16th Finance Commission
- The purpose of the upcoming formation of the 16th Finance Commission (FC) is to recommend to the States the devolution of central taxes and grants. The issues that the FC will undoubtedly be asked to look into are highlighted in the RBI’s recently released report, “State Finances: A study of Budgets.” These issues include states returning to the Old Pension Scheme (OPS) and unsustainable subsidies resulting from promises made during elections, regardless of the financial standing of the states.
The Finance Commission’s Constitution:
- Article 280 of the Indian Constitution establishes the Finance Commission, a constitutional body headed by the President of India.
- There is a chairman and four other members that the president appoints.
- The Commission is in charge of advising the President on a range of issues pertaining to the allocation of tax funds between the federal government and the states as well as state grants-in-aid.
- The President may call for a reconstitution of the Commission earlier than every five years.
Why is it necessary to restrain India’s populism?
Unbalanced Budget:
- Increasing Debt: The average debt-to-GDP ratio of Indian states rose from 22.2% to 34.5% between 2014 and 2022, with populist states like Tamil Nadu and Andhra Pradesh experiencing higher increases.
- Increased Deficit: In 2021–2022, the aggregate state budget deficit amounted to 4.1% of GDP, driven primarily by populist expenditures on free electricity, debt forgiveness, and social welfare programmes.
- Revenue Shortfalls: As a result of tax collections falling short of populist expenditure, many states have had to significantly rely on borrowing or bailouts from the federal government to make up the difference.
Distortions in the Economy:
- Decline in Investment: Some have ascribed the 10% decline in Foreign Direct Investment (FDI) entry into India in 2022 to the uncertainty engendered by protectionist and populist policies such as price controls.
- Job Growth Stagnation: India’s unemployment rate stayed over 7% in 2023 despite more government spending, suggesting that populist policies haven’t produced appreciable job growth.
- Market inefficiency: Price limitations in industries such as agriculture discourage production, causing shortages that affect consumer welfare and supply chains to break.
Degradation of Authority:
- Increase in Corruption: As populist rhetoric undermines institutional checks and balances, India’s position on Transparency International’s Corruption Perception Index fell from 80 in 2014 to 85 in 2022.
- Declining Transparency: Several states with strong populist leaders have a declining trend in the Public Affairs Index, a measure of government decision-making transparency.
Which state policies that have exacerbated the debate are some of the populist ones?
Old Pension Scheme (OPS) Reversion:
- A few Indian states have abandoned the 2004-introduced New Pension Scheme (NPS) and gone back to the Old Pension System (OPS).
- Unlike the NPS, which has liabilities for employee pensions limited to the employees’ serving lives, the OPS has perpetual obligations for pensions.
- According to an internal RBI assessment, OPS entails 4.5 times greater liability than NPS, adding 0.9% of GDP in additional costs by 2060.
- This action is viewed as retrogressive since it limits development and jeopardises the interests of next generations.
Increasing Fiscal Deficit in States:
- Due to subsidies for populist policies like free electricity, many states have deficits.
- States spend, on average, 0.87% of their Gross State Domestic Product (GSDP) on subsidies; but, some states—Punjab, for example, spend significantly more—spending 2.35% and 1.92% of their GDP, respectively.
What is the Finance Commission’s role in countering populism?
- Performance-Based Incentives: The suggestion for quantifiable performance-based incentives made by the 15th FC is a positive start. The FC promotes responsible governance and inhibits populist policies that would not be beneficial to long-term development by associating financial transfers to States with particular results, such as enhanced health, education, and agricultural indicators.
- In accordance with Article 280(3) of the Constitution, the Centre may request that the FC investigate any other matter “in the interest of sound finance,” in addition to suggesting that taxes and grants-in-aid be devolved to the States.
- While it may be difficult to classify programmes as populist or non-populist, the FC can work on creating objective standards that take into consideration the various developmental requirements of various States.
- To get an agreement on what defines populist spending, the Centre and States would need to work together.
- Fiscal Efficiency Parameters: When determining which transfers to approve, the FC may give fiscal efficiency a higher priority. Through highlighting fiscal consolidation and gauging State tax efforts, the FC may promote prudent financial management. This may serve as a disincentive for states that turn to populism without taking their financial stability into account.
- Only 2.5% of the 15th FC’s weight was allocated to fiscal efficiency as determined by tax effort (i.e., the ratio of own taxes to GDP). The 16th FC may review this.
- Public Education: The Finance Commission can help educate the public on the negative effects of populist policies. The FC may add to educated public conversation by emphasising the financial pressures that freebies cause and their long-term effects on economic growth. This will put pressure on political parties to implement sensible fiscal policies.
- Emphasis on Future Implications: The FC can highlight the long-term effects of populist policies, namely the burden borne by future generations and the growth of state debt.
- This could entail suggesting policies that stop states from taking on more debt than they can manage and making sure that financial choices support the objectives of sustainable development.
- Building Consensus: The FC can serve as a mediator and facilitator to promote communication, even though reaching an agreement between the Centre and States on restricting populist spending may prove difficult.
- A more cooperative approach to financial governance can be facilitated by the FC by supporting cooperative federalism and fostering candid conversations on fiscal issues.
- Frequent Assessment and Recommendations: The FC is able to regularly assess each State’s financial situation and offer suggestions depending on the changing macroeconomic environment. This makes it possible to respond adaptably to new problems, such as the effects of outside influences like the Covid-19 pandemic.
Way Forward:
- State taxpayers should be the ones who support populism in that state, not outsiders. According to the RBI, fiscal responsibility and reforms should be linked to fiscal transfers. A state ought to pay the price if it decides on populism and borrows money without adequate resources.
