Recently, the Sixteenth Finance Commission was chaired by economist Arvind Panagariya in Tamil Nadu. Tasked with addressing the pressing fiscal challenges facing India, the Commission has a critical role in rectifying imbalances between the Union and the States.

Opportunities and Challenges

• The Commission’s work coincides with profound changes in the global economy, particularly trends like “friendshoring” (relocating supply chains to allied countries) and “reshoring” (bringing production back to home countries). 
• These shifts in international trade and investment present new opportunities for India, especially for industrially advanced States like Tamil Nadu. 
• However, seizing these opportunities requires a delicate balance between equitable redistribution of resources to less-developed States and incentivizing growth in high-performing States.

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The Need for a New Fiscal Approach

• Since the establishment of the first Finance Commission in 1951, the goal has been to ensure equitable distribution of resources between the Union and the States. This has been done through:
  • Vertical Devolution: Allocating a share of the divisible tax pool between the Union and the States.
  • Horizontal Devolution: Redistributing resources among States, with a focus on addressing disparities.
• However, gaps between declared goals and outcomes have persisted. 
  • For instance, while the Fifteenth Finance Commission allocated 41% of the divisible tax pool to the States, the actual devolution amounted to only 33.16% of the Union’s gross tax revenue during the first four years of the award period. 
  • This shortfall is attributed to the Union’s increased reliance on cesses and surcharges, which are excluded from the divisible pool.

Recommendations for Reform

• Enhancing States’ Share:  The States’ share in the divisible pool should be increased to 50% of gross central taxes, ensuring greater fiscal autonomy.
  • This will enable States to fund and implement schemes tailored to local needs, reducing their dependence on centrally sponsored schemes that often require substantial counterpart funding.  
• Rethinking Horizontal Devolution: The current approach of redistributing resources heavily in favor of less-developed States has not consistently driven real growth. A more balanced policy is needed.
  • A progressive resource allocation methodology can incentivize high-performing States to become growth engines, driving national prosperity.
• Addressing Unique Challenges of Progressive States: States like Tamil Nadu, despite their progress, face unique demographic and urbanization challenges:
  • Demographic Shift: Tamil Nadu’s aging population, with a median age above the national average, reduces consumption-based tax revenue and increases the cost of supporting the elderly. 
    • Without targeted support, the state risks falling into the “middle-income trap” where growth stagnates before reaching higher income levels.
  • Rapid Urbanization: The state’s urban population is projected to reach 57.3% by 2031, well above the national average of 37.9%.
    • This rapid urbanization requires significant infrastructure investment to support sustainable growth and address emerging urban challenges.

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Conclusion 

While these recommendations emphasize empowering high-performing States to maximize their growth potential, it is crucial to ensure that less-developed States are not sidelined. These States require continued support to address structural challenges and reduce disparities. A balanced and strategic approach is essential—one that fosters national economic growth while ensuring equitable resource distribution to uplift poorer States alongside high-performing ones.

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