Evolution of the Finance Commission
India is a federal nation being administered through Union and Province as a result of the Montague-Chelmsford reforms enacted by the Government of India Act, 1919. This Act provides power to the provinces by the way of delegation and power to the Union to legislate for the entire nation on any subject. The power of revenue collection was distributed among the Union and Provinces. Further, in 1927, the Simon Commission in evaluating the Act, 1919 and recommending the formation of Indian Princely States and Provinces, which formed the administrative divisions of the British Government. The Government of India Act, 1935 established a federal system with Provinces and Indian States as two separate units. Under the Act, legislative controls were distributed under three lists – Federal List, Provincial List, and the Concurrent List. The act provided for collection and retention of levies by the Federal Government and spelled out details of the distribution of financial resources and grants-in-aids to the provinces. The Constitution’s Drafting Committee was clearly defined that no state has the right to separate from the federation. The Federation is a Union because it is indestructible. The Constitution of India has adopted the fiscal federal structure and provisioned the Finance Commission (FC) to establish relation between the Union and States and among the States, which were constituted in 1951 under the Article 280. Under Article 280 of the Constitution, the President of India appoints the FC every five years or earlier to make recommendations on devolution of sharable taxes and grants. All FCs are guided by three stated principles of — equalisation, equity and efficiency.
Mandate of Finance Commission
In a Federation, the states should be financially self-sufficient and should enjoy the supreme autonomy. The finances are really the complex aspects under federal relations. It is important to note that the economic and financial powers are given in the hands of the central government by the Constitution. The States have immense responsibilities, but very meagre revenue sources. Indian fiscal system has witnessed structural changes in the recent past. These structural changes are many, such as end of plan transfers (after abolishment of the Planning Commission), implementation of goods and services taxes (power transferred to the GST Council from the State), unprecedented hike in the vertical devolution (32% to 42% by FC14) of Central taxes etc. The role of federal transfers through the FC in the public finance management (PFM) as well as in the development of the nation is enormous, and it is further extended under the recent architectural changes in the fiscal system of India. It performs the roles largely defined under Article 280 of the Constitution. The FC’s transfers are for equalizing transfers of resources from the richer to the poorer states, without compromising the efficiency and performances of any state. The FC is a constitutional body appointed for every five years by the President of India to make recommendations on – (a) devolution of central taxes to states, (b) distribution of central grants to states, (c) measures to improve the finances of states to supplement the resources of local governments viz. panchayats and municipalities, and (iv) any other matter referred to it.
Role of the Finance Commission
The regional inequality in India has been continuous and persistent shown in Graph below. The regional disparity in India has been widening all along since the Seventies. The Committee of the Constitution kept in vision the need to make the whole nation into one economic space through the periodical review system and fiscal transfers to states, which is mainly guided by the principle of equalization through the FC. The FC is the only institution that addresses the objectives of the equitable regional development and devolute the central pool accordingly.
Graph 1 : Trend of Regional Disparity in India (1980 to 2019)
Vertical and Horizontal Devolution
In the background of wide extant regional disparities, it is only expected that the quinquennial FCs make their recommendations, both with respect to vertical distribution (between the Union and States) and horizontal distribution (among the States), in such a manner that the regional economic inequalities are gradually reduced. The principle of criterion for horizontal sharing in the FC are both need based and performance based. Different FCs have recommended different formula for vertical and horizontal devolutions between the Union and the States and among the states, which is shown in the Graph 2. The vertical devolution has been gradually increased over the periods from 28.5% (FC11) to 32.0% (FC13). The FC14 emphasised to increase the fiscal autonomy of the states through the major hike in the formula-based devolution by minimising the discretionary grants (plan grants) and increased to 42.0%. However, at the same time, the fact (as noted by the FC14 itself) that the overall vertical distribution has remained nearly unaltered even after FC14 recommendations. This untied unconditional revenue allows the states to spent according to their needs and priorities. In case of horizontal distribution, the different FCs adopted various criteria for distribution of central taxes among the states. Since FC7, the Commission had been adopted the population figures of 1971 in all cases where population is regarded as a factor for determination of devolution of taxes and duties and grants-in-aid. However, the FC14 has adopted the population of 2011 for first time. Area is used as a criterion since a state with larger area has to incur additional administrative costs to deliver services. The index of infrastructure, income distance and fiscal capacity distance are used to address the equity principles. While, tax efforts, fiscal disciplines and demographic performances are used to reward the better performing states. In the recommendation of recent two Commissions, environment is taken into account to improve climate and ecology in the country.
Graph 2: Vertical Devolution and Horizontal Devolution Criteria for Inter-se Tax Devolution
Over the years, the defined role of the FC has remained unchanged, nevertheless, the Terms of Reference allows to take the supplementary assignment to investigate different issues, like, the FC12 examined the fiscal situation of states and recommended relief to those states who enacted the Fiscal Responsibility and Budget Management (FRBM) Act. Likewise, FC13 assessed the impact of GST on the economy and recommend to implement and also give the grants under state specific schemes, as India is a diversified country and different states have different issues. The FC14 recommended to discontinue the plan grant which was discretionary by nature and hike allowed in the untied unconditional devolutions.
The share of central transfers to the major Indian states may be divided into three categories for an assessment of progress over the Commissions’ periods. The share in central tax devolution for the low-income states has been declining over the years, except Chhattisgarh and Madhya Pradesh, because of adoption of criteria of forest cover and increased weightage of area. Under the middle-income states, the share has been declined slightly except in Jharkhand and Rajasthan owing to the same reasons. The high-income states are benefitted through the increased share in the central devolution with only Tamil Nadu being an exception.
Graph 3: State-wise Weightage for Inter-se Tax Devolution according to Income
Source: Different FCs Reports
Grants-in-Aid
Apart from tax devolution, the FC have been using mechanism of grants-in-aid as prescribed under Article 275 of the Constitution for equalising standards of basic social services across the states. From FC6 onwards, the disparities in the provision of administrative and social services were sought to be corrected through the mechanism of upgradation grants. The FC11 and FC12 had reviewed the state of the finances of the Union and the states and suggested a plan for restructuring public finances with a view to restoring budgetary balance and maintaining macroeconomic stability through fiscal consolidation, institutional reforms (enactment of Fiscal Responsibility and Budget Management Act), Mid-Term Fiscal Plan and debt relief. The FC13 recommended to implementation of GST, power sector reforms, uniform budgetary codes across all states and state specific needs. The FC14 recommended for GST compensation to the states for fiscal prudence. Many FCs have given revenue deficit (RD) grant even after recognising the moral hazard of allowing RD in some states when others have effectively dealt with the problem. As a result, several states have shown RD in their account to attract RD grant. The FC also gives grants for local bodies (panchayats and municipals) and disaster management.
Conclusion
The FC has played an important role in sharing the resources between Centre and States based on a Constitutional division of functions and finances. It examined the fiscal situations of the Centre and the States and recommended roadmaps such as FRBM, Fiscal Consolidation, GST, etc. that will ensure sound PFM. Over the years, its role has been continuously changing. The FCs have relied mainly on devolution of taxes and duties for meeting the gaps between states’ revenues and expenditures. In this process, the advanced states received much larger shares specially through grants-in-aid, which is discretionary by nature. As a result, the inter-state disparity widened over the period rather than narrowed. This has been a serious lapse on the part of the Finance Commission.
By Dr. Bakshi Amit Kumar Sinha and Mrs. Richa Kumari
Dr. Bakshi Amit Kumar Sinha (bakshi012@gmail.com) is an Assistant Professor at Centre for Economic Policy and Public Finance, Patna and Mrs. Richa Kumari (economistricha@gmial.com) is a Research Scholar at VKS University, Ara.