A Project Assignment

On

Finance Commission of India

Submitted in partial fulfilment of the requirement for the award of the degree of

MASTER OF ARTS

In

ECONOMICS
By:
SAKSHI
UNDER THE GUIDANCE OF

PROF. ATVIR SINGH

(DEPARTMENT OF ECONOMICS)

CHAUDHARY CHARAN SINGH UNIVERSITY, MEERUT

Introduction of Finance Commission

The Finance Commission of India is a constitutional body that has survived for over

50 years on Indian soil. Formed under Article 280 of the Indian Constitution, the
Finance Commission of India functions as a quasi-judicial body. The purpose behind
the formation of this Commission is to determine the methods and formulas necessary
for distributing the tax proceeds between the Centre and states as well as among the
states. Along with this, the taxes and grants that are to be provided to the local bodies
in states for their functioning are also determined by the Finance Commission of
India.

It is to be noted that Article 281 of the Constitution provides that it is the President of
India who is required to lay the Finance Commission report before each House of
Parliament along with a note that explains the actions taken by the government on the
basis of the recommendations given by the Commission.

It was the 73rd Constitutional Amendment Act, 1992 that facilitated the constitution
of a Finance Commission at a 5 years interval by the state governments in order to
decide the division of resources between the state government, and the Panchayat
institutions at all levels.

On 22 November 1951, Kshitish Chandra Neogy was appointed as First Chairman of

the Finance Commission

Composition of Finance Commission of India

The Finance Commission of India is composed of five members which include one
Chairman, and four other members of the Commission. All of these members are
appointed by the President of India who also determines the term of their office. These
members are anyway subjected to reappointment as per requirement.

Chairman: Heads the Commission and presides over the activities. He should have had
public affairs experience.
Four Members: The Parliament determines legally the qualifications of the members
of the Commission and their selection methods.

The advisory role of the Finance Commission

The term ‘advisory’ symbolizes recommendations. Therefore, the Finance
Commission of India can be said to be a recommendatory body that gives advice to
the President of the nation, who after going through the same, applies it to make
decisions on financial matters. This advisory role of the Finance Commission is in a
way binding on the President of India. The President can either accept the
recommendations made or reject them. Further, whether to implement the
recommendations issued by the Commission or not in matters of granting money to
the states, rests on the Union Government.

The advisory role is neither of a binding nature nor can give rise to a legal beneficiary
in the state’s favor to receive money from the Union on the basis of the
recommendations made by the Commission. This has been clarified by the Indian
Constitution itself.

Functions of the Finance Commission

The Finance Commission of India has been vested with certain functions that are
determined by the President of India. The majority of these functions surround the
recommendations that are supposed to be delivered by the Commission to the
President of the nation. The functions of the Finance Commission have been listed
here under;

It is the responsibility of the Finance Commission to recommend the distribution of

the net proceeds of taxes that are supposed to be shared between the Union, and the
states, along with the inter-state distribution.

The Finance Commission recommends the principles that are applied to govern the
grants-in-aid to the states and the Union Territories by the Union from the
Consolidated Fund of India.

The Commission recommends the measures that need to be adopted to augment the
consolidated fund of a state in order to facilitate supplying of the required resources to
the panchayats and the local bodies of the state so as to avoid hindrance in their
functioning. The Commission has to carry out this function on the basis of the
recommendations made by the state finance commissions as per their requirement.
 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 a specific purpose, net of collection charges.

Aspects of Recommendations of Finance Commission

The Finance Commission recommendations cover various aspects of fiscal federalism

as described below:

1. Vertical Devolution – It refers to the share of States in the divisible pool of

Central taxes.
This aspect plays a crucial role in promoting fiscal autonomy among States.

2. Horizontal Distribution – This refers to the allocation of resources among States.

The Finance Commission makes this recommendation based on a formula so as to

ensure equitable distribution of funds and foster balanced development across the
regions.
 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.

3. Grants-in-aid – It refers to the additional transfers to specific states or sectors that

are in need of assistance or reform. For example, grants for improving the justice
delivery system or enhancing the statistical infrastructure in the States.
This aspect of Finance Commission recommendations aims to promote inclusive
growth and address regional disparities within the country.

Horizontal devolution among the States from the 11th to 15th Finance
Commission.

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.
 It can be seen that industrially developed States received much less than a rupee for
every rupee they contributed as against States like Uttar Pradesh and Bihar. This is
partly due to the fact that many corporations are headquartered in these State capitals
where they would remit their direct taxes. However, this variation can also be
attributed to the difference in GST collection among various States.

 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.
This is attributable to the higher weightage being given for equity (income gap) and
needs (population, area and forest) than efficiency (demographic performance and tax
effort).

Major recommendations of last four finance commissions of India

Twelfth Finance Commission

 The 12th FC was appointed in November 2002 under the chairmanship of C.
Rangarajan. Its report was submitted in 2004, covering the period 2005-2010.

Its specific terms of references pertained to:

i. Balancing the revenue accounts of the Centre as well as states with a view to
reduce fiscal deficits.
ii. Taxation efforts.
iii. Commercial viability of various projects undertaken by the states.

 The 12th Finance Commission suggested increasing the share of the states to
30.5 percent in the pool of central taxes.
 The commission claimed to have followed the principles of equity and fiscal
efficiency in assigning the criteria and relative weight for determining the
interest rate of states. The commission recommended the continuation of the
scheme of calamity relief fund established at the suggestion of the 11th FC.
 The Commission blamed the Centre’s fiscal policy for the increasing
indebtedness of the states over the years.
 The commission observed that the Fiscal Reform Facility introduced by the
Centre failed to play any significant role in the improvement of the states’
finance.
 The fiscal federalism in India should evolve a flexible and efficient and
equitable system of resource transfers from the Centre to states.
 The profligacy of pending should be stopped. Prudency and fiscal discipline
should govern the mode of public finance in India at all levels of the
government.
Thirteenth Finance Commission

The Thirteenth Finance Commission has submitted its report to President in

December 2009. The report was submitted by the Chairman of Commission
Dr.Vijay Kelkar.

Important recommendations of this commission:

 The commission has made recommendations for the fiscal consolidation for a
five year period from 2010 to 2015.
 The report additionally calls for climate linked fiscal incentive to states, calls
for enhanced royalty for mineral resources of states and suggests framework
for output at the state level.
 Broadly speaking, the report maintains the centre-state share of net tax
proceeds.
 The commission has asked the government to stop changing tax and duty rates
annually and switch to a three-year rolling budget.
 A rolling budget would mean tax and duty rates unchanged for a longer period,
and thus help companies and individuals to plan their financial strategies in
advance.
 The report has also assessed the impact of the proposed goods and services tax
(GST) on trade.

Fourteenth Finance commission

 The FFC has radically enhanced the share of the states in the central divisible
pool from the current 32 percent to 42 per cent which is the biggest ever
increase in vertical tax devolution.
 The last two Finance Commissions viz. Twelfth (period 2005-10) and
Thirteenth (period 2010-15) had recommended a state share of 30.5 per cent
(increase of 1 percent) and 32 per cent (increase of 1.5 percent), respectively in
the central divisible pool.
 The FFC has also proposed a new horizontal formula for the distribution of the
states’ share in divisible pool among the states. It has incorporated two new
variables: 2011 population and forest cover; and excluded the fiscal discipline
variable.
 The FFC has not made any recommendation concerning sector specific-grants
unlike the Thirteenth Finance Commission.
 Grants: Should be distributed to states for local bodies on the basis of the 2011
population data; the grants be divided into two broad categories on the basis of
rural and urban population — constituting gram panchayats, and constituting
municipal bodies respectively.
 Types of grants: A basic grant and a performance grant — the ratio of basic to
performance grant be 90:10, with respect to panchayats; and 80:20 in the case
of municipalities.
 Delinking of schemes: Eight centrally sponsored schemes (CSS) will be
delinked from support from the Centre; various CSS will now see a change in
sharing pattern, with states sharing a higher fiscal responsibility.

Fifteenth Finance commission

The final report with recommendations for the 2021-26 period was tabled in
Parliament on February 1, 2021.
 Important recommendations of this commission:

1. Share of states in central taxes

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

2. Criteria for devolution

 The criteria for distribution of central taxes among states for 2021-26 period is
same as that for 2020-21.
 However, the reference period for computing income distance and tax efforts
are different (2015-18 for 2020-21 and 2016-19 for 2021-26), hence, the
individual share of states may still change.
 Income distance: Income distance is the distance of a state’s income from the
state with the highest income.
 Demographic performance: The Commission was required to use the
population data of 2011 while making recommendations. States with a lower
fertility ratio will be scored higher on this criterion.
 Forest and ecology: This criterion has been arrived at by calculating the share
of the dense forest of each state in the total dense forest of all the states.
 Tax and fiscal efforts: This criterion has been used to reward states with higher
tax collection efficiency. It is measured as the ratio of the average per capita
own tax revenue and the average per capita state GDP during the three years
between 2016-17 and 2018-19.

3. Grants

 Sector-specific grants: Sector-specific grants of Rs 1.3 lakh crore will be given

to states for eight sectors. A portion of these grants will be performance-linked.
The sectors are: (i) health, (ii) school education, (iii) higher education, (iv)
implementation of agricultural reforms, (v) maintenance of PMGSY roads, (vi)
judiciary, (vii) statistics, and (viii) aspirational districts and blocks.
 State-specific grants: These will be given in the areas of: (i) social needs, (ii)
administrative governance and infrastructure, (iii) water and sanitation, (iv)
preservation of culture and historical monuments, (v) high-cost physical
infrastructure, and (vi) tourism
 Grants to local bodies: Grants to local bodies (other than health grants) will be
distributed among states based on population and area, with 90% and 10%
weightage, respectively. No grants will be released to local bodies of a state
 after March 2024 if the state does not constitute State Finance Commission and
act upon its recommendations by then.
 Disaster risk management: The Commission recommended retaining the
existing cost-sharing patterns between the centre and states for disaster
management funds. The cost-sharing pattern between centre and states is: (i)
90:10 for north-eastern and Himalayan states, and (ii) 75:25 for all other states.

4. Fiscal roadmap

 Fiscal deficit and debt levels: The Commission suggested that the centre bring
down fiscal deficit to 4% of GDP by 2025-26. For states, it recommended the
fiscal deficit limit (as % of GSDP) of: (i) 4% in 2021-22, (ii) 3.5% in 2022-23,
and (iii) 3% during 2023-26.

It recommended forming a high-powered inter-governmental group to (i) review

the Fiscal Responsibility and Budget Management Act (FRBM), (ii)
recommend a new FRBM framework for centre as well as states, and oversee its
implementation.

 Revenue mobilization: Income and asset-based taxation should be

strengthened, recommended the commission. To reduce excessive dependence
on income tax on salaried incomes, the coverage of provisions related to tax
deduction and collection at source (TDS/TCS) should be expanded.
 GST: Revenue neutrality of GST rate should be restored which has been
compromised by multiple rate structure and several downward adjustments.
Rate structure should be rationalized by merging the rates of 12% and 18%.
States need to step up field efforts for expanding the GST base and for ensuring
compliance.
 Financial management practices: A comprehensive framework for public
financial management should be developed. An independent Fiscal Council
should be established with powers to assess records from the centre as well as
states. The Council will only have an advisory role.

5. Other recommendations

 Health: States should increase spending on health to more than 8% of their

budget by 2022. Primary healthcare expenditure should be two-thirds of the
 total health expenditure by 2022. All India Medical and Health Service should
be established.
 Defense and internal security: A dedicated non-lapsable fund called the
Modernization Fund for Defense and Internal Security (MFDIS) should be
established. It will primarily bridge the gap between budgetary requirements
and allocation for capital outlay in defense and internal security.
 Centrally sponsored schemes (CSS): A threshold should be fixed for annual
allocation to CSS below which the funding for a CSS should be stopped (to
phase out CSS which outlived its utility or has insignificant outlay).

Conclusion
The Finance Commission is perceived to be the supreme constitutional body
regulating finance in India, both between the Centre and the states, and among the
states. There are several prominent factors that have contributed to the fall of this
esteemed institution and the same is reflected in the 12th Finance Commission. The
Central government has noticed appointments made to the Commission simply on the
grounds of distribution of patronages to the individuals belonging to some of the other
regional parties. As India witnesses the emergence of coalition parties, the detriment
suffered by the Finance Commission cannot go unnoticed. The Commission is
supposed to be technical in its approach and logical in its procedure, and
recommendations provided to the President require members who are experts in the
subject matters related to the Commission. Ignorance of such a necessity welcomes
the decaying of this constitutional body. Actions must, therefore, be taken in order to
rule out the irregularities taking place within and by the Commission.