What’s the news?

• India’s fiscal landscape, transformed by GST, calls for a comprehensive reevaluation of fiscal federalism to address tax-sharing challenges and regional disparities.

Central idea

• The 122nd Constitutional Amendment of 2016 and the subsequent introduction of the GST regime in 2017 reshaped India’s fiscal landscape, replacing production-based taxation with a consumption-oriented approach. This shift highlights the importance of reevaluating fiscal federalism as the 16th Finance Commission forms, addressing tax-sharing principles and regional balance in taxation.

What is meant by fiscal federalism?

• Fiscal federalism refers to the division of financial responsibilities and resources between different levels of government within a federal or decentralized system.
• It encompasses the principles and mechanisms by which revenues are generated, collected, shared, and spent by various levels of government, typically at the national (central) and subnational (state or regional) levels.
• India operates as a federal republic with a multi-tiered system of governance, and fiscal federalism is an essential aspect of this arrangement.

Potential challenges faced by the 16th Finance Commission

• Revisiting Tax-sharing Principles: The 16th Finance Commission faces the challenge of reexamining and redesigning tax-sharing principles due to the shift from production-based to consumption-based taxation under the GST regime.
• Efficient Tax Collection: Variations in the cost of tax collection (ranging from 7 to 10 percent) have emerged as a challenge, given the joint collection of taxes by the Union and states under GST.
• Redesigning Horizontal Distribution: The Commission must address the challenge of redesigning criteria for distributing the divisible pool among states to ensure equitable distribution of tax revenues and grants.
• Reviewing the Compensation Scheme: The necessity, viability, and desirability of the GST compensation scheme must be reviewed by the Commission, considering the performance of GST revenues over the past six years.
• Institutional Relationships: Establishing formalized institutional relationships between the GST Council and the Finance Commission presents a challenge in the evolving federal financial structure.

The need for a comprehensive reevaluation of India’s fiscal federalism

• Shift to the GST Regime: The introduction of the Goods and Services Tax (GST) regime represents a monumental shift in India’s taxation system. This change from a production-based tax system to a consumption-based one necessitates a reevaluation of fiscal federalism to align with this new tax paradigm.
• Impact on Vertical and Horizontal Imbalances: The transition from a production-based to a consumption-based tax system has the potential to rectify historical vertical imbalances in tax revenue distribution. However, it also introduces new horizontal imbalances among states due to varying consumption patterns and economic development levels.
• Equitable Resource Allocation: To ensure a fair distribution of resources among states, it is imperative to revisit the criteria for resource allocation. The reevaluation should consider the principles of fiscal federalism and the specific needs of each state within the GST framework.
• Efficiency and Transparency: An updated fiscal federalism framework can lead to increased efficiency and transparency in revenue collection, sharing, and utilization. This can help streamline fiscal processes and reduce inefficiencies.
• Adaptation to Changing Economic Realities: India’s economic landscape is dynamic, with evolving challenges and opportunities. A comprehensive reevaluation allows fiscal policies to adapt to these changes, ensuring they remain relevant and effective.
• Fiscal Responsibility: To ensure fiscal sustainability, a reevaluation should assess the long-term fiscal health of both the central government and state governments. It can recommend measures to manage fiscal deficits and public debt responsibly.

Way forward

• Mandate of the 16th Finance Commission: The government should promptly constitute the 16th Finance Commission with a clear mandate to reexamine the tax-sharing principles and other related fiscal matters.
• Define Comprehensive Terms of Reference (ToR): The ToR for the 16th Finance Commission should be carefully formulated to guide the Commission in addressing the challenges posed by the GST regime and its impact on fiscal federalism.
• Pooling of Indirect Tax Sovereignty: Given the significant changes in the tax landscape, the Commission should comprehensively assess the pooling of indirect tax sovereignty between the Union and states under the GST system.
• Redesign Tax-sharing Principles: The Commission should undertake a thorough review and redesign of tax-sharing principles, especially with regard to the divisible pool, unsettled IGST, and settlement frequencies, in alignment with the GST structure.
• Distribution Criteria Reevaluation: Reevaluate the criteria for distributing the divisible pool among states, particularly for equalizing grants, to ensure that they align with the new consumption-based tax system and address regional imbalances effectively.
• Formalize Institutional Relationships: Formalize and strengthen the institutional relationship between the GST Council and the Finance Commission to facilitate seamless coordination, information exchange, and alignment of fiscal policies.
• Engage with Stakeholders: Engage in extensive consultations with relevant stakeholders, including state governments, economists, and experts, to gather diverse perspectives and insights.

Conclusion

• The 16th Finance Commission must reshape India’s fiscal federalism for the GST era by redefining the divisible pool, improving tax collection efficiency, revisiting distribution criteria, reviewing compensation, and formalizing institutional relationships. Flexible terms of reference are crucial for these essential reforms to align the fiscal system with the new tax paradigm and promote equitable growth.

Also read:

Finance Commission and the Challenges of Fiscal Federalism

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