Resolving Vertical and Fiscal Imbalances in India: A Task for the Sixteenth Finance Commission

The Terms of Reference (ToR) of the Sixteenth Finance Commission (16th FC) have recently been announced. These ToR are based on the constitutional provisions relating to the sharing of central taxes and grants. Other clauses usually made part of the ToR of the earlier FCs have not been included. One such clause is usually related to the review of fiscal deficit and debt of the central and state governments. In this article, we argue that the subject of fiscal transfers is integrally linked to determining sustainable levels of fiscal deficit and debt and the 16th FC would need to review trends in receipts and expenditures of the two tiers of government as well as trends in fiscal deficit and debt. We observe that government finances in India have shown, in recent years, an increase in the centre’s fiscal deficit and debt relative to GDP together with a falling share of the centre’s revenue receipts in the combined revenue receipts post transfers. This has led to a significant fall in the centre’s primary expenditure relative to that of the states implying a loss of fiscal space for the centre. We show that this situation is unstable in the presence of competition for fiscal space between the central and state governments. In particular, a falling share of the centre in the combined revenue receipts post transfers would lead the central government to rely more and more on borrowing to preserve its comparative fiscal space. However, as the centre’s debt increases, its interest payments would increase and primary expenditures would fall, giving rise to further loss of fiscal space. We argue that the 16th FC should attempt to jointly resolve the issues of vertical and fiscal imbalances in the context of Fiscal Responsibility and Budget Management targets, which may also need to be reconsidered. JEL Codes: H63, H62, H7, H77