What the 16th Finance Commission Needs to Do Differently

Why in News?

• The 101^stConstitutional Amendment Act 2016 (Implementation of GST) has been the most far-reaching change from a fiscal standpoint, since the setting up of the First Finance Commission in 1951.
• The 16th Finance Commission (SFC), due to be constituted soon, must be mandated to re-examine the tax-sharing principles considering the altered landscape of fiscal federalism in India.

Finance Commission and Its Objectives

• Finance Commission
  • It is a constitutional body for giving recommendations on distribution of tax revenues between the Union and the States and amongst the States themselves.
  • The Finance Commission is constituted by the President under Article 280 of the Constitution.
  • It is constituted at the end of every fifth year or earlier, as deemed necessary by the President.
  • Parliament may by law determine the requisite qualifications for appointment of members of the Commission and the procedure of their selection.
  • On account of this, the Finance Commission (Miscellaneous Provisions) Act 1951 was passed.
• Objectives
  • It plays a crucial role in determining the fiscal framework for resource allocation between the Union and state governments.
  • FC’s recommendations consist of three key areas: vertical devolution, horizontal distribution, and grant-in-aid.
  • Vertical devolution focuses on Union to state transfers.
  • Horizontal distribution involves the allocation of resources between states based on a specific formula.
  • Grant-in-aid, covered under Article 275, includes such sums as Parliament may by law provide and shall be charged on the Consolidated Fund of India. Different sums may be fixed for different states, as per their needs.
  • There is a distinction between grants (Article 282) and grant-in-aid, as the latter operates at arm’s length and offers more flexibility in terms of control.

Post GST Changes in Fiscal Federalism Landscape

• Replacement of Production Based Taxation with Consumption Based
  • The Goods and Services Tax (GST) regime, introduced in 2017, is based on a system of concurrency of indirect taxes, where every transaction attracts central as well as state GST.
  • The inter-state transactions, as well as imports, are levied an integrated GST. With this, a consumption-based taxation system has replaced a production-based one.
  • The collection of indirect taxes in the state where goods or services are consumed, and not in the state where they are produced, changes both the vertical as well as the horizontal dynamics of federalism.
• Reconfiguration of Power Balance Amongst States
  • Earlier, the central sales tax, an origin-based tax, effectively exported the tax burden from rich and manufacturing states to the consuming states, contributing to horizontal imbalances.
  • Now, the destination principle for cross-border trading ensures that the poorer, consuming states benefit at the cost of more affluent and industrialised ones.
  • The IGST, for instance, charged during the inter-state supply of goods or services has been transferred to the destination state.
  • This move from the principle of origin to the principle of destination is reconfiguring the balance of power amongst states.

Remaining Challenges for Fiscal Federalism Post GST Changes

• Unchanged Federal Fiscal Transfer
  • The federal fiscal transfer system continues to be designed for and is based on the principles of jurisdictional separation that is connected to the origin-based tax era.
  • Its distributional criteria are also based on the earlier regime.
• The disconnect between the operational tax regime and the principles and criteria of tax sharing is contrary to the fiscal federal system and can create fault lines in the political economy of federalism. 

What the 16^th FC Needs to Do Differently?

• Re-examination and Redesign Indirect Tax Sharing
  • 16^th FC’s terms of reference (ToR) must be informed by the pooling of the indirect tax sovereignty by the Union and the states by consolidating and incorporating their respective indirect tax base.
  • State governments now share with the Union, the tax base associated with Union excise duty, service tax and parts of customs duty through the IGST.
  • In turn, the Union government has extended its tax base to sales tax/ AT, central sales tax, entry tax, luxury tax, entertainment tax, taxes on lottery, betting, gambling, and purchase tax.
  • These major changes necessitate that the statutory sharing of the indirect taxes, both vertical and horizontal, is re-examined and redesigned.
• Redefine the Divisible Pool
  • To align the principle of vertical sharing with the new system, it is important to start by redefining the divisible pool.
  • For instance, the SFC will be required to specify the modalities of making IGST completely a part of the pool.
  • As of now, only IGST with no input tax credit gets shared with the states. There must be a normative basis for credit-in-transition unsettled IGST to be included in the divisible pool.
  • This also holds for the frequency of settlements, which needs to be stipulated as it has caused a lot of cash flow issues for state governments.
• Making the Tax Collection More Efficient
  • The changed administration of GST where the Union and the states jointly and separately collect the same taxes.
  • It has led to a sharp increase and wide variation in what has been accounted for as the cost of collection of taxes. This ranges from 7 to 10 per cent.
  • Therefore, the SFC should be asked to recommend the method of calculating and apportioning the cost of collection of indirect taxes and suggest ways to reduce such taxes and make their collection more efficient.
• Redesign Horizontal Distribution System
  • The criteria for the distribution of the divisible pool among states, will have to be revisited.
  • The existing criteria especially for equalising grants have evolved into a production-based tax system. This needs to be redesigned for a consumption-based tax system.
  • The change from production to consumption will make a significant difference to the distribution of tax revenues as well as the need, nature, and distribution of equalising grants.
• Review the Compensation Scheme
  • It is important to review the need, viability, and desirability of the compensation scheme considering the revenue performance of GST during the past six years.
  • The principles of assigning the balance amount of GST compensation cess collection over the compensation released to states to the divisible pool of taxes also need to be laid down.

Way Ahead: New Institutional Structure of Federal Finance

• At another level, in the new federal finance institutional framework, those who decide the size of the divisible pool and those who distribute it - the GST Council and the FC, must have a formal institutional relationship.
• The SFC should examine how, during the period when it is not in operation, the GST Council can act as the Fiscal Council to monitor the implementation of its award.

Conclusion

• The SFC must think afresh conceptually, methodologically, and operationally.
• The ToR must not only enable and facilitate it to do so but also nudge and guide it in this direction.

Q1) How are the recommendations of the Finance Commission implemented?

The recommendations of the Finance Commission are implemented as under:- Those to be implemented by an order of the President: The recommendations relating to distribution of Union Taxes and Duties and Grants-in-aid fall in this category. Those to be implemented by executive orders: Other recommendations to be made by the Finance Commission, as per its Terms of Reference. 

Q2) What are some critical changes since the constitution of 15th FC?

The biggest challenge and change were the pandemic COVID-19 and the subsequent geopolitical challenges i.e China's aggression on LAC. The combined government debt-GDP ratio had shot up close to 90% at the end of 2020-21. Many States are facing large fiscal imbalances.

Source: The Indian Express