16th Finance Commission: The benefits of brevity in Terms of Reference

The Terms of Reference (ToR) of the 16th Finance Commission provide it flexibility to define the scope of its work, approach and methodology.

In brief

• Article 280 of the Constitution provides for the constitution of a Finance Commission (FC) to recommend intergovernmental fiscal transfers.
• The Terms of Reference (ToR) of the 16th Finance Commission are drawn mainly from the constitutional provisions.
• The task of the 16th Finance Commission is quite challenging because of an increase in vertical, horizontal, and fiscal imbalances in the recent years.

The Constitution of India mandates periodic formation of Finance Commissions to address the issues facing intergovernmental fiscal relations. Vertical imbalance arises as the Government of India (GoI) is assigned larger resources from the viewpoint of economic and collection efficiency. On the other hand, the state governments are assigned larger responsibilities as compared to their assigned resources. Fiscal transfers bring the two tiers of government into balance from the viewpoint of their resources vis-à-vis their responsibilities. Horizontal imbalance refers to the difference in state-wise fiscal capacity due to differential initial conditions as also differential current and evolving economic and fiscal conditions. 

The ToR of the 16th Finance Commission were notified by way of a press release dated 29 November 2023.

Understanding ‘sound finances’

In case of earlier Finance Commissions, quite a number of other clauses were included in the ToR, reflecting the provision under clause (d) of Article 280 of the Constitution which refers to ‘any other matter… in the interests of sound finance’. No specific matter has been referred to the 16th Finance Commission  under this clause. However, since this phrase is part of the Constitution, it should be open to the Commission to consider any matter relating to central and state finances in the interest of sound finance.

The ToR of the 16th Finance Commission can be considered as a fresh and welcome departure from the earlier practice of giving a detailed set of considerations. This implies that the Commission is free to determine scope of its work, approach and methodology. The Commission would be free to choose the Census year for state-wise population without any direction from GoI through the ToR. It may be noted, however, that the 2021 Census has not been carried out and the latest available Census data pertains to 2011. 

Linking vertical and horizontal imbalance to fiscal imbalance

The subject of determination of grants and tax devolution in India requires consideration of three types of imbalances namely, vertical, horizontal, and fiscal. Fiscal imbalance deals with the borrowing undertaken by central and state governments to fill up part of the resource gap, which is not met by the availability of resources after transfers from the GoI.

In the context of vertical imbalance, Chart 1 shows a convergence between the center’s net tax revenue and states’ tax revenues post tax devolution during FY01 to FY08. These years were covered largely by the recommendations of 11th and 12th Finance Commissions. After FY10, the gap between the two started to increase with states’ post devolution tax-GDP ratio exceeding that of the center by a wide margin, resulting in a squeezing of fiscal space for the center.

Table 1 shows that although combined revenue receipts relative to GDP have been relatively static, especially 12th Finance Commission onwards, the share of states post transfers has progressively increased. This is reflected in the falling share of the center in all the three expenditure categories namely, revenue, total and primary considering the period covered by 11th to 14th Finance Commissions. With respect to fiscal imbalance, although the enactment of center’s and states’ FRLs led to an improvement, the target for the combined debt-GDP ratio of 56% (FC12) and 60% (2018 Center’s FRBM) was never reached. 

With respect to the horizontal dimension, Table 2 shows that there is a wide variation and increasing divergence in the per capita real GSDP of both medium and large (ML) and small and hilly (SH) states. It is often considered desirable to equalize standards of publicly provided public and merit (e.g. - education, health) services through equalization of fiscal capacity so that undue migration seeking better standards of services does not take place. In this context, the equalization content of fiscal transfers would need to increase over time.