The 16th Finance Commission faces some daunting challenges

Deliberations of the 16th Finance Commission (FC) are now proceeding in earnest. The appointment of the full commission only by the end of January has left it with just 19 months until end October 2025 to complete its work and submit its recommendations, well short of the full two years or so that is usually available. Fortunately, its terms of reference have been limited to the core issues mandated by the Constitution. Unlike in the case of recent FCs, the 16th FC has not been loaded with a host of other issues under the “any other matters” clause [article 280 (3)(d)]. This gives it the opportunity to focus its deliberations on core issues without having to devote time to other issues. This is important because the commission will have to contend with some daunting challenges, a few of which are discussed here.

The first issue relates to projections of revenue, especially from taxes, for the central and state governments. Macroeconomic projections are always important inputs for economic policy decisions, but particularly so for the volume of tax devolution to the states. The FC-recommended devolution formula applied to the divisible pool of central taxes will determine the volume of tax devolution that will flow to the states. If the actual volume of central tax revenues (except cesses and surcharges) turns out be more than the projections, then the devolution flows will provide some fiscal elbow room for both the Centre and states. But if the tax revenues turn out to be less than the projections, it will lead to fiscal stress for the central government as well as all state governments. Hence, the reliability of tax revenue projections is critical and the method adopted for making projections needs to be robust. A series of repeated shocks impacting the time series data used for forecasting makes the task very challenging. The financial crisis of 2008 was followed by demonetization (2016), roll-out of the goods and services tax (2017), the covid pandemic (2020-21 and 2021-22) and finally the Ukraine and Gaza wars that have roiled international commodity markets. The 15th FC, which had to make its projections under conditions of extreme uncertainty in the middle of the covid pandemic, took the unusual step of examining the implications of three alternative growth paths. Though comparatively less now, the level of macroeconomic uncertainty is still high and projections for the 16th FC period are also likely to be subject to large error margins. Reliable forecasting of central and state revenues will thus be a very challenging exercise.

The second issue is finding a balance between the principle of subsidiarity and the compulsions of centralization. The subsidiarity principle holds that in federal governance systems, decisions are more efficient when the decision-making authority is as close as possible to the constituents affected by the decision, while higher levels of authority should hold a subsidiary role; i.e., the delegation of authority essentially moves from the lower level upwards only when the issue to be decided upon effects constituents beyond the jurisdiction of the lower-level authority (such as a state government). Examples of such externalities include national security and defence, and the maintenance of macroeconomic stability and nationwide infrastructure systems. There is also the question of equity in providing a comparable level of public services, or merit goods like subsidized food, to constituents in all states across a common national tax jurisdiction. The allocation of subjects under the Constitution’s 7th schedule to the central list, states’ list and concurrent list is broadly consistent with these competing compulsions of decentralization and centralization. However, it has been argued that the present subject allocation does not adequately take account of externalities and needs to be revisited. The 16th FC obviously cannot change the 7th schedule. But if it decides to address these issues even in its observations, it will need to tread very carefully. Any such re-allocation of subjects would be a very sensitive political issue when many states, especially those ruled by non-National Democratic Alliance (NDA) governments, have complained that the Centre is encroaching their constitutional space through the use of centrally-sponsored schemes.

A third issue is ensuring adequate resources for the third tier of government. Local governments provide many of the key services that citizens need, like water supply and sanitation. Rapid urbanization has made this particularly urgent for urban local bodies. The Constitution referred to the importance of local governments but left it to state governments to determine what functions should be delegated to local governments. Subsequently, the 73rd and 74th Constitutional amendments elaborated on this in great detail, but again left it to state legislatures to decide what should be done. There is a direct conflict of interest here between state legislators and those elected to local bodies, which accounts for the continuing weakness of most local governments. FCs are mandated to recommend measures to augment the consolidated fund of state governments to supplement the resources of local governments based on the recommendations of state finance commissions. The last three FCs struggled with this mandate, but with limited success. Some states have failed to even appoint state finance commissions on time. Even when appointed, their recommendations are often ignored. The challenge is to design suitable incentives for state governments to induce them to effectively strengthen local governments.

These are the author’s personal views.