Budget 2020: Fifteenth Finance Commission’s Interim Report Calls For Greater Fiscal Clarity

The interim report of the Fifteenth Finance Commission, tabled together with the Union Budget for 2020-21, leaves the tax devolution formula between the centre and states largely unchanged. It, however, calls for greater clarity on government finances, a new fiscal legislation and improvements in the implementation of the Goods and Services Tax.

The commission will submit its final report only in October 2020. Its interim recommendations will underpin the 2020-21 budget while final recommendations will be used for subsequent years.

Centre-State Devolution

The finance commission, headed by NK Singh, recommended an aggregate share of 41 percent of the net proceeds of the union taxes to be devolved to states in FY21. The Fourteenth Finance Commission has increased the devolution to states to 42 percent.

The vertical split of the divisible pool between the union and the states has been left largely at the same level as recommended by the previous commission, said the report. However, the aggregate share of states was recommended to be reduced by 1 percentage point to 41 percent of the divisible pool to adjust for the reorganisation of Jammu and Kashmir and Ladakh.

The state’s share would have come to around 0.85 percent. However, the commission believed that there was a strong case for enhancing this to 1 percent of the divisible pool to meet security and other needs.

For the horizontal distribution of aggregate taxes among states, the commission arrived at a need based devolution formula. While the ‘distance’ criterion continued to hold the highest weightage, demographic performance and tax efforts were also taken into account. ‘Income distance’ is the distance of the gross state domestic product of a particular state from the state with the highest GSDP.

Fund For Security Related Expenditure

The government had asked the commission to consider a funding mechanism for national security needs.

However, the finance commission stated that it intends to constitute an expert committee to consider the modalities and implementation of the non-lapsable fund or an alternative funding mechanism.

‘Real’ Fiscal Deficit

While a commission key task is to lay down rules of fiscal engagement between the centre and states, their reports often highlight important structural challenges facing government finances.

In its interim report, the finance commission highlightd that the government must abide by the definition of both debt and fiscal deficit as contained in the FRBM Act, ‘which recognises off-budget borrowings, contingent liabilities and guarantees.

Outstanding extra-budgetary liabilities need to be “clearly identified and eliminated in a time bound manner, with transparent reporting of the deficit and debt as provided in the act,” stated the commission. The commission will address this issue in its final report.

Need For A Legal Fiscal Framework

The interim report said that India needs an overarching legal fiscal framework that would mirror the revised FRBM Act. The commission recommended the constitution of an expert group to draft such a legislation which will help establish a statutory framework to to implement the essential features for a sound public fiscal management system.

While the finance commission is mandated to review the finance, deficit, debt and fiscal discipline of the centre and the states, in the ongoing macro-economic scenario, a credible fiscal and debt trajectory roadmap remains “problematic,” said the commission. However, the FRBM act should be adhered to in letter and spirit, it stated.

It gave the union government the option to invoke the escape clause, deviating by the FRBM target of 3.3 percent of the GDP by 0.5 percent. In doing so, it reiterated that the government should ensure that there is a ‘clear commitment to return to the original fiscal target in the ensuing year.’

Finance minister Nirmala Sitharaman, did invoke the escape clause for the ongoing financial year and the next fiscal year. India’s fiscal deficit settled at 3.8 percent for FY20 and is estimated at 3.5 percent for FY21.

Expenditure And Tax Reforms

The commission said that it has noted the proliferation of centrally sponsored schemes and their continuation without evaluating their outcomes. To that end, it said that it expects the government to review such schemes, prune and rationalise them to focus on key sectors and areas which are important nation-wide.

The commission also emphasised on the need for raising India’s tax-to-GDP ratio. The driver of tax reforms should be broadening of the base and streamlining rates, with steps to increase the capacity and expertise of tax administration.

The commission also called for continued efforts to improve the implementation of the Goods and Services Tax. The implementation of GST has thrown up multiple challenges, the commission said. These, according to the commission, include large shortfalls in collections vis-à-vis the original forecasts, high degree of volatility in collections, accumulation of large integrated GST (IGST) credit, continuing dependence of most states (twenty-one out of twenty-nine in 2018-19) on compensation.

“The implementation of GST continues to be work in progress, and it still needs many systemic and structural improvements to expand its scope, stabilise its operations and finally deliver its stated objectives. We need also to consider the structural implications for low consumption states,” the report said.

Power Sector Reforms

Progress on improving expenditure and prioritising public outlay has remained slow. The power sector in particular, continues to drain state exchequers and there is a critical need for reforms in this sector to improve the finances of states.for the same, said the commission’s report.