Opinion Haseeb Drabu writes: What the 16th Finance Commission needs to do differently
Due to be constituted soon, the Commission must re-examine revenue allocation among states in light of post-GST changes
The destination principle for cross-border trading ensures that the poorer, consuming states benefit at the cost of more affluent and industrialised ones. The IGST, for instance, charged during the inter-state supply of goods or services has been transferred to the destination state. 
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The 122nd Constitutional Amendment of 2016 giving the Union and states concurrent powers of indirect taxation has been the most far-reaching change from a fiscal standpoint, since the setting up of the First Finance Commission in 1951. The Goods and Services Tax (GST) regime, introduced in 2017, is based on a system of concurrency of indirect taxes, where every transaction attracts central as well as state GST. The inter-state transactions, as well as imports, are levied an integrated GST. With this, a consumption-based taxation system has replaced a production-based one. The collection of indirect taxes in the state where goods or services are consumed, and not in the state where they are produced, changes both the vertical as well as the horizontal dynamics of federalism.
Earlier, the central sales tax, an origin-based tax, effectively exported the tax burden from rich and manufacturing states to the consuming states, contributing to horizontal imbalances. Now, the destination principle for cross-border trading ensures that the poorer, consuming states benefit at the cost of more affluent and industrialised ones. The IGST, for instance, charged during the inter-state supply of goods or services has been transferred to the destination state. This move from the principle of origin to the principle of destination is reconfiguring the balance of power amongst states. Yet, the federal fiscal transfer system continues to be designed for, and is based on, the principles of jurisdictional separation that is germane to the origin-based tax era. Its distributional criteria is also based on the earlier regime. The disconnect between the operational tax regime and the principles and criteria of tax sharing is inimical to the fiscal federal system and can create fault lines in the political economy of federalism.
The 16th Finance Commission (SFC), due to be constituted soon, must be mandated to re-examine the tax-sharing principles in light of the altered landscape of fiscal federalism in India. Its terms of reference (ToR) must be informed by the pooling of the indirect tax sovereignty by the Union and the states by consolidating and subsuming their respective indirect tax base. State governments now share with the Union the tax base associated with Union excise duty, service tax and parts of customs duty through the IGST. In turn, the Union government has extended its tax base to sales tax/ VAT, central sales tax, entry tax, luxury tax, entertainment tax, taxes on lottery, betting, gambling, and purchase tax.
These major changes necessitate that the statutory sharing of the indirect taxes, both vertical and horizontal, is re-examined and redesigned. To align the principle of vertical sharing with the new system, it is important to start by redefining the divisible pool. For instance, the SFC will be required to specify the modalities of making IGST completely a part of the pool. As of now, only IGST with no input tax credit gets shared with the states. There must be a normative basis for credit-in-transition unsettled IGST to be included in the divisible pool. This also holds for the frequency of settlements, which needs to be stipulated as it has caused a lot of cash flow issues for state governments.
The changed administration of GST where, unlike earlier, the Union and the states jointly and separately collect the same taxes has led to a sharp increase and wide variation in what has been accounted for as the cost of collection of taxes. This ranges from 7 to 10 per cent. Therefore, the SFC should be asked to recommend the method of calculating and apportioning the cost of collection of indirect taxes and suggest ways to reduce such taxes and make their collection more efficient.
As regards the horizontal distribution, the criteria for the distribution of the divisible pool among states, will have to be revisited. The existing criteria, especially for equalising grants, have evolved into a production-based tax system. This needs to be redesigned for a consumption-based tax system.
The change from production to consumption will make a significant difference to the distribution of tax revenues as well as the need, nature, and distribution of equalising grants. Several things, including the pecking order of states, are bound to see major reordering and recalibration. This is especially so because the ranking of states by per capita income is vastly different from their ranking by per capita consumption.
The “gap-filling” approach devised by British Banker Otto Niemeyer in 1935 and continued under Article 275, should have been redesigned in light of the compensation law brought in by the GST Council. With the GST compensation grants extended to March 31, 2026, the fiscal after that will be the base year for the SFC award that will be operative from 2027 to 2032. It doesn’t need a crystal ball to predict that every state will, in its memorandum and submissions to the SFC, seek the extension of the compensation scheme. Therefore, it is best to enjoin upon the SFC to examine the need for compensation, the raison d’etre for which was to “compensate losses in transition to GST”. It is important to review the need, viability, and desirability of the compensation scheme in light of the revenue performance of GST during the past six years. The principles of assigning the balance amount of GST compensation cess collection over the compensation released to states to the divisible pool of taxes also need to be laid down.
At another level, in the new institutional structure of federal finance, those who decided the size of the divisible and those who distribute it — the council and the commission — must have a formal institutional relationship. The SFC should examine how, during the period when it is not in operation, the GST Council can act as the Fiscal Council to monitor the implementation of its award.
The moot point is that the SFC must think afresh conceptually, methodologically, and operationally. The ToR must not only enable and facilitate it to do so but also nudge and guide it in this direction.
The writer is the former finance minister of Jammu and Kashmir
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