours neither equity (progressivity) nor efficiency; instead, it leads to an undesirable outcome, as reported in the 15th UFC report. Abolition of efficiency criterion and introduction of revenue deficit grants have a tendency to encourage fiscal profligacy by states. The conditional grants and partial/substantial assignment of revenue expenditure responsibility of centrally sponsored schemes (24 schemes) on states, as mentioned earlier, could not reduce fiscal imbalance.
Challenges Before the 15th Union Finance Commission
The 15th UFC fails to draw lessons from the outcome of recommendations made by the 14th UFC on vertical and horizontal devolution. The newly added dimensions of contribution towards national defence by states keeping the share of vertical devolution untouched may increase vertical imbalance (Modi, 2021). The share of prescribed 42% revenue transfers to states by the 15th UFC may be lower than the 42% share of the 14th UFC, in absolute term, due to economic slowdown, which may further increase the imbalance (Ramachandran, 2021).
Drawing lessons from the critics of the 14th UFC recommendations on horizontal devolution, the 15th UFC has introduced: (a) efficiency criteria with marginal weights (2.5%) assigned to tax effort; (b) a relatively refined index for demographic change (to provide due share to states in proportion to the reduction in the size of their population) and (c) forest coverage and ecology. In case of both demographic change and forest coverage and ecology, the weight is marginal (2.5%) increased from the previous commission, 14 keeping other criteria and weights the same as used in 14th UFC (GoI, 2020). Although tax effort encourages a state to raise its own revenue, it may not be realised due to economic slowdown. The increased weight in demographic performance and forest coverage has led to the rise in total weightage of neutral criteria when compared to its weight in previous commission. When the recommendation of the 14th UFC has already been criticised on the ground of non-effectiveness of neutral criterion, the assignment of larger weightage to it by the 15th UFC is observed to be contradictory. Recommendation by the 15th UFC for reduction in the weightage of income distance method by 5% (from 50% during the 14th UFC to 45% during the 15th UFC) may be instrumental in increasing the horizontal inequality (Table 2).
Criteria and Weights (%) during Union Finance Commissions to Distribute Shared Taxes.
Criteria and Weights (%) during Union Finance Commissions to Distribute Shared Taxes.
Recommendations of 14th and 15th Union Finance Commission.
The continuation of the revenue deficit grant by the 15th UFC keeps the window open for fiscal profligacy for states. The introduction of performance-based incentive grants also leads to a rise in horizontal inequality across states when poorer states suffer most due to economic slowdown. Further, drawing lessons from the compositional shift from grants to tax devolution during 14th UFC that does not have any significant impact in reducing horizontal imbalance, the 15th UFC has brought changes in the composition of transfer from tax (general purpose transfer) to grants (conditional performance-based incentive linked grants) 15 (GoI, 2020). However, the conditional grant boosts inequality and is proved to be biased in the literature (Sen & Trebesch, 2004).
Assignment of significant weight to equity criteria is welcomed in countries with wide economic disparities. However, this assignment adversely affects fiscally stable states by assigning comparatively lower share in federal transfer. To compensate the loss some weights may be assigned to efficiency criterion that enables the equity criteria in achieving its objective. The simultaneous use of equity and efficiency criteria increases imbalances instead of reducing it, due to the existence of contradiction between two criteria. When the assignment of significant weight to equity criteria encourages rich states to be deficient state, poorer states project themselves as efficient with the assignment of significant weight to efficiency. An optimum weight adjustment criterion combining one-third weight to efficiency and two-third weights to equity as suggested by Mahamallik and Sahu (2015) may be helpful in reducing imbalances. It not only assigned weight to equity and efficiency criteria but also implicitly assigned weight to the need factor.
Historically, the UFC has been using (a) discretionary measure to address vertical imbalance, and (b) neutral, equity and efficiency criteria with varying weights to bring improvements in horizontal imbalance. The proportion in vertical devolution and weights of the above-mentioned criteria used for horizontal distribution are determined by looking at the financial position and responses to the economic policies of centre and states. However, in the present economic scenario, when states are struggling for their own fiscal capacity, treatment in the form of keeping the share in the divisible pool constant’ may not be sufficient to address the vertical imbalance. The assignment of larger weightage to neutral criteria and contraction of weight of equity criterion by the 15th UFC may end with increased horizontal inequality. When neutral criteria advocate for equal per capita share, equity favours low-income states and efficiency gives preference to high-income states. An increase in the proportion of vertical devolution and optimum weight solution of equity and efficiency for horizontal distribution as suggested by Mahamallik and Sahu (2015) may be helpful to reduce fiscal imbalances in the country.
Footnotes
Declaration of Conflicting Interests
The authors declared no potential conflicts of interest with respect to the research, authorship and/or publication of this article.
Funding
The authors received no financial support for the research, authorship and/or publication of this article.
