Finance Commission

Finance Commission: Key Insights into India’s Fiscal Federalism

To prepare for INDIAN POLITY for any competitive exam, aspirants have to know about the Finance Commission. It gives an idea of all the important topics for the IAS Exam and the polity syllabus (GS-II.). Important Finance Commission terms are important from the polity and governance perspectives in the UPSC exam. IAS aspirants should thoroughly understand their meaning and application, as questions can be asked from this static portion of the IAS Syllabus in both the UPSC Prelims and the UPSC Mains exams.

In this article, you can read about the Basics, Background, Objectives, Composition, tenure, Functions etc about the Finance Commission for the UPSC and SPSC. 

Evolution and Significance of the Finance Commission in India

• Article 280 of the constitution of India provides for a Finance Commission.
• It acts as a quasi-judicial body.
• Constituted by the President of India every fifth year or at such earlier time as he considers necessary.
• The First Finance Commission was constituted by Presidential Order dated 22.11.1951 under the chairmanship of Shri K.C. Neogy on 6th April, 1952.
• The Constitution of India envisages the Finance commission as the “balancing wheel of fiscal federalism in India”.
• Till 2014, role of finance commission in the Centre-state fiscal relations was undermined by the erstwhile Planning Commission (non-constitutional and a non-statutory body)
• Planning Commission, set up in 1950, had two key duties to perform-
  • To implement five-year plan
  • To provide the finances to the state.
• The disenchantment with the Planning Commission could be traced on two important fronts:
  • The perception that it was not able to capture the new realities of macroeconomic management at the national level.
  • It had not been conducive to sound fiscal relations between the Union and the States.
• Dr P. V. Rajamannar, the Chairman of the Fourth Finance commission, observed that the functions and responsibilities of both the Commissions overlap to a great extent. According to him –
  • Setting up of the Planning Commission curtailed the scope and functions of the Finance Commission.
  • As the entire plan, with regard to both policy and programme used to come within the purview of the Planning Commission and as the assistance to be given by the Centre for plan projects either by way of grants or loans is practically dependent on the recommendations of the Planning Commission, it is obvious that a body like the Finance Commission cannot operate in the same field.

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• Comparison of NITI Aayog and Planning Commission: NITI AYOG has a structure similar to the Planning Commission, but its functions will be limited to only acting as a policy think tank relieving it of the two more functions-
  • Formation of five year plans
  • The allocation of funds to the States.
  • The major difference in approach to planning, between NITI Aayog and Planning Commission, is that the former will invite greater involvement of the states, while the latter took a top-down approach with a one-size-fits-all plan.

Composition and Significance of the Finance Commission in India

• Comprises Chairman and 4 members appointed by the PRESIDENT.
• Hold office for such a period as specified by the President.
• Chairperson and members are eligible for reappointment.
• The Constitution authorizes PARLIAMENT to determine the qualifications of members of the commission and the manner in which they should be selected.

Qualifications of Finance Commission Members: Criteria for Stewardship in Fiscal Matters

• Chairman: Person having experience in public affair
• Members: Judge of a high court or qualified to be appointed as one.
  • Specialised knowledge of finance and accounts of the government.
  • Wide experience in financial matters and in administration.
  • Special knowledge of economics.

Disqualifications for Finance Commission Members

• If he is of unsound mind;
• If he is an undischarged insolvent;
• If he has been convicted of an offence involving moral turpitude;
• If he has such financial or other interest as is likely to affect prejudicially his functions as a member of the Commission.

Functions of the Finance Commission: Shaping Fiscal Relations in India

Finance Commission needs to make the following recommendations to the President –

• Distribution of net proceeds of taxes to be shared between the centre and the states, and allocation between the states.
• Principles governing the grant in aid (Out of the Consolidated Fund of India)
• Any other matter to refer to by the President.
• Measures needed to augment the consolidated fund of the state to supplement the resources of Panchayat and Municipality on the basis of recommendations made by the Finance Commission.
  • This function was added by the 73rd and 74th Constitutional Amendment Acts of 1992, which have granted constitutional status and protection to the Panchayats and the Municipalities respectively. 
• The Commission submits a report to the President.
• Recommendations made by the Finance Commission are advisory and hence not binding on the government. 

Finance Commission: Fiscal Federalism and Shared Tax Proceeds in India

• Under the federal structure envisaged in the Constitution, most of the taxation powers are with the Centre but the bulk of spending is done by the states.
• Such a federal structure requires transfer of resources from the Centre, which levies and collects the big taxes such as income tax and indirect taxes like excise and customs, to the states.
  • Example: Canada and Australia

Significance of Finance Commission Recommendations: Shaping Fiscal Relations in India

• The Constitution makes the recommendations of the Finance Commission non-binding on the government of the day.
• However, there is a strong precedent that governments generally go by the suggestions as far as sharing of revenues is concerned.
• These recommendations relating to distribution of Union taxes and duties and grants-in-aid are usually implemented by a Presidential order.

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What is the Constitutional Framework of the Finance Commission and how does it impact Centre-State Financial Relations?

• Article 268 to 293 deals with the provisions of financial relations between Centre and States.
• The Indian Constitution has made elaborate provisions, relating to the distribution of taxes as well as non-tax revenues and the power of borrowing, supplemented by provisions for grants-in-aid by the Union to the States.

Fiscal Federalism in India: Economic Dynamics and the Significance of Finance Commission

• Fiscal federalism can best be understood as the economic counterpart to political federalism.
• It is concerned with assigning functions to different levels of government, and providing appropriate fiscal instruments for carrying out these functions.
• It is generally believed that the Central government should provide national public goods that render services to the entire population while sub-national governments are expected to provide goods and services whose consumption is limited to their own jurisdictions.
• Governments often find it difficult to determine the specific fiscal instruments that enable the different levels of government to carry out their functions.
• However Indian Constitution lays down the functions as well as taxing powers of the Centre and States providing clarity in financial relations shared by state and the centre.

Finance Commission’s Function under Fiscal Federalism in India’s Policy Environment

• Horizontal Imbalances and Rising Regional Inequalities: Replacing the Planning Commission (which was mandated to give grants to the states as conditional transfers using the Gadgil-Mukherjee formula) with NITI Aayog (Government think tank with no resources to dispense) has reduced the policy outreach of government by relying only on single instrument of fiscal federalism i.e. Finance commission.
• Vertical Imbalance: In India’s fiscal federalism (three levels: Central Government, State Governments and the elected Local Bodies) the Central government has a far greater domain of taxation.
  • In India’s fiscal federalism, the central government has a far greater domain of taxation Central Government collects around 60% of the total taxes, while its expenditure responsibility is only 40% of the total public expenditure.
  • Vertical imbalances can adversely affect India’s urbanization, the quality of local public goods, thus further aggravating the negative externalities for the environment and climate change.
• Post-Liberalization Imbalances: Market-based reform generates more inequality due to unequal capacity among states for infrastructure development.
  • The major challenge faced by poorer states in the post reform period is to chase competitive infrastructure investment in order to attract foreign capital investment.
• Terms of Reference: of the Finance Commission is decided unilaterally by the Central government which leads to raising of various issues by state governments.
• Financial Deterioration of States: Per capita Revenue Deficit, Fiscal Deficit and Primary Deficit of states have been growing at 27.05%, 11.53% and 61.85% respectively, indicating financial deterioration of states and reflected by:
  • The mounting debt burden on States
  • Lack of scope for expansion in social and economic service.
  • Lack of scope for capital investment
  • The process of devolution of revenue becomes

How does the Finance Commission address Horizontal Imbalances in India’s Fiscal Federalism? 

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Evaluating Devolution Criteria: A Comparative Analysis of 14th and 15th Finance Commission Criteria (2015-2025)

15th Finance Commission: Key Recommendations and Devolution Criteria Analysis (2020-2025)

• 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% decrease is to provide for the newly formed UT of Jammu and Kashmir and Ladakh from the resources of the Central government.
• The Commission has said that it intends to set up an expert group to initiate a non-lapsable fund for defence expenditure.
• Criteria for Devolution: Income distance-45%; Population (2011)-15%; Area-15%; Forest and Ecology-10%; Demographic performance-12.5%; Tax Effort-2.5%.
• Income of a State: It has been computed as average per capita GSDP during the three-year period between 2015-16 and 2017-18.
  • States with lower per capita income would be given a higher share to maintain equity among states.
• Demographic Performance: criterion has been introduced to reward efforts made by states in controlling their population.
  • It will be computed by using the reciprocal of the total fertility ratio of each state, scaled by 1971 population data.
• Tax Effort: It has been used to reward states with higher tax collection efficiency.
  • It has been computed as the ratio of the average per capita own tax revenue and the average per capita state GDPduring the three-year period between 2014-15 and 2016-17.
• Off-Budget Borrowings and Compliance: The Commission observed that financing capital expenditure through off-budget borrowings detracts from compliance with the FRBM Act.
  • It recommended that both the central and state governments should make full disclosure of extra-budgetary borrowings.
  • The outstanding extra-budgetary liabilities should be clearly identified and eliminated in a time-bound manner.

Concerns and Criticisms of the 15th Finance Commission

• The population parameter used by the Commission has been criticised by some 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%).
• 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 Bihar, Uttar Pradesh, Madhya Pradesh, Rajasthan and Jharkhand is 47.8 crore.
• 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.
• Shares of the southern states, except Tamil Nadu, have fallen – Karnataka losing the most.
• 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.
• Karnataka, the biggest loser in this exercise, also had the highest tax-GDP ratio in 2017-18, as per an RBI report on State finances.
• Previous FCs used 1971 Census numbers while the 14th commission had given weight to both the 1971 (17.5%) and 2011 (10%) censuses.
• Some states have a higher potential in expanding the GST tax base while others do not. Hence the performance on this parameter cannot be a basis for fund devolution.
• Many states run social sector schemes which are welfare-oriented. If these schemes are considered populist, these States will be penalized.
• States are already under the burden of GST and devolution based on the 2011 Census will further constrain the fund position of the States.
• States resent a devolution criterion that considers the implementation of Central schemes, as tax devolution is their constitutional right and not a largesse of the Central government.
• Since revenue deficit grants are proposed to be re-looked, there may be a reduction in the fiscal autonomy of the States and conditions for borrowing from external sources will also be reviewed.

15th Finance Commission: Revenue Distribution Based on Demographics, Forest Cover and Tax Efforts

• The Finance Commission 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.
• 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, area under forest cover, and “income distance” were also used by the FC to arrive at the tax-sharing formula.

Impact of COVID-19 on Indian Finances and Finance Commission Recommendations

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 fault lines 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

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Terms of Reference: Implications for Fiscal Space and Centre-State Relations in India

• 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.
• A cash-strapped Centre will surely welcome greater say over the diminished resources.
• There is 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.

Finance Commission’s Role in Conditionality: Implications for State Borrowing and Fiscal Autonomy

• 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.
• The issue is that 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.
• 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 formulate this arrangement?
• It is difficult to see such an arrangement being rolled back once formalised.

GST Compensation Cess: Finance Commission’s Role in Balancing State Revenues

• 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 a 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.

Should the Finance Commission Be a Permanent Fixture in India’s Fiscal Framework? 

Should India Establish a Permanent Finance Commission and Fiscal Council for Improved Fiscal Governance?

CONTEXT – Former RBI Governor D. Subbarao gives his opinion on whether Fiscal Council is needed or not

• It was first recommended by the 13th Finance Commission and was subsequently endorsed by the 14th Finance Commission and then by FRBM Review Committee (headed by N.K. Singh)
• Fiscal council is a permanent agency with a mandate to independently assess the government’s fiscal plans and projections against parameters of macroeconomic sustainability.
• Council will then put out its findings in the public domain. 
• Such an open scrutiny will keep the government on the straight and narrow path of fiscal virtue and hold it to account for any default.
• It will give an independent and expert assessment of the government’s fiscal stance, and thereby aid an informed debate in Parliament.

State Finance Commission in India: Constitutional Mandate and Recommendations

• State Finance Commissions are created every five years as per 73rd and 74th Constitutional Amendment Acts 1992.
• State finance commission is a constitutional body.
• Article 243-I: The Governor of a state ensures the laying of a State Finance Commission’s recommendations to the table of the state legislature.
  • It also includes a memorandum of action taken by the government on the Commission’s report.

State Finance Commission Recommendations and their Impact on Panchayati Raj Institutions

• Reviews the financial position of the panchayats in a state and makes recommendations to the Governor about the principles that should govern the distribution of tax proceeds – village, block and district level
• Taxes, levies and fees levied or appropriated by Panchayats themselves.
• Grants-in-aid to Panchayati Raj Institutions from the consolidated fund of a state.
• Ways to improve the financial position of the Panchayati Raj Institutions.
• Measures for the overall improvement of Panchayat’s finances.

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State Finance Commissions in India: Challenges, Compliance and Reform

• Reports: As per the mandate, the fifth generation SFCs ought to have submitted reports by now. But till date, only Assam, HP, TN and Kerala have submitted their fifth SFC reports.
  • Many States are yet to cross the third SFC stage.
  • The large majority has violated the mandate of the Constitution with impunity.
• Role: The Union Finance Commissions (UFC) has been widely acknowledged as a professional and quasi-judicial body.
  • The UFC exhibits seriousness, regularity, acceptance of recommendations and their implementation.
  • But these are evidently absent when it comes to State Finance Commissions (SFCs).
  • Clearly, honouring the Constitution has become a matter of convenience.
• Personnel: The SFCs’ compositions are large of serving and/or retired bureaucrats rather than academics.
  • The State governments bear a large share of the blame for this. Overall, there has been an inadequate appreciation of the significance of SFC as an institution.
  • This is the case with the Union States as well as the professional community.

Strengthening State Finance Commissions: Insights from the 14th Finance Commission Recommendations

• Setup a National platform for interaction between various State Finance Commission.
• Simplification of account format and reports
• Timely and regular constitution of SFC by State government
• Administrative support of the State.
• Endowing adequate resources by state.
• Timely presentation of report in State Legislature.
• Comprehensive maintenance of accounts of local bodies.

Property Tax Conundrum: Challenges and Solutions in Implementation

• Few states have not delegated it to Local bodies.
• In some states where it has been delegated, rules have not been framed.
• Lack and inadequacy of databases on properties.
• Corruption in the lower strata of bureaucracy
• Property tax rates not revised periodically
• Several exemptions

Is there adequate implementation of State Finance Commission recommendations for Local Finances?

• Expedite property tax reforms
• Regular revision of taxation rates
• Minimal exemptions with “sunset clause principle”
• Vacant Land Tax: It is hardly levied in India & it should be levied.
• Betterment Tax should be levied for betterment brought about in the area
• Some public improvements result in the appreciation of the value of private assets. The owner gains but through no merit of its own.
• Advertisement Tax: It is relevant largely for urban areas but in most states conferred only on Tier I municipalities.
• Entertainment Tax: Comprehensive review to include new forms of entertainment such as cable TV, amusement parks, etc.

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