Finance Commission

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FINANCE COMMISSION

FINANCE COMMISSION One of the distinguishing institutions of India's federal polity, the Finance Commission provides a constitutional mechanism for the transfer of resources from the national to subnational governments in a fair and judicious manner. India's Constitution vests powers to levy most of the major revenue-yielding taxes, including income tax and general excise duties, with the central government. The only mass-based tax assigned to the states is the sales tax. On the other hand, many functions that require large expenditures, including police, public health, and sanitation, are assigned to the states, creating a serious gap in the fiscal system, with roughly 55 percent of aggregate expenditures undertaken at the state level, while only about 35 percent of aggregate revenues are raised by the states. All of India's states need transfers, but the most backward states need the greatest assistance from the central government to enable them to provide even minimal public services.

Article 280 of India's Constitution mandates the president to appoint an independent Finance Commission at least once every five years to recommend to the president: the proper distribution of taxes collected by the central government, that are to be shared between the central government and the states and their allocation among the states; and the principles that should govern "grants-in-aid" to states in need of assistance, which the Parliament is authorized to make under Article 275. Since 2000, revenues from all central taxes constitute a divisible pool. The president may also refer "any other matter" to the commission for its recommendations "in the interests of sound finance." Since 1993, following constitutional recognition of a "third tier" of government in the country, namely village and district panchayats and urban municipalities, the Finance Commission has been required to recommend measures to help state governments supplement the resources of the local bodies. The commission is also advised to keep in mind the revenue needs of both the central government and the states in meeting their essential expenditures. In recent years the commission has also been asked to review "the state of finances of the Union and the states" and suggest ways "to restore budgetary balance and maintain macroeconomic stability." Every commission is normally required to make recommendations to cover a five-year period.

Since independence there have been twelve Finance Commissions. Recommendations of the commission are accepted by Parliament without modification, with rare

*Criteria and relative weights for determining inter se* shares of states in union taxes: Tenth and Eleventh Finance Commissions**
Criterion	Tenth Finance Commission	Eleventh Finance Commission
(1) This reflects the difference in the per capita income of a given state from that of the highest income state or that of a group of states with the highest per capita income.
(2) As measured by formulas spelled out in the respective commission's reports.
SOURCE: Courtesy of author.
1. Population	20.0	10.0
2. Income–distance(1)	60.0	62.5
3. Area	5.0	7.5
4. Index of infrastructure	5.0	7.5
5. Tax effort(2)	10.0	5.0
6. Fiscal discipline(2)	—	7.5

exceptions, regarded almost as an impartial "award." Apart from taking note of the legitimate revenue needs of both levels of government, two cardinal commission principles have been to treat all states on a uniform basis, and to use the transfer mechanism to reduce interstate inequalities. "Upgradation grants" have been a regular feature of the transfers. Grants are also recommended for relief in the event of natural calamities. Commission transfers, comprising tax share and grants-in-aid, have generally been unconditional, the former being regarded almost as an "entitlement" of the states.

The states have persistently complained that transfers have not been adequate, though transfers to states as a proportion of central government revenues have risen from less than 25 percent in the 1950s to around 35 percent by 2002. Nevertheless, the states find it increasingly difficult to meet their expenditure out of the revenues made available to them.

Transfers have played a significant role in reducing revenue disparities among the states, per capita revenue of low-income states from their own sources usually being less than one-third that of the higher-income states. Per capita current expenditure of poorer states is nearly two-thirds that of the richer states. Even so, interstate disparities in revenue capacity have increased over the years, and federal transfers have not fully offset the fiscal disabilities of the poorer states.

A factor undermining fiscal discipline among the states has been the manner in which commission grants are determined. After laying down the formula for tax devolution, the commission assesses the budgetary position of each state by projecting its revenue and expenditure. Although the projections are made on reasonable assumptions regarding the likely growth of the states' revenue and expenditure, in reality "history" dominates the estimates, tending to breed fiscal laxity among the states. The Tenth and Eleventh Finance Commissions have tried to rectify this deficiency by introducing weights for "tax effort" and "fiscal discipline" in their tax devolution formula as shown in Table 1.

Debt relief measures recommended by the recent commissions are also linked to criteria designed to induce better fiscal management. How far such devices help inculcate fiscal discipline remains to be seen. Attaching strings to statutory transfers also raises questions about the central government's infringement of the states' fiscal autonomy.

Not all the blame for the ills of the transfer system can be attributed to the commission, however. Contrary to the constitutional scheme, a substantial portion of transfers has been routed through other channels. About one-third of the revenue transfers to the states has been dispensed by the Planning Commission, a body created to draw up and implement the five-year plan. Some funds are transferred by central ministries at their own discretion. Such multiplicity of channels with overlapping jurisdictions has blurred the overall efficiency the transfers.

Despite its perverse effects, the gap filling approach continues to cast its shadow over the commission's transfer scheme. The Ninth Commission attempted to introduce normative principles in deciding the transfers. The Eleventh also tried to anchor the transfers to objective norms. But their attempts did not go very far.

Even a fully normative transfer scheme may not succeed in inculcating fiscal discipline among the states without a credible commitment to a "no-bail-out policy" on the part of the central government. Debt relief granted by the commission periodically has not much helped to improve matters.

There is thus urgent need for reforms of the transfer system if the Finance Commission is to play the constitutional role more effectively.

Amaresh Bagchi