A Challenge to the 15th Finance Commission's Credibility

The Additional Terms of Reference were issued at the fag end, when the commission had presumably completed all required processes.

On July 29, the president of India issued an order extending the date of submission of the report of the 15th Finance Commission (FC) to November 30, 2019. The same order also includes one additional term of reference (AToR). The commission is required “to examine whether a separate mechanism for funding of defence and internal security ought to be set up and if so, how such a mechanism could be operationalised”.

Incidentally, consultative process and close examination of finances of both the levels of government provide the foundation of a finance commission’s recommendations. This is what has contributed to its high credibility and its image as an independent and non-partisan institution. The AToR is issued at the fag end when the commission has presumably completed all the above processes.

The ToR of an FC is constitutionally defined under Article 280: Distribution of the net proceeds of the  sharable taxes between the union and the states and allocation among the states; the principles that should govern grants in aid of revenues of the states out of the Consolidated Fund of India and later the 73rd and 74the amendment of the Constitution added the measures needed to augment the consolidated fund of a state to supplement the resources of the panchayats and municipalities on the basis of the recommendations of state FCs. However, under 280 (d) the President may refer any other matter in the interests of sound finance.

Beginning from the first FC, additional issues were in fact referred to successive FCs. These reflected one or the other concerns relating to sound budget and fiscal management. The AToR which relates to protecting defence and internal security expenditures of the Union government does not fit in the framework of the constitutional provision, Article 280 (d).

Similarly, defence is in the Union list and therefore the responsibility of the Union government while internal security is largely the states’. Even when states requisition para military forces, they bear the expenses. It is not, therefore, an issue that should legitimately come under the domain of the FC.

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In any case, the original ToR itself incorporates a consideration to have regards to, “The demand on the resources of the central government particularly on account of defence, internal security, infrastructure, railways, climate change, commitments towards administration of UTs without legislature and other committed expenditure and liabilities.”

There could be two reasons why this AToR is added at this stage. One, the defence expenditure declined from 2% of GDP in 2014-15 to 1.48% in 2018-19 and even lower at 1.45 % in 2019 -20 budget. Similarly, defence expenditure as a percentage of the government’s expenditure declined from 14.3% in 14-15 to 11% in 20i9-20. The other is that with the slowdown of the economy, it would be a challenge to even ensure this low level of allocation provided in the budget for 2019-20 while maintaining the fiscal deficit at 3.3%. Hence, the attempt to ring-fence the defence expenditure.

Having been referred to, what could the 15th FC do?

As noted earlier, the FC is already required to, under the original terms of reference, take into consideration the defence and internal security needs. While assessing the requirements of the Union government, the 15th FC should explicitly take into consideration the fact of the declining defence expenditure as a percentage of its total expenditure and make appropriate provisions in its expenditure projection.

The 15th FC could also recommend that the Union government reallocate expenditures wherever possible and eliminate wasteful expenditure. Further, it could suggest that the government mobilise more resources from sources such as the following: first, it should take measures to raise the tax-GDP ratio which has slumped to 11.7% in 2019-20 (Budget Estimates) as compared to 11.9% in the Revised Estimates to augment its resources to meet its expenditure requirements.

Second, it could minimise undisputed tax arrears which stood at around nine lakh crore at the end of 2017-18 and non-tax arrears of about 2 lakh crore in the same year. Similarly, the government could rationalise the tax incentives given to the corporate and non-corporate sectors – for the corporate sector alone, it was estimated at 1.39 lakh crore in 2018-19, which perhaps would decline following the recent policy decision if the corporate sector avails the lower rate of corporation tax, by giving up the incentives and exemptions they have been enjoying. Third, the Union government could monetise the huge chunk of government land under the ministry of defence, the railways etc., which the thirteenth commission, indeed, had recommended.

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What should the 15th FC not be doing?

Over the years, the FC has established itself as a non-partisan institution of fairness and neutrality in which states repose a great deal of trust. It should not do anything that has an adverse impact on the divisible pool. In any case, the divisible pool is under significant stress. First, the 15th FC may not be able to increase states’ share beyond 42% that the 14th FC recommended.

Second, with a slowdown of the economy, the divisible pool would be adversely impacted. Third, with seven state taxes being subsumed in the GST, the states’ ability to mobilise resources from their own sources has been constrained. Fourth, the GST has yet to emerge as a buoyant tax.

On the contrary, CAG (Report no. 11 of 2019) noted that its yields declined by Rs one lakh crore in the revised budget of 2018-19 as compared to the original budget for 2018-19. It might further decline until the slowdown of the economy is reversed. States’ GST revenue with 14 % growth would be protected till 2022-13 but not for the entire award period of the 15th FC.

Fifth, cess and surcharges that are outside the divisible pool have increasingly become important instruments of revenue mobilisation. Just to illustrate, while the total transfer to states and UTs were Rs 4.1 lakh crore in 2017-18, revenue mobilisation by the central government through cess and surcharge stood at 3 lakh crore or 15.7 % of Centre’s gross tax revenue.

This went up to 5.12 lakh crore in 2019-20 (BE) accounting for 21.03% of the Centre’s gross revenue as against the total transfer to states and UTs to only 5.2 lakh crore in 2019-20 (BE). Last but not the least, even after rationalisation and restructuring of the centrally sponsored schemes, there remain 28 core schemes in which the general category states are required to contribute in 40% for their costs and three optional schemes requiring states to contribute 50%. Increasing states’ contribution to Core and optional schemes has clearly led to reducing states’ fiscal space and autonomy.

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For all these reasons, the 15th FC should deal with the AToR in a way that would have no adverse impact on the divisible pool which is already under great stress.

Atul Sarma is the chairman of the OKD Institute for Social Change and Development and was a member of the 13th Finance Commission.