16th Finance Commission and Fiscal federalism

Why in News?

The Union government is gearing up to constitute the Sixteenth Finance Commission in November this year.

It will recommend the formula for sharing revenues between the Centre and the States for the five-year period beginning 2026-27.

What is the Finance Commission?

It is a constitutional body constituted every 5 years.

Article 280 of the Indian Constitution deals with it and is constituted to define the Centre-states fiscal relations.

Who will constitute?

The President will constitute a finance commission within two years from the commencement of the Constitution and thereafter at the end of every fifth year or earlier, as the deemed necessary by him/her.

Qualifications?

Parliament may by law determine the requisite qualifications for appointment as members of the commission and the procedure of selection.

Composition:

As per the constitution, the Commission consists of a chairman and four other members.

What is its Function?

Each FC is required to make recommendations on:

• Sharing of central taxes with states,
• Distribution of central grants to states,
• Measures to improve the finances of states to supplement the resources of panchayats and municipalities, and 
• Any other matter referred to it.

Terms of references:

The commission is constituted to make recommendations to the president about the distribution of the net proceeds of taxes between the Union and States and also the allocation of the same among the States themselves. It is also under the ambit of the finance commission to define the financial relations between the Union and the States. They also deal with the devolution of unplanned revenue resources.

Areas on which the 16th FC should concentrate:

Horizontal distribution:

The purpose of this horizontal distribution is that richer States compensate poorer States.

The challenge of the government before defining the ToR of the 16th FC is to ensure that this happens without further deepening the divide between Northern and Southern States.

Restraining levying of cesses and surcharges:

Raising taxes is the obvious choice for increasing revenue, but doing so would require the Centre to provide the States 41 paise (for every Rs raised).

On the other hand, it gets to retain every rupee if it raises it through a surcharge.

The FC should specify conditions under which cesses and surcharges may be imposed as well as a mechanism for capping the amount that may be raised.

Restraint on freebies:

Fiscal Responsibility and Budget Management (FRBM) Act should have acted as a check on such populist spending.

Governments have, however, devised innovative methods to increase debt without it showing up in the budget books.

The FC, in the interest of long-term fiscal sustainability, should lay down guidelines on the spending on freebies.

Challenging issues of fiscal federalism that the 16th FC may have to face:

1. There is the intersecting domain of the Finance Commission and Goods and Services Tax (GST) Council.

• The latter’s decisions impact the own tax revenue flows of states and, more importantly, the size of the central tax revenue pool which is to be shared among the central and state governments as per the recommendations of Finance Commissions.
• Clearly, Finance Commission projections of state and central tax revenues, and recommendations based on them will be impacted by decisions taken by the GST Council.
• This was a major concern even during the 15th FC deliberations when GST revenues were highly volatile, the GST administration was yet to stabilize.

2. Recent demands for greater centralization of expenditure assignment is another issue.

• India has a quasi-federal system.
• For purposes of legislation, regulation and administration, Schedule 7 of the Constitution assigns 97 subjects to the Union List, including all key subjects dealing with national security, external relations, Union finance, banking, foreign trade and major infrastructure.
• Another 66 subjects are assigned to the State List and 47 to the Concurrent List.
• But for concurrent-list subjects, in the event of differences between any state or states and the Union, the latter’s view will be decisive.
• Similarly, if there is any conflict between Union and State legislation, Union laws will prevail.
• Finally, even for State subjects, the Union government can and does intervene through centrally sponsored schemes in which it incentivizes states to take up the Centre’s chosen schemes by financing a part of the cost of these programmes.
• These economic arguments for greater centralization have to be seen in the context of larger political considerations and the distribution of political power across different levels of government.
• A change in the assignment of subjects under schedule 7, whether towards greater centralization or greater decentralization, will entail constitutional amendments.

3. Another issue is the third tier of government.

• Though the Constitution referred to the importance of local governments and Panchayati Raj institutions, it left it to the states to decide what functions from the state list in the 7th schedule should be further delegated and assigned to local governments.
• Subsequently, the 73rd and 74th constitutional amendments spelt out detailed lists of subjects that should be assigned, respectively, to Panchayati Raj institutions (PRIs) and urban local bodies (ULBs).
• But once again, it was left to the state legislatures to decide which functions, funds and functionaries should be assigned to PRIs and ULBs.
• The capacity of these institutions cannot be strengthened unless they are provided the resources to build such capacity.
• It is a ‘chicken and egg’ problem. To help break this conundrum, the 13th, 14th and 15th FCs have all attempted in different ways to ensure substantial fund flows to PRIs and ULBs.
• Vijay Kelkar, chairman of the 13th FC, suggested that consolidated funds should be created for PRIs and ULBs, funded by earmarking a share of the central GST and state GST for them.

Mains Question:

Q: Finance Commission not rocking the Federal Boat is element of Continuity for past few Commissions. In this Context, Examine the Challenging issues of fiscal federalism that the 16th FC may have to face?