Finance Commission – Issues related to devolution of resources
States and the challenge before the Finance Commission
Note4Students
From UPSC perspective, the following things are important :
Mains level: Issues related to the Devolution of funds;
Why in the News?
Recently, Tamil Nadu hosted the Sixteenth State Finance Commission, highlighting the need for fair resource allocation to performing states and addressing fiscal imbalances between the Union and states.
What are the primary challenges faced by State Finance Commissions?
- Vertical Fiscal Imbalance: There is a significant disparity in revenue-raising capabilities between the Union and state governments. The Union holds greater powers to generate revenue, while states bear most of the expenditure responsibilities. This imbalance has led to insufficient funds for states to meet developmental needs.
- Inequitable Resource Distribution: Despite efforts to achieve equitable redistribution through vertical and horizontal devolution, actual outcomes often fall short of expectations.
- For instance, the Fifteenth Finance Commission’s effective devolution was only 33.16% of the Union’s gross tax revenue, despite a declared share of 41%.
- Inadequate Devolution: The increasing reliance on cess and surcharges by the Union government has further constrained the financial resources available to states. This trend undermines the intended fiscal autonomy that states require to implement local schemes effectively.
- Demographic and Urbanization Challenges: Progressive states like Tamil Nadu face unique challenges related to ageing populations and rapid urbanisation, which strain their fiscal capacities while necessitating increased investment in infrastructure and services.
How can compliance with constitutional mandates be improved?
- Strengthening Legal Frameworks: Ensuring that SFCs operate within a robust legal framework that mandates transparency and accountability can enhance compliance with constitutional directives. This includes clearer guidelines on resource allocation and devolution processes.
- Public Disclosure: Mandating public disclosure of financial data and project details in accessible formats can foster greater transparency and allow for citizen engagement in governance, thereby ensuring that SFCs adhere more closely to their constitutional roles.
- Participatory Budgeting: Encouraging participatory budgeting practices can help align state financial decisions with local needs, ensuring that resources are allocated in a manner that reflects constitutional mandates for equitable development across regions.
What reforms are necessary to enhance the effectiveness of SFCs?
- Revising Devolution Principles: A reassessment of the principles governing vertical and horizontal devolution is essential to create a fairer distribution system that recognizes both the needs of less-developed states and the contributions of high-performing states like Tamil Nadu.
- Augmenting State Resources: Increasing the share of gross central taxes allocated to states from 41% to at least 50% could provide states with greater fiscal autonomy, allowing them to fund locally relevant initiatives effectively.
- Focus on Growth Incentives: Developing a progressive resource allocation methodology that rewards high-performing states can stimulate economic growth while ensuring that less-developed states also receive adequate support for their development needs.
- Addressing Urbanization Needs: Specific reforms aimed at addressing urbanization challenges—such as earmarking funds for infrastructure development—will be crucial for progressive states experiencing rapid urban growth.
Conclusion: State Finance Commissions must address fiscal imbalances, enhance devolution principles, and prioritise growth incentives to empower states. This is vital for achieving Sustainable Development Goals (SDGs) through equitable and inclusive development.
Mains PYQ:
Q Discuss the recommendations of the 13th Finance Commission which have been a departure from the previous commissions for strengthening the local government finances. (UPSC IAS/2013)
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Finance Commission – Issues related to devolution of resources
What is Vertical Fiscal Imbalance?
Note4Students
From UPSC perspective, the following things are important :
Prelims level: Finance Commission
Mains level: Vertical Fiscal Imbalance (VFI) in India;
Why in the News?
The financial relationship between the Union and State governments in India is imbalanced, similar to other nations with a federal constitutional structure.
What is Vertical Fiscal Imbalance (VFI)?
Vertical fiscal imbalance (VFI) refers to the mismatch between the revenue-raising powers and expenditure responsibilities of different levels of government (between the Center and state) within a country.
Why should Vertical Fiscal Imbalance (VFI) be reduced?
- Decentralization of Expenditure: States are responsible for 61% of the revenue expenditure, focusing on crucial sectors like health, education, and infrastructure, but they generate only 38% of the revenue.
- This imbalance creates a dependency on central transfers, limiting the States’ fiscal autonomy.
- Need Efficiency in Spending: Reducing VFI would provide states with more resources, allowing them to respond better to local needs and improve governance efficiency.
- Need to strengthen Fiscal Federalism: A reduction in VFI promotes a healthier system of cooperative federalism, ensuring that states have adequate resources to carry out their constitutional responsibilities and meet the demands of their populations.
- Need Preparedness for crises: VFI becomes more pronounced during crises (e.g., COVID-19), leading to fiscal stress for States. A more balanced fiscal arrangement ensures better crisis management at the sub-national level.
Present Scenario of VFI and Tax Devolution in India
- VFI Extent: The 15th Finance Commission noted that despite States‘ heavy spending responsibilities, their revenue-raising powers are limited.
- Tax Devolution Rates: The 14th and 15th FC recommended devolving 42% and 41%, however, estimates suggest that an average share of 48.94% was necessary between 2015-2023 to eliminate the VFI.
- Exclusion of Cesses and Surcharges: The exclusion of cesses and surcharges from the divisible pool of taxes shortens the net proceeds. States argue this limits the resources available to them to meet their expenditure responsibilities.
- Fiscal Responsibility: Despite the constraints, states have largely adhered to borrowing limits under fiscal responsibility legislation. However, states still struggle to meet their expenditure responsibilities, highlighting the need for greater financial support from the Centre.
| Note: The Sixteenth Finance Commission was constituted on December 31 2023 with Dr. Arvind Panagariya as the Chairman. The 16th FC has been requested to make its report available by the 31st day of October 2025 covering 5 years commencing on the 1st day of April, 2026. |
What should be the role objective of the 16th FC?
- Increase Tax Devolution: Many States demand that tax devolution from the Union’s net proceeds should be raised to 50%. The 16th Finance Commission must consider raising the devolution rate to around 49% to address the VFI and ensure sufficient untied funds for States.
- Address Cesses and Surcharges: The 16th Finance Commission should evaluate the exclusion of cesses and surcharges from the divisible pool.
- Empower States with Fiscal Autonomy: The Commission’s objective should be to empower States with greater fiscal autonomy by ensuring adequate resources for them to perform their constitutional duties without undue dependence on the Centre.
- Support Local Priorities: The Commission should aim to provide States with untied resources, enabling them to cater to jurisdictional needs and set priorities that align with their specific developmental challenges, ensuring a more responsive governance system.
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Finance Commission – Issues related to devolution of resources
[pib] XVI Finance Commission constitutes Advisory Council
Note4Students
From UPSC perspective, the following things are important :
Prelims level: XVI Finance Commission and its terms of references
Why in the News?
The Sixteenth Finance Commission (chaired by Arvind Panagariya, the former Vice-Chairman of NITI Aayog) has constituted an Advisory Council of five members.
Role and Functions of the Advisory Council
- To advise the Commission on any of the Terms of Reference (ToR) or related subjects that may be of relevance.
- To assist in the preparation of papers or research studies and to monitor or assess studies commissioned by the Finance Commission, thereby enhancing the Commission’s understanding of the issues in its ToR.
- To help broaden the Commission’s ambit and understanding by seeking the best national and international practices on matters pertaining to fiscal devolution and improving the quality, reach, and enforcement of its recommendations.
About Finance Commission
- The Finance Commission is a Constitutional body created every five years to transfer financial resources from the centre to states.
- It is a quasi-judicial body.
- The origin of the Finance Commission lies in Article 280 of the Constitution.
- The President of India shall constitute a Finance Commission every five years to give recommendations about the transfer of central revenues (tax) to the states and its allocation among them (states).
- The recommendations of the Fifteenth Finance Commission are valid up to the financial year 2025-26.
Composition of the FC:
- The Finance Commission consists of a chairman and four other members appointed by the President.
- They hold office for such a period as specified by the president in his order and are eligible for reappointment.
Qualifications:
- Parliament determines the qualifications of members of the commission and the manner in which they should be selected.
- Chairman should be a person having experience in public affairs, and
- Four other members should be selected from amongst individuals with specialized knowledge of finance, accounts, economics, or administration.
Terms of Reference for 16th Finance Commission
- Division of Tax Proceeds, principles for Grants-in-Aid, enhancing State Funds for Local Bodies and evaluation of Disaster Management Financing
PYQ:[2023] Consider the following:
For the horizontal tax devolution, the Fifteenth Finance Commission used how many of the above as criteria other than population area and income distance? (a) Only two |
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Finance Commission – Issues related to devolution of resources
What is on the agenda for the 16th Finance Commission?
Note4Students
From UPSC perspective, the following things are important :
Prelims level: Finance Commission
Mains level: Role of Finance Commission
Why in the news?
The 16th Finance Commission, under Article 280, focuses on devolving funds. Amendments like 73rd and 74th mandate it to bolster state funds for panchayats and municipalities.
About 16th Finance Commission
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How do other countries devolve funds to their local governments?
- International Comparison: Countries like South Africa, Mexico, the Philippines, and Brazil allocate significantly higher percentages of their GDP (1.6% to 5.1%) to urban local bodies compared to India’s 0.5%.
- Importance of Intergovernmental Transfers (IGTs): IGTs make up about 40% of Urban Local Bodies (ULBs) revenue in India but suffer from unpredictability, lack of earmarking for vulnerable groups, and horizontal equity.
- Financial Health of ULBs: Despite efforts by multiple Finance Commissions, financial devolution to cities in India remains inadequate, affecting city productivity and quality of life.
Why is the Census significant?
- Data Dependence: The absence of the 2021 Census data makes it challenging to accurately assess urban growth and demographic changes crucial for evidence-based fiscal devolution.
- Urban Dynamics: India has approximately 4,000 statutory towns, an equal number of Census towns, and a large number of effectively urban villages, which need accurate enumeration for effective planning and resource allocation.
- Migration Impact: The Census data is essential to capture the significant migration to Tier-2 and Tier-3 cities, impacting their infrastructure and service needs.
What about cities and the Taxation system?
- Impact of GST: The introduction of GST has reduced ULBs’ tax revenue (excluding property tax) significantly, impacting their financial autonomy.
- Low IGTs: Intergovernmental transfers from States to ULBs in India are minimal (around 0.5% of GDP), much lower than other developing nations, exacerbating fiscal challenges.
- Constitutional Provisions: Despite the 74th constitutional amendment aimed at empowering ULBs, progress has been limited over three decades, hampering urban development.
- Parallel Agencies: The growth of parallel agencies and schemes like MP/MLA Local Area Development Schemes distort the federal structure and weaken ULBs’ financial and operational autonomy.
Way forward:
- Enhanced Intergovernmental Transfers (IGTs): Increase IGTs from States to Urban Local Bodies (ULBs) to at least 2% of GDP, ensuring predictability and earmarking for vulnerable groups.
- Reform in Urban Governance and Fiscal Autonomy: Strengthen constitutional provisions to empower ULBs further, reducing dependence on parallel agencies like MP/MLA Local Area Development Schemes.
Mains PYQ:
Q How is the Finance Commission of India constituted? What do you know about the terms of reference of the recently constituted Finance Commission? Discuss. (UPSC IAS/2018)
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Finance Commission – Issues related to devolution of resources
Finance Commission and Indian cities
Note4Students
From UPSC perspective, the following things are important :
Prelims level: Finance commission
Mains level: 16th Finance Commission can catalyse municipal-level financial reforms
Why in the news?
With the new Lok Sabha and Union government in place, this final piece focuses on how the 16th Finance Commission can drive substantive public finance reforms for India’s cities.
Note: The Sixteenth Finance Commission has been requested to make its recommendations available by October 31, 2025, covering an award period of 5 years commencing 1st April, 2026.
16th Finance Commission can catalyse municipal-level financial reforms
- Strengthening State Finance Commissions: The Commission should emphasize the need for state governments to constitute state finance commissions on time, provide them with adequate resources, and ensure their recommendations are taken seriously.
- Fiscal Decentralization: The 16th FC should recommend a formula-based approach for predictable fiscal transfers from state governments to municipalities, moving away from the current practice of ad hoc, discretionary grants. This will enhance the financial autonomy of urban local bodies.
- Revenue Optimization: The Commission should incentivize municipalities to enhance their own revenues through measures like property tax reforms, user charges, and leveraging land assets. This will reduce their dependence on state grants and promote fiscal responsibility.
- Fiscal Responsibility and Budget Management: The 16th FC can provide incentives for municipalities to adopt fiscal responsibility and budget management frameworks to accelerate municipal borrowings for infrastructure development. This will enable cities to access capital markets for financing their growth.
- Transparency and Citizen Participation: The 16th FC can encourage municipalities to enhance transparency and citizen participation in urban governance for improved accountability at the neighbourhood level. This will make urban local bodies more responsive to the needs of citizens.
Need for the Reforms
- Inadequate Funding and Resource Utilization: Indian cities face significant financial shortfalls and struggle to effectively utilize the funds they have, leading to underdeveloped infrastructure and services.
- Lack of Accountability: There is minimal accountability regarding how municipal spending improves citizens’ lives, resulting in inefficient use of resources and unmet public needs.
- Fiscal Decentralization: Cities need predictable fiscal transfers for effective planning, but state governments often delay constituting State Finance Commissions (SFCs) and implementing their recommendations.
- Revenue Optimization: Cities underutilize their revenue-generating powers due to outdated valuation processes controlled by state governments. Comprehensive reforms are needed at all stages of revenue collection.
- Transparency and Fiscal Responsibility: The legal framework for financial accounting, reporting, and budgeting is inconsistent across states. Standardized formats, mandatory accounting standards, and management accounting systems are necessary to improve transparency and fiscal responsibility.
Activities by State Governments
- Timely Constitution and Implementation of State Finance Commissions: State governments must ensure the timely establishment and effective implementation of SFC recommendations to support fiscal decentralization and provide predictable funding to cities.
- Updating Valuation Processes: States should regularly update guidance values or circle rates to reflect current market values, enabling cities to optimize revenue collection and ensure financial sustainability.
- Enhancing Legal and Institutional Frameworks: States should establish and enforce standardized formats for financial accounting, reporting, and budgeting to ensure consistency, transparency, and comparability across municipalities.
- Empowering Local Governments: States should delegate reasonable expenditure authority to city councils, reducing dependency on state-level approvals and enabling more efficient and responsive local governance.
- Mandating Transparency and Citizen Participation: States should mandate public disclosure of municipal financial data and project details in machine-readable formats and support the implementation of participatory budgeting to enhance transparency and citizen involvement in governance.
Conclusion: The 16th Finance Commission can drive critical municipal-level financial reforms by strengthening state finance commissions, promoting fiscal decentralization, optimizing revenues, enhancing fiscal responsibility, and encouraging transparency and citizen participation in governance.
Mains PYQ:
Q How is the Finance Commission of India constituted? What do you know about the terms of reference of the recently constituted Finance Commission? Discuss. (15) (UPSC IAS/2018)
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Finance Commission – Issues related to devolution of resources
Premium- Indian Federalism as a Mad Hatter’s Tea Party
Note4Students
From UPSC perspective, the following things are important :
Prelims level: Article 1, Article 3; Finance Commission; NITI Aayog; Federal Ssytem; Emergency Provisions;
Mains level: Issues related to Federalism in India;
Why in the News?
In recent times, the Central government has exerted significant political and financial control over the regional states.
What is Federalism?
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Indian Federalism:
- India opted for a federal form of government because of linguistic and regional diversity. It has dual objectives, to safeguard and promote the unity, and to accommodate regional diversity.
- However, Indian Federalism has been described as quasi-federal since it contains major federation and union features (Article 1 says, “India that is ‘Bharat’, shall be the Union of the states”).
- The central government has more authority, especially in fiscal matters (due to which it is sometimes called “asymmetrical federalism”).
- Federalism is part of the basic structure which cannot be altered or destroyed under the constituent powers of the Parliament without undergoing judicial review by the Supreme Court.
Federal Features
Non-federal features
The Present Political Federal Issues in India:
- Centralization of Power: Certain propositions laid down in the Supreme Court’s judgment, have upheld the prospects of Federalism in India
- For example, the abrogation of Article 370 concerning Jammu and Kashmir’s special status by the central government without adequate consultation with the state government was seen as a move towards the Centralization of power.
- Reorganization of States: The provision under Article 3 of the Constitution states that the President shall refer the Bill for the reorganization of any State to the legislature of the State concerned to elicit its opinion.
- The recent SC’s verdict that dismissed the challenges to the abrogation of Article 370 led to a serious undermining of federalism and the rights of the elected State legislatures.
- Lack of clarity in Division of Powers: Although the subjects are enlisted in the Seventh Schedule and Emergency Provisions of the Constitution, the distribution of power between the Central government and the states lacks clarity and equity.
- For example, internal security assumes utmost importance with the Maoist challenge and cross-border terrorism, which threaten all the states across the country.
- The Constitution does not refer either to ‘security’ or ‘internal security’ anywhere. However, it mentions five related terms namely ‘pubic order’ (List II, Entry 2), ‘war’ (Article 352), ‘external aggression’ (Article 352), ‘armed rebellion’ (Article 352), and ‘internal disturbance’ (Article 355).
- Further, the imposition of President’s Rule in states under Article 356 has been recently criticized for being used arbitrarily by the central government.
- Unequal Representation in Rajya Sabha: The representation of states in Parliament and other federal institutions does not accurately reflect their population, size, or contributions. Some states are over-represented while others are under-represented.
- For example, the allocation of 80 Lok Sabha seats to Uttar Pradesh and only one to Sikkim results in unequal representation, impacting resource distribution and decision-making.
- Simultaneous Elections: Measures discussed and recommended like the “One Nation One Election” undermined India’s federal structure and conflated the different priorities voters had for National, State, and “Panchayati raj” institutions, degrading each one’s different sphere of responsibility.
The Present Fiscal Federal issues in India:
- Fiscal Divisible Pool: The states often face financial constraints due to their dependence on the central government for funds. The unequal distribution of resources can exacerbate disparities among states.
- For example, states like Bihar and Uttar Pradesh receive more funds from the central government under various schemes. However, recently the Kerala government faced serious financial crunches due to a lack of funds.
- Implementation of Goods and Services Tax (GST): GST’s implementation has raised issues related to fiscal autonomy. States have voiced concerns about the loss of their taxation powers and uncertainties regarding compensation from the central government for revenue losses.
Bodies related to the Federal System in India:
Committee Recommendation:
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Way Forward: The Centre cannot afford to ignore the importance of states to effectively respond to the Federal issues:
- Empowerment of State Governments: Strengthen the powers and autonomy of state governments in decision-making processes, allowing them greater authority over issues within their jurisdiction, and revenue management is necessary.
- Promoting Co-operative Federalism: Enhance the effectiveness of the Inter-State Council as a forum for dialogue and cooperation between the Centre and states on matters of common interest, ensuring meaningful participation of state leaders in decision-making processes.
- Need a Balanced Approach: First, the government needs to review and make necessary amendments to clarify the distribution of powers, ensuring a more balanced and transparent framework for political governance. Second, implement a balanced system of grants where states with weaker fiscal capacities receive adequate support to address developmental disparities.
- Bringing Clarity: Clearly define revenue-sharing boundaries and internal security mechanisms between the Centre and states to ensure equitable distribution of resources.
Prelims PYQ
Q) Which one of the following is not a feature of Indian federalism? (UPSC IAS/2017)
- a) There is an independent judiciary in India.
- b) Powers have been clearly divided between the Centre and the States.
- c) The federating units have been given unequal representation in the Rajya Sabha.
- d) It is the result of an agreement among the federating units.
Q) Consider the following statements: (UPSC IAS/2020)
1) The Consititution of India defines its ‘basic structure’ in terms of federalism, secularism, fundamental rights and democracy.
2) The Constitution of India provides for ‘judical review to safeguard the citizens’ liberties and to preserve the ideals on which the Constitution is based.
Which of the Statement given above is/are correct?
- a) 1 only
- b) 2 only
- c) Both 1 and 2
- d) Neither 1 nor 2
Mains PYQ
Q1 How far do you think cooperation, competition and confrontation have shaped the nature of federation in India? Cite some recent examples to validate your answer. (UPSC IAS/2020)
Q2 The concept of cooperative federalism has been increasingly emphasised in recent years. Highlight the drawbacks in the existing structure and the extent to which cooperative federalism would answer the shortcomings.
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Finance Commission – Issues related to devolution of resources
Should State Governments borrow more? | Explained
Note4Students
From UPSC perspective, the following things are important :
Prelims level: Finance Commission; State Government; FRBM Act;
Mains level: Fiscal Federalism and its challenges
Why in the News?
Recently, the SC rejected Kerala’s plea for immediate relief in its case urging the Union government to ease borrowing constraints, allowing the state to secure extra funds in the ongoing fiscal year.
State governments receive funds from three sources:
- Own revenues (tax and non-tax)
- Transfers from the Union government as shares of taxes and as grants
- Market borrowings
Fiscal Demands for Extra Funds:
- Increased Expenditure: In 2020-21, the Kerala government sharply increased its spending to 18% of its GSDP, to provide economic relief in the wake of the COVID-19 pandemic, aided by the relaxation in borrowing norms then
- Central Gov transfers to Kerala declined: As ratios of GSDP, the Union government’s transfers to Kerala declined to 2.8% in 2023-24, significantly lower than previous years, even as the State’s revenues remained at around 8.0%.
- This meant that, in 2023-24, the State government could meet its modest budget expenditure, equivalent to 14.2% of GSDP, only by raising the borrowing to 3.4% of the GSDP
Socio-Economic for Extra Funds:
- Aging Population: Kerala, like many other states, faces the challenge of an aging population, which puts pressure on pension funds and healthcare systems, necessitating long-term financial planning and investment.
- Pension Liabilities: The substantial outgo for pensions poses a financial burden on the state’s budget, requiring strategies for sustainable pension management to ensure fiscal stability.
- Youth Outmigration: Kerala experiences significant outmigration of its youth, leading to a loss of productive workforce and potential tax revenues, highlighting the need for policies to retain skilled workers and stimulate economic growth
About Net Borrowing Ceiling (NBC):
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Basis of the Net Borrowing Ceiling:
- Fiscal Responsibility Legislation: Both the central and state governments in India adhere to the FRBM Act, which establishes fiscal deficit goals to uphold fiscal discipline. Under the FRBM, states are required to maintain a fiscal deficit limit of 3% of the Gross State Domestic Product (GSDP).
- Central Government Guidelines: The central government, through the Department of Expenditure in the Ministry of Finance, sets the annual borrowing limits for each state based on a formula that considers the state’s GSDP, existing debt levels, fiscal discipline, and other relevant factors. These limits can be revised in response to special circumstances, such as natural disasters or significant economic downturns.
- Finance Commission Recommendations: The Finance Commission, which is constituted every five years, recommends how the central taxes are to be divided between the centre and the states and suggests measures to maintain fiscal stability. It also provides recommendations regarding the borrowing limits of states.
Conclusion: States need to put in place an effective forecasting and monitoring mechanism for cash inflows and outflows so that a need-based approach is followed for market borrowings and the interest cost of cash surpluses is minimized.
Mains PYQ
Q What were the reasons for the introduction of Fiscal Responsibility and Budget Management (FRBM) Act, 2013? Discuss critically its salient features and their effectiveness. (UPSC IAS/2013)
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Finance Commission – Issues related to devolution of resources
Explained: Financial Devolution among States
Note4Students
From UPSC perspective, the following things are important :
Prelims level: Article 270, Article 280 (3)
Mains level: Not Much
Introduction
- Several Opposition-ruled states, particularly from southern India, have voiced concerns over the present scheme of financial devolution, citing disparities in the allocation of tax revenue compared to their contributions.
- Understanding the concept of the divisible pool of taxes and the role of the Finance Commission (FC) is crucial in addressing these issues.
Divisible Pool of Taxes: Overview
- Constitutional Provision: Article 270 of the Constitution outlines the distribution of net tax proceeds between the Centre and the States.
- Share of taxes: Taxes shared include corporation tax, personal income tax, Central GST, and the Centre’s share of Integrated Goods and Services Tax (IGST), among others.
- Finance Commission’s Role: Article 280(3) (a) mandates FC, constituted every five years, recommends the division of taxes and grants-in-aid to States based on specific criteria.
- XVI FC: It consists of a chairman and members appointed by the President, with the 16th Finance Commission recently constituted under the chairmanship of Arvind Panagariya for the period 2026-31.
Basis for Allocation: Horizontal and Vertical Devolution
- Vertical Devolution: States receive a share of 41% from the divisible pool, as per the 15th FC’s recommendation.
- Key criteria for horizontal devolution: For horizontal devolution, FC suggested 12.5% weightage to demographic performance, 45% to income, 15% each to population and area, 10% to forest and ecology and 2.5% to tax and fiscal efforts.
- Income Distance: Reflects a state’s income relative to the state with the highest per capita income (Haryana), aiming to maintain equity among states.
- Population: Based on the 2011 Census, replacing the earlier 1971 Census for determining weightage.
- Forest and Ecology: Considers each state’s share of dense forest in the total forest cover.
- Demographic Performance: Rewards states for efforts in controlling population growth.
- Tax Effort: Rewards states with higher tax collection efficiency.
Challenges and Issues
- Exclusion of Cess and Surcharge: Around 23% of the Centre’s gross tax receipts come from cess and surcharge, which are not part of the divisible pool, leading to disparities in revenue sharing.
- Variation in State Contributions: Some states receive less than a rupee for every rupee they contribute to Central taxes, indicating disparities in revenue distribution.
- Reduced Share for Southern States: Southern states have witnessed a decline in their share of the divisible pool over successive FCs, affecting their fiscal autonomy.
Proposed Reforms
- Expansion of Divisible Pool: Including a portion of cess and surcharge in the divisible pool could enhance revenue sharing among states.
- Enhanced Weightage for Efficiency: Increasing the weightage for efficiency criteria in horizontal devolution, such as GST contribution, can promote equitable distribution.
- Greater State Participation in FC: Establishing a formal mechanism for state participation in the FC’s constitution and functioning, akin to the GST council, can ensure a more inclusive decision-making process.
Conclusion
- Addressing issues of financial devolution requires a collaborative approach between the Centre and the States, focusing on equitable distribution and fiscal federalism.
- Reforms in revenue-sharing mechanisms, along with enhanced state participation in decision-making bodies like the FC, are essential for promoting balanced development and resource allocation across the country.
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Finance Commission – Issues related to devolution of resources
Call for imposing Financial Emergency in Kerala
Note4Students
From UPSC perspective, the following things are important :
Prelims level: Financial Emergency under Article 360
Mains level: Not Much
In the news
- The Supreme Court proceeded with hearing a suit filed by the State of Kerala against the Centre for alleged arbitrary interference in its financial matters, following unsuccessful negotiations between the two parties.
- Earlier, Kerala Governor sought for the Presidential imposition of a financial emergency in the State under Article 360(1) of the Constitution due to dwindling situation of finances in the State.
What is Financial Emergency?
- Enshrined in Article 360: It is a vital provision aimed at addressing severe financial crises threatening India’s economic stability.
- Declaration and Authority: It can be declared by the President upon satisfaction that the financial stability or credit of India or any part of its territory is under threat.
- CoM Advice: The declaration is made based on the advice of the Council of Ministers, reflecting the collective responsibility of the executive branch.
Legislative Approval
- While the President can proclaim a Financial Emergency, its extension beyond two months needs approval from both Houses of Parliament.
- Once approved, it remains in effect until revoked by the President, allowing for flexible management of financial crises.
Effects and Implications
- The Centre’s executive authority expands significantly during a Financial Emergency, enabling it to issue directives to states on financial matters.
- Centralization of fiscal policies occurs, with the President empowered to reserve money bills passed by state legislatures for consideration.
- Austerity measures, including salary and allowance reductions for public officials, can be implemented to address economic challenges.
Judicial Review and Criticism
- 38th Amendment Act (1975) made the President’s decision final and immune from judicial review.
- However, the 44th Amendment Act (1978) allowed for judicial scrutiny.
- This amendment ensured checks and balances within the constitutional framework, preventing unchecked executive authority.
Historical Context and Usage
- Financial Emergencies have been sparingly invoked in India’s history, despite facing significant financial crises such as in 1991.
- The cautious utilization of this provision underscores the importance of aligning its implementation with democratic principles and federalism.
Conclusion
- The Supreme Court’s intervention in the Kerala-Centre financial dispute underscores the importance of cooperative federalism in addressing intergovernmental conflicts.
- The forthcoming hearings aim to reconcile differences and ensure the equitable distribution of resources, fostering harmonious relations between the Centre and states.
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Finance Commission – Issues related to devolution of resources
The severe erosion of fiscal federalism
Note4Students
From UPSC perspective, the following things are important :
Prelims level: Fiscal deficit
Mains level: Net Borrowing Ceiling (NBC)
Central Idea:
The article discusses Kerala’s protest against the imposition of a Net Borrowing Ceiling (NBC) by the Central Government, which restricts the state’s ability to borrow funds. It argues that this imposition undermines fiscal federalism and challenges the constitutional authority of the state legislature over financial matters.
Key Highlights:
- Kerala Chief Minister Pinarayi Vijayan leads a protest against the Central Government’s imposition of a financial embargo on Kerala.
- The NBC limits states’ borrowings, including those from state-owned enterprises like the Kerala Infrastructure Investment Fund Board (KIIFB), leading to a severe financial crisis in Kerala.
- The article questions the constitutionality of including state-owned enterprises’ debt in the state’s total debt, arguing that it encroaches on the state legislature’s authority over financial matters.
- Kerala’s Fiscal Responsibility Act, 2003, aims to reduce fiscal deficit, demonstrating the state’s commitment to fiscal discipline.
- The article criticizes the move towards “annihilative federalism,” where the central government’s actions detrimentally affect states’ ability to meet welfare obligations.
Key Challenges:
- Balancing fiscal discipline with the need for states to fund development projects and welfare schemes.
- Addressing the erosion of fiscal federalism and the encroachment of central authority over state finances.
- Resolving the conflict between the powers of the central government and state legislatures regarding financial matters.
- Mitigating the impact of borrowing restrictions on states’ ability to fulfill their financial obligations.
Key Terms:
- Net Borrowing Ceiling (NBC): Limit imposed on states’ borrowings from all sources.
- Kerala Infrastructure Investment Fund Board (KIIFB): State-owned body responsible for funding infrastructure projects.
- Fiscal Responsibility Act: Legislation aimed at reducing fiscal deficit and promoting financial discipline.
- Fiscal Federalism: Distribution of financial powers and responsibilities between the central government and states.
- Annihilative Federalism: Central government actions that undermine states’ financial autonomy and welfare obligations.
Key Quotes:
- “The wide array of constitutional issues…point at the severe erosion of fiscal federalism in the country.”
- “The borrowing restrictions are an example of ‘annihilative federalism’ at play.”
Key Examples and References:
- Kerala’s protest led by Chief Minister Pinarayi Vijayan against the financial embargo imposed by the Central Government.
- The inclusion of KIIFB’s debt in Kerala’s total debt, leading to funding constraints for welfare schemes.
- Comparison of Kerala’s fiscal deficit reduction efforts with the central government’s fiscal deficit estimates.
Key Facts and Data:
- Kerala’s fiscal deficit reported to have reduced to 2.44% of the GSDP.
- Central government’s fiscal deficit estimated to be 5.8% for 2023-2024.
Critical Analysis:
The article underscores the tension between central authority and state autonomy in financial matters, highlighting the constitutional ambiguity surrounding the imposition of borrowing restrictions. It argues for a balanced approach that acknowledges states’ fiscal responsibilities while ensuring fiscal discipline.
Way Forward:
- Reevaluate the imposition of borrowing restrictions to ensure they do not unduly impede states’ ability to meet financial obligations.
- Enhance dialogue and cooperation between the central government and states to address fiscal challenges while respecting constitutional principles.
- Clarify the division of financial powers between the central government and state legislatures to mitigate conflicts and promote fiscal federalism.
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Finance Commission – Issues related to devolution of resources
Arvind Panagariya appointed as Sixteenth Finance Commission chief
Note4Students
From UPSC perspective, the following things are important :
Prelims level: Finance Commission
Mains level: Read the attached story
Central Idea
- The Centre has appointed Arvind Panagariya, a renowned trade economist and former Niti Aayog vice chairman, as the chairman of the Sixteenth Finance Commission.
Who is Arvind Panagariya?
- Panagariya is a professor at Columbia University.
- He served as the first vice chairman of the Niti Aayog from 2015 to 2017, succeeding the Planning Commission.
About Finance Commission
- Establishment: The Finance Commission (FC) of India was established by the President in 1951 under Article 280 of the Indian Constitution.
- Purpose: Its primary role is to define and regulate the financial relations between the central government and the individual state governments.
- Legislative Framework: The Finance Commission (Miscellaneous Provisions) Act, 1951, further outlines the qualifications, appointment, disqualification, term, eligibility, and powers of the Finance Commission.
- Composition: Appointed every five years, the FC comprises a chairman and four other members.
- Evolution: Since the First FC, changes in India’s macroeconomic landscape have significantly influenced the Commission’s recommendations.
Constitutional Provisions
- Article 268: Facilitates the levy of duties by the Centre, with collection and retention by the States.
- Article 280: Outlines the FC’s composition, qualifications for members, and its terms of reference. It mandates the FC to recommend the distribution of net tax proceeds between the Union and States and the allocation among States. It also addresses the financial relations between the Union and States and the devolution of unplanned revenue resources.
Key Functions of the Finance Commission
- Tax Devolution: Recommends how net tax proceeds should be distributed between the Center and States.
- Grants-in-Aid: Determines the principles governing these grants to States.
- Augmenting State Funds: Advises on measures to enhance the States’ Consolidated Funds to support local bodies and panchayats, based on State Finance Commissions’ recommendations.
- Other Financial Functions: Addresses any other financial matters referred by the President.
Members of the Finance Commission
- Structure and Standards: The Finance Commission (Miscellaneous Provisions) Act, 1951, provides a structured format and global standards for the FC.
- Qualifications and Powers: Specifies rules for members’ qualifications, disqualification, appointment, term, eligibility, and powers.
- Composition: The Chairman is chosen for their experience in public affairs. The other members are selected based on their judicial experience, knowledge of government finances, administrative and financial expertise, or special economic knowledge.
Challenges for the 16th Finance Commission
- Overlap with GST Council: The coexistence with the GST Council, a permanent constitutional body, presents a new challenge.
- Conflict of Interest: Decisions by the GST Council on tax rates could impact the FC’s revenue-sharing calculations.
- Feasibility of Recommendations: While the Centre often adopts the FC’s suggestions on tax devolution and fiscal targets, other recommendations may be overlooked.
Major Outstanding Recommendations
- Fiscal Council Creation: The 15th FC proposed a Fiscal Council for collective macro-fiscal management, but the government has shown reluctance.
- Non-Lapsable Fund for Internal Security: Though the Centre agreed ‘in principle’ to establish this fund, its implementation details are pending.
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Finance Commission – Issues related to devolution of resources
Cabinet clears terms of reference for 16th Finance Commission
Note4Students
From UPSC perspective, the following things are important :
Prelims level: Finance Commission
Mains level: Read the attached story
Central Idea
- The Union Cabinet approved the terms of reference (ToR) for the Sixteenth Finance Commission.
- The Commission will devise a formula for revenue sharing between the Centre and the States for the period starting April 1, 2026.
About Finance Commission
- Establishment: The Finance Commission (FC) of India was established by the President in 1951 under Article 280 of the Indian Constitution.
- Purpose: Its primary role is to define and regulate the financial relations between the central government and the individual state governments.
- Legislative Framework: The Finance Commission (Miscellaneous Provisions) Act, 1951, further outlines the qualifications, appointment, disqualification, term, eligibility, and powers of the Finance Commission.
- Composition: Appointed every five years, the FC comprises a chairman and four other members.
- Evolution: Since the First FC, changes in India’s macroeconomic landscape have significantly influenced the Commission’s recommendations.
Constitutional Provisions
- Article 268: Facilitates the levy of duties by the Centre, with collection and retention by the States.
- Article 280: Outlines the FC’s composition, qualifications for members, and its terms of reference. It mandates the FC to recommend the distribution of net tax proceeds between the Union and States and the allocation among States. It also addresses the financial relations between the Union and States and the devolution of unplanned revenue resources.
Key Functions of the Finance Commission
- Tax Devolution: Recommends how net tax proceeds should be distributed between the Center and States.
- Grants-in-Aid: Determines the principles governing these grants to States.
- Augmenting State Funds: Advises on measures to enhance the States’ Consolidated Funds to support local bodies and panchayats, based on State Finance Commissions’ recommendations.
- Other Financial Functions: Addresses any other financial matters referred by the President.
Members of the Finance Commission
- Structure and Standards: The Finance Commission (Miscellaneous Provisions) Act, 1951, provides a structured format and global standards for the FC.
- Qualifications and Powers: Specifies rules for members’ qualifications, disqualification, appointment, term, eligibility, and powers.
- Composition: The Chairman is chosen for their experience in public affairs. The other members are selected based on their judicial experience, knowledge of government finances, administrative and financial expertise, or special economic knowledge.
Challenges for the 16th Finance Commission
- Overlap with GST Council: The coexistence with the GST Council, a permanent constitutional body, presents a new challenge.
- Conflict of Interest: Decisions by the GST Council on tax rates could impact the FC’s revenue-sharing calculations.
- Feasibility of Recommendations: While the Centre often adopts the FC’s suggestions on tax devolution and fiscal targets, other recommendations may be overlooked.
Major Outstanding Recommendations
- Fiscal Council Creation: The 15th FC proposed a Fiscal Council for collective macro-fiscal management, but the government has shown reluctance.
- Non-Lapsable Fund for Internal Security: Though the Centre agreed ‘in principle’ to establish this fund, its implementation details are pending.
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Finance Commission – Issues related to devolution of resources
Why is Bihar demanding the Special Category Status?
Note4Students
From UPSC perspective, the following things are important :
Prelims level: Special Category Status
Mains level: Read the attached story
Central Idea
- Recently, Bihar govt passed a resolution seeking Special Category Status (SCS) for the state.
- This demand comes in light of the revelations from the “Bihar Caste-based Survey, 2022,” which unveiled that nearly one-third of Bihar’s population continues to grapple with poverty.
Special Category Status (SCS): An Overview
- Definition: SCS is a classification conferred by the Central government to support the development of states facing geographical or socio-economic disadvantages.
- Origins: SCS was instituted in 1969, based on the recommendations of the 5th Finance Commission (FC).
- Criteria: Five criteria are assessed before granting SCS, including factors like hilly terrain, low population density, and economic backwardness.
- Historical Allocation: Initially, three states—Jammu & Kashmir, Assam, and Nagaland—were granted SCS. Subsequently, eight more states, including Himachal Pradesh and Uttarakhand, received this status.
Benefits of having SCS
- Financial Assistance: SCS states used to receive grants based on the Gadgil-Mukherjee formula, accounting for approximately 30% of total central assistance.
- Devolution of Funds: Post the abolition of the Planning Commission and the recommendations of the 14th and 15th FCs, SCS assistance has been subsumed into increased devolution of funds for all states (now 41% in the 15th FC).
- Funding Ratio: SCS states enjoy a favourable 90:10 Centre-State funding split for centrally sponsored schemes, compared to 60:40 or 80:20 for general category states.
- Additional Incentives: SCS states receive concessions in customs and excise duties, income tax rates, and corporate tax rates to attract investments.
Why Bihar’s Demand for SCS?
- Resource Challenges: Bihar attributes its poverty and underdevelopment to limited natural resources, irregular water supply for irrigation, recurring floods in the north, and severe droughts in the south.
- Industrial Shift: The state’s bifurcation led to the relocation of industries to Jharkhand, creating unemployment and investment voids.
- Per-Capita GDP: Bihar’s per-capita GDP, at around ₹54,000, consistently ranks among the lowest in India.
- Welfare Funding: Chief Minister Nitish Kumar asserts that Bihar houses approximately 94 lakh poor families and that SCS recognition would generate about ₹2.5 lakh crore, crucial for funding welfare initiatives over the next five years.
SCS Demands from Other States
- Andhra Pradesh: Since its bifurcation in 2014, Andhra Pradesh has sought SCS due to revenue loss post-Hyderabad’s transfer to Telangana.
- Odisha: Odisha’s appeal for SCS underscores its vulnerability to natural disasters, such as cyclones, and a significant tribal population (around 22%).
- Central Government’s Response: Despite these demands, the Central government, citing the 14th Finance Commission’s report, which recommended against granting SCS to any state, has consistently rejected them.
Is Bihar’s Demand Justified?
- Criteria Fulfillment: Bihar meets most SCS criteria but lacks hilly terrain and geographically difficult areas, crucial for infrastructural development.
- Alternative Solutions: In 2013, the Raghuram Rajan Committee proposed a ‘multi-dimensional index’ methodology instead of SCS, which could be revisited to address Bihar’s socio-economic challenges effectively.
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Finance Commission – Issues related to devolution of resources
What the 16th Finance Commission needs to do differently
Note4Students
From UPSC perspective, the following things are important :
Prelims level: 16th Finance Commission
Mains level: 16th Finance Commission and India's fiscal federalism
What’s the news?
- India’s fiscal landscape, transformed by GST, calls for a comprehensive reevaluation of fiscal federalism to address tax-sharing challenges and regional disparities.
Central idea
- The 122nd Constitutional Amendment of 2016 and the subsequent introduction of the GST regime in 2017 reshaped India’s fiscal landscape, replacing production-based taxation with a consumption-oriented approach. This shift highlights the importance of reevaluating fiscal federalism as the 16th Finance Commission forms, addressing tax-sharing principles and regional balance in taxation.
What is meant by fiscal federalism?
- Fiscal federalism refers to the division of financial responsibilities and resources between different levels of government within a federal or decentralized system.
- It encompasses the principles and mechanisms by which revenues are generated, collected, shared, and spent by various levels of government, typically at the national (central) and subnational (state or regional) levels.
- India operates as a federal republic with a multi-tiered system of governance, and fiscal federalism is an essential aspect of this arrangement.
Potential challenges faced by the 16th Finance Commission
- Revisiting Tax-sharing Principles: The 16th Finance Commission faces the challenge of reexamining and redesigning tax-sharing principles due to the shift from production-based to consumption-based taxation under the GST regime.
- Efficient Tax Collection: Variations in the cost of tax collection (ranging from 7 to 10 percent) have emerged as a challenge, given the joint collection of taxes by the Union and states under GST.
- Redesigning Horizontal Distribution: The Commission must address the challenge of redesigning criteria for distributing the divisible pool among states to ensure equitable distribution of tax revenues and grants.
- Reviewing the Compensation Scheme: The necessity, viability, and desirability of the GST compensation scheme must be reviewed by the Commission, considering the performance of GST revenues over the past six years.
- Institutional Relationships: Establishing formalized institutional relationships between the GST Council and the Finance Commission presents a challenge in the evolving federal financial structure.
The need for a comprehensive reevaluation of India’s fiscal federalism
- Shift to the GST Regime: The introduction of the Goods and Services Tax (GST) regime represents a monumental shift in India’s taxation system. This change from a production-based tax system to a consumption-based one necessitates a reevaluation of fiscal federalism to align with this new tax paradigm.
- Impact on Vertical and Horizontal Imbalances: The transition from a production-based to a consumption-based tax system has the potential to rectify historical vertical imbalances in tax revenue distribution. However, it also introduces new horizontal imbalances among states due to varying consumption patterns and economic development levels.
- Equitable Resource Allocation: To ensure a fair distribution of resources among states, it is imperative to revisit the criteria for resource allocation. The reevaluation should consider the principles of fiscal federalism and the specific needs of each state within the GST framework.
- Efficiency and Transparency: An updated fiscal federalism framework can lead to increased efficiency and transparency in revenue collection, sharing, and utilization. This can help streamline fiscal processes and reduce inefficiencies.
- Adaptation to Changing Economic Realities: India’s economic landscape is dynamic, with evolving challenges and opportunities. A comprehensive reevaluation allows fiscal policies to adapt to these changes, ensuring they remain relevant and effective.
- Fiscal Responsibility: To ensure fiscal sustainability, a reevaluation should assess the long-term fiscal health of both the central government and state governments. It can recommend measures to manage fiscal deficits and public debt responsibly.
Way forward
- Mandate of the 16th Finance Commission: The government should promptly constitute the 16th Finance Commission with a clear mandate to reexamine the tax-sharing principles and other related fiscal matters.
- Define Comprehensive Terms of Reference (ToR): The ToR for the 16th Finance Commission should be carefully formulated to guide the Commission in addressing the challenges posed by the GST regime and its impact on fiscal federalism.
- Pooling of Indirect Tax Sovereignty: Given the significant changes in the tax landscape, the Commission should comprehensively assess the pooling of indirect tax sovereignty between the Union and states under the GST system.
- Redesign Tax-sharing Principles: The Commission should undertake a thorough review and redesign of tax-sharing principles, especially with regard to the divisible pool, unsettled IGST, and settlement frequencies, in alignment with the GST structure.
- Distribution Criteria Reevaluation: Reevaluate the criteria for distributing the divisible pool among states, particularly for equalizing grants, to ensure that they align with the new consumption-based tax system and address regional imbalances effectively.
- Formalize Institutional Relationships: Formalize and strengthen the institutional relationship between the GST Council and the Finance Commission to facilitate seamless coordination, information exchange, and alignment of fiscal policies.
- Engage with Stakeholders: Engage in extensive consultations with relevant stakeholders, including state governments, economists, and experts, to gather diverse perspectives and insights.
Conclusion
- The 16th Finance Commission must reshape India’s fiscal federalism for the GST era by redefining the divisible pool, improving tax collection efficiency, revisiting distribution criteria, reviewing compensation, and formalizing institutional relationships. Flexible terms of reference are crucial for these essential reforms to align the fiscal system with the new tax paradigm and promote equitable growth.
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Finance Commission – Issues related to devolution of resources
Why normative recommendations of finance commissions remain on paper
Note4Students
From UPSC perspective, the following things are important :
Prelims level: Finance Commissions
Mains level: Finance Commissions and its role, recommendations and challenges in implementation
What is the news?
- This article critically examines the historical outcomes of the 13th FC and underscores the need for realistic expectations regarding the forthcoming 16th FC
Central idea
- The Finance Commissions (FC) in India play a crucial role in determining the fiscal framework for resource allocation between the Union and state governments. Established under Article 280 of the Constitution, the FCs provide recommendations on vertical devolution, horizontal distribution, and grants-in-aid. However, the effectiveness of these recommendations in achieving their intended objectives remains a matter of contention
Purpose and Scope of Finance Commissions
- Finance Commissions are constituted under Article 280 of the Constitution and their recommendations encompass three key areas: vertical devolution, horizontal distribution, and grant-in-aid.
- Vertical devolution focuses on Union to state transfers
- Horizontal distribution involves the allocation of resources between states based on a specific formula.
- Grant-in-aid, covered under Article 275, provides financial assistance to states deemed in need.
- It is important to note the distinction between grants and grant-in-aid, as the latter operates at arm’s length and offers more flexibility in terms of control.
Recommendations of the previous Finance Commission
13th Finance Commission Recommendations:
- Increase the number of court working hours using existing infrastructure.
- Enhance support to Lok Adalats.
- Provide additional funding to State Legal Services Authorities to enhance legal aid for the marginalized.
- Promote the use of Alternative Dispute Resolution (ADR) mechanisms.
- Enhance the capacity of judicial officers and public prosecutors through training programs.
- Support the creation of a judicial academy in every state for training purposes.
- Allocate funds for the setting up of specialized courts.
15th Finance Commission Recommendations:
- Gather quantifiable data on the level of various services available in different states.
- Collect corresponding unit cost data to estimate cost disabilities among states.
- Fill gaps in statistical data through the efforts of the Ministry of Statistics.
Challenges encountered in the implementation of Finance Commission recommendations
- Lack of Implementation of Homilies: The recommendations made by Finance Commissions, both at the Union and state levels, are often ignored as mere pious intentions. This indicates a lack of commitment and follow-through in translating the recommendations into concrete actions.
- Conditionalities and Expenditure Restrictions: The objections raised by some states in the article indicate challenges related to conditionalities attached to grants. Conditionalities may restrict the expenditure options of states, creating obstacles in implementing the recommended reforms.
- Inadequate Resource Allocation: The allocated funds for specific reforms may not be sufficient, leading to inadequate implementation. Financial constraints and competing budgetary priorities can limit the availability of resources needed to effectively execute the recommended measures.
- Lack of Coordination: The implementation of Finance Commission recommendations requires cooperation between the Union and state governments. Any lack of coordination or disagreements between these entities can hinder the execution of reforms
Way forward: Need for realistic expectations regarding the forthcoming 16th FC
- Acknowledging Implementation Challenges: Recognize the challenges and complexities involved in implementing Finance Commission recommendations, such as coordination issues, administrative capacity, and resistance to change. This understanding will help shape realistic expectations and strategies for addressing these challenges.
- Strengthening Implementation Mechanisms: Focus on improving the implementation mechanisms and processes. This includes enhancing coordination and cooperation between the Union and state governments, strengthening administrative capacity at all levels, and streamlining the implementation of conditionalities to facilitate smoother execution.
- Robust Monitoring and Evaluation: Establish effective monitoring and evaluation mechanisms to track the progress and outcomes of implemented reforms. Regular assessment will help identify implementation gaps and provide opportunities for course correction and improvement.
- Building Stakeholder Consensus: Foster stakeholder engagement and consensus-building to ensure the buy-in and ownership of recommended reforms. Engage relevant stakeholders, including government departments, civil society organizations, and local communities, to create a shared vision and collective commitment towards implementation.
- Learning from Past Experiences: Analyze past experiences and identify the reasons behind the limited implementation of previous recommendations. This will help inform future strategies, learning from the challenges faced and replicating successful implementation models.
- Advocacy and Public Awareness: Create awareness among the public about the importance of Finance Commission recommendations and their impact on governance and development. Foster advocacy efforts to generate public support and hold governments accountable for implementing the recommended reforms.
Conclusion
- Finance Commissions in India fulfill a critical role in determining fiscal transfers between the Union and state governments. However, the implementation of their recommendations often falls short of expectations due to various challenges and limitations. By critically analyzing the past experiences of Finance Commissions, it becomes evident that a more pragmatic approach is necessary to align expectations with the actual outcomes.
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Finance Commission – Issues related to devolution of resources
Finance Commission and the Challenges of Fiscal Federalism
Note4Students
From UPSC perspective, the following things are important :
Prelims level: Finance commission and its role, Concepts: Cess, surcharges, grants, freebies etc
Mains level: Fiscal Federalism, challenges and the role of Finance commission
Central Idea
- The government is set to appoint a Finance Commission in the coming months to address the crucial matter of distributing the Centre’s tax revenue among the States. This article examines the significance of the Finance Commission in India’s fiscal federalism, highlighting the changing dynamics post-reforms and the ensuing debates surrounding the horizontal distribution formula.
Evolution of the Finance Commission
- Constitutional Provision: The Finance Commission is a constitutional body established under Article 280 of the Indian Constitution. It was first constituted in 1951.
- Primary Objective: The primary objective of the Finance Commission is to recommend the distribution of financial resources between the Union (Centre) and the States.
- Five-Year Cycle: The Finance Commission is appointed every five years, or as specified by the President of India. The recommendations of the Commission cover a five-year period.
- Composition: The Commission consists of a Chairman and other members appointed by the President. The Chairman is usually a person with a background in economics, finance, or public administration.
- Terms of Reference: The President determines the terms of reference for each Finance Commission, which guide the Commission in its deliberations and recommendations.
Significance of the Finance Commission in India’s fiscal federalism
- Vertical and Horizontal Distribution: The Finance Commission determines the vertical share, which is the proportion of the Centre’s tax revenue that should be given to the States, ensuring a fair allocation of resources. It also formulates the horizontal sharing formula, which determines how this revenue should be distributed among the States.
- Addressing Fiscal Disparities: The Finance Commission plays a crucial role in addressing these disparities by providing financial transfers to less economically developed states. Through revenue deficit grants and other means, the Commission helps bridge the fiscal gap and supports states with limited revenue-raising capacity.
- Promoting Cooperative Federalism: The Finance Commission acts as an institutional mechanism that fosters cooperative federalism by facilitating intergovernmental fiscal transfers. It encourages collaboration and coordination between the Centre and the States, fostering a sense of shared responsibility in fiscal matters.
- Constitutional Mandate: The Finance Commission is constitutionally mandated under Article 280 of the Indian Constitution. Its existence and functioning are enshrined in the constitutional framework, ensuring its independence and impartiality in making recommendations.
- Five-Year Review Cycle: The regular appointment of the Finance Commission every five years ensures a periodic review of the fiscal arrangements between the Centre and the States. This allows for adjustments and revisions based on evolving economic and social realities, ensuring that fiscal transfers remain relevant and effective.
- Expertise and Recommendations: The Finance Commission comprises experts in the fields of economics, finance, and public administration. Its recommendations are based on in-depth analysis, consultations, and assessments of various factors, including population, fiscal capacity, and development needs. These recommendations provide valuable insights and guidance to the Centre and the States in fiscal decision-making.
- Resolving Fiscal Conflicts: The Finance Commission helps resolve conflicts and disputes between the Centre and the States regarding fiscal matters. By providing an independent and objective platform for negotiation and deliberation, it promotes a sense of fairness and transparency in fiscal resource allocation.
- Strengthening Fiscal Discipline: The Finance Commission plays a role in promoting fiscal discipline and accountability. By assessing the fiscal performance and needs of the States, it encourages responsible fiscal behavior and discourages imprudent spending practices
Facts for Prelims
| Aspect | Vertical Distribution | Horizontal Distribution |
| Definition | Allocation of the Centre’s tax revenue between the Centre and the States | Allocation of funds among the States |
| Determined by | Finance Commission | Finance Commission |
| Factors considered | Fiscal capacity, needs of the States, population figures, and relevant indicators | Population, area, fiscal capacity, demographic trends, development indicators, and relevant parameters |
| Objective | Provide a fair and equitable share of revenue to the States | Promote equitable development and address regional imbalances |
| Purpose | Ensure States have sufficient resources for expenditure requirements and promote balanced development | Provide greater financial support to States with lower fiscal capacity and greater development needs |
| Focus | Centre-State distribution of revenue | State-State distribution of funds |
| Outcome | Ensures fair allocation of revenue between the Centre and the States | Reduces disparities and fosters balanced growth among the States |
Changing dynamics post reforms
- Decreased Role of Plan Financing: In the pre-reform era, the Centre had the flexibility to compensate States through plan financing. However, post-reforms, there has been a decline in fresh investments in public sector undertakings (PSUs) and the abolition of the Planning Commission in 2014. As a result, the Finance Commission has become the primary mechanism for the vertical and horizontal distribution of resources, making its role more critical.
- Devolution of Tax Revenues: With the amendment of the Constitution in 2000, States were given a share in the Centre’s tax revenue pool. This devolution of tax revenues has increased the significance of the Finance Commission in determining the distribution of funds between the Centre and the States.
- Shift in Population Figures: The use of population figures in determining the distribution of resources has seen a shift from the earlier practice of using 1971 census data to considering 2011 census data. This shift has led to debates and controversies, particularly among States that have successfully controlled population growth rates, as it can affect their share of devolution.
- Deepening Faultlines: In recent years, faultlines between States have deepened along political, economic, and fiscal dimensions. The outcome of elections and regional disparities in terms of infrastructure, private investment, social indicators, and the rule of law have widened the north-south gap and brought regional imbalances into focus. Managing these faultlines while ensuring equitable distribution poses challenges for the Finance Commission.
- Concerns of Fiscal Incapacity vs. Fiscal Irresponsibility: The Finance Commission faces the challenge of determining the extent to which a State’s deficit is due to its fiscal incapacity or fiscal irresponsibility. Striking a balance between supporting deficit-ridden States without penalizing fiscally responsible ones is a complex task, as providing more to one State would mean giving less to others.
- Changing Economic Landscape: The post-reform period has witnessed shifts in India’s economic landscape, with some states experiencing higher growth rates and greater fiscal capacity compared to others. This dynamic requires the Finance Commission to consider the changing economic realities and ensure that the distribution formula reflects the current context
Addressing the concerns related to cesses and surcharges
- Clear Guidelines: The Finance Commission should lay down clear guidelines on when and under what circumstances cesses and surcharges can be levied. These guidelines should ensure that cesses and surcharges are not used as routine measures but rather as exceptional instruments to address specific needs or challenges.
- Cap on Amount Raised: The Finance Commission can suggest a formula or mechanism to cap the amount that can be raised through cesses and surcharges. This would prevent excessive reliance on these instruments and ensure that they do not become a substantial portion of the Centre’s total tax revenue.
- Transparency and Accountability: The government should enhance transparency and accountability in the utilization of funds generated through cesses and surcharges. It should provide regular reports on the utilization of these funds, demonstrating how they contribute to the intended purposes and benefit the states and the overall economy.
- Consultation with States: The Finance Commission should engage in extensive consultations with states while formulating guidelines regarding cesses and surcharges. States should have the opportunity to provide their input, share their concerns, and suggest ways to strike a balance between the Centre’s revenue requirements and the states’ financial autonomy.
- Alignment with Fiscal Responsibility: Any levies on cesses and surcharges should be in line with the principles of fiscal responsibility and budget management. The Finance Commission can ensure that these instruments are used judiciously and do not undermine the fiscal discipline goals set by the FRBM Act.
- Review and Evaluation: Regular review and evaluation of the impact of cesses and surcharges should be conducted to assess their effectiveness in achieving the intended objectives. The Finance Commission can play a crucial role in monitoring the usage of these instruments and recommending necessary adjustments based on the evaluation outcomes.
Implementing restraint on freebies
- Clear Definition: Establishing a clear definition of what constitutes a freebie is crucial to avoid ambiguity and misuse of resources. It should encompass measures that go beyond essential public services and infrastructure development and instead focus on non-essential giveaways or subsidies.
- Fiscal Responsibility and Budgetary Constraints: The Finance Commission can emphasize the importance of adhering to fiscal responsibility guidelines and staying within budgetary constraints. This ensures that resources are allocated judiciously and in a sustainable manner, avoiding the accumulation of unsustainable debt.
- Prioritization of Essential Services: Encouraging governments to prioritize essential public services, such as healthcare, education, and infrastructure, over non-essential freebies. This ensures that resources are allocated to areas that have a more significant and long-lasting impact on the overall well-being and development of the population.
- Evaluation of Impact: Regular evaluation of the impact of freebies on the economy, fiscal health, and the intended beneficiaries is essential. This evaluation can help identify any unintended consequences, potential wastage of resources, or negative effects on economic growth.
- Public Awareness and Discourse: Creating public awareness about the implications of excessive freebies and the importance of responsible fiscal management. Encouraging open discourse and dialogue among citizens, policymakers, and experts can foster a deeper understanding of the long-term consequences of unsustainable giveaways.
- Role of the Finance Commission: The Finance Commission can play a pivotal role in setting guidelines and recommendations for restraint on freebies. This includes providing advice on responsible fiscal management and ensuring that resource allocation aligns with long-term development goals.
Conclusion
- The Finance Commission plays a crucial role in India’s fiscal federalism. To address concerns regarding cesses, surcharges, and freebies, the Commission must provide clear guidelines, ensure transparency, and emphasize long-term fiscal sustainability. Stakeholder consultation, periodic evaluation, and public awareness are key to maintaining a balance between meeting welfare needs and promoting responsible fiscal management.
Also read:
| The curious case of Fiscal Federalism in India |
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Finance Commission – Issues related to devolution of resources
16th Finance Commission to be constituted in November
Note4Students
From UPSC perspective, the following things are important :
Prelims level: Finance Commission
Mains level: Read the attached story
The Union government is gearing up to constitute the Sixteenth Finance Commission in November this year to recommend the formula for sharing revenues between the Centre and the States for the five-year period beginning 2026-27.
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:
- Who will constitute: 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.
- Qualifications: Parliament may by law determine the requisite qualifications for appointment as members of the commission and the procedure of selection.
- Terms of references: 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
- Devolution of taxes: Distribution of net proceeds of taxes between Center and the States, to be divided as per their respective contributions to the taxes.
- Grants-in-aid: Determine factors governing Grants-in-Aid to the states and the magnitude of the same.
- Augment states fund: 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 committee of the state.
- Any financial function: 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
Key challenges ahead for 16th FC
- Overlap with GST Council: A key new challenge for the 16th FC would be the co-existence of another permanent constitutional body, the GST Council.
- Conflict of interest: The GST Council’s decisions on tax rate changes could alter the revenue calculations made by the Commission for sharing fiscal resources.
- Feasibility of recommendations: Centre usually takes the Commission’s recommendations on States’ share of tax devolution and the trajectory for fiscal targets into account, and ignores most other suggestions.
Major outstanding recommendations
- Creating a Fiscal Council: The 15th FC has suggested creating a Fiscal Council where Centre and States collectively work out India’s macro-fiscal management challenges, but the government has signalled there is no need for it, he pointed out.
- Creating a non-lapsable fund for internal security: The centre accepted to set up a non-lapsable fund for internal security and defense ‘in principle’, its implementation still has to be worked out.
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Finance Commission – Issues related to devolution of resources
Process to set up 16th Finance Commission set to kick off soon
Note4Students
From UPSC perspective, the following things are important :
Prelims level: Finance Commission
Mains level: Not Much
The Centre will soon kick off the process to set up the Sixteenth Finance Commission, with the Finance Ministry likely to notify the terms of reference.
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:
- Who will constitute: 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.
- Qualifications: Parliament may by law determine the requisite qualifications for appointment as members of the commission and the procedure of selection.
- Terms of references: 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
- Devolution of taxes: Distribution of net proceeds of taxes between Center and the States, to be divided as per their respective contributions to the taxes.
- Grants-in-aid: Determine factors governing Grants-in-Aid to the states and the magnitude of the same.
- Augment states fund: 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 committee of the state.
- Any financial function: 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
Key challenges for 16th FC
- Overlap with GST council: A key new challenge for the 16th FC would be the co-existence of another permanent constitutional body, the GST Council.
- Conflict of interest: The GST Council’s decisions on tax rate changes could alter the revenue calculations made by the Commission for sharing fiscal resources.
- Feasibility of recommendations: Centre usually takes the Commission’s recommendations on States’ share of tax devolution and the trajectory for fiscal targets into account, and ignores most other suggestions.
Major outstanding recommendations
- Creating a Fiscal Council: The 15th FC has suggested creating a Fiscal Council where Centre and States collectively work out India’s macro-fiscal management challenges, but the government has signalled there is no need for it, he pointed out.
- Creating a non-lapsable fund for internal security: The centre accepted to set up a non-lapsable fund for internal security and defense ‘in principle’, its implementation still has to be worked out.
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Finance Commission – Issues related to devolution of resources
The curious case of Fiscal Federalism in India
Note4Students
From UPSC perspective, the following things are important :
Prelims level: Finance commission, NITI Aayog
Mains level: Issues with cooperative Federalism
Context
- NITI Aayog has not taken any major steps since its constitution to promote cooperative federalism. Contrary to its public statements on promoting cooperative federalism, the Government of India has been accused of doing exactly the opposite. The following instances clearly demonstrate as to how the central government’s policies have undermined the spirit of federalism and eroded the autonomy of the States.
Why the states are angry over hypocrisy of the Centre?
- Centre raises off budget borrowings states are restricted: The borrowings by corporations against State guarantees are mostly used for capital investment. The Centre has also been raising off Budget borrowings but mainly for meeting revenue expenditure.
- CAG report on extra budgetary resources: The Comptroller and Auditor General of India (C&AG) Report on the Compliance of FRBM Act for 2017-18 and 2018-19 pointed out as many as eight instances of meeting revenue expenditure through Extra Budgetary Resources (EBR).
- Unjustified limitations on states: Revenue expenditure met through EBR by the Centre amounted to ₹81,282 crore in 2017-18 and ₹1,58,107 crore in 2018-19. Such borrowings were not reflected in the Budget of the central government. In view of this, treating off Budget borrowings of State corporations as States’ borrowings retrospectively is totally unjustified.
Unhappiness about the grants by the finance commission’s recommendations?
- Special grants are not given to states: The Fifteenth Finance Commission, in its first report, had recommended a special grant to three States amounting to ₹6,764 crore to ensure that the tax devolution in 2020-21 in absolute terms should not be less than the amount of devolution received by these States in 2019-20. This recommendation was not accepted by the Union Government.
- Nutritional grants are accepted: the recommendation relating to grants for nutrition amounting to ₹7,735 crore was not accepted.
- Grants to states are refused by the Centre: A similar approach has been followed by the Union Government with regard to grants to States recommended by the Finance Commission for the period 2021-26.
- Sector and state specific grants: The sector specific grants and State specific grants recommended by the Commission amounting to ₹1,29,987 crore and ₹49,599 crore, respectively, have not been accepted. This clearly demonstrates that the Union Government has undermined the stature of the institution of the Finance Commission and cooperative federalism.
How borrowing of the states is controlled by the Centre?
- Changes in off budget borrowing norms: decision to treat off Budget borrowings from 2021-22 onwards serviced from the State budgets as States’ borrowings and adjusting them against borrowing limits under Fiscal Responsibility and Budget Management (FRBM) in 2022-23 and following years is against all norms.
- No recommendations by finance commission: This is the first time that the Government of India is proposing to treat off Budget borrowings as government borrowings retrospectively from 2021-22. The Government of India has indicated that such a decision is in accordance with the recommendation of the Finance Commission. In fact, there is no recommendation to this effect by the Fifteenth Finance Commission. The Finance Commission recommended that governments at all tiers may observe strict discipline by resisting any further additions to the stock of off Budget transactions.
- No amendment to FRBM act: It observed that in view of the uncertainty that prevails now, the timetable for defining and achieving debt sustainability may be examined by a high-powered intergovernmental group and that the FRBM Act may be amended as per the recommendations of this group to ensure that the legislations of the Union and the States are consistent. No such group has been appointed so far by the Centre.
Cess and Surcharge- A tool to raise revenue for Centre not available to the states
- Rising share of cess and surcharges: The government has been resorting to the levy of cesses and surcharges, as these are not shareable with the States under the Constitution. The share of cesses and surcharges in the gross tax revenue of the Centre increased from 13.5% in 2014-15 to 20% in the Budget estimates for 2022-23.
- States don’t get all share in divisible pool: Though the States’ share in the Central taxes is 41%, as recommended by the Fifteenth Finance Commission, they only get a 29.6% share because of higher cesses and surcharges.
- Undermining the purpose of cess: The C&AG in its Audit Report on Union Government Accounts for 2018-19 observed that of the ₹2,74,592 crore collected from 35 cesses in 2018-19, only ₹1,64,322 crore had been credited to the dedicated funds and the rest was retained in the Consolidated Fund of India. This is another instance of denying States of their due share as per the constitutional provisions.
- Increasing centrally sponsor scheme and burden on state: Committee after committee appointed by the Government of India has emphasised the need to curtail the number of Centrally Sponsored Schemes (CSS) and restrict them to a few areas of national importance. But, what the Government of India has done is to group them under certain broad umbrella heads (currently 28). In addition, in 2015, the Centre increased the States’ share in a number of CSS, thereby burdening States. Most of the CSS are operated in the subjects included in the State list. Thus, States have lost their autonomy.
- NITI Aayoge recommendations are not accepted: The Sub-Committee of Chief Ministers appointed by NITI Aayog has recommended a reduction in the number of schemes and the introduction of optional schemes. These recommendations have not been acted upon.
Conclusion
- Finance commission is balancing wheel of fiscal federalism. Share of states in central taxes may have increased but cess and surcharges have also increased. Off budget borrowing on states can lifted provided should reduce the unnecessary freebies in the state budget.
Mains Question
Q. Fiscal federalism is tilted in favour of Centre. Elaborate. How Cess and surcharges are discriminatory against the state governments?
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Finance Commission – Issues related to devolution of resources
Finance Commission’s Approach to Equitable Delivery of Goods and Services
Note4Students
From UPSC perspective, the following things are important :
Prelims level: NA
Mains level: Equitable delivery
Context
- 15th Finance commission on horizontal devolution agreed that the Census 2011 population data better represents the present need of States, to be fair to, as well as reward, the States which have done better on the demographic front, Finance commission has assigned a 12.5 per cent weight to the demographic performance criterion. Population, area, forest and ecology, demographic performance, tax efforts, income and distance are the criteria for horizontal distribution of funds.
Why equitable delivery is necessary in the country?
- To fulfil the need of basket of Goods: There is a basket of goods and services that should be delivered by the State. It is best not to call them public goods, since “public goods” have a specific meaning for economists and this basket has items that are typically collective private goods.
- To achieve Aantodaya approach (last person): Curlew Island is in the Andaman and Nicobar Islands. Until the 2011 Census, it had a population of two. Pulomilo Island, also in Andaman and Nicobar, had a population of 20 in 2011. At the time of elections, we read of astounding attempts made, so that voters in remote locations can vote. No one should be disenfranchised because of remoteness of location. By the same token, a resident, regardless of location, must be entitled to that basket.
- To achieve poverty alleviation: The quality of public services affects economic growth via its impact on poverty alleviation, human capital formation and corruption.
What are the Problems with Equitable delivery targets?
- High cost of delivery: States can have differential sources of revenue. Alternatively, the cost of delivering that basket may vary across geographical zones.
- Problems associated with migration: Over time, villages of course get depopulated. They are reclassified, get absorbed into larger agglomerations, or disappear because of migration.
How equitable delivery can be achieved?
- State need to take honest responsibility: The State cannot abdicate its responsibility of providing the basket.
- Economic compulsion: Migration is a voluntary decision, often driven by the pull (and push) of economic forces. That voluntary decision cannot be replaced by fiat.
- Dividing the pool between the governments: The Union Finance Commission has a vertical task, dividing the divisible pool between the Union government and states.
- Adjusting to the criteria set by FC: It also has a horizontal task, dividing State share between different states. Accordingly, from the 1st to the 15th, Finance commission have adopted different formulae, with an attempt to also create incentives, by attaching weights to fiscal efficiency and even demographic performance.
- This leaves variables like population, geographical area, income distance, infrastructure distance and forest cover:
- expenditure equalisation based on needs/costs of public services;
- Revenue equalisation measured by the ability of the state to raise revenue from one or more sources; and
- Macro indicators covering broader economic or non-economic indicators that approximate fiscal capacity, where data constraints make it difficult to apply the other approaches.
- Addressing Geographic area and population: Needs/costs are sought to be measured through geographical area and population. All Finance Commissions have used area as another criterion in the devolution formula on the ground of need — the larger the area, greater is the expenditure requirement for providing comparable services.
Conclusion
- Equitable access to public goods and services in low income and inequal (economic inequality) country like India is cumbersome task. Finance commission is trying their best for equitable allocation of resources.
Mains Question
Q. How Equity is different from equality? What is the finance commission’s criteria for horizontal allocation of resources among the states ?
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Finance Commission – Issues related to devolution of resources
Skewed divisible pool
Note4Students
From UPSC perspective, the following things are important :
Prelims level: Finance commission
Mains level: Fiscal federalism
Context
- The centralisation of fiscal powers in India has been blamed for the poor fiscal health of the states.
Why in news?
- Chief Ministers expressed their concern about dwindling State revenues in a NITI Aayog meeting chaired by the Prime Minister.
- They sought a higher share in the divisible pool of taxes and an extension of GST compensation, both of which have long remained a bone of contention between the Union government and the States.
Need for financial devolution
- To strengthen democracy at grass root level with more revenue resources for better service delivery.
- To increase accountability to people so performance can be realized as direct contact with people.
What is divisible pool of taxes?
- The divisible pool is that portion of gross tax revenue which is distributed between the Centre and the States. The divisible pool consists of all taxes, except surcharges and cess levied for specific purpose, net of collection charges.
What is fiscal federalism?
- Fiscal federalism refers to how federal, state, and local governments share funding and administrative responsibilities within our federal system. The funding for these programs comes from taxes and fees.
Poor state of state finances
- Stagnant revenue: Since States cannot raise tax revenue because of curtailed indirect tax rights — subsumed in GST, except for petroleum products, electricity and alcohol — the revenue has been stagnant at 6% of GDP in the past decade.
- Distorted expenditure: While States lost their capacity to generate revenue by surrendering their rights in the wake of the Goods and Services Tax (GST) regime, their expenditure pattern too was distorted by the Union’s intrusion, particularly through its centrally sponsored schemes.
- Decline in share: The ability of States to finance current expenditures from their own revenues has declined from 69% in 1955-56 to less than 38% in 2019-20.
- Stress on finance: States’ financial health had taken a turn for the worse with the implementation of the Ujwal DISCOM Assurance Yojana, farm loan waivers, as also the slowdown in growth in 2019- 20.
Key fact to remember
Finance Commission keeps tax devolution for states at 41% in FY22
How fiscal centralisation impacts on states?
- Cut in the corporate tax: The recent drastic cut in corporate tax, with its adverse impact on the divisible pool, and ending GST compensation to States have had huge consequences.
- States paying high interest rates: States are forced to pay differential interest — about 10% against 7% — by the Union for market borrowings.
- Centrally sponsored schemes curbing autonomy: There are 131 centrally sponsored schemes, with a few dozen of them accounting for 90% of the allocation, and States required to share a part of the cost.
Suggestions for strong fiscal federalism
- Creation of federal institution: We need to create another institution in the form of a GST state secretariat that can bring together senior officers from the Centre and states in an institutional forum registered under the Society Act.
- State Finance Commissions: should be accorded the same status as the Union Finance Commission and the 3Fs of democratic decentralization (funds, functions, and functionaries) should be implemented properly.
- Robust GST regime: Transparency, simplification and rationalisation of GST will help states to recover soon.
Way Forward
- Relook on various exemptions to rationalise the taxes/levies
- Augmentation of Tax Administration Structure
- Technology-based Tax Administration may also be further expanded to cover even utility charges like water, street lights, sanitation charges, etc.
Conclusion
- It is important now to rethink the design and structure of a genuine fiscal partnership, which should not merely be a race to garner more resources, but a creative attempt to move towards a vibrant Indian value chain that can catapult India’s growth rate closer to the quest for double-digit growth.
Mains question
Q. Why it is important now to rethink the design and structure of a genuine fiscal partnership? Discuss this in context of Skewed divisible pool and state of fiscal federalism in India.
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Finance Commission – Issues related to devolution of resources
fiscal federalism in India
Note4Students
From UPSC perspective, the following things are important :
Prelims level: Finance Commission
Mains level: Paper 2- Issues with fiscal federalism in India
Context
The centralisation of fiscal powers in India has been blamed for the poor fiscal health of the states.
Centralisation of fiscal powers: A background
- Jawaharlal Nehru believed that socio-economic inequities could be addressed through the planning process.
- A degree of centralisation in fiscal power was required to address the concerns of socio-economic and regional disparities.
- As a result asymmetric federalism is inherent to the Indian Constitution.
- India was never truly federal — it was a ‘holding together federalism’ in contrast to the ‘coming together federalism,’ in which smaller independent entities come together to form a federation (as in the United States of America).
- In fact, the Government of India Act 1935 was more federal in nature than the Constitution adopted on January 26, 1950 as the first offered more power to its provincial governments.
- Historically, India’s fiscal transfer worked through two pillars, i.e., the Planning Commission and the Finance Commission.
- But the waning of planning since the 1990s, and its abolition in 2014, led to the Finance Commission becoming a major means of fiscal transfer as the commission itself broadened its scope of sharing all taxes since 2000 from its original design of just two taxes — income tax and Union excise duties.
- Today, the Finance Commission became a politicised institution with arbitrariness and inherent bias towards the Union government.
- Tamil Nadu government constituted a committee under Justice P.V. Rajamannar in 1969, the first of its kind by a State government, to look at Centre-State fiscal relations and recommend more transfers and taxation powers for regional governments.
Declining fiscal capacity of the states
- While States lost their capacity to generate revenue by surrendering their rights in the wake of the Goods and Services Tax (GST) regime, their expenditure pattern too was distorted by the Union’s intrusion, particularly through its centrally sponsored schemes.
- The ability of States to finance current expenditures from their own revenues has declined from 69% in 1955-56 to less than 38% in 2019-20.
- While the expenditure of the States has been shooting up, their revenues did not.
- Stagnant revenue: Since States cannot raise tax revenue because of curtailed indirect tax rights — subsumed in GST, except for petroleum products, electricity and alcohol — the revenue has been stagnant at 6% of GDP in the past decade.
Implications of fiscal centralisation in India
- Use of non-divisive cess: Even the increased share of devolution, mooted by the Fourteenth Finance Commission, from 32% to 42%, was subverted by raising non-divisive cess and surcharges that go directly into the Union kitty.
- This non-divisive pool in the Centre’s gross tax revenues shot up to 15.7% in 2020 from 9.43% in 2012, shrinking the divisible pool of resources for transfers to States.
- Cut in the corporate tax: The recent drastic cut in corporate tax, with its adverse impact on the divisible pool, and ending GST compensation to States have had huge consequences.
- States paying high interest rates: States are forced to pay differential interest — about 10% against 7% — by the Union for market borrowings.
- Centrally sponsored schemes curbing autonomy: There are 131 centrally sponsored schemes, with a few dozen of them accounting for 90% of the allocation, and States required to share a part of the cost.
- They spend about 25% to 40% as matching grants at the expense of their priorities.
- These schemes, driven by the one-size-fits-all approach, are given precedence over State schemes, undermining the electorally mandated democratic politics of States.
- In fact, it is the schemes conceived by States that have proved to be beneficial to the people and that have contributed to social development.
- Driven by democratic impulses, States have been successful in innovating schemes that were adopted at the national level.
- The diversion of a State’s own funds to centrally sponsored schemes, thereby depleting resources for its own schemes, violates constitutional provision.
- Deepening inequality: The World Inequality Report estimates ‘that the ratio of private wealth to national income increased from 290% in 1980 to 555% in 2020, one of the fastest such increases in the world.
- The poorest half of the population has less than 6% of the wealth while the top 10% nearly grab two-third of it’.
- India’s tax-GDP ratio has been one of the lowest in the world — 17% of which is well below the average ratios of emerging market economies and OECD countries’ about 21% and 34%, respectively.
- Its income tax base has been very narrow.
- Indirect tax still accounts for about 56% of total taxes.
- Instead of strengthening direct taxation, the Union government slashed corporate tax from 35% to 25% in 2019 and went on to monetise its public sector assets to finance infrastructure.
Conclusion
In sum, India’s fiscal federalism driven by political centralisation has deepened socio-economic inequality, belying the dreams of the founding fathers who saw a cure for such inequities in planning. It has not altered inter-state disparities either.
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Finance Commission – Issues related to devolution of resources
Private: Fifteenth Finance Commission Recommendations For Local Government Funds
The Fifteenth Finance Commission has raised the vertical devolution recommended to local governments to 4.23% with a reasonably estimated amount of ₹4,36,361 crore. Compared with the Fourteenth Finance Commission there is a 52% increase in the vertical share.
Evolution
- Post–Independence Period: After the Constitution came into force, Article 40 made a mention of panchayats and Article 246 empowers the state legislature to legislate with respect to any subject relating to local self-government.
- However, this inclusion of panchayats into the Constitution was not unanimously agreed upon by the then decision-makers, with the major opposition having come from the framer of the Constitution himself i.e. B.R.Ambedkar.
- What is a village but a sink of localism, a den of ignorance, narrow-mindedness and communalism
- It was after much discussion among the supporters and opponents of the village panchayat that the panchayats finally got a place for themselves in the Constitution as Article 40 of the Directive Principles of State Policy.
- Since the Directive Principles are not binding principles, the result was the absence of a uniform structure of these bodies throughout the country.
- After independence, as a development initiative, India had implemented the Community Development Programmes (CDP) on the eve of Gandhi Jayanti, the 2nd October, 1952 under the major influence of the Etawah Project undertaken by the American expert, Albert Mayer.
- It encompassed almost all activities of rural development which were to be implemented with the help of village panchayats along with the participation of people.
- In 1953, the National Extension Service was also introduced as a prologue to CDP. But the programme did not yield much result.
- There were various reasons for the failure of CDP like bureaucracy and excessive politics, lack of people participation, lack of trained and qualified staff, and lack of local bodies interest in implementing the CDP especially the village panchayats.
- In 1957, the National Development Council constituted a committee headed by Balwant Rai Mehta to look into the working of community development programme.
- The team observed that the major reason for the failure of the CDP was the lack of people’s participation.
- The committee suggested a three-tier PRIs, namely, Grama Panchayats (GPs) at the village level, Panchayat Samiti (PSs) at the block level, and Zilla Parishad (ZPs) at the district level.
- As a result of this scheme of democratic decentralization was launched in Rajasthan on October 2, 1959.
- In Andhra Pradesh, the scheme was introduced on 1st November, 1959. The necessary legislation had also been passed and implemented in Assam, Gujarat, Karnataka, Madhya Pradesh, Maharashtra, Orissa, and Punjab etc.
- The appointment of the Ashok Mehta Committee in 1977 did bring new thinking in the concepts and practice of the Panchayat Raj.
- The committee recommended a two-tier Panchayat Raj institutional structure consisting of Zilla Parishad and Mandal Panchayat.
- In order to use planning expertise and to secure administrative support, the district was suggested as the first point of decentralization below the state level.
- Based on its recommendation, some of the states like Karnataka incorporated them effectively.
- In subsequent years in order to revive and give a new lease of life to the panchayats, the Government of India had appointed various committees.
- The most important among them are the Hanumantha Rao Committee (1983), G.V.K. Rao Committee (1985), L.M.Singhvi Committee (1986) and the Sarkaria Commission on Centre-State relations (1988), P.K. Thungan Committee (1989) and Harlal Singh Kharra Committee (1990).
- The G.V.K. Rao Committee (1985) recommended making the “district” as the basic unit of planning and also holding regular elections while the L.M.Singhvi committee recommended providing more financial resources and constitutional status to the panchayats to strengthen them.
- The Amendment phase began with the 64th Amendment Bill (1989) which was introduced by Rajiv Gandhi seeking to strengthen the PRIs but the Bill was not passed in the Rajya Sabha.
- The Constitution (74th Amendment) Bill (a combined bill for the PRIs and municipalities) was introduced in 1990, but was never taken up for discussion.
- It was during the Prime Ministership of P.V.Narasimha Rao that a comprehensive amendment was introduced in the form of the Constitution 72nd Amendment Bill in September 1991.
- 73rd and 74th Constitutional Amendments were passed by Parliament in December, 1992. Through these amendments local self-governance was introduced in rural and urban India.
- The Acts came into force as the Constitution (73rd Amendment) Act, 1992 on April 24, 1993 and the Constitution (74th Amendment) Act, 1992 on June 1, 1993.
Salient Features of the Constitution 73rd and 74th Amendments
- These amendments added two new parts to the Constitution, namely, added Part IX titled “The Panchayats” (added by 73rd Amendment) and Part IXA titled “The Municipalities” (added by 74th Amendment).
- Basic units of democratic system-Gram Sabhas (villages) and Ward Committees (Municipalities) comprising all the adult members registered as voters.
- Three-tier system of panchayats at village, intermediate block/taluk/mandal and district levels except in States with population is below 20 lakhs (Article 243B).
- Seats at all levels to be filled by direct elections Article 243C (2).
- Seats reserved for Scheduled Castes (SCs) and Scheduled Tribes (STs) and the chairpersons of the Panchayats at all levels also shall be reserved for SCs and STs in proportion to their population.
- One-third of the total number of seats to be reserved for women.
- One third of the seats reserved for SCs and STs also reserved for women.
- One-third offices of chairpersons at all levels reserved for women (Article 243D).
- Uniform five year term and elections to constitute new bodies to be completed before the expiry of the term.
- In the event of dissolution, elections compulsorily within six months (Article 243E).
- Independent Election Commission in each State for superintendence, direction and control of the electoral rolls (Article 243K).
- Panchayats to prepare plans for economic development and social justice in respect of subjects as devolved by law to the various levels of Panchayats including the subjects as illustrated in Eleventh Schedule (Article 243G).
- 74th Amendment provides for a District Planning Committee to consolidate the plans prepared by Panchayats and Municipalities (Article 243ZD).
- Budgetary allocation from State Governments, share of revenue of certain taxes, collection and retention of the revenue it raises, Central Government programmes and grants, Union Finance Commission grants (Article 243H).
- Establish a Finance Commission in each State to determine the principles on the basis of which adequate financial resources would be ensured for panchayats and municipalities (Article 243I).
- The Eleventh Scheduled of the Constitution places as many as 29 functions within the purview of the Panchayati Raj bodies.
- The following areas have been exempted from the operation of the Act because of the socio-cultural and administrative considerations:
- Scheduled areas listed under the V Schedule in the states of Andhra Pradesh, Bihar, Gujarat, Himachal Pradesh, Madhya Pradesh, Maharashtra, Orissa and Rajasthan.
- The states of Nagaland, Meghalaya and Mizoram.
- The hill areas of district of Darjeeling in the state of West Bengal for which Darjeeling Gorkha Hill Council exists.
- In conformity with provisions in the Constitution Amendment Act, an Act called the Provisions of Panchayats (Extension to the Scheduled Areas) Act, 1996 passed by the Government of India.
Evaluating the Panchayati Raj Institutions at 28
- PRIs has witnessed simultaneously a remarkable success and a staggering failure in the journey of 28 years depending on the goalposts against which they are evaluated.
- While the PRI has succeeded in creating another layer of government and political representation at the grass-roots level, it has failed to provide better governance.
- There are about 250,000 PRIs and urban local bodies, and over three million elected local government representatives.
- The 73rd and 74th Amendments required that no less than one-third of the total seats in local bodies should be reserved for women. At 1.4 million, India has the most women in elected positions. Seats and sarpanch/pradhan positions were also reserved for SC/ST candidates.
- Research using PRIs has shown that having female political representation in local governments makes women more likely to come forward and report crimes.
- In districts with female sarpanchs, significantly greater investments are made in drinking water, public goods.
- Moreover, the states have also provided the statutory safeguards for many devolution provisions, which have considerably empowered local governments.
- Successive (central) Finance Commissions have, so substantially, increased fund allocations for local bodies and also the grants have been increased.
- 15th Finance Commission is also considering to further increase the allocations for local governments to match the international standards.
Issues
- The grey area is the lack of adequate funds. There is a need to enlarge the domain of panchayats to be able to raise their own funds.
- The interference of area MPs and MLAs in the functioning of panchayats also adversely affected their performance.
- The 73rd amendment only mandated the creation of local self-governing bodies, and left the decision to delegate powers, functions, and finances to the state legislatures, therein lies the failure of PRIs.
- The transfer of various governance functions—like the provision of education, health, sanitation, and water was not mandated. Instead the amendment listed the functions that could be transferred, and left it to the state legislature to actually devolve functions.
- There has been very little devolution of authority and functions in the last 26 years.
- Because these functions were never devolved, state executive authorities have proliferated to carry out these functions. The most common example is the terrible state water boards.
- The major failure of the Amendment is the lack of finances for PRIs. Local governments can either raise their own revenue through local taxes or receive intergovernmental transfers.
- The power to tax, even for subjects falling within the purview of PRIs, has to be specifically authorized by the state legislature. The 73rd Amendment let this be a choice open to the state legislatures—a choice that most states have not exercised.
- A second avenue of revenue generation is intergovernmental transfers, where state governments devolve a certain percentage of their revenue to PRIs. The constitutional amendment created provisions for State Finance Commissions to recommend the revenue share between state and local governments. However, these are merely recommendations and the state governments are not bound by them.
- Though finance commissions, at every level, have advocated for greater devolution of funds, there has been little action by states to devolve funds.
- PRIs are reluctant to take on projects that require any meaningful financial outlay, and are often unable to solve even the most basic local governance needs.
- PRIs also suffer from structural deficiencies i.e. no secretarial support and lower levels of technical knowledge which restricted the aggregation of bottom up planning .
- There is a presence of adhocism i.e. lack of clear setting of agenda in gram sabha, gram samiti meetings and no proper structure.
- Though women and SC/STs has got representation in PRIs through reservation mandated by 73rd amendment but there is a presence of Panch-Pati and Proxy representation in case of women and SC/STs representatives respectively.
- Accountability arrangements remain very weak even after 26 years of PRIs constitutional arrangement.
- The issue of ambiguity in the division of functions and funds has allowed concentration of powers with the states and thereby restraining the elective representatives who are more aware and sensitive to the ground level issues to take control.
Suggestions
- Genuine fiscal federalism i.e. fiscal autonomy accompanied by fiscal responsibility can provide a long term solution without this PRIs will only be an expensive failure.
- 6th report of 2nd ARC, ‘Local Governance- An inspiring journey into the future’’, had recommended that there should be a clear-cut demarcation of functions of each tier of the government.
- States should adopt the concept of ‘activity mapping’, wherein each state clearly delineates the responsibilities and roles for the different tiers of the government in respect to the subjects listed in the Schedule XI.
- The subjects should divided and assigned to the different tiers on the basis of accountability to the public.
- States like Karnataka and Kerala have taken some steps in this direction but overall progress has been highly uneven.
- There is need for bottom up planning especially at the district level, based on grassroots inputs received from Gram Sabha.
- Karnataka has created a separate bureaucratic cadre for Panchayats to get away from the practice of deputation of officials who often overpowered the elected representatives.
- Such practices needs to be replicated in other states for strengthening the true character of local self governance.
- The center also needs to financially incentivize states to encourage effective devolution to the panchayats in functions, finances, and functionaries.
- Training should be provided to local representatives to develop expertise so that they contribute more in planning and implementation of policies and programmes.
- To solve the problem of proxy representation social empowerment must precede the political empowerment.
- Recently states like Rajasthan and Haryana have set certain minimum qualification standards for Panchayat elections. Such necessary eligibility can help in improving effectiveness of governance mechanism.
- These standards should apply for MLAs and MPs also and in this direction government should speeden up efforts for universal education.
- There should be clear mechanisms to ensure that States comply with the constitutional provisions, particularly in the appointment and implementation of the recommendations of the State Finance Commissions (SFCs).
Way Forward
- The need of the hour is to bring about a holistic change in the lives of beneficiaries among the villagers by uplifting their socioeconomic and health status through effective linkages through community, governmental and other developmental agencies.
- Government should take remedial action in the interest of democracy, social inclusion and cooperative federalism.
- People’s demands for the sustainable decentralisation and advocacy should focus on a decentralisation agenda. The framework needs to be evolved to accommodate the demand for decentralisation.
- It is important to have clarity in the assignment of functions and the local governments should have clear and independent sources of finance.
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Finance Commission – Issues related to devolution of resources
Still no recognition of the third tier
Note4Students
From UPSC perspective, the following things are important :
Prelims level: Not much
Mains level: Paper 2- Critique of the Fifteenth Finance Commission recommendations with regard to local government
The article highlights the issues with the Fifteenth Finance Commission recommendations with regard to the third tier of the local governments.
Significance of Finance Commission recommendations for local government
- The primary task of the Union Finance Commission is to rectify the vertical and horizontal imbalances in resources and expenditure responsibilities between Union and States including the third tier of local governments.
- Part IX and Part IX-A were incorporated into the Constitution by the 73rd and 74th Constitutional Amendment.
- Part IX and Part IX-A mandate the Union Finance Commission to supplement the resources of panchayats and municipalities on the basis of the recommendations of the State Finance Commission.
- Now, nearly 2.5 lakh local governments and over 3.4 million elected representatives form the real democratic base of the Indian federal polity.
Increase in vertical devolution
- The Fifteenth Finance Commission has raised the vertical devolution recommended to local governments to 4.23% with a reasonably estimated amount of ₹4,36,361 crore.
- Compared with the Fourteenth Finance Commission there is a 52% increase in the vertical share.
- Even if we deduct the grant of ₹70,051 crore earmarked for improving primary health centres, the share is still an all-time high of 4.19%.
- All the Commissions since the Eleventh Commission have tied specific items of expenditure to local grants and the Fifteenth Finance Commission has raised this share to 60% and linked them to drinking water, rainwater harvesting, sanitation and other national priorities in the spirit of cooperative federalism.
Reduction in performance-based grants
- The Fifteenth Finance Commission has reduced the performance-based grant to just ₹8,000 crore — and that too for building new cities, leaving out the Panchayati Raj Institutions (PRIs) altogether.
- The performance-linked grants were introduced by the Thirteenth Finance Commission and covered a wide range of reforms.
- The transformative potential in designing performance-linked conditionalities for improving the quality of decentralised governance in the context of indifferent states is missed.
Encouraging standardisation of accounting system
- An important recommendation of the Fifteenth Finance Commission is the entry-level criterion to avail the union local grant (except health grant) by local governments.
- For panchayats, the condition is the online submission of annual accounts for the previous year and audited accounts for the year before.
- For urban local governments, two more conditions are specified: fixation of the minimum floor for property tax and improvement in its collection.
- It is not clear why gram panchayats are left out from this.
- Although Finance Commissions, from the Eleventh to the Fourteenth, have recommended measures to standardise the accounting system and update the auditing of accounts, the progress made has been halting.
- Therefore, the entry-level criteria of the Fifteenth Finance Commission are timely.
Missed opportunity to ensure minimum public services
- The Fifteenth Finance Commission failed to carry policy choices forward systematically.
- Articles 243G, 243W and 243ZD read along with the functional decentralisation of basic services like drinking water, public health care, etc., mandated in the Eleventh and Twelfth schedules demand better public services and delivery of ‘economic development and social justice’ at the local level.
- A good opportunity to ensure comparable minimum public services to every citizen irrespective of her choice of residential location has not been taken forward in an integrated manner.
Missing equalisation principle for the local government
- The Fifteenth Finance Commission claims that it seeks to achieve the “desirable objective of evenly balancing the union and the states”.
- It is not clear why there is no recognition of the third tier in this balancing act.
- It may be relevant to recall that the Alma-Ata declaration of the World Health Organization (1978) which outlined an integrated, local government-centric approach with a simultaneous focus on access to water, sanitation, shelter and the like.
- There is no integrated approach in the recommendations of the Fifteenth Finance Commission about the local governments (in contrast to the recommendations of the Thirteenth Finance Commission).
- Although the Fifteenth Finance Commission stresses the need to implement the equalisation principle, it is virtually silent when it comes to the local governments.
Equity and efficiency sidelined
- The Fifteenth Finance Commission employed population (2011 Census) with 90% and area 10% weightage for determining the distribution of grant to States for local governments.
- The same criteria were followed by the Fourteenth Finance Commission.
- While this ensures continuity, equity and efficiency criteria are sidelined.
- Abandoning tax effort criterion incentivises dependency, inefficiency and non-accountability.
Consider the question “Discuss the various aspects of the Fifteenth Finance Commission’s recommendations with regard to local governments.”
Conclusion
In sum, if decentralisation is meant to empower local people, the primary task is to fiscally empower local governments to deliver territorial equity. We are far from this goal.
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Finance Commission – Issues related to devolution of resources
Fifteenth Finance Commission has increased proportion of grants conditional on reforms
Note4Students
From UPSC perspective, the following things are important :
Prelims level: State Finance Commission
Mains level: Paper 2- Conditional grants to incentivise the states for reforms
The article highlights the crucial recommendations made by the 15th Finance Commission and also explains the importance of conditions for grants from the Centre to push the state for reforms.
Crucial recommendations by 15th Finance Commission
- The Fifteenth Finance Commission’s report for the period 2021-22 to 2025-26 outlines some crucial recommendations for state governments.
- These recommendations cover tax devolution, grants from the Centre, and the guidelines for the borrowings that they are permitted to incur over the medium-term.
- The commission has recommended that 41 per cent of the government’s divisible pool of taxes be transferred to state governments.
Horizontal devolution formula
- The horizontal devolution formula specifies each state’s share in the overall pie.
- The 15th FC was required to use the states’ population as per the 2011 Census — a highly contentious change.
- It has also introduced a demographic performance criterion.
- Additionally, it has also introduced a new criterion –tax effort.
- Tax effort is measured by the ratio of the three-year average of per-capita own tax revenues and per-capita gross state domestic product (GSDP).
- The net result of the change in criteria is that the share of 10 states in the divisible pool has declined.
- Karnataka is the biggest loser, while Maharashtra is the biggest gainer.
Grants from the Centre conditioned on reforms in states
- Another major set of the commission’s recommendations pertain to grants from the Centre.
- In a major shift, the 15th FC has sharply increased the proportion of grants whose receipt is conditional on specified reforms being undertaken.
- 57 per cent of the 15th FC-recommended grants accepted so far by the GoI are conditional, relative to just 17 per cent for the 14th FC (including J&K).
What are the conditions
1) Setting up of State Finance Commission (SFC) and applicability of SFC’s recommendations for 5 years only
- Constitution requires state governments to set up State Finance Commissions (SFC).
- The 15th FC has asserted that the mandate of any given SFC is intended to be applicable only for five years.
- It revealed that only 15 states have set up their fifth or sixth SFCs, whereas several states have not moved beyond their second or third SFC.
- Accordingly, a staggering 84 per cent of the Rs 4.4 trillion grants for local bodies recommended by the 15th FC are conditional on the states setting up SFCs for the coming five-year period, and acting on their recommendations by March 2024.
2) Availability of online accounts
- Another entry-level condition for availing grants by rural and urban local bodies pertains to the timely availability of their accounts online from 2021-22 onwards.
3) Notiflying floor rate for property tax
- For the receipt of grants by the urban bodies, states are required to notify a floor rate for property tax by 2021-22, and demonstrate consistent year-wise improvement from 2022-23 onwards.
- This will complement the conditions set previously by SEBI for ULBs to become eligible to raise municipal bonds.
Changes in limit on net borrowings of state governments
- The commission has recommended that the normal limit for net borrowings of state governments be fixed at 4 per cent of GSDP in 2021-22.
- This will ease to 3.5 per cent by 2022-23, thereafter reverting to the erstwhile 3 per cent limit till 2025-26.
- The additional borrowing space of 0.5 per cent of GSDP for states is conditional on the completion of power sector reforms.
Prospect of huge gaps in states’ revenue in the future
- The states’ fiscal arithmetic will alter in 2022-23 with the GST compensation set to cease at the end of June 2022 as things stand today.
- The ensuing drop in grants, combined with the tapering of the front-loaded revenue deficit grants is likely to leave a big gap in some states’ revenues.
Consider the question “What are the conditions laid down by the 15th Finance Commission on the states for the central grants? How these conditions could benefit the states?”
Conclusion
The question is whether this revenue gaps will force the states to move on both the power sector reforms, which have proven challenging in the past, and the municipal reforms, so that their resource availability may be enhanced.
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Finance Commission – Issues related to devolution of resources
15th Finance Commission could catalyse accountability, effective governance at grassroots
Note4Students
From UPSC perspective, the following things are important :
Prelims level: Not much
Mains level: Paper 2- Catalysing accountability and creative governance in local government
The article explains the innovative approach adopted by the Fifteenth Finance Commission in devolution of funds.
Steep hike in grants
- Local governments are the closest to the people at the grassroots level.
- They provide critical civic amenities such as roads, water and sanitation, and primary education and health.
- With this in view, the Fifteenth Finance Commission (FFC) has recommended grants of Rs 4,36,361 crore from the Union government to local governments for 2021-26.
- This is an increase of 52 per cent over the corresponding grant of Rs 2,87,436 crore by its predecessor for 2015-20.
Innovation in recommendations
1) Scaling of capacities in municipalities
- The Commission has recommended Rs 8,000 crore as performance-based grants for incubation of new cities and Rs 450 crore for shared municipal services.
- This is designed to foster innovations in urban governance to transform our cities with speed and scale.
- There is an urgent need for synergistically combined area-based development to spur economic growth and job creation, and decongesting through the development of satellite townships.
- Separately, the massive scaling of capacities in municipalities, particularly the 4,000-odd smaller ones, cannot be done by building capacities in each one of them, but through institutional and technological innovations, without compromising their autonomy.
- The shared municipal services model, with mobile internet, maps, platform thinking, and outsourced services all taken together, can help us fast-track the creation of municipal capacities at scale.
- This is one of the innovations in the FFC recommendations.
2) Allocation covers all three tiers of panchayats
- Of grants for all local governments with 90 per cent weightage on population and 10 per cent on area remains unchanged from the Fourteenth Finance Commission.
- For panchayats, the FFC allocations cover all the three tiers — village, block, and district — as well as the Excluded Areas in a state exempted from the purview of Part IX and Part IX-A of the Constitution.
- Funds to all three can improve functional coordination and facilitate the creation of assets collectively across smaller jurisdictions.
- This is the second new aspect of the FFC recommendations.
3) Focus on metropolitan governance
- The FFC calls for a focus on urban agglomerations (UAs) that include urban local bodies, census towns and outgrowths.
- In 2011, out of the total urban population of 377 million, 61 per cent lived in UAs.
- The FFC has emphasised the need to focus on the complex challenges of air quality, drinking water supply, sanitation, and solid waste management in the million-plus UAs and cities.
- Thus, for 2021-26, there is a Million-plus Challenge Fund of Rs 38,196 crore that can be accessed by million-plus cities only through adequate improvements in their air quality and meeting service level benchmarks for drinking water supply, sanitation, and solid waste management.
- This focus on metropolitan governance through substantive but 100 per cent outcome-based grants is the third innovation.
- For ULBs other than the million-plus category, the total grants are Rs 82,859 crore.
- The grants to local governments, both urban (less than a million category) and rural, contain a mix of basic, tied as well as performance grants.
4) Entry-level conditions
- The efficiency, smooth functioning and accountability of local bodies have been plagued by:
- (i) lack of readily accessible and timely audited accounts,
- (ii) absence of timely recommendations of State Finance Commissions and suitable actions thereon,
- (iii) inadequate mobilisation of property tax revenues (especially in ULBs).
- Finance Commissions in the past have drawn pointed attention to these issues, but with limited success.
- These entry-level conditions for availing any grants and their applicability to all local governments is the fourth innovation.
Consider the question “Examine the innovative approach adopted by the Fifteenth Finance Commission for the devolution of funds to panchayats and municipal bodies.”
Conclusion
Hopefully, over the next five years, through a partnership among the Union, states, and local governments, in the spirit of cooperative federalism, these recommendations and innovations will catalyse progress in the accountability and effectiveness of local governments in India.
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Finance Commission – Issues related to devolution of resources
In difficult times, Fifteenth Finance Commission rose to the challenge
Note4Students
From UPSC perspective, the following things are important :
Prelims level: Finance Commission
Mains level: Paper 2- Recommendations of Fifteenth Finance Commission
The article analyses the various recommendations of the Fifteenth Finance Commission and their impact.
Unique challenges
- Many new and unique demands were placed on the 15th Finance Commission.
- The major challenge being addressing the issue of the 2011 population census evoking a sharp response from the southern states.
- Other issues include the non-lapsable defence fund and the use of certain parameters for performance incentives.
- The Commission was also required to perform the task of assessing and projecting the fiscal roadmap for the Union and state amid an uncertain domestic environment due to shortfall in the GST collection, further accentuated in the year 2020 by the global pandemic.
Key recommendations
The Commission, in its final report, recommended vertical devolution at 41 per cent, adjusting 1 per cent for the erstwhile state of Jammu and Kashmir.
1) Horizontal distribution
- For horizontal distribution, the commission has tried to harmonise the principles of expenditure needs, equity and performance.
- This is achieved by the introduction of efficiency criteria of tax and fiscal efforts and by assigning 12.5 per cent weight to demographic performance.
- Consideration of demographic performance will help in resolving the demographic debate and incentivising states in moving towards the replacement rate of population growth.
2) Principles governing grant-in-aid
- Grants are important as they are more directly targeted and equalise the standards of basic social services to some extent.
- The Commission has recommended a total grant of Rs 10,33,062 crore during 2021-26.
- Grant is broadly characterised into: (a) revenue deficit grants (b) grants for local governments (c) grants for disaster management (d) sector-specific grants and (e) state-specific grants.
- Many of these grants are linked with performance-based criteria, thereby promoting principles of transparency, accountability, and leading to better monitoring of expenditures.
- However, the Commission was asked to examine whether revenue deficit grants should be provided at all to the states.
- Some states stressed that revenue deficit grants have serious disincentives for tax efforts and prudence in expenditure and, hence, these should be discontinued.
- Fiscally stressed states of Kerala, West Bengal and Punjab are regular recipients of these grants due to high debt legacy.
3) Conditional grants to local bodies
- This Commission’s grant for local government is different from that of its predecessors for the set of entry-level conditions:
- (a) Constitution of State Finance Commissions.
- (b) Timely auditing and online availability of accounts for rural local bodies coupled with
- (c) Notifying consistent growth rate for property tax revenue for urban local bodies.
- Secondly, the recommendations are in alignment with the national programmes of Swachch Bharat Mission and Jal Jeewan Mission.
4) Incubation of new cities and urban grants
- It is for the first time that a Finance Commission has recommended Rs 8,000 crore to states for incubation of new cities, granting Rs 1,000 crore each for eight new cities.
- The focus of urban grants for million-plus cities is improvement in air quality and meeting the service level benchmark of solid waste management and sanitation.
5) Grants for health and setting up of disaster mitigation fund
- The commission recommended channelising the health grant of Rs 70,051 crore through local bodies, addressing the gaps in primary health infrastructure.
- The Commission’s recommendation for setting up the state and national level Disaster Risk Mitigation Fund (SDRMF), in line with the provisions of the Disaster Management Act, is both well-timed and necessary.
- For the first time, the Finance Commission has introduced a 10-25 per cent graded cost-sharing basis by the states for the NDRF and NDMF which has not been appreciated by the states.
6) Non-lapsable fund for defence
- The Commission has recommended setting up of a dedicated non-lapsable fund, the Modernisation Fund for Defence and Internal Security (MFDIS).
- Objective of the fund is to bridge the gap between projected budgetary requirements and budget allocation for defence and internal security and to provide greater predictability for enabling critical defence capital expenditure.
- The fund will have four specific sources: (a) Transfers from the Consolidated Fund of India, (b) disinvestment proceeds of DPSEs, (c) proceeds from the monetisation of surplus defence land and (d) proceeds of receipts from defence land likely to be transferred to state governments and for public projects in the future.
- The total indicative size of the proposed MFDIS over the period 2021-26 is Rs 2,38,354 crore.
- The Union government has accepted this recommendation in principle.
Consider the question “Examine the various principles on which the Fifteenth Finance Commission based the horizontal distribution of states share.”
Conclusion
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.
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Finance Commission – Issues related to devolution of resources
Finance Commission dips into states’ share for Centre’s expenditure
Note4Students
From UPSC perspective, the following things are important :
Prelims level: Finance Commission and its recommendations
Mains level: Paper 2- Fifteenth Finance Commission report and federalism
The article analyses the recommendations of fifteenth Finance Commission and their implications for the federalism in India.
Major recommendations accepted by the government
- Report of the fifteenth Finance Commission (XVFC) was laid before the Parliament.
- The finance minister announced the acceptance of its recommendation of retaining the share of states in central taxes at 42 per cent.
- She also stated that on its recommendation revenue deficit grants of Rs 1.18 lakh crore to the states have been provided for in the budget.
- Some of the recommendations, however, have far-reaching implications on government finances, both of the Centre and the states.
- Keeping in view the extant strategic requirements for national defence in a global context, XVFC has, in its approach, recalibrated the relative shares of the Union and the states in gross revenues receipts.
Issues with the recalibration for national defence
- Recalibration enables the Union to set aside resources for special funding on defence.
- The states have been made to pay Rs 7,000 crore to bridge [the] Centre’s gap between projected budgetary requirements and budget allocation for defence and internal security defence.
- But this is an expenditure that the Centre is obliged to fund.
- For the first time, a finance commission has carved out resources meant for distributable statutory grants and dipped into the states’ revenue share, as against the tax share, in order to finance the Centre’s exclusive expenditure obligation.
- What has been done is not in line with the system envisaged in the Constitution.
- This move will eventually put the fiscal federal system under systemic strain.
- In operational terms, too, this move is a significant departure.
- So far, the Centre has been used to pre-empting resources from the kitty to be distributed among the states but only to finance expenditures in areas earmarked for states.
- This was done through the centrally-sponsored schemes, but at least the states’ money was being used in the states, even if on a discretionary rather than a criteria basis.
- Now, with this move of earmarking and financing of funds for sectors, it is the states’ money that is being used to finance the Centre’s expenditure.
- This is certainly not cooperative federalism.
Changes in horizontal distribution: More weightage to efficiency and performance
- In horizontal distribution, the criteria used by successive finance commissions for devolving taxes across states have always been linked to need — based on equity, tempered by efficiency.
- From 92.5 per cent of funds to a state being devolved based on need and equity, the XVFC has reduced these two components to 75 per cent.
- The remaining 25 per cent are to be devolved on considerations of efficiency and performance.
- This is the lowest weightage for equity, making the XVFC transfers potentially the least progressive ever.
Structural changes not taken into account
- The Finance Commission has not even made any serious effort to review the existing scheme of transfers in light of the changed federal landscape.
- The existing criteria for the devolution have evolved in, and for, a production-based tax system.
- The XVFC should have reformulated the distributional criteria for a consumption-based tax system [GST].
- The structural change from production to consumption will make a significant difference to distribution as well as the need, nature and distribution of equalising grants.
- This is the same manner in which the revenue deficit grants have been carried forward.
- Ideally, the “gap-filling” approach should have been redesigned in light of the compensation law providing a minimum-guaranteed revenue of 14 per cent to every state.
Consider the question “For the first time, a finance commission has carved out resources meant for distributable statutory grants and dipped into the states’ revenue share, as against the tax share, in order to finance the Centre’s exclusive expenditure obligation. What are the issues with this move?”
Conclusion
The Fifteenth Finance Commission report is not aligned with the new landscape of federalism and does not address the key issues.
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Finance Commission – Issues related to devolution of resources
Municipal finance reform through Finance Commission recommendations
Note4Students
From UPSC perspective, the following things are important :
Prelims level: Finance Commission
Mains level: Paper 2- Transformation of financial governance of municipalities
Transforming the financial governance of India’s municipalities
- Interim report of the Fifteenth Finance Commission of India (XV FC) indicates that it could fundamentally transform the financial governance of India’s municipalities.
- Final report for FY 2021-22 to FY 2025-26 is expected to be tabled along with the forthcoming Budget 2021-22.
- Building on the track record of previous finance commissions, the XV FC Commission has significantly raised the bar on financial governance of India’s municipalities in the interim report in at least four specific ways.
4 Provisions in the interim report
1) Increase in the outlay for municipalities
- It has set aside Rs 29,000 crore for FY 2020-21 and indicated the intent to raise the share of municipalities in the total grants’ of local bodies including panchayats gradually over the medium term, from the existing 30 per cent to 40 per cent.
- This could result in the outlay over five years being in the range of Rs 1,50,000-Rs 2,00,000 crore compared to Rs 87,000 crore during the XIV FC period.
2) Ensuring financial accountability through conditions
- Two very important entry conditions have been set for any municipality in India to receive FC grants:
- 1) Publication of audited annual accounts.
- 2) Notification of floor rates for property tax.
- These two entry conditions lay strong foundations for financial accountability of municipalities and own revenue enhancement respectively.
- Similarly, the Atmanirbhar Bharat Abhiyan links Rs 50,000 crore of additional borrowing limits for states to reforms in property taxes and user charges for water and sanitation.
- There is also a thrust on municipal bonds and municipal finance reform conditions under AMRUT.
3) Distinguishing between million-plus urban agglomerations, and other cities
- The XV FC has adopted an approach of distinguishing between million-plus urban agglomerations, and other cities.
- This is well-founded, based on the pattern of urbanisation in India, where 53 million-plus urban agglomerations comprising 250-plus municipalities account for approximately 44 per cent of the total urban population.
- The remaining 4,250-plus municipalities comprise 56 per cent of the total urban population.
- Of the remaining 56 per cent, there is a “long tail” of approximately 3,900 municipalities with 33 per cent of the total urban population.
- The XV FC has now provided for 100 per cent outcome-based funding of approximately Rs 9,000 crore to 50 million-plus urban agglomerations (excluding Union Territories) with specific emphasis on air quality, water supply and sanitation and basic grants to the rest of the cities, with 50 per cent of the end-use tied to water supply and sanitation.
- For the first time, there is also an acknowledgement of the metropolitan area as a unified theatre of action to solve complex challenges of air quality, water and sanitation, with implicit emphasis on inter-agency coordination.
4) Common digital platform for municipal accounts
- The report recommends a common digital platform for municipal accounts, a consolidated view of municipal finances and sectoral outlays at the state level, and digital footprint of individual transactions at source, the FC has broken new ground and demonstrated farsightedness.
Role of the state governments
- The ultimate responsibility for municipal finance reforms remains with state governments.
- Constitutional bodies such as the finance commission can, at best, prepare the ground and provide incentives and disincentives.
- We need municipal legislation to reflect progressive and enabling financial governance of our cities through five reform agendas:
- 1) Fiscal decentralisation including strengthening state finance commissions.
- 2) Revenue optimisation to enhance own revenues.
- 3) Fiscal responsibility and budget management to accelerate municipal borrowings.
- 4) Institutional capacities towards an adequately skilled workforce.
- 5) Transparency and citizen participation (for democratic accountability at the neighbourhood level).
- The first step needs to be predictable fiscal transfers from state governments to municipalities and other civic agencies on a formula-based approach as against the present practice of ad hoc, discretionary grants.
- State finance commissions would need to emulate the XV FC and its predecessors, and emerge as credible institutions.
- State governments need to ensure that state finance commissions are constituted on time, resourced right, and their recommendations taken seriously.
Consider the questions “Financial governance of our cities faces several challenges. Discuss the reforms that could transform the financial governance of municipalities”
Conclusion
The state government must act on these reform agenda and ensure the transformation of financial governance of their municipalities.
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Finance Commission – Issues related to devolution of resources
N.K. Singh calls for a fresh look at the Seventh Schedule
Note4Students
From UPSC perspective, the following things are important :
Prelims level: 7th Schedule
Mains level: Federalism issue raised by the Agricultural Bills
Fifteenth Finance Commission chairman N.K. Singh has called for a fresh look at the Constitution’s Seventh Schedule, which forms the basis for allocating subjects to the Centre and States.
Try this PYQ:
Q.Which of the following provisions of the Constitution of India have a bearing on Education?
- Directive Principles of State Policy
- Rural and Urban Local Bodies
- Fifth Schedule
- Sixth Schedule
- Seventh Schedule
Select the correct answer using the codes given below:
(a) 1 and 2 only
(b) 3, 4 and 5 only
(c) 1, 2 and 5 only
(d) 1, 2, 3 4 and 5
Why such calls by Mr NKS?
- Singh said these issues needed urgent consideration to reinforce trust in fiscal federalism.
- He urged a review of both the Seventh Schedule and Article 282 of the Constitution so as to give more flexibility to States in implementing centrally sponsored schemes.
- Many have argued that the trust between various forms of government is waning.
- Since the farmers’ agitation, these are seen through the prism of suspicion and mistrust.
Q. The federal organisation of powers under the Constitution’s Seventh Schedule needs review. In light of this, examine the problems faced by the distribution and suggest the challenge the review would face.
What is the Seventh Schedule?
- This Schedule of the Indian Constitution deals with the division of powers between the Union government and State governments.
- It defines and specifies the allocation of powers and functions between Union & States. It contains three lists; i.e. 1) Union List, 2) State List and 3) Concurrent List.
The Union List
- It is a list of 98 (Originally 97) numbered items as provided in the Seventh Schedule.
- The Union Government or Parliament of India has exclusive power to legislate on matters relating to these items.
The State List
- It is a list of 59 (Originally 66) items.
- The respective state governments have exclusive power to legislate on matters relating to these items.
The Concurrent List
- There are 52 (Originally 47) items currently in the list.
- This includes items which are under the joint domain of the Union as well as the respective States.
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Finance Commission – Issues related to devolution of resources
15th Finance Commission submits report to President
Note4Students
From UPSC perspective, the following things are important :
Prelims level: Finance Commission
Mains level: Mandate of the Finance Commission
The 15th Finance Commission, chaired by NK Singh, on Monday submitted its final report for 2021-22 to 2025-26 to the President.
Try this PYQ:
With reference to the Finance Commission of India, which of the following statements is correct?
(a) It encourages the inflow of foreign capital for infrastructure development
(b) It facilitates the proper distribution of finances among the Public Sector Undertakings
(c) It ensures transparency in financial administration
(d) None of the statements (a), (b) and (c) given above is correct in this context
Key recommendations that would feature in its final report:
- A separate defence and national security: The viability of creating a separate defence and national security fund as suggested by the Centre.
- States would keenly await these recommendations as it may translate into a lower share of funds for them.
- GST compensation dues to States: The panel is also expected to factor in unpaid GST compensation dues to States for this year, while working out State’s revenue flow calculations for the years beyond 2022.
Formula that decides a State’s share:
| Weight in 15th FC | Parameters | Weight in 14th FC |
| 15 (2011 Census) | Population | 27.5 (17.5 – 1972, 10 – 2011 Census) |
| 15 | Area | 15 |
| 10 | Forest and Ecology | 7.5 |
| 45 | Income Distance | 50 |
| 12.5 | Demographic Performance | – |
| 2.5 | Tax Effort |
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.
Why need the Finance Commission?
- 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.
- The first FC was established in 1951 by Dr B.R. Ambedkar, the then-incumbent law minister, to address these imbalances.
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
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Finance Commission – Issues related to devolution of resources
Fifteenth Finance Commission
Note4Students
From UPSC perspective, the following things are important :
Prelims level: Finance Commission
Mains level: Finance Commission, Its evolving role in fiscal federalism
Three years after it was constituted, the Fifteenth Finance Commission has finalised its report for fund devolution from the Centre to States for the five years from 2021-22 to 2025-26.
Fifteenth Finance Commission
- The Fifteenth Finance Commission (XV FC) was constituted on November 27, 2017.
- It was constituted against the backdrop of the abolition of the Planning Commission and the distinction between Plan and non-Plan expenditure, and introduction of the Goods and Services Tax (GST).
What is the Finance Commission?
- The 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.
Why in news now?
- That report of the XV FC had pared the States’ share of the divisible tax pool from 42%, as recommended by the Fourteenth Finance Commission, to 41%, citing the creation of the UT of Jammu and Kashmir and Ladakh.
- The Commission had then said that some of the key recommendations it was required to make would feature in its final report, including the viability of creating a separate defence and national security fund.
- The panel is also expected to factor in unpaid GST compensation dues to States for this year while working out States’ revenue flow calculations for the years beyond 2022.
Must read:
[Burning Issue] 15th Finance Commission and its recommendations (Part I)
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Finance Commission – Issues related to devolution of resources
India needs a Fiscal Council
Note4Students
From UPSC perspective, the following things are important :
Prelims level: Idea of fiscal council
Mains level: Paper 2- Fiscal Council
The newscard highlights the need of bipartisan, independent Fiscal Council to report and analyse FRBM discrepancies by the Government.
Try this question for mains:
Q.Fiscal Council is an important institution needed to complement the rule-based fiscal policy. Discuss.
What is a Fiscal Council?
- A Fiscal Council is an independent fiscal institution (IFI) with a mandate to promote stable and sustainable public finances.
- They aim to provide nonpartisan oversight of fiscal performance and/or advice and guidance — from either a positive or normative perspective — on key aspects of fiscal policy.
- These institutions assist in calibrating sustainable fiscal policy by making an objective and scientific analysis.
Voices for a Fiscal Council
- The 13th Finance Commission recommended that a committee be appointed by the Ministry of Finance which should eventually transform itself into a Fiscal Council.
- The FC expected it to conduct an annual independent public review of FRBM compliance, including a review of the fiscal impact of policy decisions.
- The FRBM Review Committee too made a similar recommendation underlining the need for an independent review by the Finance Ministry appointing the Council.
Why need a fiscal council?
(1)Burgeoning deficits
- For the current year, even without any additional fiscal stimulus, the deficit is estimated at about 7% of GDP as against 3.5% estimated in the Budget due to a sharp decline in revenues.
- The consolidated deficit of the Union and States could be as high as 12% of GDP and the overall debt could go up to 85%.
- Thus it is necessary that the government must return to a credible fiscal consolidation path once the crisis gets over.
(2)Transparency issues
- Besides large deficits and debt, there are questions of comprehensiveness, transparency and accountability in the Budgets.
- The practice of repeated postponement of targets, timely non-settlement of bill payments and off Budget financing to show lower deficits has been common.
- The report of the CAG of India in 2018 has highlighted various advances done to keep the liabilities hidden.
Fiscal Council can be a game changer. How?
- First, an unbiased report to Parliament helps to raise the level of debate and brings in greater transparency and accountability.
- Secondly, costing of various policies and programmes can help to promote transparency over the political cycle to discourage populist shifts in fiscal policy and improve accountability.
- Third, scientific estimates of the cost of programmes and assessment of forecasts could help in raising public awareness about their fiscal implications and make people understand the nature of budgetary constraint.
- Finally, the Council will work as a conscience keeper in monitoring rule-based policies, and in raising awareness and the level of debate within and outside Parliament.
Issues meddling between
- The problem is that a Council created by the Finance Ministry and reporting to it can hardly be expected to be independent.
Diverse role to play ahead
- According to the IMF, there were 36 countries with IFIs in 2014 and more have been established since.
- While most of the IFIs are in advanced countries, emerging economies too have also shown growing interest in them.
- Although their common agenda has been to function as watchdogs, there is considerable diversity in their structure and functions.
- Over the years, monitoring compliance with fiscal rules and costing policies and programmes have become major tasks of these councils.
Way forward
- When the markets fail, governments have to intervene.
- Whenever governments seem obstructed, it is here that we need systems and institutions to ensure checks and balances.
- In that respect, a Fiscal Council is an important institution needed to complement the rule-based fiscal policy.
Conclusion
- Of course, it is not a ‘silver bullet’; if there is no political will, the institution would be less effective, and if there is political will, there is no need for such an institution.
- That is also true of the FRBM Act. While we cannot state that the FRBM Act has been an unqualified success, it has also not been an abject failure either.
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Finance Commission – Issues related to devolution of resources
NPA issue in India:Complete analysis
Note4Students
From UPSC perspective, the following things are important :
Prelims level: Finance commission and related constitutional provisions
Mains level: Implication in federal relation; scope for reforms
The Financial Stability Report (FSR) released by RBI recently has once again underlined the vulnerability of the Indian public sector banks (PSBs). They have been under a severe balance sheet crisis even before the pandemic, and the crisis created by the pandemic, and the moratorium offered, will explode when the chickens come to roost.
Current banking scenario in India
According to the FSR
- The gross non-performing assets would go up from 11.3% in March 2020 to 15.2% in March 2021, and to 16.3% under a very severe stress scenario.
- The CRAR is estimated to deteriorate from 14.6% in March to 13.3% in the baseline scenario, and to 11.8% under a very severe stress scenario.
- The volume of recapitalisation required is humongous.
What is a Non-Performing Asset (NPA)?
- You may note that for a bank, the loans given by the bank is considered as its assets. So if the principle or the interest or both the components of a loan is not being serviced to the lender (bank), then it would be considered as a Non-Performing Asset (NPA).
- Any asset which stops giving returns to its investors for a specified period of time is known as Non-Performing Asset (NPA).
- Generally, that specified period of time is 90 days in most of the countries and across the various lending institutions. However, it is not a thumb rule and it may vary with the terms and conditions agreed upon by the financial institution and the borrower.
Reasons for rise in NPA in India
- Historical factors -Between early 2000’s and 2008 Indian economy were in the boom phase. During this period Banks especially Public sector banks lent extensively to corporate. However, the profits of most of the corporate dwindled due to slowdown in the global economy, the ban in mining projects, and delay in environmental related permits affecting power, iron and steel sector, volatility in prices of raw material and the shortage in availability of. This has affected their ability to pay back loans and is the most important reason behind increase in NPA of public sector banks.
- Relaxed lending norms : One of the main reasons of rising NPA is the relaxed lending norms especially for corporate honchos when their financial status and credit rating is not analyzed properly. Also, to face competition banks are hugely selling unsecured loans which attributes to the level of NPAs.
- Lack of contigency planning: Banks did not conducted adequate contingency planning, especially for mitigating project risk. They did not factor eventualities like failure of gas projects to ensure supply of gas or failure of land acquisition process for highways.
- Restructuring of loan facility was extended to companies that were facing larger problems of over-leverage& inadequate profitability. This problem was more in the Public sector banks.
- Unforseen economic shocks like Demonetization and Covid 19
What is the impact of NPAs?
- Lenders suffer a lowering of profit margins.
- Stress in banking sector causes less money available to fund other projects, therefore, negative impact on the larger national economy.
- Higher interest rates by the banks to maintain the profit margin.
- Redirecting funds from the good projects to the bad ones.
- As investments got stuck, it may result in it may result in unemployment.
- In the case of public sector banks, the bad health of banks means a bad return for a shareholder which means that the government of India gets less money as a dividend. Therefore it may impact easy deployment of money for social and infrastructure development and results in social and political cost.
- Investors do not get rightful returns.
- Balance sheet syndrome of Indian characteristics that is both the banks and the corporate sector have stressed balance sheet and causes halting of the investment-led development process.
- NPAs related cases add more pressure to already pending cases with the judiciary.
What are the various steps taken to tackle NPAs?
1.Corporate Debt Restructuring – 2005
It is for reducing the burden of the debts on the company by decreasing the rates paid and increasing the time the company has to pay the obligation back.
2.5:25 rule – 2014
- Also known as, Flexible Structuring of Long Term Project Loans to Infrastructure and Core Industries.
- It was proposed to maintain the cash flow of such companies since the project timeline is long and they do not get the money back into their books for a long time, therefore, the requirement of loans at every 5-7 years and thus refinancing for long term projects.
3.Joint Lenders Forum – 2014
- It was created by the inclusion of all PSBs whose loans have become stressed. It is present so as to avoid loans to the same individual or company from different banks.
- It is formulated to prevent instances where one person takes a loan from one bank to give a loan of the other bank.
4.Mission Indradhanush – 2015
The Indradhanush framework for transforming the PSBs represents the most comprehensive reform effort undertaken since banking nationalization in the year 1970 to revamp the Public Sector Banks (PSBs) and improve their overall performance by ABCDEFG.
- A-Appointments: Based upon global best practices and as per the guidelines in the companies act, separate post of Chairman and Managing Director and the CEO will get the designation of MD & CEO and there would be another person who would be appointed as non-Executive Chairman of PSBs.
- B-Bank Board Bureau: The BBB will be a body of eminent professionals and officials, which will replace the Appointments Board for the appointment of Whole-time Directors as well as non-Executive Chairman of PSBs
- C-Capitalization: As per finance ministry, the capital requirement of extra capital for the next four years up to FY 2019 is likely to be about Rs.1,80,000 crore out of which 70000 crores will be provided by the GOI and the rest PSBs will have to raise from the market.
| Financial Year | Total Amount |
| FY15-16 | 25,000 Crore |
| FY16-17 | 25,000 Crore |
| FY17-18 | 10,000 Crore |
| FY18-19 | 10,000 Crore |
| Total | 70,000 Crore |
- D-DEstressing: PSBs and strengthening risk control measures and NPAs disclosure.
- E-Employment: GOI has said there will be no interference from Government and Banks are encouraged to take independent decisions keeping in mind the commercial the organizational interests.
- F-Framework of Accountability: New KPI(key performance indicators) which would be linked with performance and also the consideration of ESOPs for top management PSBs.
- G-Governance Reforms: For Example, Gyan Sangam, a conclave of PSBs and financial institutions. Bank board Bureau for transparent and meritorious appointments in PSBs.
5.Strategic debt restructuring (SDR) – 2015
- Under this scheme banks who have given loans to a corporate borrower gets the right to convert the complete or part of their loans into equity shares in the loan taken company. Its basic purpose is to ensure that more stake of promoters in reviving stressed accounts and providing banks with enhanced capabilities for initiating a change of ownership in appropriate cases.
6.Asset Quality Review – 2015
- Classify stressed assets and provision for them so as to secure the future of the banks and further early identification of the assets and prevent them from becoming stressed by appropriate action.
7.Sustainable structuring of stressed assets (S4A) – 2016
- It has been formulated as an optional framework for the resolution of largely stressed accounts.
- It involves the determination of sustainable debt level for a stressed borrower and bifurcation of the outstanding debt into sustainable debt and equity/quasi-equity instruments which are expected to provide upside to the lenders when the borrower turns around.
8.Insolvency and Bankruptcy code Act-2016
- It has been formulated to tackle the Chakravyuha Challenge (Economic Survey) of the exit problem in India.
- The aim of this law is to promote entrepreneurship, availability of credit, and balance the interests of all stakeholders by consolidating and amending the laws relating to reorganization and insolvency resolution of corporate persons, partnership firms and individuals in a time-bound manner and for maximization of value of assets of such persons and matters connected therewith or incidental thereto.
9.Pubic ARC vs. Private ARC – 2017
- This debate is recently in the news which is about the idea of a Public Asset Reconstruction Companies (ARC) fully funded and administered by the government as mooted by this year’s Economic Survey Vs. the private ARC as advocated by the deputy governor of RBI Mr. Viral Acharya.
- Economic survey calls it as PARA (Public Asset Rehabilitation Agency) and the recommendation is based on a similar agency being used during the East Asian crisis of 1997 which was a success.
10.Bad Banks – 2017
- Economic survey 16-17, also talks about the formation of a bad bank which will take all the stressed loans and it will tackle it according to flexible rules and mechanism. It will ease the balance sheet of PSBs giving them the space to fund new projects and continue the funding of development projects.
11.Prompt corrective action
- PCA is a framework under which banks with weak financial metrics are put under watch by the RBI.
- The RBI introduced the PCA framework in 2002 as a structured early-intervention mechanism for banks that become undercapitalised due to poor asset quality, or vulnerable due to loss of profitability.
- It aims to check the problem of Non-Performing Assets (NPAs) in the Indian banking sector.
12.RBI’s revised stressed asset resolution norms
- The RBI in June 2019 released a revised set of norms on stressed asset resolution which are substantially less stringent from the previous one.
About the February 2018 RBI circular
- Through a notification issued on Feb 12, 2018 the RBI laid down a revised framework for the resolution of stressed assets, which replaced all its earlier instructions on the subject.
- Banks were required to immediately start working on a resolution plan for accounts over Rs 2,000 crore, which was to be finalised within 180 days.
- In the case of non-implementation, lenders were required to file an insolvency application.
- RBI termed it necessary to substitute the existing guidelines with a harmonized and simplified generic framework for resolution of stressed assets.
- Also, banks have to recognise loans as non-performing even if the repayment was delayed by just one day.
- Not adhering to the timelines in the circular would attract stringent supervisory and enforcement actions.
What did the revised framework replace?
- The circular went into effect on the same day that it was issued, and all existing schemes for stressed asset resolution were withdrawn with immediate effect.
- The circular was ostensibly intended to stop the “evergreening” of bad loans the practice of banks providing fresh loans to enable timely repayment by borrowers on existing loans.
- The RBI warned banks that not adhering to the timelines laid down in the circular, or attempting to evergreen stressed accounts, would attract stringent supervisory and enforcement actions.
New circular of the RBI
- The new framework gives lenders a breather from the one-day default rule whereby they had to draw up a resolution plan (RP) for implementation within 180 days of the first default.
- It gives lenders (scheduled commercial banks, all-India financial institutions and small finance banks) 30 days to review the borrower account on default.
- During this review period, lenders may decide on the resolution strategy, including the nature of the RP and the approach for its implementation.
- Lenders may also choose to initiate legal proceedings for insolvency or recovery.
- The new circular is also applicable to small finance banks and systemically important non-deposit taking non-banking financial companies (NBFCs) and deposit-taking NBFCs.
- In cases where the RP is to be implemented, all lenders have to enter into an intercreditor agreement (ICA)for the resolution of stressed assets during the review period to provide for ground rules for finalisation and implementation of the RP in respect of borrowers with credit facilities from more than one lender.
- Under the ICA, any decision agreed to by the lenders representing 75 per cent of total outstanding credit facilities by value and 60 per cent by number will be binding upon all the lenders. In particular, the RPs will provide for payment which will not be less than the liquidation value due to the dissenting lenders.
- In cases where the aggregate exposure of a borrower to lenders (scheduled commercial banks, all-India financial institutions and small finance banks) is ₹2,000 crore and above, the RP has to be implemented within 180 days from the end of the review period, and the reference date has been set as June 7, 2019.
- In the case of borrowers in the ₹1,500 crore and above but less than ₹2,000 crore category, January 1, 2020 has been set as the reference date for implementing the RP. In the less than ₹1,500 crore category, the RBI will announce the reference date in due course.
What if the Resolution Plan is delayed?
- There is a disincentive for banks if they delay implementing a viable resolution plan.
- In case the plan is not implemented within 180 days from the end of the review period, banks have to make additional provision of 20% and another 15% if the plan is not implemented within 365 days from the start of the review period.
- The additional provisions would be reversed if resolution is pursued under Insolvency and Bankruptcy Code (IBC).
Further reforms needed
- Banks have to accept losses on loans (or ‘haircuts’).
- They should be able to do so without any fear of harassment by the investigative agencies.
- The Indian Banks’ Association has set up a six-member panel to oversee resolution plans of lead lenders. To expedite resolution, more such panels may be required.
- An alternative is to set up a Loan Resolution Authority, if necessary through an Act of Parliament.
- Also, the government must infuse at one go whatever additional capital is needed to recapitalise banks — providing such capital in multiple instalments is not helpful
- The quality of lending by PSB must be improved in future so that the same problem does not arise again.
- To provide Public sector banks with greater autonomy the shareholding of the government can be reduced to less than 50 percent or 33 percent.
- A second requirement is that public sector banks should become board-managed institutions, with the board responsible for all appointments, including that of the chief executive officer (CEO). If the shares of the government are actually transferred to a holding company, then decisions regarding appointments could be taken by the board of the new company on the recommendation of the board of the bank.
- The objective of creating a genuinely commercial environment in which public sector banks can function and managements are made accountable can only be achieved if the government is willing to step back from exercising direct control.
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Finance Commission – Issues related to devolution of resources
[pib] 15th Finance Commission submits report on Agricultural Exports
Note4Students
From UPSC perspective, the following things are important :
Prelims level: Finance Commission
Mains level: Finance Commission, Its evolving role in fiscal federalism
The High-Level Group on Agricultural Exports set up by the Fifteenth Finance Commission has submitted its report to the Commission.
Try this PYQ from CSP 2019
Q.In India, which of the following reviews the independent regulators in sectors like telecommunications, insurance, electricity, etc.?
- Ad Hoc Committees set up by the Parliament
- Parliamentary Department Related Standing Committees
- Finance Commission
- Financial Sector Legislative Reforms Commission
- NITI Aayog
Select the correct answer using the code given below.
(a) 1 and 2
(b) 1, 3 and 4
(c) 3, 4 and 5
(d) 2 and 5
Why focus on Agri-exports?
- India’s agricultural export has the potential to grow from USD 40 billion to USD 70 billion in a few years.
- The estimated investment in agricultural export could be in the tune to USD 8-10 billion across inputs, infrastructure, and processing and demand enablers.
- Additional exports are likely to create an estimated 7-10 million jobs.
- It will lead to higher farm productivity and farmer income.
Highlights of the report
(A) The HLEG has made its recommendations, major among which are:
- Focus on 22 crop value chains – demand-driven approach.
- Solve Value Chain Clusters (VCC) holistically with a focus on value addition.
- Create a State-led export plan with participation from stakeholders.
- Private Sector should play an anchor role.
- The centre should be an enabler.
- The robust institutional mechanism to fund and support implementation.
(B) State-led Agri Exports
The Group has recommended a State-led Export Plan – a business plan for a crop value chain cluster. It will lay out the opportunity, initiatives and investment required to meet the desired value chain export aspiration.
The Group has also said that for its success, the following factors needed to be considered:-
- Plans should be collaboratively prepared with private sector players and Commodity Boards.
- Leveraging of state plan guide and value chain deep dives.
- The private sector should play an anchor role in driving outcomes and execution.
- The centre should enable state-led plans.
- Institutional governance should be promoted across the state and centre.
- Funding through the convergence of existing schemes, Finance Commission allocation and private sector investment.
Back2Basics: Finance Commission (FC)
- The FC is a constitutionally mandated body that decides, among other things, the sharing of taxes between the Centre and the states.
- Article 280 (1) requires the President to constitute, “within two years from the commencement of this Constitution.
- And thereafter constitute FC at the expiration of every fifth year or at such earlier time as the President considers necessary.
- An FC “which shall consist of a Chairman and four other members”.
Divisible Pool of Taxes
- Under Article 280(3) (a) the FC must make recommendations to the President “as the distribution between the Union and the States of the net proceeds of taxes which are to be, or maybe, divided between them under this Chapter and the allocation between the States of the respective shares of such proceeds”.
- Accordingly, the FC determines a formula for tax-sharing between the states, which is a weighted sum of the states’ population, area, forest cover, tax capacity, tax effort and demographic performance, with the weights expressed in percentages.
- This crucial role of the Commission makes it instrumental in the implementation of fiscal federalism.
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Finance Commission – Issues related to devolution of resources
For the sake of sound fiscal federalism
Note4Students
From UPSC perspective, the following things are important :
Prelims level: FRBM Act
Mains level: Paper 2- Issue of devolution to state under the recommendations of 14th finance commission.
Faultlines in the Centre-State fiscal relations have widened due to Covid. This article examines how States are not getting what they should as per the 14th Finance Commission report.
Centre-state tussle
- The tussle for the rights of States has been focused on Article 356.
- Partial behaviour by the Governors, regional party governments were politically destabilised.
- Little was done to implement the report of Justice R.S. Sarkaria Commission on Centre-State relations.
- The new faultline in the Centre-State relation could be over the way report of 14th Finance Commission is being implemented.
- This began well before COVID-19, but the pandemic and its economic disruption have brought things to an edge.
Issues over the implementation of 14th Finance Commission report
- The 14th Finance Commission report in 2015 promised devolution of more finances to the States.
- As part of the process, States would have new responsibilities, especially in the social sector.
- The Goods and Services Tax (GST) regime was also justified as a grand bargain that would eventually leave all States better off.
- In reality, tax devolution to States has been consistently below 14th Finance Commission projections.
- One reason for this has been the economic slowdown, and lower-than-expected GST collections.
- The shortfall in GST collection for 2018-2019 was 22% when compared to projections.
- Payments to the States have been delayed as well.
- There is a ₹6.84 lakh crore gap between what the 14th Finance Commission promised to States and what they have received.
- States undertook programmes and projects spending 46% more than the Central Government; today the figure is 64%.
- Despite spending less than the states the Centre’s fiscal deficit exceeds the consolidated State deficit by 14%.
Need to revisit the FRBM provisions
- Due to pandemic, the fiscal deficit for States, collectively, is inevitably going to breach the projection of 2.04%.
- As per provisions of the Fiscal Responsibility and Budget Management (FRBM) Act, the GSDP can actually accommodate a fiscal deficit of 3%.
- Now, post-pandemic, this limit will be crossed.
- The FRBM has an “escape clause” that allows for a one-time relaxation of the fiscal deficit threshold upto 0.5% in a time of exigency.
- The escape clause has been utilised by the Centre but it has proven woefully insufficient in addressing the current crisis.
- Fiscal policymakers and technocrats agree that the rigidity of the FRBM has to be revisited.
- It should allow for greater flexibility and consultation as to when and how the “escape clause” can be applied.
- The Centre has gone in for subjective interpretation, imposing conditions that are outside the scope of the FRBM.
Consider the question “Fiscal tensions have emerged as a new front in the Centre-State relations. Suggest the steps the Centre should take to address it.”
Conclusion
Centre government needs to be more considerate of the financial woes of the State and try to deliver on the recommendations of the 14th Finance Commission report.
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Finance Commission – Issues related to devolution of resources
Need for fiscal decentralisation
Note4Students
From UPSC perspective, the following things are important :
Prelims level: Finance Commission and its role
Mains level: Paper 2- Fiscal decentralisation.
Covid pandemic has turned the fiscal health of states from bad to worse. This article highlights the role of the Finance Commission as a neutral arbiter in the Centre-state relation in achieving the delicate balance. It has highlighted certain issues that the commission has to consider when it submits its report. So, what are those issues? Read to know…
Disruption in fiscal consolidation and impact on Centre-state relations
- Due to COVID, there is a collapse in general government revenues and the consequent rise in the deficit levels.
- It has disrupted the glide path of fiscal consolidation.
- But it has also deepened the faultlines in Centre-state fiscal relations.
- The Centre is trying to claw back the fiscal space ceded to the states and assert its dominance over the country’s fiscal architecture.
- This coupled with the fiscal constraints exposed by the pandemic have made it harder to maintain the delicate balance needed to manage the contesting claims of the Centre and the states
Why the 15th Finance Commission report is critical for decentralisation
- It will be ironic if the ongoing health crisis that has ended up exposing the limitations of a centralised approach, ends up reversing the trend towards fiscal decentralisation.
- The Commission’s report will be critical on two counts:
- First, it will determine how India’s fiscal architecture is reshaped.
- Second, how Centre-state relations are reset as the country attempts to recover from the COVID-19 shock.
1. Will the burden of reducing debt/gdp fall equally on Centre and state?
- The glide path of fiscal consolidation laid out by the FRBM review committee had envisaged bringing down general government debt to 60 per cent of GDP by 2022.
- This is unlikely to materialise now.
- Factoring in the additional borrowings, the debt-to-GDP ratio may well be over 80 per cent this year.
- Thus the fiscal consolidation roadmap will have to be reworked.
- As per its terms of reference, the Finance Commission will lay out the new path to be followed by both Centre and states.
- But the question is: Will the burden of debt reduction fall equally upon the Centre and states?
- Or will the Commission allow the Centre to have greater leeway when it comes to fiscal consolidation?
2. Will the conditional extension of borrowing limit be formalised?
- Recently, the Centre eased the states’ budget constraint, allowing them to borrow more this year.
- But this extra borrowing was conditional upon states implementing reforms in line with the Centre’s priorities.
- Despite protests, most states are likely to comply with the conditions, to varying degrees.
- But the issue is: As the hit from the ongoing crisis spreads over multiple years, state governments may want to maintain their expansionary fiscal stance next year as well.
- Then, will the Finance Commission, in line with its terms of reference, go along with the Centre’s stance and recommend imposing conditions on additional borrowing and formalise this arrangement?
- It is difficult to see such an arrangement being rolled back once formalised.
3. GST compensation cess
- The GST council, in which the Centre effectively has a veto, is yet to clearly spell out its views on the extension of the compensation cess to offset states losses beyond the five-year period.
- The Commission will have to weigh in on this too.
- At this time the Centre is struggling to fulfil its promise of assuring states their GST revenues.
- In such situation, will the Commission argue in favour of extending the compensation period, as states desire, but, perhaps, lowering the assured 14 per cent growth in compensation and linking it to nominal GDP growth?
- As GST revenue accounts for a significant share of states’ income, how this plays out will also have a bearing on their ability to bring down their debt levels.
4. Issue of tax devolution
- In some sense, accepting the recommendations of the 14th Finance Commission was a fait accompli.
- The terms of reference of the 15th Finance Commission points to the present government’s desire to claw back the fiscal space offered to the states.
- But is clawing back fiscal space now a prudent approach?
- A cash-strapped Centre will surely welcome greater say over the diminished resources.
- And there a strong argument for the Centre to have far greater fiscal space than it currently enjoys.
- This is partly because the fiscal multiplier of central government capital spending is greater than that by the states.
- But also the nature of politics may well push in that direction.
- Centralisation of political power may well lead to demands for centralisation of resources.
- However, surely fiscal space can be created by a review of the Centre’s own spending programme.
Need to relook at the Centre’s expenditure priorities
- Over the past decades, there has been a substantial increase in the Centre’s spending on items on the state and concurrent list.
- This shift has occurred even as grants by the Centre to states exceed the former’s revenue deficit.
- This, as some have pointed out, effectively means that the Centre is borrowing to transfer to states.
- Surely, a relook at the Centre’s expenditure priorities would create greater fiscal space for it.
What the Finance Commission can do?
- Any attempt to shift the uneasy balance in favour of the Centre will strengthen the argument that this government’s talk of cooperative federalism serves as a useful mask to hide its centralising tendencies.
- As a neutral arbiter of Centre-state relations, the Finance Commission should seek to maintain the delicate balance in deciding on contesting claims.
- This may well require giveaways especially if states are to be incentivised to push through legislation on items on the state and concurrent list.
- The fiscal stress at various levels of the government necessitates a realistic assessment of the country’s macro-economic situation, the preparation of a medium-term roadmap, as well as careful calibration of the framework that governs Centre-state relations.
- At this critical juncture, the Finance Commission should present the broad contours of the roadmap.
- Though it could request for another year’s extension to present its full five-year report citing the prevailing uncertainty.
Consider the question “COVID pandemic has put the States in the dire fiscal position. What we need is more of the fiscal decentralisation now.” In light of this, along with other factors, elaborate on the role 15th Finance Commission could play in this regard.
Conclusion
Finance Commission has to play an important role in achieving the delicate balance in the conflicting domain of finance by addressing the concerns of both the players.
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Finance Commission – Issues related to devolution of resources
Needed, greater decentralisation of power
Note4Students
From UPSC perspective, the following things are important :
Prelims level: Federal system.
Mains level: Paper 2-Why it is said that there is a paradox in the federal system of India? Covid-19 has highlighted the need for decentralisation in India.
Context
Even as States have taken up positions of leadership in the pandemic response, federal limitations are becoming hurdles.
State governments at the position of leadership
- In the fight against the pandemic, one of the striking features of governance has been the signal role played by State Chief Ministers across India.
- Proactive measures: Even before the Union government invoked the Disaster Management Act, 2005, many State governments triggered the Epidemic Diseases Act, 1897, and installed a series of measures to combat what was then an oncoming onslaught of COVID-19.
- These actions have not always been perfect. Some of them have even disproportionately trenched upon basic civil liberties.
- But, by and large, they have been tailored to the reality faced on the ground by the respective governments.
- Policies to address local concerns: States such as Maharashtra, Kerala, Tamil Nadu, Rajasthan, and Karnataka have shaped their policies to address their direct, local concerns.
- They have communicated these decisions to the public with clarity and consideration, helping, in the process, to lay out a broad framework for the nation.
- Not just the laboratories of democracy: In doing so, they have acted not merely as “laboratories of democracy”, to paraphrase the former U.S. Supreme Court Justice Louis Brandeis, but also as founts of reasoned authority.
Federal arrangements placing limitations on the states
- Equally, though, as much as State governments have taken up positions of leadership, they have repeatedly found themselves throttled by the limitations of the extant federal arrangement.
- The Centre for Policy Research has pointed out at least three specific limitations.
- Funds and structuring own package: The inability of States to access funds and thereby structure their own welfare packages.
- Curbs imposed by PFMS: The curbs imposed by a public finance management system (PFMS) that is mired in officialdom.
- This has prevented States from easily and swiftly making payments for the purchase of health-care apparatus such as ventilators and personal protective equipment.
- Disruption of supply chains: Three, the colossal disruption of supply chains not only of essential goods and services but also of other systems of production and distribution, which has placed States in a position of grave economic uncertainty.
- Need to decentralise: As these limitations demonstrate an urgent need to decentralise administration, where States — and local bodies acting through such governments — are allowed greater managerial freedom.
- Under such a model, the Union government will command less but coordinate more.
Indian federalism-two distinct levels
- There are varying accounts of what Indian federalism truly demands.
- Two levels: What is manifest from a reading of the Constitution is that it creates two distinct levels of government: one at the Centre and the other at each of the States.
- The Seventh Schedule to the Constitution divides responsibilities between these two layers.
- The Union government is tasked with matters of national importance, such as foreign affairs, defence, and airways.
- But the responsibilities vested with the States are no less important. Issues concerning public health and sanitation, agriculture, public order, and police, among other things, have each been assigned to State governments.
- In these domains, the States’ power is plenary.
- This federal architecture is fortified by a bicameral Parliament.
- Significantly, this bicameralism is not achieved through a simple demarcation of two separate houses, but through a creation of two distinct chambers that choose their members differently-
- A House of the People [Lok Sabha] comprising directly elected representatives and a Council of States [Rajya Sabha] comprising members elected by the legislatures of the States.
Financial autonomy of the states
- Ensuring financial autonomy: In formulating this scheme of equal partnership, the framers were also conscious of a need to make States financially autonomous.
- No overlap: To that end, when they divided the power to tax between the two layers of government they took care to ensure that the authority of the Union and the States did not overlap.
- Therefore, while the Centre, for example, was accorded the power to tax all income other than agricultural income and to levy indirect taxes in the form of customs and excise duties, the sole power to tax the sale of goods and the entry of goods into a State was vested in the State governments.
- The underlying rationale was simple: States had to be guaranteed fiscal dominion to enable them to mould their policies according to the needs of their people.
History of paradox in federal system of India
- Despite this plainly drawn arrangement, the history of our constitutional practice has been something of a paradox.
- It is invariably at the level of the States that real development has fructified.
- But the Union has repeatedly displayed a desire to treat States, as the Supreme Court said in R. Bommai v. Union of India, as mere “appendages of the Centre”.
- Time and again, efforts have been made to centralise financial and administrative power, to take away from the States their ability to act independently and freely.
- Following five examples demonstrated that the point made here.
1 Matters of finance-what was expected in theory did not realise
- Consider the widely hailed decision to accept the 14th Finance Commission’s recommendation for an increase in the share of the States in total tax revenues from 32% to 42%.
- While, in theory, this ought to have enabled the States to significantly increase their own spending, in reality, as a paper authored by Amar Nath H.K. and Alka Singh of the National Institute of Public Finance and Policy suggests, this has not happened.
- What went wrong? Gains made by the States, as the paper underlines, have been entirely offset by a simultaneous decline in share of grants and by a concomitant increase in the States’ own contribution towards expenditures on centrally sponsored schemes.
2. Goods and Service Tax
- The decline in the sovereignty of the states: Notably, the creation of a Goods and Services Tax regime, which far from achieving its core purpose of uniformity has rendered nugatory the internal sovereignty vested in the States.
- By striking at the Constitution’s federal edifice, it has made the very survival of the States dependent on the grace of the Union.
- The tension today is so palpable that a number of the States are reported to have written to the Union Finance Ministry.
- More than four months’ worth of Goods and Services Tax compensation to the States — reportedly totalling about a sum of ₹40,000 crore — remains unreleased.
3. Passing a bill as a money bill
- The Union government’s centralising instinct, though, has not been restricted to matters of finance.
- It has also introduced a slew of legislation as money bills, in a bid to bypass the Rajya Sabha’s sanction, even though these laws scarcely fit the constitutional definition.
4. Role of the Governors
- Similarly, the role of the Governors has been weaponised to consolidate political power.
5. Article 370
- But perhaps most egregious among the moves made is the gutting of Article 370 and the division of Jammu and Kashmir into two Union Territories.
- It was done without securing consent from the State Legislative Assembly.
Conclusion
Perhaps a crisis of the kind that COVID-19 has wrought will show us that India needs greater decentralisation of power; that administration through a single central executive unit is unsuited to its diverse and heterogeneous polity. We cannot continue to regard the intricate niceties of our federal structure as a nettlesome trifle. In seeing it thus, we are reducing the promise of Article 1 of the Constitution, of an India that is a Union of States, to an illusory dream.
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Finance Commission – Issues related to devolution of resources
Why has Kerala sought a relaxation of FRBM rules?
Note4Students
From UPSC perspective, the following things are important :
Prelims level: FRBM Act
Mains level: Read the attached story
Kerala CM has urged the Centre to provide Kerala with flexibility under the Fiscal Responsibility and Budget Management (FRBM) Act so as to ensure that the State’s finances are not adversely impacted.
FRBM Act
- The FRBM is an act of the parliament that set targets for the Government of India to establish financial discipline, improve the management of public funds, strengthen fiscal prudence and reduce its fiscal deficits.
- It was first introduced in the parliament of India in the year 2000 by Vajpayee Government for providing legal backing to the fiscal discipline to be institutionalized in the country.
- Subsequently, the FRBM Act was passed in the year 2003.
Features of the FRBM Act
- It was mandated by the act that the following must be placed along with the Budget documents annually in the Parliament:
- Macroeconomic Framework Statement
- Medium Term Fiscal Policy Statement and
- Fiscal Policy Strategy Statement
Fiscal Indicators
It was proposed that the four fiscal indicators be projected in the medium-term fiscal policy statement viz.
- Revenue deficit as a percentage of GDP,
- Fiscal deficit as a percentage of GDP,
- Tax revenue as a percentage of GDP and
- Total outstanding liabilities as a percentage of GDP
Why is Kerala seeking flexibility under the FRBM?
- Kerala was one of the earliest States to announce an economic package of ₹20,000 crore to mitigate the impact on livelihoods and overall economic activity.
- Kerala’s current fiscal position means that it can borrow about ₹25,000 crore during the financial year 2020-21.
- However the State government is understandably concerned that the stringent borrowing cap under the fiscal responsibility laws should not constrain its borrowing and spending ability over the remaining 11 months.
- This is a crucial period when the state would have to meet other expenditure for routine affairs related to the running of the State’s socio-economic programmes as well as the post pandemic recovery.
How does a relaxation of the FRBM work?
- The law does contain what is commonly referred to as an ‘escape clause’.
- Under Section 4(2) of the Act, the Centre can exceed the annual fiscal deficit target citing grounds that include national security, war, national calamity, collapse of agriculture, structural reforms and decline in real output growth of a quarter by at least three percentage points below the average of the previous four quarters.
- The ongoing pandemic could be considered as a national calamity.
- This would allow both the Union government and States including Kerala to undertake the much-needed increases in expenditure to meet the extraordinary circumstances.
When have the FRBM norms been relaxed in the past?
- There have been several instances of the FRBM goals being reset.
- But the most significant FRBM deviation happened in 2008-09, in the wake of the global financial crisis, when the Centre resorted to a focused fiscal stimulus: tax relief to boost demand and increased expenditure on public projects.
- This was aimed to create employment and public assets, to counter the fallout of the global slowdown.
- This led to the fiscal deficit climbing to 6.2%, from a budgeted goal of 2.7%.
- Simultaneously, the deficit goals for the States too were relaxed to 3.5% of GSDP for 2008-09 and 4% of GSDP for fiscal 2009-10.
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Finance Commission – Issues related to devolution of resources
Private: Interim report of the 15th Finance Commission (FC)
What is the news: The interim report of the 15th Finance Commission (FC) has been tabled in Parliament this budget session.
Terms of Reference of XV-FC
XV-FC is mandated to give recommendations regarding
- The distribution between the Union and the States of the net proceeds of taxes which are to be divided between them.
- The allocation between the States of the respective shares of such proceeds.
- The principles which should govern the grants in aid of the revenues of the States out of the Consolidated Fund of India.
- The measures needed to augment the Consolidated Fund of a State to supplement the resources of the Panchayats and Municipalities in the State based on the recommendations made by the Finance Commission of the State.
The Commission shall review the current fiscal status of the Union and the States, and recommend a fiscal consolidation roadmap. The Commission may also examine whether revenue deficit grants be provided at all.
While making the recommendations, the XV-FC may consider
- Resources of Central and State governments and their potential and fiscal capacity.
- Demand on the resources of respective governments.
- Impact of the enhanced devolution following 14th FC on the fiscal situation.
- Impact of GST and compensation for the losses in revenues for 5 years.
The Commission may consider proposing performance-based incentives to the States based on
- Efforts made in expansion and deepening of tax net under GST.
- Efforts and progress made in moving towards the replacement rate of population growth.
- Achievements in the implementation of flagship schemes of Government of India, disaster-resilient infrastructure, and sustainable development goals.
- Progress made in increasing capital expenditure, eliminating losses of the power sector, and improving the quality of such expenditure in generating future income streams.
- Progress made in increasing tax/non-tax revenues.
- Promoting savings by the adoption of Direct Benefit Transfers and Public Finance Management System.
- Promoting digital economy and removing layers between the government and the beneficiaries.
- Progress made in promoting ease of doing business and promoting labour-intensive growth.
- Provision of grants in aid to local bodies for basic services and implementation of a performance grant system in improving the delivery of services.
- Control or lack of it in incurring expenditure on populist measures.
- Progress made in sanitation, solid waste management and bringing in a behavioural change to end open defecation.
The Commission shall use the population data of 2011 while making its recommendations.
The Commission may review the present arrangements on financing Disaster Management initiatives regarding the funds constituted under the Disaster Management Act, 2005.
Recommendations of the 15th Finance Commission
The 15th Finance Commission proposed recommendations for both vertical and horizontal devolution.
Vertical Devolution
- 41% of the divisible pool to be devolved to the States in the year 2020-21.
- FC-XIV which had recommended 42%, had a view that tax devolution should be the primary route of transfer of resources to States as they are a more objective form of transfer of resources as compared to other forms.
- The XV-FC also agrees with this view but reduced the States’ share to 41% because of the re-organization of the State of Jammu & Kashmir into UTs of Ladakh and Jammu & Kashmir through the Jammu & Kashmir Re-organization Act, 2019.
- UTs are the responsibilities of the Union and their demands have to be met from the Union Government’s resources.
Horizontal Devolution
- Horizontal devolution is done primarily to enable the States to provide basic public goods and services with equivalent tax effort.
- The various criteria to be considered for horizontal devolution are classified into three broad groups as follows.
- Need-based criteria: Population, area and forest & ecology form the need-based criteria. This is needed to address the fiscal gap of States existing due to the structural mismatch between the States’ resources and their expenditure liabilities.
- Equity-based criterion: Income distance forms the equity-based criterion to ensure fiscal equalization given the large differences in the resource base available and status of development within the country.
- Performance-based criteria: Demographic performance and tax effort are part of the performance-based criteria that is framed to reward and incentivize States to perform better, in terms of utilization of resources available to them.
Table 1 Horizontal Devolution Criteria
| Criteria | 14th FC | 15th FC |
| Income Distance | 50.0 | 45.0 |
| Population of 1971 | 17.5 | – |
| Population of 2011 | 10.0 | 15.0 |
| Area | 15.0 | 15.0 |
| Forest Cover | 7.5 | – |
| Forest & Ecology | – | 10.0 |
| Demographic Performance | – | 12.5 |
| Tax Effort | – | 2.5 |
| Total | 100 | 100 |
- Population: Only 2011 Census numbers are used as per the ToR. Population criterion is assigned a weight of only 15 per cent as some of the other criteria will also be scaled by it.
- Area: A moderate weight of 15 per cent for the area criterion is assigned larger area incurs some additional administrative costs but it may not lead to a proportional increase in the cost of providing services.
- Forest and Ecology: This criterion is for the ecological services being provided by a State’s forest cover to the country as a whole and is arrived at by calculating the share of the dense forest of each State in the aggregate dense forest of all the States. A weight of 10 per cent is assigned for the forest and ecology criterion.
- Income Distance: Distance of per capita income is the criteria used to make the devolution formula more equalizing and progressive, and provides higher devolution to States with lower per capita income and lower own tax capacity. The XV-FC retained the income distance criterion with a weight of 45 per cent.
- Demographic Performance: An abrupt change from 1971 Census data to 2011 Census data should not unfairly penalize some States which have performed well on population control. Hence, the commission recommended introducing a new performance-based criterion to reward States who have performed well on the demography front. This criterion of demographic performance is computed by using the reciprocal of TFR of each State, scaled by the population data of Census 1971. States which have achieved lower TFR will be scored higher and vice versa. This criterion is assigned a weight of 12.5 per cent.
- Tax Effort: The inclusion of tax effort as a performance-based criterion will reward the States with higher tax collection efficiency and encourage all States to be more tax efficient. It is computed by taking the ratio of the average of per capita own tax revenue of a State over three years and its per capita GSDP and scaling this ratio by the population of the State. Total weight of 2.5 per cent has been assigned to this criterion.
- Uttar Pradesh and Bihar have received the largest devolutions for 2020-21 while Karnataka and Kerala saw the largest decreases in the share of the divisible pool.
Grants in Aid
- Revenue Deficit Grants: 14 states are estimated to face a revenue deficit post-devolution.
- The Commission has recommended revenue deficit grants worth Rs 74,341 crore to these 14 states.
- Furthermore, the three states of Karnataka, Mizoram, and Telangana received special grants to make up the shortfall between untied transfers received by these States in the form of tax devolution plus revenue deficit grant in 2020-21 vis-a-vis the corresponding amount in 2019-20.
- Sectoral Grants: The XV-FC is considering recommending sectoral grants for nutrition, health, pre-primary education, judiciary, rural connectivity, railways, statistics and police training, and housing during its tenure.
- Of these, grants for nutrition, to augment the efforts of the States towards reducing and ultimately eliminating malnutrition, is specifically recommended even in 2020-21.
- Performance-based Incentives: Six broad areas are identified to provide performance-based incentives to States.
1. Implementation of Agriculture Reforms
2. Development of Aspirational Districts and Aspirational Blocks
3. Power Sector Reforms
4. Enhancing Trade including Exports
5. Incentives for Education
6. Promotion of Domestic and International Tourism
Empowering Local Bodies
Some significant changes made by XV-FC compared to previous Finance Commissions:
- To recommend grants to all tiers of the Panchayati Raj to enable pooling of resources to create durable community assets and improve their functional viability.
- To give grants to the Fifth and Sixth Schedule areas and Cantonment Boards.
- To provide for tied grants in the critical sectors of sanitation and drinking water to ensure additional funds to the local bodies over and above the funds allocated for these purposes under the centrally sponsored schemes (CSS), Swachh Bharat and Jal Jeevan Missions.
- To account for increasing urbanization the share of urban local bodies in Finance Commission grants to local bodies should be gradually increased to 40 per cent over the medium term.
- Since larger cities will tend to grow faster with the agglomeration effect, the fifty Million-Plus cities in the country need differentiated treatment, with special emphasis on meeting the challenges of bad ambient air quality, groundwater depletion and sanitation.
Grants to Local Bodies:
- The Commission has recommended a total of Rs 90,000 crore for grants to the local bodies in 2020-21.
- This amounts to 4.31% of the divisible pool.
- These grants will be made available to all three tiers of Panchayat- village, block, and district.
- The inter-se distribution of grants for local bodies among the States may be based on population and area in the ratio of 90:10.
- For 2020-21, the proportion of grants between rural and urban local bodies recommended by the XV-FC is in the ratio of 67.5:32.5.
- For all urban bodies, the distribution of grants for 2020-21 is based on population.
Disaster Risk Management
- To promote local-level mitigation activities, mitigation funds shall be set up at both national and state levels in the form of NDMF and State Disaster Mitigation Funds (SDMF), following the Disaster Management Act.
- The Commission recommended the creation of funds for disaster mitigation along with disaster response, which will now together be called as National Disaster Risk Management Fund (NDRMF) and State Disaster Risk Management Funds (SDRMF).
- Recommended grants for the State Disaster Risk Management Fund is Rs 28,983 crore. Out of this, the share of SDRF shall be 80 per cent and the share of SDMF 20 per cent. The allocation for the National Disaster Risk Management Fund is Rs 12,390 crore.
- Allocations for NDRF / SDRF will be further sub-divided into
- Response and Relief – 40 per cent
- Recovery and Reconstruction – 30 per cent
- Capacity Building – 10 per cent
What is the Finance Commission?
- Article 280 of the Constitution of India provides for a quasi-judicial body, the Finance Commission.
- It is constituted by the President of India every fifth year or at such earlier time as he considers necessary.
- The recommendations made by the Finance Commission are only advisory in nature and hence, not binding on the government.
- The 15th Finance commission makes recommendations for the period of 2020-2025 (5 years).
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Finance Commission – Issues related to devolution of resources
Private: Recommendations of the 15th Finance Commission
Note4Students
From UPSC perspective, the following things are important :
Prelims level: Finance Commission
Mains level: Recommendations of the Finance Commissions
The Fifteenth Finance Commission (FC) has considered the 2011 population along with forest cover, tax effort, area of the state, and “demographic performance” to arrive at the states’ share in the divisible pool of taxes.
Quick recap: Finance Commission (FC)
- The FC is a constitutionally mandated body that decides, among other things, the sharing of taxes between the Centre and the states.
- Article 280 (1) requires the President to constitute, “within two years from the commencement of this Constitution.
- And thereafter constitute FC at the expiration of every fifth year or at such earlier time as the President considers necessary.
- An FC “which shall consist of a Chairman and four other members”.
Divisible Pool of Taxes
- Under Article 280(3) (a) the FC must make recommendations to the President “as the distribution between the Union and the States of the net proceeds of taxes which are to be, or may be, divided between them under this Chapter and the allocation between the States of the respective shares of such proceeds”.
- Accordingly, the FC determines a formula for tax-sharing between the states, which is a weighted sum of the states’ population, area, forest cover, tax capacity, tax effort and demographic performance, with the weights expressed in percentages.
- This crucial role of the Commission makes it instrumental in the implementation of fiscal federalism.
Major recommendations of 15th FC
- The report of the 15th FC, along with an Action Taken Report, was tabled in Parliament on Saturday.
- The Commission has reduced the vertical devolution — the share of tax revenues that the Centre shares with the states — from 42% to 41%.
- The 1 per cent decrease in the vertical devolution is roughly equal to the share of the erstwhile state of J&K, which would have been 0.85% as per the formula described by the Commission.
- The Commission has said that it intends to set up an expert group to initiate a non-lapsable fund for defence expenditure.
- The terms of reference of the Commission included considering the Centre’s demand for funds for defence and national security.
- It may do so by creating a separate fund from the gross tax revenue before computing the divisible pool — which means that states would get a smaller share of the taxes.
The new parameter: 2011 census Population
- As had been widely anticipated, shares of the southern states, except Tamil Nadu, have fallen — with Karnataka losing the most.
- The population parameter used by the Commission has been criticised by the governments of the southern states.
- The previous FC used both the 1971 and the 2011 populations to calculate the states’ shares, giving greater weight to the 1971 population (17.5%) as compared to the 2011 population (10%).
Why 2011 census was used?
- The 15th FC has reasoned that the terms of reference leave it with no choice but to use the 2011 population; it has also argued that in the interest of fiscal equalization, it is necessary to use the latest Census figures.
- The use of 2011 population figures has resulted in states with larger populations like UP and Bihar getting larger shares, while smaller states with lower fertility rates have lost out.
- The combined population of the Bihar, Uttar Pradesh, Madhya Pradesh, Rajasthan and Jharkhand is 47.8 crore.
- This is over 39.48% of India’s total population, and is spread over 32.4% of the country’s area, as per the 2011 Census.
- On the other hand, the southern states of Tamil Nadu, Kerala, Karnataka and undivided Andhra Pradesh are home to only 20.75% of the population living in 19.34% of the area, with a 13.89% share of the taxes.
- This means that the terms decided by the Commission are loaded against the more progressive (and prosperous) southern states.
Various criteria used
- In order to reward population control efforts by states, the Commission developed a criterion for demographic effort — which is essentially the ratio of the state’s population in 1971 to its fertility rate in 2011 — with a weight of 12.5%.
- The total area of states, the area under forest cover, and “income distance” were also used by the FC to arrive at the tax-sharing formula.
- Income distance is calculated as the difference between the per capita gross state domestic product (GSDP) of the state from that of the state with the highest per capita GSDP, with states with less income getting a higher share in order to allow them to provide services comparable to those provided by the richer ones.
- The Commission used the per capita GSDP of Haryana as the reference for calculating the income distance, and gave it a weight of 45%, down from the 50% assigned by the 14th FC.
- The weight assigned to state area was unchanged at 15%, and that of forest cover was increased from 7.5% to 10%.
Ambiguity over the criterion
- The effect of the demographic effort in increasing states’ devolution is not clear.
- Shares of states like Maharashtra, Himachal Pradesh and Punjab, along with Tamil Nadu, all of which have fertility rates below the replacement level, have increased slightly.
- On the other hand, Andhra Pradesh, Kerala, Karnataka, and West Bengal’s shares have fallen, even though their fertility rates are also low.
- Incidentally, Karnataka, the biggest loser in this exercise, also had the highest tax-GSDP ratio in 2017-18, as per an RBI report on state finances.
- Tax effort was also used by the Commission to decide the states’ shares, with a weight of 2.5%.
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Finance Commission – Issues related to devolution of resources
Finance Commission
Note4Students
From UPSC perspective, the following things are important :
Prelims level: Finance Commission
Mains level: Finance Commission, Its evolving role in fiscal federalism
- The report of the Fifteenth Finance Commission, along with an Action Taken Report, was tabled in Parliament.
- The Commission, headed by N K Singh, had submitted its Report to the President in December 2019.
- The government had accepted the recommendations of the Commission “in substantial measure a/c to FM.
The Finance Commission and its purpose
- Article 280 of the Constitution requires that a Finance Commission be constituted to recommend the distribution of the net proceeds of taxes between the Centre and states, and among the states.
- Much has changed since the First Commission was set up in November 1951 under the Chairmanship of K C Neogy, a former member of the Constituent Assembly and diwan of a princely state.
- The President has appointed 14 more Commissions since then.
Why need Finance Commission?
- The framers of the Constitution were seeking to address the vertical imbalance between the taxation powers and expenditure and responsibilities of the federal government and the states, and the horizontal imbalance, or inequality, between states that were at different stages of development.
- Ensuring inclusiveness is, therefore, a key mandate of the Finance Commission.
- That means assigning weights to things like population, the fiscal distance between the top ranked states and the others, etc.
- It is not that the best-performing state will be allocated the highest share — even if delivery execution and governance are better — rather, the effort will be to narrow the development gap between states.
Constitution of the Finance Commission
- The Finance Commission Rules, 1951, lay down the criteria for being members of the constitutional body.
- Members:
- those having special knowledge of finance and accounts of government with wide knowledge and experience in financial matters and in administration,
- or with special knowledge of economics, and
- those who have been qualified to be appointed as a judge of a High Court
Notable members
- In the years following the reforms of the 1990s, Commissions have been headed by reputed economists and administrators — from A M Khusro, who headed the Eleventh Finance Commission, to Chakravarthi Rangarajan, Vijay Kelkar, and Y V Reddy, who were Chairmen of subsequent Commissions.
- Senior politicians like K Brahmananda Reddy, Y B Chavan and N K P Salve had helmed earlier Commissions.
- Before N K Singh, an economist and career administrator who subsequently joined politics, the last politician in this role was K C Pant, who then went on to be Deputy Chairman of the Planning Commission.
Changing role of the Finance Commission
- What has changed dramatically since the 1950s, when the First Commission presented its recommendations on the transfer of resources between the Centre and the states, is the scale of distribution of tax proceeds.
- From 10% of the total tax receipts of the Centre in 1950, it rose to a record 42% after the recommendations of the Fourteenth FC headed by Y V Reddy — a share that made previous awards look conservative, and sat well with the spirit of cooperative federalism.
- The Fifteenth FC has recommended that this allocation be reduced by a percentage point to 41% in order to meet the security and special needs of the erstwhile state of Jammu and Kashmir.
- The other significant change has been in the equation between the central and state governments as a result of the recommendations of the Twelfth FC which reshaped lending by the federal government to states.
- The Fourteenth Commission recommended the creation of a Fiscal Council; the Thirteenth had set out detailed measures on implementing GST with a grand bargain for states.
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