Reimagining Fiscal Federalism: The Role of the Sixteenth Finance Commission   

Context
The Government of Tamil Nadu recently hosted the Sixteenth Finance Commission, chaired by economist Arvind Panagariya. This Commission, with its panel of eminent experts, is entrusted with resolving critical fiscal challenges and addressing imbalances in the Union-State financial relationship. Its recommendations will define India's economic trajectory for the next five years and lay the groundwork for long-term fiscal health.

Global Economic Shifts: Challenges and Opportunities

The Commission’s work coincides with transformative global economic shifts, including trends like friendshoring and reshoring, which are reshaping international trade and investment. For India, these developments offer unique opportunities, particularly for progressive States. However, achieving a balance between equitable resource redistribution and incentivizing high-performing States remains a pressing challenge.

Since its establishment in 1951, each Finance Commission has sought to address contemporary fiscal issues through vertical and horizontal devolution:

• Vertical devolution governs the sharing of revenue between the Union and States.
• Horizontal devolution determines how resources are distributed among States to reduce developmental disparities.

Despite these mechanisms, gaps between intended objectives and actual outcomes persist, necessitating a re-evaluation of priorities.

Equitable Devolution: Redefining the Framework

Vertical Devolution: Increasing State Autonomy

Vertical devolution focuses on distributing the Union’s tax revenue with States to empower developmental initiatives. However, this system has been undermined by the Union's increasing reliance on non-divisible revenue sources like cesses and surcharges, which are excluded from the divisible pool.

• For instance, the Fifteenth Finance Commission recommended a 41% allocation to States from the divisible pool. Yet, actual devolution stood at only 33.16% of the Union's gross tax revenue during the first four years of its award period.
• This discrepancy weakens States' fiscal autonomy and their ability to implement developmental programs effectively.

Horizontal Devolution: Toward Balanced Growth

Horizontal devolution aims to bridge regional disparities by considering factors like population, area, and developmental needs. While well-intentioned, its outcomes have often been suboptimal:

• Redistribution policies have predominantly focused on equalizing resources rather than rewarding performance.
• This has resulted in limited progress in recipient States and dissatisfaction among high-performing ones.

A more balanced approach is essential—one that expands the national economic pie while ensuring equitable distribution. Progressive resource allocation models could incentivize high-performing States to sustain their momentum while aiding less-developed regions in meeting baseline developmental goals.

Challenges Faced by Progressive States

1. Declining Revenue from Consumption-Based Taxes

Aging populations consume less, reducing revenue from taxes like GST. This decline hampers States' fiscal capacity, especially those reliant on consumption-based taxes.

2. Rising Social Expenditure

With demographic transitions, progressive States face increasing demands for healthcare, pensions, and social welfare programs. This strains budgets and reduces the funds available for developmental projects, risking economic stagnation.

3. Infrastructure Development

Urbanization demands significant investments in transportation, housing, waste management, and energy. Without adequate funding, these projects risk stagnation, resulting in overcrowded cities and declining public services.

4. Environmental Concerns

Rapid urbanization exacerbates environmental issues like pollution, loss of green spaces, and climate-related risks. Coastal States like Tamil Nadu are particularly vulnerable and require proactive investments in climate-resilient infrastructure.

5. Social Equity Challenges

Migrant populations in urban centers increase the need for equitable access to housing, healthcare, and education. Addressing these issues requires targeted policies and resource allocation.

6. Reduced Incentives for Performance

High-performing States often feel penalized in the current redistribution model, which prioritizes less-developed States. This lack of incentives undermines their motivation to sustain ambitious developmental initiatives.

The Way Forward

1. Tailored Fiscal Solutions

The unique challenges of progressive States demand a nuanced approach. The Sixteenth Finance Commission should:

• Incentivize performance by rewarding high-growth States.
• Address urbanization pressures through targeted infrastructure funding.
• Support demographic transitions by reallocating resources for aging populations.

2. Envisioning Inclusive Development

The Commission’s mandate extends beyond fiscal allocations. It must:

• Foster manufacturing and economic growth.
• Develop climate-resilient urban infrastructure.
• Promote inclusive development that benefits all States, regardless of their current status.

3. Balancing Redistribution and Growth

A balanced approach to devolution can create a win-win scenario:

• High-performing States can sustain growth through adequate incentives.
• Less-developed States can achieve foundational development goals, contributing to national progress.

Conclusion

The Sixteenth Finance Commission has a pivotal role in reshaping India’s fiscal framework. By prioritizing equitable resource distribution and incentivizing performance, it can address regional disparities without stifling progress. Its recommendations will set the stage for inclusive and sustainable growth, ensuring that every State contributes to and benefits from India’s collective advancement.

This Commission is not just a fiscal arbiter it is a visionary architect of India’s future, steering the nation toward resilience, equity, and global economic leadership.