An Incentive to Reform

Context: While the Fifteenth Finance Commission (FFC) has increased the proportion of grants conditional on reforms by states, the question is whether it will move the state towards reforms.

Some Crucial recommendations of the Fifteenth Finance Commission (FFC) (2021-22 to 2025-26):

• Vertical tax devolution: in line with the previous FC, 41% of the divisible pool of taxes to state governments, after adjusting for the Union Territory of Jammu and Kashmir (J&K).
• Horizontal devolution: Changes in the criteria introduced - 
  • State population as per the 2011 Census.
  • Demographic performance: to reward states performing well in the last decade.
  • Tax effort: measured by the ratio of the three-year average of per-capita own tax revenues and per-capita Gross State Domestic Product (GSDP).
• Central grants to states: including revenue deficit grants, grants for local bodies and disaster management and mitigation (accepted by the Centre); 59% higher than the 14th FC.
• Increased share of conditional grants: 57% of the grants accepted so far by the government are conditional, relative to just 17% for the 14th FC; these conditions are:
  • Setting up of State Finance Commissions (SFC): 84% of the grants for local bodies are conditional on the states setting up SFCs for the coming five-year period by March 2024.
  • Urban and Rural local bodies should keep their accounts online from 2021-22 onwards.
  • Property tax: States are required to notify a floor rate for property tax by 2021-22 and demonstrate performance for receiving grants for urban bodies.
• Unconditional Revenue grants: to 17 states to aid the loss of revenue during pandemic.
• Net borrowings of state: fixed at 4% of GSDP in 2021-22, 3.5% by 2022-23, and to 3% limit till 2025-26.
  • Additional borrowing of 0.5% of GSDP is conditional on the completion of power sector reforms.

Issues with the FC’s recommendation

• Decline in central tax devolution to states: peaked at Rs 7.6 trillion in 2018-19, which declined by 15% a year for next two years and is forecasted to be Rs 6.7 trillion in 2021-22 (lower than 2017).
  • Decline in the horizontal share of 10 states: Karnataka is the biggest loser, while Maharashtra is the biggest gainer.
• Long-term issues: Drop-in grants and tapering off of revenue deficit grants will impact states’ finances.
• State-specific and sector-specific grants are not yet accepted by the Centre.