More climate change variables needed in 16th Finance Commission’s tax distribution formula, say experts

As the union government gears up to constitute the 16^th Finance Commission (FC) – the constitutional body for centre-state financial relations – experts recommend including variables related to climate change, beyond forest cover, to determine the division of tax revenue among states. So far, the last two Finance Commissions, which cover a period of ten years, focused solely on forest cover within the climate change criterion that was incorporated into the Terms of Reference (TOR) for the 13^th FC. Based on the TOR determined by the central government, FC gives a formula for sharing tax revenue, between union and state and also among states themselves.

With climate change challenges increasing, experts say there is a need for composite formulae that include other climate-change related variables such as biodiversity, ecosystem services etc.

Lekha Chakraborty, a professor at the National Institute of Public Finance and Policy (NIPFP), told Mongabay India that climate change is dynamic and forest cover is just one dimension of it. The need to incorporate other variables related to climate change is important. However, the 16^th FC has to take a call on whether they want to use a composite formula (that brings together multiple variables) to proxy climate change or a single indicator approach (that focuses on one variable), she said. In a 2021 paper, she wrote about the positives and negatives of the single indicator formula and a composite formula.

Adding more indicators to the formula could increase the incentive to protect and restore forests or direct conservation toward certain types of forests, says environmental economist Jonah Busch, a climate economics fellow at Conservation International, who has done extensive research on the tax devolution formula and its impact in India and globally. He gives the example of the Brazilian state of Pará, which allocates funds based on deforestation reduction. The Brazilian state of Tocantins and the Indonesian province of North Kalimantan allocate funds based on forest fire control.

While encouraging a multi-variable formula, both the experts, however, feel that adding other factors may make the formula complex and tough to measure.

An environment and development economist who is associated with Iora Ecological Solution as Senior Economic Advisor, Madhu Verma, says, “We have been advocating quality and area of forest, both should be considered in the devolution formula. A forest represents a biodiversity-rich area and not a monoculture. If the FC wants to address climate change through forest cover, it must look at biodiversity. During the 14^th FC, we gave a 10-parameter formula to measure biodiversity. It was joint work of Iora Ecological Solution and Forest Survey of India (FSI) and Indian Institute of Forest Management (IFM),” she said.

Verma added, “I will rather say the whole set of ecosystem services should be considered as a factor. The FC can look at whether states are able to protect the forest or not. Similarly, there is a possibility that monoculture is promoted as forest. It does not serve any purpose and is not the true value of allocating money to forests.”

The untied fund legacy

The Finance Commission’s formulae for tax sharing have evolved since the first one, constituted in 1951, for the period 1952-1957. Since then, FCs have been constituted at intervals of every five years with the 15th one currently being implemented and the 16th FC, to be constituted in November and applicable starting next year.

Initially, the formula for distributing tax among states respectively, known as horizontal devolution, gave significant weightage, around 80% to 90%, to the population of the states, meaning states with higher population were given a higher share of the tax. Then, the 7^th FC drastically reduced the weightage assigned to the population to 25% and increased the weightage given to equity, in which income, land area, and sometimes infrastructure and fiscal discipline too, played a significant role in determining how much each state would receive from the central government.

Similarly, there have been changes in determining the funds allocation for environmental initiatives. The 12^th and 13^th FCs, which covered the period from 2005 to 2015, gave specific-purpose grants to states, for forestry, amounting to Rs. 10 billion and Rs. 50 billion, respectively. However, it is important to note that these grants comprised less than 0.05% of the total funds transferred from the central government to the states, says Jonah Busch.

Ecological Fiscal Transfers (EFT) – where public revenue is shared based on ecological indicators – were introduced in 2015 with the 14^th FC which incorporated forest cover as a criterion for tax devolution, allocating it a weightage of 7.5% in the distribution formula for the tax transfer during the period 2015-16 to 2019-2020.

The total funds allocated for the states during the 14^th FC were an estimated Rs. 47.06 trillion (lakh crores), shared Madhu Verma, during a workshop with Mongabay India. Approximately Rs. 3.53 trillion was attributed to the forestry sector within this allocation, which is a 7.5% weightage in the distribution formula.

The 15^th FC retained the variable of forest cover for tax distribution, increasing the weightage to 10%, which translates to a projected tax devolution of Rs. 4.22 trillion over five years to states, based on their forest cover.

Commenting over the shift from 12^th FC to now, Jonah Busch says that fiscal transfers that are earmarked for a specific department or programme have traditionally been much smaller than fiscal transfers to the general state budget. For example, the specific-purpose grants for forestry under the 12^th and 13^th FC were a fraction of the general-purpose transfers (those not assigned to specific purpose) that followed under the 14^th and 15^th FC.

The formula-based finance commission transfers are unconditional and are not tied to the department of Forest or Ecology.

On whether there is a need for conditions to ensure the funds are invested in the environment, Busch says that, at least in principle, the enticement of receiving larger general-purpose transfers should motivate states to invest in forest protection.

Chakraborty from NIPFP adds that FC transfers are unconditional and provide fiscal autonomy for states to prioritise expenditure decisions. It is important to continue this criterion related to climate change in the fiscal devolution formula. Changing the strategy from unconditional to conditional transfers is not required by eliminating the criterion on climate change from the scientific devolution formula. “However, I have no hesitation to support conditional transfers for states based on climate change-related requirements, in addition to the unconditional transfers, but not by eliminating the existing criterion in the tax-transfer formula,” she added.

Since 2005, the central government has been sharing annual forest grants to states which are intended both as compensation mechanisms and incentive mechanisms, it remains unclear how much the grants for forests have contributed to increased forest cover in the states.

Two studies, one published in Environmental Research Communications in 2020, and another published in Economic and Political Weekly (EPW) in 2022, concluded that there is no significant change in the state’s forestry budget despite the fact that they received incentives (through EFT) for maintaining land under forest.

The study published in EPW stated, “Forest preservation in whatever form did not result in higher allocations for forests by the states across the periods covered by the 12^th, 13^th, and 14^th FCs.” The study found that there is no significant impact of EFT (which was introduced in the 14th FC) on forest cover too.

The study, Fiscal Transfer for Forest Cover, analysed the biennial State of Forest Reports by the Forest Survey of India (FSI) up to 2019 and found that between 2007 and 2019, the overall percentage of land covered by forests increased slightly from 20.87% to 21.52%. However, states with high forest cover experienced a loss of forested acreage, while states with lower initial cover gained forested land. The paper also emphasised the role of the Compensatory Afforestation Fund Management and Planning Authority (CAMPA), which allows for converting forest land to non-forest uses under certain conditions. It found that states receiving a larger share of compensatory funds through CAMPA had a higher percentage of forest land diverted.

Verma told Mongabay India that the allocation to the forest sector’s contribution came as a grant till the 13th FC which was very small amount. The 14th and 15th FC saw increases through inclusion in the formula of divisible pool of taxes which has gone to the states but within the states, the compensatory money did not go to forest department and hence could not serve any purpose of incentivising conservation of forests of states. “Thus, 16th FC may like to ensure the true value and intent of allocation to forests,” she adds.

Jonah Busch notes that EFTs, worldwide, are gaining momentum to compensate sub-national governments for environmental protection efforts. He states that EFT has significantly increased globally, from $0.35 billion in 2007 to $23 billion in 2020, spanning countries like Brazil, Portugal, France, China, and, notably, India. Indonesia and Malaysia have also introduced national EFT programmes. However, when assessing its impact on India’s forests, Busch notes that as of 2020, EFT had not led to a noticeable increase in forest cover or state forestry budgets. Nevertheless, he acknowledges that this assessment was made before the 15^th FC sent a strong signal to states by increasing the share of forest-dependent revenue from 7.5% to 10% and updating the year for measuring forest cover, he adds.

Banner image: Deer park on the way to Tirumala. The last two Finance Commissions, which cover a period of ten years, focused solely on forest cover within the climate change criterion. Photo by Hemanth/Wikimedia Commons.