This year’s Union budget was accompanied by the unveiling of the Fifteenth Finance Commission’s report for the period 2021-22 to 2025-26. This report outlines some crucial recommendations for state governments, covering tax devolution, grants from the Centre, and the guidelines for the borrowings that they are permitted to incur over the medium-term.

Context

The Finance Commission is a constitutional body formed by the President of India to give suggestions on centre-state financial relations.
The 15th Finance Commission was required to submit two reports. The commission’s chairman is N. K. Singh, with its full-time members being Ajay Narayan Jha, Ashok Lahiri and Anoop Singh.
The first report, consisting of recommendations for the financial year 2020-21, was tabled in Parliament on February 1, 2020.

Background

What is the Finance Commission?

The Finance Commission (FC) was established by the President of India in 1951 under Article 280 of the Indian Constitution.
It was formed to define the financial relations between the central government of India and the individual state governments.
The Finance Commission (Miscellaneous Provisions) Act, 1951 additionally defines the terms of qualification, appointment and disqualification, the term, eligibility and powers of the Finance Commission.
As per the Constitution, the FC is appointed every five years and consists of a chairman and four other members.
Since the institution of the First FC, stark changes in the macroeconomic situation of the Indian economy have led to major changes in the FC’s recommendations over the years.

Constitutional Provisions

Several provisions to bridge the fiscal gap between the Centre and the States were already enshrined in the Constitution of India, including Article 268, which facilitates levy of duties by the Centre but equips the States to collect and retain the same.

Article 280 of the Indian Constitution defines the scope of the commission:

The President will constitute a finance commission within two years from the commencement of the Constitution and thereafter at the end of every fifth year or earlier, as the deemed necessary by him/her, which shall include a chairman and four other members.
Parliament may by law determine the requisite qualifications for appointment as members of the commission and the procedure of selection.
The commission is constituted to make recommendations to the president about the distribution of the net proceeds of taxes between the Union and States and also the allocation of the same among the States themselves. It is also under the ambit of the finance commission to define the financial relations between the Union and the States. They also deal with the devolution of unplanned revenue resources.

Important functions

Distribution of net proceeds of taxes between Center and the States, to be divided as per their respective contributions to the taxes.
Determine factors governing Grants-in-Aid to the states and the magnitude of the same.
To make recommendations to the president as to the measures needed to augment the Fund of a State to supplement the resources of the panchayats and municipalities in the state on the basis of the recommendations made by the finance commission of the state.
Any other matter related to it by the president in the interest of sound finance.

Members of the Finance Commission

The Finance Commission (Miscellaneous Provisions) Act, 1951 was passed to give a structured format to the finance commission and to bring it to par with world standards.
It laid down rules for the qualification and disqualification of members of the commission, and for their appointment, term, eligibility and powers.
The Chairman of a finance commission is selected from people with experience of public affairs. The other four members are selected from people who:

Are, or have been, or are qualified, as judges of a high court,
Have knowledge of government finances or accounts, or
Have had experience in administration and financial expertise; or
Have special knowledge of economics

Major Highlights of the Report 2021-26

The final report with recommendations for the 2021-26 period was tabled in Parliament on February 1, 2021. Key recommendations in the report for 2021-26 include:

[A] Share of states in central taxes

Vertical devolution: The share of states in the central taxes for the 2021-26 period is recommended to be 41%, same as that for 2020-21.
This is less than the 42% share recommended by the 14^th Finance Commission for 2015-20 periods.
The adjustment of 1% is to provide for the newly formed union territories of Jammu and Kashmir, and Ladakh from the resources of the centre.

[B] Criteria for devolution

Table below shows the criteria used by the Commission to determine each state’s share in central taxes, and the weight assigned to each criterion.
The criteria for distribution of central taxes among states for 2021-26 period is same as that for 2020-21.
However, the reference period for computing income distance and tax efforts are different (2015-18 for 2020-21 and 2016-19 for 2021-26), hence, the individual share of states may still change.

Table : Criteria for Horizontal Devolution

Criteria	14^thFC 2015-20	15^thFC 2020-21	15^th FC 2021-26
Income Distance	50.0	45.0	45.0
Area	15.0	15.0	15.0
Population (1971)	17.5	–	–
Population (2011)^#	10.0	15.0	15.0
Demographic Performance	–	12.5	12.5
Forest Cover	7.5	–	–
Forest and Ecology	–	10.0	10.0
Tax and fiscal efforts*	–	2.5	2.5
Total	100	100	100

Income distance: Income distance is the distance of a state’s income from the state with the highest income.
Demographic performance: The Commission was required to use the population data of 2011 while making recommendations. The demographic performance criterion has been used to reward efforts made by states in controlling their population. States with a lower fertility ratio will be scored higher on this criterion.
Forest and ecology: This criterion has been arrived at by calculating the share of the dense forest of each state in the total dense forest of all the states.
Tax and fiscal efforts: This criterion has been used to reward states with higher tax collection efficiency. It is measured as the ratio of the average per capita own tax revenue and the average per capita state GDP during the three years between 2016-17 and 2018-19.

[C] Grants

Over the 2021-26 periods, the following grants will be provided from the centre’s resources:

(1) Sector-specific grants

Sector-specific grants of Rs 1.3 lakh crore will be given to states for eight sectors. A portion of these grants will be performance-linked.
He sectors are: (i) health, (ii) school education, (iii) higher education, (iv) implementation of agricultural reforms, (v) maintenance of PMGSY roads, (vi) judiciary, (vii) statistics, and (viii) aspirational districts and blocks.

(2) State-specific grants

The Commission recommended state-specific grants of Rs 49,599 crore.
These will be given in the areas of: (i) social needs, (ii) administrative governance and infrastructure, (iii) water and sanitation, (iv) preservation of culture and historical monuments, (v) high-cost physical infrastructure, and (vi) tourism

(3) Grants to local bodies

Grants to local bodies (other than health grants) will be distributed among states based on population and area, with 90% and 10% weightage, respectively.
No grants will be released to local bodies of a state after March 2024 if the state does not constitute State Finance Commission and act upon its recommendations by then.

(4) Disaster risk management

The Commission recommended retaining the existing cost-sharing patterns between the centre and states for disaster management funds.
The cost-sharing pattern between centre and states is: (i) 90:10 for north-eastern and Himalayan states, and (ii) 75:25 for all other states.
State disaster management funds will have a corpus of Rs 1.6 lakh crore (centre’s share is Rs 1.2 lakh crore).

[D] Fiscal roadmap

(1) Fiscal deficit and debt levels

The Commission suggested that the centre bring down fiscal deficit to 4% of GDP by 2025-26.
For states, it recommended the fiscal deficit limit (as % of GSDP) of: (i) 4% in 2021-22, (ii) 3.5% in 2022-23, and (iii) 3% during 2023-26.
It recommended forming a high-powered inter-governmental group to: (i) review the Fiscal Responsibility and Budget Management Act (FRBM), (ii) recommend a new FRBM framework for centre as well as states, and oversee its implementation.

(2) Revenue mobilization

Income and asset-based taxation should be strengthened, recommended the commission.
To reduce excessive dependence on income tax on salaried incomes, the coverage of provisions related to tax deduction and collection at source (TDS/TCS) should be expanded.
Stamp duty and registration fees at the state level have large untapped potential.

(3) GST

Revenue neutrality of GST rate should be restored which has been compromised by multiple rate structure and several downward adjustments.
Rate structure should be rationalized by merging the rates of 12% and 18%.
States need to step up field efforts for expanding the GST base and for ensuring compliance.

(4) Financial management practices

A comprehensive framework for public financial management should be developed.
An independent Fiscal Council should be established with powers to assess records from the centre as well as states.
The Council will only have an advisory role.

[E] Other recommendations

(1) Health

States should increase spending on health to more than 8% of their budget by 2022.
Primary healthcare expenditure should be two-thirds of the total health expenditure by 2022.
All India Medical and Health Service should be established.

(2) Defence and internal security

A dedicated non-lapsable fund called the Modernization Fund for Defence and Internal Security (MFDIS) should be established.
It will primarily bridge the gap between budgetary requirements and allocation for capital outlay in defence and internal security.
The fund will have an estimated corpus of Rs 2.4 lakh crore over the five years (2021-26). Of this, Rs 1.5 lakh crore will be transferred from the Consolidated Fund of India.
Rest of the amount will be generated from measures such as disinvestment of defence public sector enterprises, and monetisation of defence lands.

(3) Centrally sponsored schemes (CSS)

A threshold should be fixed for annual allocation to CSS below which the funding for a CSS should be stopped (to phase out CSS which outlived its utility or has insignificant outlay).
Third-party evaluation of all CSS should be completed within a stipulated timeframe.
Funding pattern should be fixed upfront in a transparent manner and be kept stable.

Criticisms of the report

(1) 2011 census population as criteria

The commission’s proposal to use the 2011 Census figures as the basis to allocated union tax revenues will adversely affect the ability of Tamil Nadu and Kerala to provide an effective welfare state for their residents.
The basis for this claim is that southern states have (through a combination of improved health and education) reduced birth rates and total fertility rates far more than the northern states,.
Thus allocation union tax revenues on the basis of population will “punish” the southern states for following sensible policies.

(2) Creating a regional divide

In spite of this balancing act, however, the South has lost out. This yet again creates a North-South divide.
Karnataka was the biggest loser, with its share being slashed from 4.71% to 3.65%.
Of the five biggest losers, four are the southern states of Kerala, Karnataka, Andhra Pradesh and Telangana.

Significance of FC recommendations

As a federal nation, India suffers from both vertical and horizontal fiscal imbalances.
Vertical imbalances between the central and state governments result from states incurring expenditures disproportionate to their sources of revenue, in the process of fulfilling their responsibilities.
However, states are better able to gauge the needs and concerns of their inhabitants and therefore more efficient at addressing them.
Horizontal imbalances among state governments result from differing historical backgrounds or resource endowments, and can widen over time.

Conclusion

The positive of India being a political and economic union is what the XVFC tries to convey.
However, FCs has always struggled in balancing between ensuring equitable fund distribution among regions and fair fiscal federalism.
The best way forward would be to adhere to the letter and spirit of the constitution by balancing the Union and state’s revenue powers with expenditure responsibilities listed in the 7th schedule.
The government must appreciate the problems raised by states, and attempt to address the contemporary issues relevant to the terms of reference.

The report starts with the famous quote of Mahatma Gandhi: “The future depends on what we do in the present”. It would be interesting to see the impact of these overarching and revolutionary recommendations in the times ahead.