Context: There is a need to modify the fiscal devolution principles in the light of economic shocks provided by the COVID crisis. Issues with the current fiscal devolution: • Failure of Compensation Framework under the Good and Services Tax regime: The promise of 14% revenue growth has proved difficult for the Centre to afford because: − It creates a moral hazard for the states- allowing them to propose rate reductions without fear of revenue consequences. − Low revenue collection due to COVID by the Centre. • Neglect of Counter-Cyclical fiscal policy: which leads to inefficient macro-economic behaviour. − When the economy faces a negative shock, and economic activity goes down, the government should cushion its impact by spending more and taking fewer taxes from the private sector − However, States are forced to constrain their deficits under the fiscal responsibility laws. • Violation of responsibility by the Centre: in terms of optimal allocation: − The optimal borrower for counter-cyclical purposes is the Centre, because It has greater financing options (it can even borrow abroad); can borrow at low rates It has much greater taxing authority under the Constitution. Modified Devolution Framework: would contain three critical features: • Counter-cyclical: to be provided only during crises; • Targeted: provided to fiscally responsible states that have brought their debt below certain levels, or reduced their debt by certain amounts. • Automatic: avoiding the delays and the political jockeying that would come into play if the transfers were to be discretionary. Significance of the framework • Defining a crisis: The Finance Commission should define a crisis that would trigger such a transfer, For, E.g. decline in GDP growth of 3% points, would increase the regular devolution (41%) by 3 %. Promoting counter-cyclical transfers: A large step toward counter-cyclical transfers was already taken under goods and services tax (GST) in the form of compensation. − This acts as de-facto insurance. • Incorporates the lessons learned from compensation debacle: − Promotion of desirable incentives: because it would be given to fiscally prudent states, it would promote fiscal responsibility and provide only during the crises. − Affordable costs: due to low-interest rates borne by the Centre as compared to the states. • Advantages of the Framework: − Provides states with incentives to rebuild their shattered finances.
− Aid macro-management of the economy: through the following of the key principle of counter- cyclicality.
− Helps restore trust between the Centre and states.