For the first time, the terms of reference given to the Finance Commission of India included the aspect of fund allocation for modernisation of defence forces (capital outlay for defence forces, minus allocation for land and works) and the internal security apparatus. Accordingly, the report submitted by the Fifteenth Finance Commission, covering the period 2021-2026, includes a chapter (Chapter 11) on the subject, with some key recommendations. The main recommendation is to constitute a dedicated, non-lapsable, Modernisation Fund for Defence and Internal Security (MFDIS), under the Public Accounts of India, with standard reporting and audit requirements. The chapter has delineated the fund requirements for internal security, to be managed by the Ministry of Home Affairs.

It has long been argued that one of the major reasons for sub-optimal defence modernisation in India is the lack of clarity and commitment of financial allocations, related to long-term and short-term plans. While the Long-term Integrated Perspective Plans (LTIPP) of the armed forces, covering a period of 15 years, have been based on an indicative percentage growth anticipated in fund allocation, the Five Year Defence Plans have been subjected to greater scrutiny at the Ministry of Defence (Finance) and the Ministry of Finance (MOF); defence five-year plans have been continued, though national level five-year plans were discontinued after a decision in 2015. It is also learnt that the Department of Military Affairs is working on a Defence Capability Integrated Plan, to cover a period of ten years.

There have been instances when defence five-year plans were not approved, despite detailed and protracted discussions. In some cases, the plan was approved late, during the plan period. Even when priority was accorded and timeliness of approval ensured, the next challenge of fund allocation in line with the plan estimates often became insurmountable. During the 7th plan (1987-1992), against an envisaged requirement of INR 71,398 crore, the allocation was INR 51,188 crore. During first three years of the 13th plan (2017-2022), the shortfall has been reported as INR 7,37,357 crore It is widely recognised that shortfalls between allocations envisaged and funds actually made available have been a recurring theme, leading to capability gaps. This aspect has been repeatedly highlighted by the Standing Committee of the Parliament on Defence. Given this background, it was a welcome step to ask the finance commission to examine the issue holistically against the backdrop of overall resource assessment, fiscal management, and devolution.

The finance commission has pointed out that over the last ten years; the defence budget has shown a trend growth rate (TGR) of 9.6 percent (revenue 11 percent, capital 6.1 percent). The actual capital expenditure has shown a TGR of 5.7 percent since 2011-12. As per data provided by the Ministry of Defence (MOD) to the finance commission, the total plan projection for 2021-26 is INR 17, 46,000 crore and the estimated allocation is INR 9,01,000 crore. The projected shortfall, therefore, is INR 8, 45,000 crore. Revenue and capital projections have been based on annual growth rate of 7 percent and 16 percent respectively. It can be seen that this is quite opposite of the TGR of the last ten years, and unless suitable policy interventions are made, the wide gap between plans and TGR would continue.

The report has taken into account inputs and suggestions from ministries/departments and other stakeholders, particularly with respect to increasing the resource pool for modernisation. Expectedly, states indicated that they were against any reduction in the divisible pool, a view that was accepted by the commission, with due consultation on legal issues and constitutional mandate. To bridge the gap between allocations and actual requirements for modernisation (capital), through supplemental support to annual budgets, the finance commission has recommended recalibration of the relative shares of the Union and States in gross revenue receipts, by reducing the commission grants component by 1 percent. This is expected to leave a sum of INR 1,53,354 crore with the Union government, for the period 2021-26.

It has further recommended that the government raise an amount of INR 85,000 crore through four specific sources identified, which are, transfer from the Consolidated Fund of India, disinvestment proceeds of Defence Public Sector Enterprises (DPSEs), proceeds from monetisation of defence lands, and receipts for lands likely to be transferred for public projects. The total recommended size of the MFDIS, for the period 2021-26 is INR 2,38,354 crore. It has clarified that only this pool will be non-lapsable, and any unused portion of annual budget will continue to be governed by extant provisions. An empowered committee will operate the MFDIS, with maximum annual outgo capped at INR 51,000 crore (any amount exceeding this will be deposited in the Consolidated Fund of India). From the projections for capital budget indicated by the MOD, and the annual size of MFDIS recommended by the finance commission, it can be seen that gap funding through this route can be around 28 percent (of projections) in 2021-22, declining to around 21 percent in 2025-26.

The concept of a dedicated fund, for supplemental support to annual defence budget, has many potential benefits. It should enable reversal of TGR currently skewed in favour of revenue budget, arrest the trend of declining capital outlay as a percentage of defence expenditure, and provide much-needed funding support for modernisation. Though it does not directly delve into the subject of programme budgeting, it can facilitate better linkage between plans, programmes and resource allocation, which in turn would improve management and control. More work would however need to be done, to address the twin objectives of predictability and gap-funding. With fiscal uncertainty at an all-time high, and a target of debt and fiscal consolidation in medium-term (to bring down combined fiscal deficit from estimated 11.6 percent to about 6.8 percent in 2025-26), predictability based only on annual budgets may be difficult.

In the beginning, the primary source for additional funding is likely to be from the Consolidated Fund of India, since monetisation of defence lands and disinvestment of DPSEs have long gestations periods and high levels of uncertainty. Views on surrender of defence lands may also vary, taking into account any requirements for the future. Monetisation of encroached lands will have added complexities, and higher uncertainty about timelines. The overall experience with respect to disinvestment targets in Union budgets is also a pointer with regard to disinvestment of DPSEs. Since the aim is to bring predictability (and hence reduce uncertainty), managing inward flow from identified sources, other than the Consolidated Fund of India, will be a major challenge.

In the action taken report tabled in the Parliament, the government has indicated in-principle acceptance of the recommendation of setting up MFDIS. It has also stated that details and modalities for implementation will be worked out. Since the period of currency of the finance commission has already commenced with effect from 1 April 2021, there is a need to finalise the implementation plan soon. The government should announce the size of the MFDIS, annual supplemental support for each financial year, as well as annual cap limits. It would also be useful to align the Defence Plan periods with that of the finance commission, to enable review by successive finance commissions. A mid-term review of MFDIS can also be aligned with medium-term expenditure framework statement, as required by the Fiscal Responsibility and Budget Management Act.

Institution of MFDIS should also enable more accurate fiscal guidance for defence plans, with a limited margin of error. Availability of MFDIS should not influence or restrict annual budgetary allocations, as the same would defeat the primary objective of gap funding. It should also lead to approval of defence plans that are aligned better with indicative budgetary support for five years, instead of a broad-brush percentage assumption, which the planners themselves are sceptical about. The challenges of acquisition process and capital expenditure management will remain, but availability of non-lapsable fund will provide some cushion. A new opportunity has been created to move from statistical to output-oriented planning and budgeting. This can include using part of MFDIS towards projects that require new technologies, and consequently R&D, both in private and public sectors, to reduce dependence on foreign sources for some hi-tech equipment. A sound template, effective implementation and speedy execution of MFDIS would provide the desired fillip to defence modernisation in India. It can be a major step in refining the resource allocation process for defence forces, and making it more responsive to the emerging external and internal environments.