Why is it in the News?`

During a NITI Aayog meeting chaired by the Prime Minister, Chief Ministers voiced their apprehensions regarding the declining revenues of the states.

Context:

• The Finance Commission holds a crucial role in suggesting the distribution formula for States' allotment of Union tax revenue.
• The formulation has witnessed changes over time in terms of the inclusion and significance of different factors, with tax contribution emerging as a central point of debate.
• It is essential to underscore the historical context, principles of equity and efficiency, and the repercussions of integrating the Goods and Services Tax (GST) regime into the distribution formula

What is the Finance Commission?

• The Finance Commission is a constitutional body responsible for providing recommendations on the distribution of tax revenues among the Union and the States, as well as among the States themselves.
• The President constitutes the Finance Commission under Article 280 of the Constitution.
  • It is established at the end of every fifth year, or earlier if deemed necessary.
• Qualifications and Selection: Parliament, through legislation, determines the qualifications for Commission members and the selection process.
  • The Finance Commission (Miscellaneous Provisions) Act, 1951, addresses these aspects.
• Mandate: The Commission's duties include making recommendations to the President on the distribution of tax proceeds between the Union and States, principles guiding grants-in-aid, measures to enhance State Consolidated Funds, and any other financial matters referred by the President in the interest of sound finance.
• Composition: The Commission comprises a Chairman and four members appointed by the President.
• Member Qualifications: The Chairman is selected from individuals with experience in public affairs, while the four other members are chosen from those with qualifications such as being former or eligible High Court Judges, and possessing expertise in government finances, administration, or economics.
• Tenure: Each member serves a specified term, as determined by the President, and is eligible for reappointment.
• Non-Binding Recommendations: The recommendations of the Finance Commission are advisory and not binding on the government.

The History and Evolution of the Distribution Formula:

• The historical development of the Finance Commission's distribution formula has played a pivotal role in shaping India's fiscal federalism.
• Initially focusing on personal income tax and Union excise duties, the formula underwent substantial changes with the introduction of the 10th Finance Commission, reflecting a more nuanced understanding of fiscal relations between the Union and States.
• Expansion of Revenue Streams with the 10th Finance Commission: The introduction of the 10th Finance Commission marked a significant transformation as all Central tax revenues were consolidated, expanding the range of revenue streams in the distribution formula.
  • This departure from the earlier approach acknowledged the necessity for a comprehensive framework to address the intricate fiscal dynamics among the States.
• Equity and Efficiency as Guiding Principles: The distribution formula shifted its focus to prioritise equity and efficiency.
  • Equity considerations aimed to rectify imbalances by allocating larger shares to revenue-scarce and high-expenditure States, while the efficiency principle rewarded states demonstrating proficiency in revenue collection and spending practices.
  • This departure from the earlier needs-based criteria recognized the importance of incentivizing states to enhance fiscal capacities for the country's overall economic well-being.
• Dynamic Interplay of Equity and Efficiency: The ongoing normative debate within the Indian fiscal framework is exemplified by the dynamic interplay between equity and efficiency in successive Finance Commissions' recommendations.
  • Striking the right balance between these principles remains a complex task, and the formula has evolved to reflect the changing priorities of fiscal federalism.
• Inclusion of Various Indicators: While early Finance Commissions incorporated indicators such as population, per capita income, and area in the distribution formula, a notable shift towards a more comprehensive and consolidated approach has occurred since the 10th Finance Commission.
  • The convergence of income tax and Union excise duties into a single formula from the 10th Finance Commission onward aimed to streamline the approach and ensure consistency across different revenue sources.

Evaluating Efficiency Indicators in the Distribution Formula:

• Tax contribution serves as an efficiency indicator, offering insights into a state's developmental level and economic structure.
  • Historically, it has been assigned a relatively modest weight, ranging from 10% to 20% within the distribution formula.
• In the early commissions, population, a key indicator of expenditure needs, played a dominant role, commanding weights between 80% and 90%.
• From the year 2000 onward, the distribution formula incorporated tax effort and fiscal discipline as efficiency indicators, each carrying approximately 15% weight.
  • However, these indicators encountered challenges stemming from their instability, influenced by discretionary tax policies and unexpected shifts in tax bases.

The Reasons to Consider Petrol Consumption and GST in the Distribution Formula as Efficiency Measures:

• Petroleum Consumption as a Supplementary Indicator: In addition to GST, considering petroleum consumption as an efficiency indicator adds depth to the formula.
  • Union excise duty and sales tax on petroleum products, excluded from GST, significantly contribute to the national exchequer.
  • The stable and consistent nature of relative shares of petroleum consumption across states makes it an attractive supplementary indicator for assessing a state's contribution to specific tax categories.
• Stability and Uniformity in GST Contributions: In contrast to previous indicators, GST provides a unified tax system that minimizes variations in tax efforts among states.
  • While the absolute amount of GST revenue generated may vary based on the size and economic structure of each state, the relative contributions remain stable over time.
  • This stability is crucial for establishing a fair and consistent measure of a state's efficiency, particularly in revenue collection.
• Accurate Reflection of State's Tax Base through GST Revenue: The implementation of the Goods and Services Tax (GST) has transformed India's taxation landscape, introducing a consumption-based destination tax system that is equally divided between State and Central governments.
  • This structure offers a unique opportunity for a precise estimation of a state's tax contribution.
  • The inherent symmetry in GST ensures that the State GST accrual mirrors the Central GST accrual to the Union government from that state, making GST a stable and reliable measure of a state's tax base.
• Exclusion of Discretionary Policies in GST: One significant advantage of incorporating GST into the distribution formula is its insulation from discretionary tax policies.
  • Unlike tax effort, which can be influenced by state-specific policy decisions, GST reflects the accurate tax base of a state, unaffected by varying policy choices.
  • This characteristic makes GST a more objective and reliable indicator of a state's contribution to the national exchequer.
• Linkage to Income Levels: A compelling rationale for including both GST and petroleum consumption lies in their indirect reflection of the relative differences in the incomes accrued to the residents of a state.
  • Consumption patterns are inherently tied to income levels, making the shares of CGST and Union excise duty accurate proxies for assessing both personal and corporate income tax contributions.
• Proposal for Weightage Increase: Given the fair and accurate nature of GST and petroleum consumption as efficiency metrics, there is a strong proposal for the 16th Finance Commission to assign a more substantial weightage to these indicators.
  • A weightage of at least 33% has been suggested, considering the significant role these indicators play in reflecting a state's contribution to the national exchequer.

Conclusion

The transformation of the Finance Commission's distribution formula has moved from a reliance on population-centric indicators to embracing efficiency measures. The introduction of the GST regime, coupled with stable indicators such as petroleum consumption, offers an opportune moment to reassess the distribution formula. As the 16th Finance Commission contemplates the next formula, assigning appropriate weight to tax contribution as an efficiency indicator can guarantee a fair and accurate portrayal of states' contributions to the national exchequer.