States and the Challenge Before the Finance Commission
06-12-2024
06:37 AM

Context
- The Government of Tamil Nadu recently hosted the Sixteenth Finance Commission, chaired by renowned economist Arvind Panagariya.
- With its panel of distinguished experts, the Commission is uniquely positioned to tackle critical fiscal challenges and rectify the existing imbalances in the financial relationship between the Union and the States.
- Its decisions will not only shape the economic trajectory of India for the next five years but will also set the foundation for the country’s fiscal health in the decades ahead.
Global Economic Shifts and Opportunities for Finance Commission
- The Sixteenth Finance Commission's work comes at a time of significant global economic transformations.
- Emerging concepts like friendshoring and reshoring are redefining international trade and investment.
- For India, and progressive States, these trends offer unique opportunities.
- However, the challenge lies in achieving a dual objective: equitable redistribution of resources and incentivising high-performing States to maintain their growth momentum.
- Since its inception in 1951, each Finance Commission has sought to address the fiscal challenges of its time, often through vertical and horizontal devolution of resources.
- Vertical devolution pertains to the Union-State revenue sharing, while horizontal devolution aims to allocate resources among States to bridge developmental disparities.
- Despite these efforts, significant gaps between intended objectives and actual outcomes persist.
The Case for Equitable Devolution
- Vertical Devolution: A Need for Increased State Autonomy
- Vertical devolution refers to the sharing of the central tax pool between the Union and the States.
- Historically, Finance Commissions have sought to increase the States’ share to empower them in implementing developmental programs.
- However, the effectiveness of this mechanism has been diluted due to the Union's increasing reliance on non-divisible revenue sources such as cesses and surcharges.
- For instance, while the Fifteenth Finance Commission recommended allocating 41% of the divisible pool to States, the effective devolution during the first four years of its award period stood at only 33.16% of the Union's gross tax revenue.
- This discrepancy arises from the Union’s practice of collecting a significant portion of its revenue through cesses and surcharges, which are not shared with States.
- Horizontal Devolution: A Shift Towards Balanced Growth
- Horizontal devolution addresses the distribution of resources among States, considering factors like population, area, and developmental indicators.
- While this mechanism aims to uplift less-developed States, its outcomes have often been suboptimal.
- The redistribution policies of the past have focused predominantly on equalising resources without adequately incentivising performance, resulting in limited real growth in many recipient States.
- This raises a critical question: Should the focus remain on redistributing a smaller national economic pie to less-developed States, or should the goal be to expand the national pie while ensuring equitable distribution?
- A more balanced approach is essential and there should be a progressive resource allocation methodology.
- For instance, the Finance Commission can create a system where high-performing States receive adequate resources to sustain their growth trajectory while less-developed States are supported in achieving baseline development goals.
Challenges Faced by Progressive States
- Declining Revenue from Consumption-Based Taxes
- Older populations typically consume less, reducing the revenue generated from consumption-based taxes like Goods and Services Tax (GST).
- For States that rely heavily on such taxes, this decline can create a fiscal deficit that hampers their ability to fund developmental initiatives.
- Rising Social Expenditure
- As the population ages, the demand for healthcare, pensions, and social welfare programs increases.
- This puts additional strain on the State's finances, forcing it to allocate a larger share of its budget to non-productive expenditures.
- If left unaddressed, this could lead to stagnation in developmental spending and slow economic growth.
- Infrastructure Development
- Rapid urbanisation necessitates massive investments in infrastructure, including transportation networks, housing, water supply, waste management, and energy systems.
- Without adequate funding, these critical projects can stagnate, leading to overcrowded cities, inadequate public services, and declining quality of life.
- Environmental Concerns
- Urbanisation often exacerbates environmental challenges, such as air and water pollution, loss of green spaces, and climate-related vulnerabilities like flooding.
- For a coastal State like Tamil Nadu, these risks are particularly acute and demand proactive resource allocation to build climate-resilient cities.
- Social Equity Issues
- Urban areas tend to attract a diverse population, including migrant workers seeking better opportunities.
- This influx can create social equity issues, such as access to affordable housing, healthcare, and education, which require targeted interventions.
- Rising Costs of Developmental Programs
- High-performing States are expected to maintain their momentum by investing in infrastructure, innovation, and welfare programs.
- However, inadequate fiscal transfers from the Union and the burden of counterpart funding for centrally sponsored schemes leave little room for discretionary spending.
- Reduced Incentives for Performance
- Progressive States often feel penalised for their success.
- The redistribution model prioritises less-developed States, sometimes at the expense of rewarding high-performing ones.
- This lack of incentives can demotivate these States from continuing their ambitious development programs.
Way Forward
- The Need for Tailored Solutions
- The unique challenges faced by progressive States like Tamil Nadu highlight the need for tailored fiscal policies and resource allocation frameworks.
- The Sixteenth Finance Commission must recognise these challenges and adopt a more nuanced approach to devolution.
- By providing adequate incentives, addressing urbanisation pressures, and supporting demographic transitions, the Commission can ensure that these States not only sustain their growth but also serve as role models for inclusive and sustainable development across India.
- Envisioning a Balanced Future
- The Sixteenth Finance Commission’s mandate extends beyond fiscal allocations.
- It must envision a future where all States, regardless of their developmental status, contribute to and benefit from the nation’s progress.
- This involves creating manufacturing growth, addressing urbanisation challenges, and ensuring climate resilience.
- The Commission's decisions will shape not just fiscal policies but the socioeconomic fabric of the country, influencing millions of lives and solidifying India’s position as a global economic leader.
Conclusion
- The Sixteenth Finance Commission holds immense responsibility in recalibrating India’s fiscal framework.
- By prioritising equitable resource distribution and incentivising high-performing States, it can address developmental disparities without stifling progress.
- The Commission’s decisions will serve as a cornerstone for India’s journey toward inclusive and sustainable growth, ensuring every State’s potential is realized in the nation’s collective advancement.
Q) Why is an aging population a significant challenge for progressive States like Tamil Nadu?
An aging population reduces revenue from consumption-based taxes as older individuals tend to spend less. At the same time, it increases social expenditure on healthcare, pensions, and welfare programs, placing a dual financial burden on the State. This challenge can lead to economic stagnation if not addressed effectively, risking Tamil Nadu falling into the middle-income trap.
Q) What are the major challenges posed by rapid urbanisation in progressive States?
Rapid urbanization in States like Tamil Nadu demands substantial investment in infrastructure, such as housing, transportation, and utilities, to support the growing urban population. Additionally, it exacerbates environmental concerns like pollution and climate vulnerabilities, while also raising issues of social equity, such as access to affordable housing and public services for migrant populations.
Source:The Hindu