15th Finance Commission

Jan 2020: 15th FC submitted its report for to the President Ram Nath Kovind.

Tax collections have dented, as nominal GDP growth rate at 6.1% in July-September
quarter stood at about half of anticipated growth rate in Budget.

With India adopting GST, historical trends in revenue collections have ceased to be relevant
to forecast future revenues, according to National Institute of Public Finance and Policy
study commissioned by 15th FC.

Of total GST collections, a lion’s share goes to states. So, a fall in GoI’s tax collections,
even without a decline in states’ own tax collections, could hurt state finances.

There are concerns over delays in GoI’s compensation to states due to transition to GST.
Given that states account for about 58% of total government expenditure, GoI should release
the money even if that means borrowing more and widening fiscal deficit.

15th FC chairman N K Singh underscored the need for symmetry in working of GST
Council and FC. This makes sense. He said FC look at projections of expenditure and
revenue, but issues such as GST rates exemptions, changes and implementation of indirect
taxes are entirely within the domain of GST Council. Since both FC and GST Council are
constitutional bodies, coordination mechanism between the two is now an inescapable
necessity.

N K Singh also urged GST Council to review its tax design and decision-making, saying
that states have complained to FC about their autonomy becoming constrained. The council
must focus on systemic reform of tax. It should broaden the tax base, bringing petroleum
products, NG and electricity, besides real estate, under GST. This will complete the credit
chain.

Data analytics must be deployed to follow up audit trail by GST and physical volumes of
industry output. If a certain quantity of steel is produced and final taxed steel goods add up
to a lower volume, it would suggest leakage.

Polyester fibre is made by a few producers, and Surat is reported to have learnt to
circumvent GST.

Ideally, two GST rates and a simpler structure will benefit consumers. NIPFP study says
there is scope for improvement in compliance in GST regime. Extensive use of ‘reverse-
charge’ mechanism on all large buyers — so that they collect the tax on their input
purchases, leaving small suppliers only with filing of returns — would simplify things.

A stable final GST structure will ensure sustained increase in revenues, yielding a bounty in
medium term.

The interim report of 15th SC has largely preserved the devolution mathematics of its
predecessor, belying concerns of a sizeable cut in States’ share.
Commission has recommended a 1% reduction in vertical split of divisible pool of
tax revenues accruing to States to 41%. This follows the reorganisation of erstwhile
State of J&K into UT of J&K and Ladakh. While former State’s notional share based
on parameters for horizontal devolution would have been about 0.85%, FC has cited
security and other special needs of 2 territories to enhance their aggregate share to
1%, which would be met by GoI.
As part of an effort to balance the principles of fiscal needs, equity and performance
as well as need to ensure stability and predictability in transfers, the criteria for the
horizontal sharing of taxes among States have been rejigged.
A crucial new parameter, demographic performance, has been added. Having been
mandated to adopt population data from 2011 Census, FC has incorporated the
additional criterion to ensure that States that have done well on demographic
management are not unfairly disadvantaged.
And since the norm also indirectly evaluates performance on human capital outcomes
of education and health, it has been assigned a weight of 12.5%. This should address
the concerns voiced by several States over switch to the 2011 Census from 1971 data.
Among the States, with the exception of Tamil Nadu, all other four southern States
see a reduction in recommended share of taxes for year 2020-21.
Suggested devolution to Odisha and UP have also shrunk in % terms. Crucially, the
FC has flagged issues dogging GST, especially as indirect taxes constitute almost half
total tax revenues of GoI.
The FC’s effort to improve granularity in devolution to local bodies has generated
some interesting results. ULBs, especially municipalities in cities with populations of
more than one million, are set to get a larger share of pie. However, increase in % of
outcome-tied funds to 50%, from 10%, could prove vexing to the last mile providers
of basic services in India’s federal and highly fragmented structure of governance.
FC has also been justifiably critical of Union and State tendency to finance spending
through off-budget borrowings and via parastatals. It has done well to ask that such
extra-budgetary liabilities be clearly earmarked and eliminated in a time-bound
manner.
GoI has rejected 15th FC’s recommendation to give special grants worth Rs. 6800
crore to States in 2020-21 to ensure that they do not receive less than previous year’s
allocation.
Major recommendations accepted by GoI include 41% share for States out of the
divisible pool of tax collections, suggested grants-in-aid and post-devolution revenue
deficit grants of Rs. 75000 crore for 14 States.
It also accepted recommendations for grants to ULBs, disaster-related grants and
sectoral grants.
The Centre asked the Commission to reconsider the recommendation for special
grants “as it introduces a new principle”. These grants were suggested to ensure that
in 2020-21, “no State receives in absolute terms less than what it received in 2019-20
on account of tax devolution and revenue deficit grants.”

The ripple effects of fiscal crisis faced by GoI are now being felt by state. This could potentially strain
already deteriorating relationship between the two. The stress on state finances comes from
multiple sources.
First, with GoI’s tax revenues falling, it has lowered tax devolution to states in 2019-20, upsetting the
latter’s budget maths.

Second, Budget speech seems to suggest that shortfall in states’ GST collections will be
compensated only to the extent of collections through the compensation cess, and no more.

Third, with GoI accepting some recommendations of 15th Finance Commission, the share of some
southern states in divisible tax pool has declined.

Other proposals by FC could impact transfers to state, are also likely to be contested.

In 2019-20, as against a budgeted target of Rs 8.09 lakh crore, the share of states in gross tax
revenues fell by Rs 1.53 lakh crore. Part of the shortfall, Rs 58,843 crore, is because GoI had
transferred a higher amount to states in 2018-19. The remaining is because of lower tax collections
this year. This shortfall will have a bearing on states’ spending.

Another source of contestation has been the issue of GST compensation. Budget notes that,
“hereinafter, transfers to the fund would be limited only to collection by way of GST compensation
cess” — hinting at the possibility that states will be compensated only to the extent of collections
through compensation cess. This move, presumably because GoI’s own finances are under pressure,
will amount to GoI reneging on its promise of protecting states revenue, and could be a justiciable
matter.

Another bone of contention has been the use of 2011 population estimates for estimating tax
devolution. While FC has chosen to minimise criticism by factoring in demographic performance,
the share of many, mostly southern states has fallen. This will further strain these states’ finances.
Further, while FC recommended special grants to ensure that no state receives a lower amount in
absolute terms post devolution, GoI has not accepted it. Moreover, possibility of setting up a non-
lapsable fund or an alternative mechanism for defence and internal security — also on account of
GoI’s limited fiscal space — if carved out from gross tax collections will further reduce the divisible
pool for states.

15th FC has considered 2011 population along with forest cover, tax effort, area of the state, and
“demographic performance” to arrive at states’ share in divisible pool of taxes.

Shares of southern states, except TN, have fallen — with Karnataka losing the most.

This crucial role of the Commission makes it instrumental in the implementation of fiscal federalism.

The Commission has reduced the vertical devolution — the share of tax revenues that GoI shares with
states — from 42% to 41%. The 1% decrease is roughly equal to the share of erstwhile J&K, which
would have been 0.85% as per the formula described by FC.

FC said that it intends to set up an expert group to initiate a non-lapsable fund for defence
expenditure.

The population parameter used by the Commission has been criticised by governments of the southern
states. The previous FC used both the 1971 and the 2011 populations to calculate states’ shares,
giving greater weight to 1971 population (17.5%) as compared to 2011 population (10%). 15th FC has
reasoned that the ToR leave it with no choice but to use 2011 population; it has also argued that
in the interest of fiscal equalisation, it is necessary to use the latest Census figures.

The use of 2011 population figures has resulted in states with larger populations like UP and Bihar
getting larger shares, while smaller states with lower fertility rates have lost out.

The combined population of Hindi-speaking northern states (Bihar, Uttar Pradesh, Madhya Pradesh,
Rajasthan and Jharkhand) is 47.8 crore. This is over 39.48% of India’s total population, and is spread
over 32.4% of country’s area, as per 2011 Census. They also get a slightly more than the proportional
share of the divisible pool of taxes (45.17%).

On the other hand, southern states of Tamil Nadu, Kerala, Karnataka and undivided Andhra Pradesh
are home to only 20.75% of population living in 19.34% of area, with a 13.89% share of the taxes.
This means that the terms decided by FC are loaded against the more progressive (and prosperous)
southern states.

In order to reward population control efforts by states, FC developed a criterion for demographic
effort —ratio of state’s population in 1971 to its fertility rate in 2011 — with a weight of 12.5%.

However, the effect of demographic effort in increasing states’ devolution is not clear. Shares of
states like Maharashtra, Himachal Pradesh and Punjab, along with Tamil Nadu, all of which have
fertility rates below replacement level, have increased slightly.

On the other hand, Andhra Pradesh, Kerala, Karnataka, and West Bengal’s shares have fallen, even
though their fertility rates are also low.

Incidentally, Karnataka, the biggest loser in this exercise, also had the highest tax-GSDP ratio in
2017-18, as per an RBI report on state finances. Tax effort was also used by FC to decide the states’
shares, with a weight of 2.5%.

The total area of states, area under forest cover, and “income distance” were also used by FC to arrive
at the tax-sharing formula.

Income distance is calculated as the difference between per capita GSDP of the state from that of the
state with the highest per capita GSDP, with states with less income getting a higher share in order to
allow them to provide services comparable to those provided by the richer ones.

FC used per capita GSDP of Haryana as reference for calculating income distance, and gave it a
weight of 45%, down from 50% assigned by 14th FC. The weight assigned to state area was
unchanged at 15%, and that of forest cover was increased from 7.5% to 10%.
The Financial Stability Report (FSR) released by RBI in 2020 underlined the vulnerability of
the Indian public sector banks (PSBs). They have been under a severe balance sheet
crisis even before the pandemic, and the crisis created by the pandemic, and the
moratorium offered, will explode when the chickens come to roost.

According to the FSR, under a baseline scenario, the gross non-performing assets would go
up from 11.3% in March 2020 to 15.2% in March 2021, and to 16.3% under a very severe
stress scenario. The volume of recapitalisation required is humongous.
Lasting reform would entail addressing the difficult issue of the role of the government
owning and running commercial banks itself.

Ownership of banks by the government alters the structure of incentives and accountability
and hampers effective regulation and supervision.

The Narasimham committee in 1998 recommended that government ownership and

Privatising the ownership of the banks will change the structure of incentives and
accountability, enabling more effective supervision and regulation, and subject them to
market discipline.