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14th Finance Commission tax formula raises fund flow to states
February, 26th 2015

The Union government on Tuesday said it has accepted the recommendation of the 14th Finance Commission to share 42% of its net tax revenue with states during the five-year period starting 2015-16, up from the existing 32%. The move, which comes days before the government’s first full-year budget on Saturday, allows greater fiscal policy space to states, even at the cost of leaving less revenue for its own schemes and programmes.

Prime Minister Narendra Modi in a letter written to chief ministers said the centre has wholeheartedly accepted the recommendations of the 14th Finance Commission, “although it puts a tremendous strain on the centre’s finances.”

Mint first reported the recommendation of the commission on 14 January.

The recommendations of the commission headed by former Reserve Bank of India governor Y.V. Reddy are expected to form part of the Union budget on 28 February.
Justifying its decision of a higher devolution of net central taxes, the commission said since cess and surcharges are not part of the divisible pool of central taxes, states need to be compensated with a higher percentage devolution from central tax pool. The share of cess and surcharges in gross tax revenue of the Union government increased from 7.53% in 2000-01 to 13.14% in 2013-14.

The commission said it recognizes that amount equivalent to more than 60% of the divisible pool goes to states in various forms of transfers and keeping in view the Union government’s expenditure responsibilities, there is little scope to increase the share of aggregate transfers. Hence, the commission recommended a compositional shift in transfers from greater guaranteed devolution based on the formula than higher grants-in-aid.

The commission said increasing the share of tax devolution to 42% of the divisible pool would serve to increase the flow of unconditional transfers to states and leave enough fiscal space for the centre to carry out specific purpose transfers to states.

“We are of the view that tax devolution should be the primary route of transfer of resources to states since it is formula-based and thus conducive to sound fiscal federalism. However, to the extent that formula-based transfers do not meet the needs of specific states, they need to be supplemented by grants-in-aid on an assured basis and in a fair manner,” the commission said.

The commission has assumed a nominal gross domestic product (GDP) growth rate of 13.5% during the five-year award period.

D.K. Srivastava, chief policy advisor, EY India said the recommendations will lead to a sea change in the architecture of the Centre-state financial relations. “While squeezing the state for discretionary transfer, states’ economy has been enhanced by giving them more control to guarantee transfers. Overall, this will increase the efficiency on the government resource and state and local governments will understand their priorities better”.

The commission has also adhered to the recommendation of the Kelkar committee on the fiscal consolidation road map charted for the central government, which the Modi government made part of its budget in July last year. The fiscal deficit targets for 2015-16 and 2016-17 have been kept unchanged at 3.6% and 3% of GDP. The commission also hoped that improvement in the macro-economic conditions and revival of growth as well as tax reforms should enhance the total tax revenues of the Union government, enabling it to eliminate the revenue deficit completely much earlier than 2019-20.

The commission, however, recommended an amendment to the Fiscal Responsibility and Budget Management (FRBM) Act, inserting a new section mandating the establishment of an independent fiscal council to undertake assessment of the fiscal policy implications of budget proposals and their consistency with fiscal policy and rules.

“In order to accord greater sanctity and legitimacy to fiscal management legislation, we urge the Union government to replace the existing FRBM Act with a Debt Ceiling and Fiscal Responsibility Legislation,” it added.

The commission has done away with the distinction between special and general category states. Instead, it has provided post-devolution revenue deficit grants for 11 states where devolution alone could not cover the assessed gap. It has also recommended doing away with plan and non-plan distinction in revenue expenditure of state governments. It has minimized the use of conditionalities and incentives while increasing untied transfers.

On goods and services tax (GST), the commission said in the absence of clarity on the design of GST and the final rate structure, it is unable to estimate revenue implications and quantify the amount of compensation in case of revenue loss. It said the centre may have to initially bear an additional fiscal burden due to the GST compensation. “This fiscal burden should be treated as an investment which is certain to yield substantial gains to the nation in the medium and long run. We also believe that GST compensation can be accommodated in the overall fiscal space available with the Union government.”

It suggested that 100% compensation be paid to the states in the first, second and third years, 75% compensation in the fourth year and 50% compensation in the fifth and final year. It also recommended creation of an autonomous and independent GST compensation fund through legislative actions “in a manner that it gives reasonable comfort to states, while limiting the period of operation appropriately.”

However, in a dissent report, part-time commission member and former member of the Planning Commission Abhijit Sen suggested to reduce the share of tax devolution to states to 38% from the majority view of 42%. “With the centre’s net tax resources shrinking by nearly 1% of GDP as a result of the higher devolution, implementing these shifts will require fairly drastic alteration to present arrangements,” Sen held.

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