Contents

1. Road bumps
2. Quality of reciprocity

Road bumps

Context:

On Monday, the Fifteenth Finance Commission submitted its report with recommendations on the formula for sharing the divisible pool of tax revenues between the Centre and the States for the next five years to the President.

Relevance:

GS Paper 2: Functions & responsibilities of the Union and the States; issues and challenges of federal structure; Devolution of powers and finances to local levels; challenges therein.

Mains questions

1. Article 280 of the Constitution requires that a Finance Commission be constituted to recommend the distribution of the net proceeds of taxes between the Centre and states, and among the states. Discuss the statement in context of recommendations of 15th Finance commission. 15 marks
2. The framers of the Constitution were seeking to address the vertical imbalance between the taxation powers and expenditure and responsibilities of the federal government and the states, and the horizontal imbalance, between states that were at different stages of development. Assess the role of 15th Finance Commission to address the vertical and horizontal imbalances in India. 15 marks

Dimensions of the article:

• About the Finance Commission of India.
• Recommendations of 15th Finance commission.
• Issues related to Fiscal federalism in India.
• Finance commission and fiscal federalism in India.
• Way forward

About the Finance commission in India

• Article 280 of the Constitution provides for a Finance Commission as a quasi-judicial body.
• It consists of a chairman and four other members to be appointed by the President every 5th year or at such earlier time as he considers necessary.
• The Finance commission makes recommendations to the President on following matter so The distribution of the net proceeds of taxes between the centre and the states, and the allocation between the states of the respective shares of such proceeds.
  • The principle that should govern the grants-in-aid to the states by the centre (out of the Consolidated Fund of India).
  • The measures to augment the Consolidated Fund of a state to supplement the resources of local governments on the basis of recommendations made by the state finance commission.
  • Any other matter referred to it by the President.
• Recommendations made by the Finance commission are only advisory in nature.
• The Constitution empowers the FC to go beyond the core issues of how to divide taxes vertically between centre and the states on the one hand and horizontally between states on the other.
• It also allows FC to make broader recommendations in the interests of sound finance.

Recommendations of 15th Finance commission

Key recommendations in the first report (2020-21 period) include:

• Devolution of taxes to states: The share of states in the centre’s taxes is recommended to be decreased from 42% during the 2015-20 period to 41% for 2020-21.  The 1% decrease is to provide for the newly formed union territories of Jammu and Kashmir, and Ladakh from the resources of the central government.
• Criteria for devolution: The criteria used by the Commission to determine each state’s share in central taxes, and the weight assigned to each criterion.  We explain some of the indicators below.

• Income distance: Income distance is the distance of the state’s income from the state with the highest income.  The income of a state has been computed as average per capita GSDP during the three-year period between 2015-16 and 2017-18.  States with lower per capita income would be given a higher share to maintain equity among states.
• Demographic performance: The Terms of Reference (ToR) of the Commission required it to use the population data of 2011 while making recommendations.   Accordingly, the Commission used only 2011 population data for its recommendations. States with a lower fertility ratio will be scored higher on this criterion.
• Forest and ecology: This criterion has been arrived at by calculating the share of dense forest of each state in the aggregate dense forest of all the states.
• Tax effort: This criterion has been used to reward states with higher tax collection efficiency.   It has been computed as the ratio of the average per capita own tax revenue and the average per capita state GDP during the three-year period between 2014-15 and 2016-17.

• Grants-in-aid:  In 2020-21, the following grants will be provided to states: (i) revenue deficit grants, (ii) grants to local bodies, and (iii) disaster management grants.  The Commission has also proposed a framework for sector-specific and performance-based grants.
  • Revenue deficit grants: In 2020-21, 14 states are estimated to have an aggregate revenue deficit of Rs 74,340 crore post-devolution.  The Commission recommended revenue deficit grants for these states.
  • Special grants: In case of three states, the sum of devolution and revenue deficit grants is estimated to decline in 2020-21 as compared to 2019-20.  These states are Karnataka, Mizoram, and Telangana.
  • Sector-specific grants: Sector-specific grants for the following sectors will be provided in the final report: (i) nutrition, (ii) health, (iii) pre-primary education, (iv) judiciary, (v) rural connectivity, (vi) railways, (vii) police training, and (viii) housing.
  • Performance-based grants: Guidelines for performance-based grants include: (i) implementation of agricultural reforms, (ii) development of aspirational districts and blocks, (iii) power sector reforms, (iv) enhancing trade including exports, (v) incentives for education, and (vi) promotion of domestic and international tourism. 
  • Grants to local bodies:  The grants will be divided between states based on population and area in the ratio 90:10. The grants will be made available to all three tiers of Panchayat- village, block, and district.
  • Disaster risk management:  The Commission recommended setting up National and State Disaster Management Funds (NDMF and SDMF) for the promotion of local-level mitigation activities.

• Recommendations on fiscal roadmap:
  • Fiscal deficit and debt levels: The Commission noted that recommending a credible fiscal and debt trajectory roadmap remains problematic due to uncertainty around the economy.  It recommended that both central and state governments should focus on debt consolidation and comply with the fiscal deficit and debt levels as per their respective Fiscal Responsibility and Budget Management (FRBM) Acts.
  • Off-budget borrowings: The Commission observed that financing capital expenditure through off-budget borrowings detracts from compliance with the FRBM Act.   It recommended that both the central and state governments should make full disclosure of extra-budgetary borrowings.   The outstanding extra-budgetary liabilities should be clearly identified and eliminated in a time-bound manner.
  • Statutory framework for public financial management: The Commission recommended forming an expert group to draft legislation to provide for a statutory framework for sound public financial management system.  It observed that an overarching legal fiscal framework is required which will provide for budgeting, accounting, and audit standards to be followed at all levels of government.
  • Tax capacity: In 2018-19, the tax revenue of state governments and central government together stood at around 17.5% of GDP.  The Commission noted that tax revenue is far below the estimated tax capacity of the country.  Further, India’s tax capacity has largely remained unchanged since the early 1990s.   In contrast, tax revenue has been rising in other emerging markets.  The Commission recommended: (i) broadening the tax base, (ii) streamlining tax rates, (iii) and increasing capacity and expertise of tax administration in all tiers of the government.
  • GST implementation: The Commission highlighted some challenges with the implementation of the Goods and Services Tax (GST).  These include: (i) large shortfall in collections as compared to original forecast, (ii) high volatility in collections, (iii) accumulation of large integrated GST credit, (iv) glitches in invoice and input tax matching, and (v) delay in refunds.  The Commission observed that the continuing dependence of states on compensation from the central government  for making up for the shortfall in revenue is a concern.  It suggested that the structural implications of GST for low consumption states need to be considered.

Issues related to 15th Finance commission in India

• New Defence Fund: The 15th Finance Commission’s terms of reference were amended after they were first issued to examine if a separate mechanism for funding defence and internal security is possible. This had led to speculation that states will have to contribute to such a fund, in turn leading to a drop in their share of central government’s taxes.
• Using 2011 Census to calculate population for allocation of Union tax revenue in place of 1971 Census. This seems to be penalizing those states which have focused on family planning and population control.

Finance Commission and federalism in India

• The Constitution envisages the Finance Commission as the balancing wheel of the Fiscal federalism in India.
• Every successive Finance Commission  has to do a political balancing act by giving more resources to the states given the growing importance of subnational governments in the Indian political economy.
• It also needs to ensure that centre is not fiscally constrained given its role in key national public goods such as defence.
• Successive finance commissions have increased the proportion of tax revenue that goes to the states—a necessary change given the growing importance of direct taxes as well as the need for higher spending by state governments in local public goods.
• The First Finance Commission headed by K.C. Neogy had recommended that the states get a tenth of total taxes collected centrally. That share has steadily increased. The 14th Finance Commission headed by Y. V. Reddy recommended that the share of the states should be 42%.
• Federalism can flourish only when it is accompanied by a strong central agency that credibly enforces the rules for a new political economy equilibrium.

Way forward

The Centre has to discharge its coordinating, corrective and lead functions in a truly federal set-up. The States should have their due share in responsibilities as well as rights. The centre should accept the recommendations of 15th Finance Commission report in true spirit and give more fiscal space to states so that they can fulfil their constitutional obligations.

Background

1: Constitutional provisions dealing with Centre-state fiscal relations

• Article 246: division of taxation powers (now amended under GST) 
• Articles 268 (refers to duties levied by the Union but collected and appropriated by the States) and 269 (taxes on the sale of goods and taxes on the consignment of goods) • Article 271 relates to surcharges
• Article 275 (1) and Article 282: Grants to States
• Article 280 mandates the setting up of a Finance Commission
• Articles 292 and 293: define the borrowing powers of the Union and the States, respectively.

Quality of reciprocity

Context:

Visit to Nepal by Army chief signals continuity of ties, distance travelled by both countries from summer of discontent.

Relevance:

GS Paper 2: India and its Neighbourhood (relations)

Mains questions

1. Nepal-India relations are deep, wide-ranging, and unique, but also fraught with complexities. Much of the complexity stems from the fact that the political leadership handles only a small part of this very important bilateral relationship. Discuss 15 marks

Dimensions of the article

• Evolution of India-Nepal relations
• Significance of Nepal for India
• Divergence between India and Nepal relations
• Way forward

Evolution of India-Nepal relations

As close neighbours, India and Nepal share a unique relationship of friendship and cooperation characterized by open borders and deep-rooted people–to–people contacts of kinship and culture. There has been a long tradition of free movement of people across the borders. To add up the formal flavour to such historic relations, the two countries established diplomatic relations on 17 June 1947.

The India–Nepal Treaty of Peace and Friendship of 1950 forms the bedrock of the special relations that exist between India and Nepal. Under the provisions of this Treaty:

• The Nepalese citizens have enjoyed unparalleled advantages in India, availing facilities and opportunities at par with the Indian citizens.
• The Treaty has allowed Nepal to overcome the disadvantages of being a land–locked country.
• An open border between the two countries.
• Allows Nepali nationals to work in India without a work permit, to apply for government jobs and the civil services (except for the IFS, IAS, and IPS).
• To open bank accounts and buy property.

Significance of Nepal for India

• Strategic importance: Nepal is a buffer state between India and China.
• Internal security: Nepal shares a long open border with India. There is alleged link between Naxalites and Maoist in Nepal.
• Socio-economic development of bordering states especially Bihar and Uttar Pradesh.
• To counter terrorist activities close to border areas: Many hard core terrorists had been apprehended in Nepal close to India’s border.
• Nearly 30 lakh Nepalis (some 10 per cent of Nepal’s population) are employed in India; this includes some 50,000-60,000 soldiers.
• Disaster management: India can cooperate with Nepal by constructing dams on rivers which flow from Nepal to India. It will address the flood in Gangetic plain specially in Bihar.
• Hydroelectricity:  Nepal has huge potential of hydroelectricity, which will fulfil the energy demand in India.

Areas of cooperation:

• Trade and economy: India is Nepal’s largest trade partner and the largest source of foreign investments, besides providing transit for almost the entire third country trade of Nepal.
• Connectivity: Nepal being a landlocked country, it is surrounded by India from three sides and one side is open towards Tibet which has very limited vehicular access. India is looking to develop the inland waterways for the movement of cargo, within the framework of trade and transit arrangements, providing additional access to sea for Nepal calling it linking Sagarmatha (Mt. Everest) with Sagar (Indian Ocean).
• Development Assistance: Government of India provides development assistance to Nepal, focusing on creation of infrastructure at the grass-root level. The areas assistance include infrastructure, health, water resources, and education and rural & community development.
• Defence Cooperation: Bilateral defence cooperation includes assistance to Nepalese Army in its modernization through provision of equipment and training.
• Cultural: There have been initiatives to promote people-to-people contacts in the area of art & culture, academics and media with different local bodies of Nepal.

India has signed three sister-city agreements for twinning of Kathmandu-Varanasi, Lumbini-Bodhgaya and Janakpur-Ayodhya.

Divergence between India and Nepal relations

• Territorial dispute: Nepal’s Parliament cleared a Constitution Amendment Bill that endorses the country’s new map that includes territories with India — Limpiadhura, Lipulek and Kalapani.

• India is worried about Nepal growing close relation with China. China has taken a firm step to extend the Silk Road Economic Belt to South Asia, by working out a blueprint of connecting Nepal with the Eurasian transport corridor.
• China-Nepal relations have political and strategic implications for India.
• Nepal had signed Transit agreement with China mainly aimed at reducing Nepal’s overwhelming economic dependence on India.
• At present 98 per cent of Nepal’s third country trade goes through India and to the port of Kolkata.
• Nepal and China concluded a 10-day military drill as India’s influence on its Himalayan neighbors continues to ebb and flow.
• There is a set pattern of the Kathmandu regime using the China card whenever it runs into difficulties with its own people and India lends support to the Nepali people’s cause.

Way forward

There is a set pattern of the Nepal flashing the China card more frequently in recent pasts. Its neighbourhood policies vis-à-vis India and China are changing. India, therefore, has to deal with its immediate neighbours with prudence and sensitivity and ensure that they are not alienated. Nepal must act as a bridge between two rising nations and help bring co-operation prosperity and peace in the region.