Whither fiscal federalism: Carving out defence fund out of the divisible pool hurts constitutional propriety

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Updated: August 06, 2019 7:07 AM

The Centre wants a special fund for defence even as its defence-spend to GDP ratio has shrunk, and its spending on state subjects rose from 14% (2005) to 20% (2012)

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As per media reports, the government has proposed to the president to extend the term of the 15th Finance Commission up to November 30 and amend the terms of reference (TOR) to create a non-lapsable fund for defence and internal security imperatives. The official statement states, “The amendment provides that the 15th Finance Commission shall also examine whether a separate mechanism for funding of defence and internal security ought to be set up and if so, how such a mechanism could be operationalised”. The additional TOR may be issued by the President anytime soon.

Article 280 specifies the basic terms of reference relating to: (i) the distribution of divisible pool of taxes between the Union and the states and the allocation of the shares of individual states; (ii) the principles that should govern the grants in aid of revenues of the states out of the consolidated fund of India and the sums to be paid to each of the states under Article 275; and (iii) the measures needed to augment the consolidated fund of a state to supplement the resources of rural and urban local bodies based on the recommendations of State Finance Commissions and (iv) any other matter in the interest of sound finance.

The proposed additional term is being issued under the fourth provision. In fact, the TOR issued while appointing the 15th Finance Commission states,“While making the recommendations, the Commission shall have regard among other considerations to… The demand on the resources of the Central government particularly on account of defence, internal security, infrastructure, railways, climate change, commitments towards administration of UTs without legislature, and other committed expenditure and liabilities”. It is now proposed to mandate the setting up of a separate mechanism for funding of defence and internal security and operationalising it.
The problem with the proposal is: Can the Commission recommend the creation of a non-lapsable fund separate from fiscal space provided after tax devolution? If the recommendation is to create such a fund from the divisible pool before determining the shares of the Union and states in tax devolution, there will be questions of constitutional propriety. On the other hand, if the fund is recommended from the Centre’s consolidated fund after tax devolution, it is superfluous, for the Centre does not need a recommendation to allocate the funds to the subjects within its domain.

Past Finance Commissions have considered the requirements of the Centre for defence and internal security as required by the TOR. The 14th Finance Commission, for example, projected higher defence revenue expenditure (including salaries) of 30% in FY17, which was also supposed to incorporate the pay commission impact and allowed for an increase of 20% for the remaining years of its award. The capital expenditure requirements are not covered in the Finance Commissions’ projections. Despite this, the defence spend-GDP ratio declined from over 2% in FY15 to 1.48% in FY19 and is proposed even lower, at 1.45%, in FY20. As a ratio of total central expenditure, it has declined from 14.3% in FY16 to 11% in FY20.

The Constitution divides the responsibilities of the Union and states in terms of the Union, State and Concurrent lists, and the Commission is required to assess expenditures to meet their constitutional obligations. Curiously, while the expenditures on subjects like defence, entirely in the Union list, have shown a decline over the years, the Centre has been spending more and more on state and concurrent subjects. The 14th Finance Commission has noted that the ratio of the Centre’s spending on state subjects in the total increased from 14% in 2005 to 20% in 2012, and its share in spending on concurrent subjects increased from 13% to 17%. It would not be incorrect to infer that it is the Centre’s foray into state subjects through centrally sponsored schemes, along with higher spends on interest payments (24% of total expenditure), have crowded out defence expenditures.

It is curious that, even as the Centre is so concerned about protecting the allocation to defence, as to warrant an additional TOR to the Finance Commission, it has allowed the defence expenditure-GDP ratio as well as total expenditures to decline year after year. There is nothing that prevents the central government from making a higher allocation and it does not require the Commission to mandate a separate funding mechanism. Defence is entirely in the Union List. Internal security has both Union and State governments spending on it and, to the extent the Central forces are used by the States, the latter are charged.

What has prompted this additional TOR? The only explanation seems to be to nudge the Finance Commission to recommend lower share to the states in tax devolution. The central government, even after accepting the recommendations of the 14th Finance Commission, has not yet reconciled to the higher share of 42% to states. This is reflected in the TOR of the 15th Finance Commission in Para 5 (iv), which asks the Commission to take into consideration, “The impact on the fiscal situation of the Union government of substantially enhanced tax devolution to States following the recommendation of the 14th Finance Commission, coupled with the continuing imperative of the national development programme including New India – 2022”. In fact, this is despite the fact that the states’ share in tax devolution recommended by the 14th Finance Commission was only marginally higher than the previous Commission’s, if the plan grants under the Gadgil formula and discretionary grants recommended by the earlier Commissions are considered. In fact, to the extent that devolution was higher, the Union government undertook two measures to contain it.

First, in the name of consolidation and rationalisation of Centrally Sponsored Schemes, it increased the matching contributions of the States. Second, all discretionary changes to raise tax revenues were done by increasing cesses and surcharges to keep the proceeds outside the divisible pool. Therefore, repeatedly professing commitment to cooperative federalism looks only rhetorical.

The 15th Finance Commission is in the process of finalising its recommendations. During their visits to the states, most of the states must have demanded higher devolution and expressed their concern about shrinking fiscal space to meet expenditures on constitutionally mandated services, like basic education, healthcare, water supply and sanitation, agriculture and urban development. It appears that the proposal for additional TOR is to persuade the Commission not to provide it with larger fiscal space, not for additional allocation for defence but for central schemes under the rubric of New India – 2022. The Commission is a constitutional body and while it should make fair assessments of the requirements of the Centre and the states, it should simply ignore this additional term. If the Centre wants to increase allocation to defence and make it non-lapsable, it could very well do so from its consolidated fund.

(The writer is Chief economic advisor, Brickwork Ratings. Views are personal)

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