The Fifteenth Finance Commission Report

In the wake of the unprecedented Covid-19 pandemic, the Fifteenth Finance Commission (15th FC) emerges as a beacon of insight and guidance, presenting its comprehensive report titled Finance Commission in COVID Times. This seminal document meticulously dissects the multifaceted dimensions of the crisis, casting a spotlight on its far-reaching impact across global economies, with a particular focus on its ramifications within the intricate tapestry of India’s economic landscape. With a consultative and collaborative ethos at its core, the 15th FC navigates through the layers of challenges posed by the pandemic, shedding light on both its tangible and intangible facets, ultimately offering a blueprint for a resilient and prosperous future. The report contains 14 chapters including Introduction, Summary, and twelve major themes.

Let us understand each of them in detail.

1. Intergovernmental Fiscal Relations: Lessons from International Experience

Inter-governmental fiscal relations globally are shaped by political, economic, and constitutional factors. Recent trends show a gradual shift towards fiscal decentralisation, with increased vertical devolution of taxes to sub-national governments. However, crises like economic depressions and pandemics can lead to centralisation in fiscal relations.

Impact of the COVID-19 crisis Amidst the COVID-19 crisis, sub-national governments face unprecedented challenges marked by economic downturns and strained finances, particularly in vital sectors like health care and education. Despite global fiscal measures, sub-national revenue shortfalls persist, exacerbated by borrowing constraints and fiscal rules. Central banks have expanded roles to provide liquidity support, yet tension persists between centralised crisis responses and decentralised spending to mitigate inequalities. Many countries establish coordination mechanisms to tailor support and strengthen financial management. The crisis threatens sub-national fiscal sustainability, with tax revenues expected to recover slowly, posing challenges to sustainable development goals (SDGs). While global responses aim to alleviate immediate impacts, sustainable fiscal strategies and coordinated efforts are crucial for addressing regional disparities and fostering economic recovery.

Resource availability Many federations confronted challenges in devolving funds to sub-national levels due to resource availability. India’s general government revenue as a percentage of the GDP is among the lowest of BRICS (Brazil, Russia, India, China, and South Africa) countries and much below the Organisation for Economic Cooperation and Development (OECD) group average. Tax revenue in India stood at about 17 per cent of the GDP in 2018–19, remaining constant since the 1990s.

However, tax revenue is under significant pressure during the COVID-19 crisis. Moreover, cesses and surcharges imposed by the union government curtail the proportion of revenues eligible for transfers to states. There exists a compelling case for elevating India’s tax ratio to create fiscal space, enhance social protection, invest in infrastructure, and foster inclusive growth. Lessons from other emerging markets indicate that narrowing the tax gap can lead to substantial increases in tax revenue over a few years.

Lessons for India from international experience

• Implement comprehensive tax reforms to focus on revenue administration and policy changes.
• Broaden the tax base for direct and indirect taxes, with a focus on efficiency and compliance.
• Shift focus to indirect taxation like value-added tax (VAT), ensuring progressivity and efficiency.
• Sustain revenue increases through administration reforms and better property tax collection.
• Implement tax reforms without burdening the poor, ensuring progressivity and simplification. The move to goods and services tax (GST) in India is positive, but further reforms are needed to enhance progressivity and efficiency.
• Introduce broad reforms of property, personal income, and corporate taxes to complement the GST reforms.
• Implement base-broadening and rate-reducing measures and improve tax administration capacity at all government levels.

Overall, tax reforms are essential for India to enhance revenue, support economic growth, and empower sub-national governments to address local needs effectively.

Vertical fiscal gap The vertical fiscal gap represents the disparity between sub-national own-revenue and their expenditure, reflecting the relative fiscal autonomy of sub-national governments. This gap varies considerably across countries due to factors such as the level of revenue decentralisation, economic conditions, and institutional frameworks. In the OECD, the average vertical gap stands at approximately 40 per cent, highlighting the diverse fiscal landscapes among member countries. However, this figure masks significant divergence, with gaps ranging from as low as 6 per cent to as high as 82 per cent. Federations generally exhibit lower vertical gaps compared to unitary countries, underscoring the relatively greater revenue-raising capacity of sub-national governments within federated systems.

Vertical gap in India is larger and increasing as compared to most federations, reflecting heavy reliance on transfers from the Union rather than on own tax revenues by states. This imbalance stems from the effective assignment of expenditure and revenue powers between the Union and the states. Inefficiencies in addressing the vertical gap result in unfunded spending mandates, inadequate provision of public services at the sub-national level, or excessive sub-national government borrowing. Crises, such as the current COVID-19 crisis, exacerbate these imbalances by widening the wedge between sub-national revenues and expenditure responsibilities. Despite higher tax devolution from the Union, rising fiscal deficits in many states indicate growing vertical imbalances, driven by inadequate transfers relative to expenditure needs and revenue-raising capacity.

The vertical fiscal gap and imbalances highlight the need for effective fiscal reforms to address revenue shortfalls, enhance fiscal sustainability, and ensure efficient allocation of resources at both the Union and state levels in India.

Horizontal fiscal gap The horizontal fiscal gap across states reflects differences in revenue capacities and public service spending needs. Equalisation transfer systems aim to minimise these fiscal imbalances among jurisdictions.

International practices vary but commonly provide unconditional transfers from the federal government to states, differentiated by fiscal capacity. Well-designed systems limit moral hazard risks and avoid short-term political influence.

Fiscal capacity for formula-based transfers can be measured using three general approaches: (a) expenditure equalisation based on the costs and demands of public services; (b) revenue equalisation based on the state’s ability to raise revenue from one or more sources; and (c) macro-indicators covering broader economic or non-economic indicators that approximate fiscal capacity in situations where it is difficult to apply the other approaches due to data constraints.

Purpose of Conditional Transfers

Equalisation transfers address fiscal capacity deficiencies and horizontal imbalances, not regional development, or specific policy needs.

Discretionary central government transfers with conditions address infrastructure, regional development, and social policy objectives.

Types of Conditions

• Input or process-based conditions are common, focusing on fund use or service processes. Examples include input-based matching transfers and South Africa’s matching transfers to teaching hospitals. However, excessive input-based controls can hinder efficient service delivery.
• Output-based conditions are more efficient in achieving the desired results. Canada’s health transfer programme serves as a model for output-based conditional federal transfers.

Reforms aim to adopt output-based conditions for service delivery performance. Challenges include operational issues, especially in low-income countries and achieving compliance. Penalties for non-compliance range from fund reduction to rewarding good performance.

Most systems are a mix of vertical and horizontal, and revenue and cost equalisation systems. Examples include Canada (revenue equalisation), Australia (both revenue and expenditure equalisation), and Germany (partial revenue equalisation).

India’s equalisation system India’s system is simpler but does not directly reflect state fiscal capacities. It uses macro-indicators like per capita income, population, and area/forest cover. GST revenues are not equalised but allocated based on destination/consumption. Concerns include non-proportional population weight and co-existence of 1971 and 2011 population levels. Transitioning to revenue and/or expenditure equalisation could offer advantages in the longer run. While India’s equalisation system aligns with international best practices, there are opportunities for improvement to better reflect state fiscal capacities and achieve fuller equalisation.

India’s specific-purpose transfers are declining but still significant, accounting for about 30 per cent of total transfers. Concerns arise due to the large number of discretionary schemes and lack of outcome linkage.

2. Setting the Context: Analysis of the Past

About Union finances

• From 2011–12 to 2018–19, there was fiscal consolidation despite challenges from increased devolution. Fiscal deficit reduced from 5.9 per cent to 3.4 per cent, and revenue deficit decreased from 4.5 per cent to 2.4 per cent, although it was higher than recommended by the 13th and 14th finance commissions. The COVID-19 pandemic impacted fiscal consolidation in 2019–20 and 2020–21.
• Tax-to-GDP ratio increased modestly from 10.2 per cent to 11 per cent, with buoyant income tax partially offset by reduced corporation tax. Increasing tax mobilisation by the union government is imperative due to the low tax-GDP ratio.
• Debt to GDP ratio decreased from 51.8 per cent in 2011–12 to 47.9 per cent in 2018–19, mainly due to reduced fiscal deficit and nominal GDP growth outpacing nominal interest rates.
• GDP and revenue growth in the terminal year of the current award period are expected to be below 14th FC estimates, leading to uncertainty in revenue and tax projections.
• Cesses and surcharges increased, affecting the divisible pool. GST merger replaced several cesses and surcharges in 2017–18.
• Dividends from the RBI, public sector financial institutions, and central public sector enterprises (CPSEs) were robust, becoming the largest contributor in non-tax revenue. Dependence on the RBI dividends is notable.
• Disinvestment receipts fell short of the 14th FC estimates. Government’s methods of disinvestment offer scope for improvement but pose sustainability challenges.
• Expenditure contracted by over two percentage points of the GDP, mainly due to subsidy reduction. Food subsidies increased due to the National Food Security Act (NFSA), 2013 commitments and annual higher minimum support prices for wheat and rice.
• Committed expenditures remained relatively stagnant, except in 2017–18 due to pay and pension revisions. Unanticipated expenditures like One Rank One Pension (OROP) added to fiscal pressure.
• Fiscal consolidation occurred with altered fiscal roadmap, but there was substitution of expenditure in some sectors through extra-budgetary resources (EBRs). Recent economic slowdown may require expansionary measures, impacting fiscal indicators.
• The award period’s decisions will be crucial for setting the tone of fiscal correction path amid economic challenges.

About state finances

• Between 2011–12 and 2018–19, there was a decline in the fiscal position of states, marked by an increase in the aggregate gross fiscal deficit and revenue deficit relative to the GDP. However, states managed to keep fiscal deficits within targets excluding the Ujwal DISCOM Assurance Yojana (UDAY) borrowings, despite stress on revenue accounts due to declining own-tax revenue and rising expenditure.
• Borrowings under the UDAY programme severely affected fiscal indicators for 2015–16 and 2016–17. States face ongoing challenges in reforming the power sector and ensuring compliance with UDAY timelines to prevent further fiscal strain.
• Aggregate debt and liabilities relative to the GDP increased from 22.6 per cent in 2011–12 to 24.5 per cent in 2018-19, indicating a growing burden on state finances.
• Implementation of the 14th FC recommendations led to an increase from 2.9 per cent in 2011–12 to 4 per cent in 2018–19 in tax devolution from the Union to states as a proportion of the GDP, providing states with more untied funds and greater expenditure flexibility.
• States’ share in gross tax revenue (GTR) of the union government declined from 62.1 per cent in 2010–11 to 58.3 per cent in 2018–19 partly due to increased cesses and surcharges. Additionally, some states experienced a decline of 0.3 per cent in own-tax revenues even before the introduction of the GST, necessitating a reversal of this trend.
• States faced GST revenue shortfalls and high volatility in collections, mitigated by GST compensation till June 2022. States need to enhance GST implementation, curb tax evasion, and explore structural changes to boost own revenue.
• States’ own non-tax revenue as a percentage of GDP remained stagnant, requiring increased efforts from state governments to improve this revenue stream.
• Revenue expenditure as a proportion of the GDP increased significantly from 12.3 per cent in 2011–12 to 13.7 per cent in 2018–19, primarily driven by social services and moderate increases in economic services. Capital expenditure remained steady, except for spikes in 2015–16 and 2016–17 due to UDAY.
• States’ expenditure on social services, including education and health, has steadily risen, but with significant inter-state disparities, posing challenges to achieving Sustainable Development Goals (SDG) targets.
• Farm loan waivers and increased subsidies strain State finances, potentially impacting credit culture by encouraging defaults and discouraging responsible borrowing. Each waiver granted complicates future decisions on similar demands.

3. Pandemic Times: Analysis of the Future 2021–26

Tax-to-GDP ratio enhancement Projections indicate a gradual increase in the tax-to-GDP ratio of the union government, expected to rise from 9.8 per cent in 2020–21 to 10.5 per cent by 2025–26. This growth is attributed to administrative and procedural reforms aimed at bolstering tax compliance and thereby improving revenue gains.

Subsidy reforms

• Ongoing efforts to reform subsidies, particularly in key sectors such as food, fertiliser, and petroleum, have shown promising results.
• Notable achievements, including the automation of the supply chains of subsidised food grains and the elimination of ghost ration cards, have effectively curbed the rise in food subsidies.
• Recommendations include structural reforms within entities like the Food Corporation of India (FCI) to enhance efficiency in handling storage and transportation of food grains, thereby alleviating subsidy burdens.
• Projections for petroleum subsidies are contingent upon consumption changes and international prices, while fertiliser subsidy levels are expected to remain consistent, adjusted for inflation.

Gross state domestic product (GSDP) growth Growth projections for the GSDP are formulated based on historical trends and sectoral assessments, ensuring equitable distribution across states by categorising them according to per capita revenue expenditure.

Revenue expenditure adjustments

• Comparable data sets are developed for states to adjust revenue expenditure, ensuring uniformity across regions.
• Fiscal discipline is maintained by accounting for subsidies, grants, and other expenditure items.

Pensions, salaries, and defence expenditure

• Projections for salary and pension expenditure are made cautiously, considering modest growth rates amidst fiscal constraints.
• Defence revenue expenditure is expected to align with the GDP growth during 2021-26 to sustain asset maintenance.

Recommendations

Continue tax reforms Sustain administrative and procedural reforms to boost tax compliance and revenue generation.

Subsidy rationalisation Implement structural reforms in subsidy administration, particularly within the food and fertiliser sectors. Consider revising central issue prices of subsidised food grains to offset cost increases.

GSDP growth monitoring Vigilantly monitor GSDP growth to ensure equitable distribution across states based on per capita revenue expenditure.

Fiscal discipline Uphold fiscal discipline by controlling non-development expenditure, especially in salaries, pensions, and defence. Prudently manage scarce resources, prioritising developmental expenditure.

Normative principles Ensure fiscal sustainability by reprioritising expenditure and minimising inefficiencies. Channelise savings into developmental expenditure while effectively managing scarce resources.

Accounting standardisation Standardise accounting practices across states to facilitate comparability and consistent fiscal analysis, addressing inconsistencies to ensure accurate and comparable data for analysis.

4. Resource Mobilisation

The Covid-19 pandemic has presented significant challenges for fiscal policy and taxation, necessitating a delicate balance between increased government spending and declining revenues. This analysis focuses on administrative, operational, and policy changes required to effectively address these challenges.

Administrative/operational changes

• Fraudulent activities, particularly in the input tax credit (ITC) claims, pose a significant challenge to the GST tax compliance system. Gaps in filing returns, especially GSTR-1, hinder effective monitoring of tax evasion. Discrepancies between the GST payments made by companies and the data reported in the GST returns highlight inefficiencies in the system.
• The revenue neutrality of GST has been compromised due to challenges in correcting the inverted duty structure and problems with invoice matching.
• Despite growth in the number of tax returns, there is a significant portion of non-corporate entities with undeclared incomes. The tax base remains narrow due to a multitude of exemptions and deductions.
• A substantial stock of direct tax demands remains under dispute, impacting revenue realisation.
• High stamp duty rates and undervaluation of properties lead to revenue loss for states.

Recommendations

• Implementing a robust system for invoice matching to prevent ITC frauds is imperative. Enhancing compliance through strict enforcement of return filing deadlines and improving coordination between tax authorities to ensure consistency in data and facilitate crosschecks are essential measures.
• Streamlining technology platforms for prompt filing of returns and accurate invoice matching is crucial. Restoring rate neutrality of GST through structural reforms and streamlining the GST rate structure is imperative.
• Utilising information from the GST returns and bank transactions to track non-compliant entities effectively is necessary. Expanding coverage of tax deduction and collection mechanisms to discourage tax evasion is vital for broadening the tax base.
• Establishing an apex body within the Central Board of Direct Taxes (CBDT) and Central Board of Indirect Taxes and Customs (CBIC) to ensure consistency in tax interpretation is essential. Improving the quality of orders, conducting multi-year audits, and maintaining case-wise data for effective dispute resolution are crucial steps.
• Digitising property records and integrating them with registration systems to capture market values accurately is necessary. Streamlining property valuation methodologies to reflect market realities and enhance revenue from property registrations is crucial for fiscal stability.
• Stamp duty and registration fees at the state government level hold significant untapped potential. State governments should integrate computerised property records with transaction registration systems. Methodologies for property valuation must be streamlined to ensure regular and realistic updates. These steps will enhance property taxation at the local government level.

Tax policy changes

• In the GST regime, an inverted duty structure exists for many items, leading to large refunds and reduced net tax collections. If the input tax credit ratio exceeds the value-added ratio, it indicates an imbalance in the tax structure. Thus, customs duty collections can benefit from policy adjustments, including broad banding industrial finished products, streamlining and reducing non-tariff barriers, and continuing zero rating for imports.
• Significant growth in the number of personal income tax returns indicates increased formalisation of the economy. A large proportion of individuals fall within lower income brackets, resulting in a skewed tax contribution. Thus, professions tax, levied by states, needs revision to supplement local government resources effectively. Parliament should be empowered to periodically revise the tax ceiling of professions and index the ceiling to accumulated inflation to maintain its real value over time. This revision in the tax limits must be guided by the recommendations of the Finance Commission.
• The current ceiling prescribed under the Constitution requires adjustment to reflect inflation and income growth. Thus, it is recommended to reduce exemptions and deductions to curb tax evasion, review concessions provided for perquisites comprehensively and maintain threshold limits to enhance tax regime stability and improve tax planning.

Institutional and tax policy changes

Restoring GST rate neutrality The equilibrium of GST rates has been disrupted due to successive downward adjustments since its inception. Prior to GST implementation, estimates of the revenue neutral rate (RNR) varied between 11.6 per cent and over 17 per cent. However, the current effective GST rate has declined from 14.4 per cent to 11.6 per cent as per the RBI estimation after multiple rate adjustments.

Widening the direct tax base Discrepancies between reported incomes in income tax returns and those estimated from the national accounts underscore the imperative to broaden the tax base. In the fiscal year 2017–18, the gross total income reported under IT returns was Rs 53.4 lakh crore; whereas the income reported in the national accounts for the same period amounted to Rs 102.7 lakh crore. Such disparities hint at potential tax evasion and underreporting.

Strengthening devolution of taxation powers Insufficient devolution of taxation powers impedes resource mobilisation, particularly at the third tier of the government. An over-reliance on consumption-based taxes diminishes the progressivity of the tax system. Hence, it is imperative to reassess constitutional entitlements to income and asset-based taxation across various tiers of the government.

Recommendations

• Merge rates of 12 per cent and 18 per cent to rationalise the GST structure.
• Adopt a three-rate structure comprising merit rate, standard rate, and demerit rate, around 28–30 per cent.
• Minimise exemptions to augment efficiency and revenue gains.
• Simplify deductions and exemptions to broaden and deepen the income tax base.
• Enhance tax information systems and administration to bolster compliance and accuracy.
• Diminish over-reliance on consumption-based taxes by expanding income and asset-based taxation.
• Undertake devolution of taxation powers to the third tier of government, particularly in asset-based taxes.
• Strengthen local administrative capacity to facilitate efficient tax collection and resource mobilisation.

5. Towards Cooperative Federalism: Balancing Equity and Efficiency

Vertical devolution

The Constitution of India mandates both the Union and the states to raise revenues through various taxation sources, delineating expenditure responsibilities across three lists: Union List, State List, and Concurrent List, symbolising a decentralised governance structure. Despite the Union government raising 62.7 per cent of total resources in 2018–19, the states incurred 62.4 per cent of the aggregate expenditure, highlighting a significant vertical imbalance where the Union possesses greater revenue-raising powers while states bear higher expenditure responsibilities. In 2018–19, states could raise only 44.8 per cent of their total expenditure from their own resources, necessitating 55.2 per cent of state expenditures to be funded through vertical resources transfers or borrowing.

Recommendations for addressing vertical imbalance

• To ensure predictability and stability in resource allocation, particularly amid the pandemic, the 15th FC has proposed retaining the vertical devolution at 41 per cent, consistent with previous recommendation for the 2020–21 period. This aligns with the 42 per cent level of the divisible pool advised by the 14th FC. However, vertical devolution has been adjusted to account for the altered status of the former State of Jammu and Kashmir, now divided into the Union Territories of Ladakh and Jammu and Kashmir.
• The Union and states must collaborate to recalibrate fiscal responsibilities, ensuring a more equitable distribution of revenue-raising and expenditure obligations.
• States need to focus on enhancing revenue generation capacities through efficient taxation policies, improved tax administration, and promotion of economic growth.
• Vertical transfers from the Union to the states should be allocated transparently and accountably, considering the actual needs and developmental priorities of each state.
• Both Union and state governments should prioritise fiscal discipline to reduce reliance on debt financing, mitigating the risk of fiscal vulnerability in the long term.

Horizontal devolution

Horizontal devolution distributes the states’ aggregate share in the divisible pool among them, based on evolving objective parameters or formulae. The recommendation aims to bridge the vertical fiscal gap, provide equity, equalise fiscal capacities, and account for cost differentials among states. To maintain stability and equitable distribution, continuing the current criteria and weights for horizontal devolution from 2021–22 to 2025–26 is suggested. This approach ensures stability and equity in resource allocation among states, aligning with the principles of cooperative federalism.

The 15th FC acknowledges the significance of the Census 2011 population data in representing the present needs of states and has assigned a 12.5 per cent weight to the demographic performance criterion to reward states that have performed better demographically. Tax effort criterion has been reintroduced to reward fiscal performance.

6. Empowering Local Governments

For local government, the recommendations aim to foster effective governance, sustainable development, and equitable resource distribution, laying the groundwork for resilient and thriving local communities.

• The recommended grant size for local governments for the period 2021–2026 is set at Rs 4,36,361 crore, ensuring a predictable flow of funds for better planning and resource utilisation. This fixed amount is crucial in navigating uncertainties and fostering effective governance.
• Specific allocations within this grant include Rs 8,000 crore for new city incubation, Rs 450 crore for shared municipal services, and Rs 70,051 crore for strengthening the primary healthcare system amidst the pandemic. The remainder, Rs 3,57,860 crore, is allocated between rural and urban local bodies based on specified ratios over the award period.
• Allocation among states is determined by population and area, with a changing ratio between rural and urban local bodies over time, reflecting evolving needs and demographics.
• To qualify for grants for 2024–25 and 2025–26, states must establish state finance commissions (SFCs) and act on their recommendations by March 2024. Additionally, online availability of provisional and audited accounts for local bodies is mandated, with compliance requirements phased in gradually.
• A key emphasis is placed on increasing property tax revenues as a vital revenue source for local governments. Conditions are set for setting minimum floor rates and achieving growth in collections, ensuring financial sustainability and independence.
• Recommendations include both untied grants and grants earmarked for specific purposes like sanitation, drinking water, and rainwater harvesting, bolstering resources for rural local bodies.
• Urban centres are categorised into Million-Plus cities and other cities/towns, each receiving tailored grant recommendations based on population and specific needs.
• Grants for Million-Plus cities are tied to performance indicators related to air quality improvement and meeting service level benchmarks for essential services.
• Nodal ministries are designated for monitoring and disbursing grants to urban local bodies, with detailed targets and evaluation criteria provided to ensure accountability and transparency.
• Significant grants are allocated to strengthen primary health infrastructure, recognising the pivotal role of local governments, particularly in pandemic response.

7. Disaster Risk Management

The 15th Finance Commission (15th FC) introduced a comprehensive set of changes and recommendations in its report on disaster risk management, covering the period from 2020–21 to 2025–26.

New methodology for allocation Departing from the previous expenditure-based approach, the 15th FC introduced a novel methodology for allocating funds to states. This methodology integrates three critical factors: capacity, reflecting past expenditure; risk exposure, encompassing area and population; and hazard and vulnerability, evaluated through a disaster risk index. To manage disaster-related finances, the commission established the National Disaster Risk Management Fund (NDRMF) at the national level and the State Disaster Risk Management Fund (SDRMF) at the state level.

Changes in funding structure The 15th FC overhauled the funding structure to ensure a more balanced allocation. They designated 20 per cent of the total grants for state disaster mitigation funds (SDMFs) and allocated the remaining 80 per cent for state disaster response funds (SDRFs). Furthermore, the response fund was divided into three windows: Response and Relief (40 per cent), Recovery and Reconstruction (30 per cent), and Preparedness and Capacity Building (10 per cent).

Cost-sharing arrangement In a bid to ensure equitable burden-sharing between the Centre and the states, the 15th FC proposed a graded cost-sharing arrangement. Under this scheme, states would contribute 10 per cent up to Rs 250 crore, 20 per cent up to Rs 500 crore, and 25 per cent for all assistance exceeding 500 crore of the assistance received from the NDRF/NDMF, thereby discouraging excessive demands from states.

Earmarked allocations The 15th FC identified six key priorities under the national and state disaster management funds. These priorities include drought mitigation plans, urban flooding reduction, seismic and landslide risk management, and erosion mitigation. Additionally, funds were allocated for the resettlement of displaced people affected by erosion and for the expansion and modernisation of fire services.

Mitigation funds and recommendations

• Establishment of mitigation funds at national and state levels as per the Disaster Management Act.
• Utilisation of mitigation funds for local-level interventions promoting environment-friendly settlements and livelihood practices.
• Recommended total corpus of Rs 1,60,153 crores for disaster management during 2021–26, with Union’s share at Rs 1,22,601 crore and States’ share at Rs 37,552 crores.
• Six earmarked allocations totalling Rs 11,950 crores recommended for priority areas.
• It has proposed that states contribute 25 per cent towards allocation, except for the North Eastern Hill (NEH) states, which are required to contribute only 10 per cent.

Alternate sources of funding

• Proposal for reconstruction bonds issuance post-disaster.
• Utilisation of contingent credit/stand-by facility from International Financial Institutions (IFIs).
• Utilisation of crowd funding platforms and corporate social responsibility (CSR) contributions for disaster funding.
• Introduction of insurance and risk pooling mechanisms for disaster relief.

Other recommendations

• Development of an outcome framework linked to Sendai Framework Indicators.
• Establishment of streamlined payment system from the Ministry of Home Affairs to the Ministry of Defence.
• Creation of dedicated capacity for managing the NDRMF and SDRMF.
• Utilisation of post-disaster needs assessment (PDNA) as standard methodology.
• Establishment of disaster database for comprehensive disaster management tracking.
• Disbursing assistance to women members of households for enhanced inclusivity.

8. Pandemic and Beyond: Building Resilience in Health Sector

India’s healthcare system, highlighted by the Covid-19 pandemic, faces significant challenges that the private sector alone cannot address. Government intervention is necessary due to health care being a merit good with substantial externalities. The pandemic exacerbated existing issues, particularly in states with weak health systems, leading to a decline in non-Covid essential services delivery, with government hospitals bearing a disproportionate burden.

Covid-19 emphasised the urgent need for increased investments in the public health system to respond to emergencies, outbreaks, and deliver essential services. Without additional funding, progress towards national health goals and sustainable development goals (SDGs) would be hindered, and health inequalities, especially among vulnerable populations, could worsen.

Critical gaps in essential public health responses, including testing, surveillance, and critical care provision, were evident during the
COVID-19 pandemic due to limited laboratory capacity and inadequate infrastructure. Strengthening convergence between disease control programmes and service delivery systems is essential to prepare for future health crises.

Primary health care plays a crucial role in improving health outcomes, but infrastructure and human resource gaps persist, particularly in rural areas. Addressing these gaps through investments in primary healthcare infrastructure and training programmes for healthcare professionals is vital.

Policy recommendations

• Increase health spending by states to over 8 per cent of their budget by 2022.
• Prioritise primary healthcare and increase expenditure to two-thirds of total health expenditure by 2022.
• Increase public health expenditure to 2.5 per cent of the GDP by 2025, with progressive increases by both Union and state governments.
• Provide flexibility in centrally sponsored schemes (CSS) to allow states to tailor implementation to local needs.
• Shift inter-governmental fiscal health financing focus from inputs to outputs/outcomes.
• Provide support and guidance from the Government of India in key areas like medical research and clinical protocols.
• Establish an All-India Medical and Health Service as envisaged under Section 2A of the All-India Services Act, 1951 to address inter-state disparities in doctor availability.
• Restructure the MBBS curriculum to include specialisation and encourage AYUSH as an elective subject for medicine undergraduates.
• Address asymmetry in medical college distribution and utilise all health facilities for specialist training.
• Utilise foreign medical degree holders by designing skills-based training programmes.

Grants/financial recommendations

• Allocate Rs 1,06,606 (forms 0.1 per cent of GDP) crore for health sector grants with Rs 70,051 crore through local governments and Rs 31,755 crore to states, along with Rs. 4,800 crores as state-specific grants.
• Provide unconditional health grants to local governments to strengthen primary healthcare infrastructure.
• Invest in critical care hospitals, public health laboratories, and training programmes for allied healthcare professionals to address human resource shortages and build resilience against future health crises.
• Administer grants through the Ministry of Health and Family Welfare (MoHFW) and allow for flexibility in utilisation within each state’s share.

9. Performances-Based Incentives and Grants

Incentivising educational outcomes Grants totalling Rs 4,800 crore over four years, with Rs 1,200 crore should be yearly allocated from 2022–23 to 2025–26. These grants aim to incentivise states to enhance educational outcomes, focusing on indicators such as the Performance Grading Index (PGI) to improve the quality of education across the country.

Grants for higher education Rs 6,143 crores should be allocated for the development of online learning platforms and professional courses in regional languages for higher education, specifically targeting fields like medicine and engineering. This initiative aims to broaden access to higher education and skill development opportunities, especially for students from diverse linguistic backgrounds.

Performance-based incentives for agricultural reforms Recognising the importance of agricultural reforms, Rs 45,000 crores should be given as performance-based incentives for states. These grants are intended to encourage states to implement reforms such as amending land-related laws to align with NITI Aayog’s model law, enhancing groundwater management, boosting agricultural exports, and increasing production of key crops like oilseeds, pulses, and wood-based product.

Recommendations

Education States are encouraged to utilise the allocated grants effectively to improve educational outcomes, with a focus on enhancing infrastructure, teacher training, and student performance. Monitoring mechanisms should be put in place to ensure accountability and transparency in the utilisation of funds.

Higher education The Ministry of Education should oversee the implementation of initiatives aimed at expanding online learning platforms and developing professional courses in regional languages. Collaboration with educational institutions and industry stakeholders is crucial to designing relevant and high-quality programmes that meet the demands of the job market.

Agricultural reforms States are urged to enact necessary reforms in their agricultural policies, including amendments to land-related laws and implementation of sustainable water management practices. Incentive-based grants should be utilised to promote innovation, technology adoption, and productivity enhancement in the agricultural sector. Monitoring mechanisms should track progress and ensure compliance with reform targets.

10. Defence and Internal Security

The commission emphasises the constitutional duty of both the Union and states to uphold India’s sovereignty and ensure defence and internal security. The report notes the Union’s specific responsibility, outlined in Article 355, to protect states against external aggression and internal disturbance.

Previous finance commissions have primarily focused on revenue expenditure for defence, leaving capital expenditure largely unaddressed. This has resulted in a reliance on borrowings for capital investment in defence.

• The commission highlights the absence of a mechanism for reverse flow in the inter-governmental transfer system, respecting constitutional principles regarding the divisible pool of resources.
• The commission acknowledges past finance commissions’ establishment of overall revenue transfer limits, based on the Union’s gross revenue receipts, although these limits have been frequently exceeded.
• In recognition of global strategic requirements for national defence, the commission has re-calibrated the relative shares of Union and states in gross revenue receipts. This adjustment allows the Union to allocate resources towards the proposed Modernisation Fund for Defence and Internal Security (MFDIS) which may be called Rashtriya Suraksha Naivedyam Kosh or any other appropriate name.

Recommendations

Creation of a special fund The commission recommends earmarking Rs 1.53 lakh crore annually from gross revenue receipts for investment in defence capital expenditure and internal security. Additionally, it proposes the establishment of a dedicated, non-lapsable fund, named, the Modernisation Fund for Defence and Internal Security (MFDIS) with a total indicative size of Rs 2,38,354 crores over the period 2021–26.

Diversification of funding sources The commission suggests multiple sources for funding the special fund, including transfers from the Consolidated Fund, disinvestment proceeds of public sector enterprises (DPSEs), and monetisation of surplus defence land.

Operational mechanisms The proposed fund will be operated by a high-powered committee (HPC), ensuring transparent administration, public reporting, and audit procedures. The Ministry of Defence (MoD) and Ministry of Home Affairs (MHA) will have exclusive access to specific portions of the fund for their respective purposes.

Long-term fiscal planning The commission recommends a review of existing expenditures to prioritise defence and internal security, alongside measures to reduce salary and pension liabilities and promote indigenous production over defence imports.

Reforms in defence pension The commission advises the MoD to implement reforms in defence pension schemes to align them with non-defence pensions, including considerations like transitioning to the New pension scheme (NPS) and enhancing resettlement opportunities for ex-servicemen.

Promotion of indigenous defence production The MoD is encouraged to reduce dependency on defence imports through a strategic roadmap that incentivises indigenous production, aiming for a significant increase in domestic production by 2025-26.

11. Fiscal Consolidation Roadmap

Centre’s recommendations

The central government aims to decrease its fiscal deficit to 4 per cent of GDP by 2025–26, projecting a reduction in total liabilities from 62.9 per cent of GDP in 2020–21 to 56.6 per cent in 2025–26. To achieve this, a proposal for a high-powered inter-governmental group is put forth to review the Fiscal Responsibility and Budget Management Act (FRBM) and recommend a new framework.

States’ recommendations

States are advised to adhere to specific fiscal deficit limits as a percentage of gross state domestic product (GSDP): 4 per cent in 2021–22, 3.5 per cent in 2022–23, and 3 per cent during 2023–26. They are also permitted to utilise unutilised borrowing from the initial four years (2021–25) in subsequent years within the 2021–26 period. Additionally, states undertaking power sector reforms are allowed additional borrowing equivalent to 0.5 per cent of GSDP.

Revenue mobilisation: recommendations

Efforts are suggested to strengthen income and asset-based taxation mechanisms. This includes expanding provisions related to tax deduction and collection at source (TDS/TCS) to lessen dependence on income tax. Utilising the untapped potential of stamp duty and registration fees at the state level is also emphasised. Furthermore, integrating computerised property records with transaction registration and streamlining property valuation methodologies by state governments are recommended to enhance revenue mobilisation efforts.

Goods and services tax: recommendations

The need to address the inverted duty structure between intermediate inputs and final outputs in the GST is highlighted. Additionally, restoring the revenue neutrality that has been compromised by multiple GST rates and adjustments is deemed necessary. To streamline the GST structure, merging rates of 12 per cent and 18 per cent is suggested. Moreover, it is recommended to increase field efforts by states to expand the GST base and ensure compliance.

12. Fiscal Architecture and Financial Management

Comprehensive framework for public financial management

• The current lack of a comprehensive framework for public financial management practices poses significant challenges in ensuring efficiency, transparency, and accountability in fiscal operations at both the Centre and state levels.
• Without a standardised framework, there is a risk of inconsistencies and inefficiencies in financial management practices across different governmental entities.

Establishment of independent fiscal council

It is crucial to enhance oversight and accountability in fiscal matters. This council, empowered to assess fiscal records from both the Centre and states, can provide valuable insights and recommendations for improving fiscal management practices. By maintaining an advisory role, the council ensures independence from enforcement activities, thereby promoting transparency and integrity in fiscal decision-making processes.

Phased adoption of standard-based accounting and financial reporting The adoption of standard-based accounting and financial reporting practices is essential for enhancing transparency and comparability in financial reporting across governmental entities. A phased approach to adoption, coupled with consideration of accrual-based accounting in the long term, can facilitate the transition towards more robust financial management practices. These measures would enable stakeholders to make informed decisions based on accurate and reliable financial information.

Prevention of off-budget financing

• Off-budget financing and other non-transparent means of financing pose significant risks to fiscal integrity and accountability.
• By refraining from such practices, both the Centre and states can maintain transparency in fiscal operations, thereby fostering trust among stakeholders and the public.
• Adherence to transparent financing practices is essential for upholding fiscal discipline and ensuring the sustainability of public finances.

Standardised framework for reporting contingent liabilities

• The absence of a standardised framework for reporting contingent liabilities may lead to inconsistencies and inaccuracies in financial reporting.
• Establishing clear guidelines and norms for reporting contingent liabilities is crucial to ensure transparency and accountability in fiscal disclosures.
• A standardised framework would enable stakeholders to assess the potential risks associated with contingent liabilities accurately.

Improvement in macroeconomic and fiscal forecasting Enhancing the accuracy and consistency of macroeconomic and fiscal forecasting is essential for effective fiscal planning and decision-making. By leveraging the latest techniques and enhancing the technical capacities of personnel involved in forecasting and budgeting processes, both the Centre and states can improve the reliability of fiscal forecasts. Timely and accurate forecasts are vital for formulating sound fiscal policies and ensuring the sustainability of public finances.

Amendments in state fiscal responsibility legislation

• Ensuring consistency between state fiscal responsibility legislations and the Centre’s legislation, particularly regarding the definition of debt, is essential for promoting fiscal discipline and coherence.
• States should amend their fiscal responsibility legislations to align with the Centre’s framework, thereby enhancing the effectiveness of fiscal management practices across the country.

Diversification of short-term borrowings for states

• Providing states with more avenues for short-term borrowings, beyond ways and means advances and overdraft facilities from the Reserve Bank of India, can enhance their financial flexibility and liquidity management.
• Diversification of borrowing sources enables states to mitigate risks associated with overreliance on a single financing instrument, thereby promoting fiscal resilience and stability.

Formation of independent debt management cell for states

• Establishing an independent debt management cell at the state level is crucial for efficient management of borrowing programmes and debt obligations.
• Such a cell can oversee debt issuance, monitor debt levels, and implement strategies to optimise borrowing costs, thereby promoting prudent debt management practices and fiscal sustainability.

Recommendations

• Develop a comprehensive framework for public financial management practices to ensure consistency, transparency, and accountability in fiscal operations across all levels of government.
• Establish an independent Fiscal Council with advisory powers to assess fiscal records from both the Centre and states, thereby enhancing oversight and transparency in fiscal matters.
• Prepare a phased plan for the adoption of standard-based accounting and financial reporting practices, with consideration given to eventual adoption of accrual-based accounting for improved financial transparency and accountability.
• Ensure that both the Centre and states refrain from resorting to off-budget financing or any non-transparent means of financing to uphold fiscal integrity and transparency.
• Develop a standardised framework for reporting contingent liabilities to ensure consistency and accuracy in financial disclosures across governmental entities.
• Enhance the accuracy and reliability of macroeconomic and fiscal forecasting techniques through the adoption of latest methodologies and capacity-building initiatives.
• States should amend their fiscal responsibility legislations to align with the Centre’s framework, particularly regarding the definition of debt, to promote coherence in fiscal management practices.
• Provide states with additional avenues for short-term borrowings to enhance their financial flexibility and liquidity management, reducing dependency on a single financing instrument.
• Establish independent debt management cells at the state level to ensure efficient management of borrowing programmes and debt obligations, thereby promoting fiscal sustainability and prudent debt management.

Criticism of the 15th FC Report

• The President of India extended the submission deadline for the 15th Finance Commission’s report to November 30, 2019, and added an additional term of reference (AToR) related to funding mechanisms for defence and internal security. The AToR, focusing on defence and internal security funding, seems to deviate from the constitutional mandate of the Finance Commission outlined in Article 280, which primarily concerns the distribution of taxes between the Union and states, grants in aid, and measures to augment state resources.
• The responsibility for defence lies with the Union government, while internal security is largely managed by the states, raising questions about whether this issue falls under the purview of the Finance Commission.
• The original terms of reference of the Finance Commission already encompass considerations for defence and internal security needs, rendering the addition of this AToR redundant.
• The declining trend in defence expenditure as a percentage of the GDP and total government expenditure raises concerns about maintaining adequate funding while meeting fiscal deficit targets.
• The Finance Commission could recommend reallocating expenditures, minimising tax arrears, rationalising tax incentives, and monetising government assets to generate additional revenue for defence funding.
• It is imperative for the Finance Commission not to adversely impact the divisible pool or exacerbate fiscal stress on states, particularly given the challenges posed by the GST regime and reduced revenue transfers from the Centre to states.
• The Finance Commission’s recommendations should focus on mitigating the fiscal crisis faced by states and ensuring fair and equitable resource distribution, rather than endorsing policies that favour fiscal centralisation or erode state revenues.
• The Finance Commission’s failure to address the Centre’s growing reliance on cesses and surcharges, which reduce resources available for devolution to states, reflects a bias towards central policies.
• The Commission’s emphasis on performance-linked grants and conditional transfers to local bodies may constrain states’ policy autonomy and prioritise central objectives over state-level needs.
• Recommendations regarding local government funding should prioritise fiscal empowerment and territorial equity, considering the vital role of decentralised governance in delivering public services and promoting development at the grassroots level.

As India stands at the crossroads of global and domestic macroeconomic challenges, the 15th FC report emerges as a lodestar, guiding policymakers towards a resilient and prosperous future. Grounded in the principles of collaborative federalism, it serves not only as a testament to the commission’s vision but also as a blueprint for India’s journey towards inclusive growth and development. Despite some positive aspects such as higher vertical devolution to local governments, critical lacunae remain, including a lack of emphasis on fiscal empowerment for local bodies and insufficient consideration of the equalisation principle. Addressing these issues is essential to ensure fair and equitable resource distribution and promote effective decentralised governance in India.

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