Constitutional provisions relating to fiscal and financial powers of the states

FEDERAL FINANCE
MEANING: Federation may be defined as a form of political association in which two or more states constitute a political unity with a common government but in which the member states retain a measure of internal autonomy. We can notice some important definitions of federal finance by experts.

Principles of Federal Finance

Finance is the foundation of a Government. Financial provisions of the constitution have a special significance to the federal Government and the constituent units. The Indian Union has a written constitution. The Constitution splits the powers in various fields between the Central Government and the States. In the financial field, the Indian Constitution has very elaborate provisions. Such are not found in other federal constitutions. The financial relations between the Centre and the States are among the most difficult problems in a federation. Complete separation of taxation powers appears to be more logical, but as has been remarked by K. Santhanam, it has given rise to a new set of difficult problems relating to transfer of funds from the Centre to the States.

The major principles are three:

(i) the Centre as well as the States should be autonomous and neither should be unduly dependent on the other for its finances;

(ii) both should be able to obtain enough funds for their legitimate expenses; and

(iii) the receipts should grow with the need for expenditure. The reconciliation of these principles is never easy, but at times, it may become very difficult. It is true that in no federation have the Central and State governments seen eye to eye. That is why there is not a single democratic federation in which argument about the division of power and authority between the Union and its constituent units has come to an end. It is the scope and quality of the debate that matters. What is needed is a functional and not a political or ideological approach.

CONSTITUTIONAL PROVISIONS

The Indian Constitution has all the features of a federation with the specification of financial powers and functional responsibilities of the Centre and the States and the institutions needed for a federal structure and a well defined mechanism for intergovernmental transfers to address vertical and horizontal imbalances which characterise most federations.

Independent Indian Republic adopted its constitution on Jan. 26, 1950. Article, 280 of the Constitution provided for an Independent Finance Commission to be appointed periodically. Out of many sources of federal transfers at least tax sharing and unconditional grants were to be explicitly facilitated by the Finance Commission. Income tax under Article 2707 and the union excise duty under Article 272 were the tax and duties sharable with the States before all the Central taxes were made shareable through 80th amendment of the constitution. Grants under Article 2828 were outside the preview of Finance Commission. Besides sharing of tax and duty the State also receive grants-inaid of their revenue under Article 275. The Finance Commission also recommends quantum of such grants. Therefore Finance Commission, which is the unique feature of Indian federalism, has to recommend the percentage of proceeds to be shared with the States, and the principle and criteria that should become basis for distribution of such proceeds among the States.

 Allocation of Revenues between the Centre and the States

Revenue Sharing Fist finance commission was appointed in Nov.1951 whose report was submitted in Dec.1952. Since then Twelfth Finance Commissions have submitted their reports. Devolutions in the form of tax sharing and grants-in-aid up to March 31, 2010 will be governed by the recommendations of Twelfth Finance Commission. Thirteenth has already been constituted to make the recommendations of transfers after March 2010. Center was assigned the greater share from the divisible pool. It was thus maintaining a dominant position. States in such circumstance were naturally dependent on the Center for the resources not only to carry out the expenditure for socio economic development but also to discharge their statutory functions. States were given only 55 per cent of the net proceeds9 from ‘income tax’ and 40 per cent of ‘union excise duty’ collected from only three items. But every successive Finance Commission increased the share of States. Second Finance Commission increased the States’ share of income tax from 55 per cent to 60 per cent. As far as share in ‘union excise duty’ is concerned number of articles duty from which was to distributed were raised to eight, however share itself was reduced to 25 per cent from the 40 per cent as recommended by the First Finance Commission.

The Third and Fourth Finance Commissions further raised States’ share in ‘income tax’ to 66.7 per cent, and 75 per cent respectively. Share of States in ‘union excise duty’ was lowered to 20 per cent by the Third Finance Commission from 25 per cent by its predecessor. But at the same time the articles to be covered for this purpose were raised from eight (Second Finance Commission) to thirtyfive by the Third Finance Commission. The Fourth Finance Commission brought all the articles under the sharable pool, ‘union excise duty’ from which was to be shared with the States.

Fifth Finance Commission maintained the status quo, keeping the States share of ‘income tax’ and ‘union excise duty’ to be at 75 per cents and 20 per cents respectively, as was the award of the Fourth Finance Commission. Sixth Finance Commission increased the States share’ marginally by raising the share from ‘income tax’ from 75 per cent to 80 per cent while that from ‘union excise duty’ was kept at the same level of 20 per cent. Thus between First and Sixth Finance Commission States’ share had increased in many respect. But devolutions have always been one of the sources of uneasiness for Centre - State relations. Two items that have been frequently mentioned as the irritants  for the financial relations between Center and States were the surcharge on ‘personal income tax’ and ‘corporate income tax’. These items did not constitute the shareable pool (before Eightieth amendment) but certainly affect the ‘income tax’ proceeds, which is shareable, because the ‘corporate tax’, which is levied on the profit of the companies reduces the amount of dividend of the shareholders, resulting in lesser amount of ‘income tax’ collection. Surcharge on ‘income tax’ therefore used to be resented by the States. Argument was that if the tax tolerance exists, the same may be used for ‘income tax’. Devolution in the form of Grants-in-aid of revenue under Article 275 was used to cover the deficit in the revenue account of the States.

Other grants and loans for socio economic development and for specific purposes (provided under Article 282,293) were devolved to the States through other agencies. Seventh Finance Commission provided a quantum jump as far as States’ share was concerned. It, not only double the States’ share in the ‘union excise duty’ from 20 per cent to 40 per cent but also raised the share in ‘income tax’ from 75 per cent, in Sixth Finance Commission award, to 80 per cent. Thus the total devolution recommended was substantially enhanced by Seventh Finance Commission. The relief to the States’ finances was substantial as “It has for the first time left significant surpluses with all States”.

 Eighth Finance Commission further raised the States share in ‘union excise duty to 45 per cent while leaving the ‘income tax’ share intact. Ninth Finance Commission did not recommend any change in so far as tax sharing is concerned, while Tenth Finance Commission made slight changes in both ‘income tax’ shares to be reduced from 85 per cent to 77.5 per cent while at the same time increasing the share in ‘union excise duty’ from 45 per cent to 47.5 per cent. The next major structural change for revenue sharing came through the Eightieth amendment of Indian constitution. It made all the Central taxes to be shareable with the States. Therefore one of the irritant in Center-State financial relations could be removed as surcharge on ‘income tax’ and a tax on corporate income would no longer put the States to some kind of disadvantage as now the States became eligible to share the aggregate buoyancy of Central taxes.

The amendment came when Eleventh Finance Commission was all set to finalise its recommendations. States’ share was thus revised and fixed at 29.5 per cent, which was raised to 30.5 per cent by Twelfth Finance Commission. One and very clear conclusion that can be drawn that the trend in devolution through ‘revenue sharing’ has been consistently moving in favors of States. The Center’s monopoly over more elastic sources of revenue has been diluted considerably. Therefore the award of Seventh Finance Commission and Eightieth Constitutional amendment could be termed as landmarks. The saying goes; there is hardly any thing in Public finance, which is not influenced by the political economic factors. So is true here.

The growing assertiveness of States succeeded in getting things changed to their favour only when they were politically well placed. Seventh Finance Commission recommendations came when many States were not only ruled by the non Congress parties, their leaders were having a considerable say at the Central level as it was ruled by Janata Party which was amalgamation of many parties who’s leaders were very strong in their respective States. As regards the other change (Central tax becoming shareable), there was first stable coalition government at the helm in Centre. In this coalition many regional parties were having decisive say.

The basic point of financial relations is the division of tax-sources between the Centre and the States. There should be no overlapping of tax jurisdiction,
otherwise, it will cause confusion and conflict. The distribution of taxes in India is more logical and thorough than in other federations. The Union List (List I) contains powers and functions of the Union. It enumerates the taxes and levies which can be imposed by the Union Government. The State List (List II) enumerates the taxes and levies which can be imposed by the States. List III, which is the Concurrent list, does not include any sources of taxation. There is, thus, an attempt to avoid all overlapping.
 

Taxing Powers

In the Constitution, there is a clear demarcation of the taxation powers of the Union and the States. Under Article 246 of the Constitution, there are three Lists, namely, the Union List, the State List and the Concurrent List. In respect of the subjects listed in the Union List including taxes, Centre has the exclusive power to make laws. Similarly, for the taxes listed in the State List, States have exclusive power to make laws. No taxes are listed in the Concurrent List. Thirteen taxes are listed in the Union List. The important taxes listed in the Union List or those assigned to the Centre are taxes on income other than agricultural land, duties of custom, duties of excise except those on alcoholic liquor for human consumption, corporation tax, estate duty in respect of property other than agricultural land, terminal taxes on goods and passengers carried by railways, sea or air, taxes other than stamp duty on transactions in stock exchanges and futures markets and taxes on sale and purchase of goods other than newspapers, when such sale takes place in the course of inter-State trade or commerce. Nineteen taxes are listed in the State List. The important taxes listed in the State List are land revenue, taxes on agricultural income, taxes on land and buildings, taxes on mineral rights subject to restrictions imposed by Parliament, duties of excise on alcoholic liquor for human consumption, taxes on sale and purchase of goods other than newspapers, taxes on goods and passengers carried by road, taxes on vehicles, taxation on professions, taxes on luxuries including on entertainments, taxes on entry of goods into a local area and taxes on advertisements other than those published in newspapers and broadcast by radio or television.

Article 268 to 281 of the Indian Constitution deal with the distribution of revenue between the Union and the States. In the Seventh Schedule items 82 to 92(a) in the Union List and items 45 to 63 in the State List refer to sources of taxation. As regards the division of taxing power, taxes that have an interstate base are under the legislative jurisdiction of the Union, while those having a local base came under the jurisdiction of the States. The Union List contains 12 items of taxation. Though they are all in the Union List, it does not mean that the revenues from these accrue to the Union.
        The Constitution (Eightieth Amendment) Act, 2000 has altered the pattern of sharing of Central taxes between the Centre and the States in a fundamental way. Prior to this amendment, Taxes on Income other than agriculture income and Union duties of excise were shared with States under articles 270 and 272 respectively. The Eightieth Amendment Act has substituted a new article for article 270 and omitted the old article 272. The new article 270 provides as under: “270(1) All taxes and duties referred to in the Union List, except the duties and taxes referred to in articles 268 and 269, respectively, surcharge on taxes and duties referred to in article 271 and any cess levied for specific purposes under any law made by Parliament shall be levied and collected by the Government of India and shall be distributed between the Union and the States.” The Finance Commission is now required to recommend such percentage of taxes or duties referred to in the new article 270 that may be assigned to the States and also recommend the manner in which these may be distributed among the States. The main changes brought about by this amendment are as follows:
a) All Central taxes and duties, except those referred in articles 268 and 269 respectively and surcharges and cesses, are to be shared between the Centre and the States.
b) Only States in which these taxes and duties are ‘leviable in that year’ are entitled to get a share in these taxes and duties.
c) A percentage of “net proceeds” of these taxes and duties as may be prescribed by the President by order after considering the recommendations of the Finance Commission is to be shared by States.
d) The percentage of “net proceeds” of these taxes and duties which is assigned to the States in any financial year shall not form part of the Consolidated Fund of India.

States Taxes
There are 19 items (as against 12 in the Union List) of which the most important are land revenue, duties of excise on alcoholic liquors and narcotic\ drugs, general sales tax and sales tax on motor spirit, stamps and registration, taxes on motor vehicles, entertainment taxes and electricity duties. Every State levies these taxes by law and collects and appropriate them. There is no complication about States’ taxes. There is no tax item in the Concurrent list, hence, no question of common source of taxation. Article 274 of the Constitution protects the interest of the States. The purpose of this Article is to safeguard the financial interests of the States and prevent any possible inroads by the Centre into the revenue preserves of the States, by making it obligatory for the Union Government to take consent of the States through the President.

Expenditure Responsibilities

The Union and the State Lists under the Seventh Schedule prescribed in the Constitution under Article 246 contain subjects in respect of which the Union and the States have exclusive jurisdiction to make laws, respectively. In addition, a few subjects are listed in the Concurrent List in respect which both the Union and the States have concurrent powers to make laws. Conforming to the broad pattern prevalent in other federations, subjects of national importance, such as, defence, foreign affairs, money and banking, communications, national highways, shipping, ports, airways and macroeconomic management have been assigned to the Union. Subjects of regional concern, such as, public order, agriculture, irrigation, public health and sanitation, roads and bridges not specified in the Union List and industries other than those declared by Parliament to be of strategic importance are assigned to States. The important subjects specified in the Concurrent List are criminal law, administration of justice, contracts, forests, economic and social planning, population control and family planning, education and newspapers. The subjects listed in the Union and the State Lists broadly define the expenditure responsibilities of the Centre and the States, respectively.

Institutional Mechanism for Intergovernmental Transfers

From the division of subjects between the Union and the States, it is clear that there is an asymmetry between the taxation powers and the functional responsibilities. While the Centre is assigned with taxes with higher revenue potential, States are assigned with more functional responsibilities. To address the issue of a gap in the resources assigned to States and their expenditure responsibilities, the Constitution provides an institutional mechanism in the form of a Finance Commission and other enabling provisions for the transfer of resources from the Centre.

Article 280 mandates the setting up of a Finance Commission within two years from the commencement of the Constitution and thereafter at the expiration of every fifth year or at such earlier time as the President of India considers necessary. The duties of the Finance Commission as prescribed under this Article are, a) the distribution between the Union and the States of the net proceeds of taxes which are to be, or may be, divided between them and the allocation between the States of the respective shares of such proceeds, b) the principles which should govern the grants-in-aid out of the Consolidated Fund of India, c) the measures needed to augment the Consolidated Fund of a State to supplement the resources of the panchayats and municipalities in the State, and d) any other matter referred to the Commission by the President in the interests of sound finance. Under Article 281, every recommendation made by the Finance Commission together with an explanatory memorandum as to the action taken thereon is required to be laid before each House of Parliament.

  All the taxes and duties refereed to in the Union List with the exception of duties referred to in Articles 268 and 269 and surcharges referred to in Article 271 and any cesses levied for specific purposes, shall be distributed between the Union and the States under Article 270. Article 268 refers to duties levied by the Union but collected and appropriated by the States. These are such stamp duties and such duties of excise on medicinal and toilet preparations as are mentioned in the Union List. Under Article 269, taxes on the sale of goods and taxes on the consignment of goods shall be collected by the Government of India but shall be assigned to States.

 Distribution of States’ Share

The intricate issue is the horizontal sharing or how the States’ share to be distributed amongst them. It becomes complicated because of the fact that States are heterogeneous in terms of GSDP, population, poverty, and infrastructure etc. And as a result of this they vastly differ in terms of fiscal capacity. In view of equity objective poor States have to be accorded priority but as discussed earlier this militates against the objective of efficiency. The criteria and weights used for tax devolution by the Finance Commissions tend to move towards equity approach. For the distribution of proceed from income tax ‘Population’ has been the dominating criteria up to Seventh

Finance Commission with first, third and fourth giving 80 per cent and second, fifth, sixth and seventh giving it 90 per cent weight, the rest 20 per cent or 10 per cent was to be distributed on the basis of contribution of respective States in the ‘income tax’ collection. As for ‘union excise’ population was given 100 per cent weight by First Finance Commission which declined to 90 per cent in second, further declined to 80 per cent, remained so in fifth as well. Third Finance Commission did not specify as to how the excise duty to be distributed. Sixth Finance Commission further reduced this weight to 75 per cent. States backwardness started receiving attention since Fourth Finance Commission when it was accorded 20 per cent weight. It was reduced to 6.66 per cent but simultaneously a criterion of income distance was added with 13.34 per cent weight, which was raised to 25 per cent by the Sixth Finance Commission. For ‘union excise duty’ criteria was diversified for the first time by the Seventh Finance Commission which, besides population, added ‘inverse of per capita income’, poverty and ‘revenue equalisation’ with each assigned 25 per cent weight.

Eighth Finance Commission onwards ‘income distance’ became the principal determinant. It remained with 45 per cent weight for ‘income tax’ distribution under Eighth and Ninth Finance Commission. Tenth Finance Commission raised it to 60 per cent. As for as ‘union excise duty is concerned ‘income distance’ has been the principal determinant with 45 per cent weight each under Eighth, Ninth Finance Commission. Population that was the dominant criterion for ‘income tax’ distribution at least up to Seventh Finance Commission and for ‘union excise’ up to Sixth Finance Commission had lost that primacy in case of ‘union excise’ and ‘income tax’ respectively from Seventh and Eighth Finance Commissions onward. The reason for dilution of population as weight was a clear-cut shift in favor of equity.

Though revenue equalisation was assigned 25 per cent weight for the distribution of ‘union excise’ any Finance Commission thereafter did not use it in any significant measure. While Tenth and Eleventh Finance Commissions evolved other criteria like area, index of infrastructure and fiscal discipline, income distance continued to be the dominant criterion.Twelfth Finance Commission while reducing the weight of income distance from 62.5 per cent under Eleventh Finance Commission, to 50 per cent while at the same time increased the weight assigned to population from 10 per cent under Eleventh Finance Commission to 25 per cent. It also added, for the first time, a new element in the criteria namely the ‘tax efforts’.

Thus in general, equity principle dominated in case of Twelfth Finance Commission award too. In short “we have tried to evolve a formula that balances equity with fiscal efficiency. Equity considerations however dominate, as they should, in any scheme of federal transfers trying to implement the equalisation principle”.

Shared taxes consist of non-corporate income tax and union excise: duty. The net proceedsfrom non-corporate income tax excluding revenue from certain items such as tax on Union emoluments, and surcharges are compulsorily shareable between the Centre and the States under Articles 270 and 271 of the Constitution. On the other hand, revenue from Union excise duties may be shared between the Centre and the States under Article 272 of the Constitution.An important feature of tax devolution recommended by the Finance Commissions has been that while the criteria adopted for distributing them are different from the principles adopted for giving grants-in-aid, nowhere is it made clear that the economic objectives of the two instruments are different (Rao, M.G, 1987).

The tax devolution has been recommended mainly on the basis of general economic indicators whereas, grants-in-aid has been given to offset the residuary fiscal disadvantages of the States as quantified by the Commissions. Even in the case of tax devolution, the principles adopted for the distribution of the net proceeds from non- corporate income tax have been very different until the Seventh Commission from those employed for Union excise duties on the rationale that the former is compulsorily shareable and the latter is not. The criteria adopted for the distribution of shared taxes have also 35 been matter of controversy The important issues discussed on the criteria for tax devolution are:

(i) the relevance of the 'contribution' factor in distributing the share of income tax,

(ii) the relevance of backwardness factor in tax devolution; and

(iii) the appropriate in dicator of backwardness to be employed for tax devolution.

Almost all the Commissions have assigned 10-20 per cent weight to the 'contribution' factor in distributing the proceeds from income tax though the rationale for doing so has not been adequately explained in terms of either economic or legal arguments. This has been done in spite of the Finance Commissions themselves asserting that there is no principle of compensation or reimbursement involved36. The rationale for assigning some weight to the contribution factor appears to be, "Receipts from devolution constitute right. Its status is similar to the taxes levied and collected by the States".(Rao, V.K.R.V., 1973). The alternative view point, however, has been forcefully put forward by Rajkrishna, (India, 1979) in his minute of dissent to the Seventh Finance Commission wherein he has argued that there is no case for assigning any weight to the collection factor.

The second important issue on tax devolution relates to the use of backwardness indicator in the tax devolution formula. Here again, the view that tax devolution should be mainly made on the basis of population and that the backwardness factor should not be brought in as criterion (Rao, V.K.R.V., 1973) is not shared by many. The predominant view is that, in view of the glaring disparities in the provision of public services among the States, use of population as the only basis is clearly inadequate (Hicks, U.K., 1961, Sastry, 1966, Lakdawala, 1967). After the Seventh Finance Commission significantly increased the role of tax devolution in the total statutory transfers by doubling the States' share of excise duties from 20 per cent to 40 per cent, and with mounting criticism on the lack of progressivity in transfers, the subsequent Commissions have assigned substantial weight to the backwardness indicators. Another important issue concerns the appropriate indicator of backwardness to be used in the tax devolution formula.

It has been stated that the criteria for backwardness to be used by the Finance Commission should be general rather than specific (Rao, V.K.R.V.,1973). Thus, the composite index of backwardness used by the Fourth and the Fifth Finance Commissions which was estimated by assigning equal weights to some selected socio-economic variables), or the per capita SDP employed by the subsequent Commissions either in the 'inverse' or in the 'distance' form, did not invite much criticism However, the use of relative levels of poverty or poverty ratio in tax devolution formula employed by the Seventh Commission was severe ly criticised by Dandekar (1979) on the ground that the poverty line employed was not State-specific and the adjustment for consumer price differences took into account only the differential growth in prices and not differential price levels themselves. The use of poverty ratio in the first report of the Ninth Finance Commission came in for even more serious criticism. Bagchi (1988) considers the use of the  poverty factor in tax devolution even conceptually incorrect.

The distribution of tax shares among the States on the basis of various economic indicators by different Finance Commissions has led to each State arguing for the adoption of indicators advantageous to it. The lack of agreement in the factors to be employed even among the researchers on the subject, has not helped to settle the issue. Before we close our discussion on tax devolution, it is important to highlight two important issues relevant to intergovernmental fiscal relations. The first is the amendment to the Income-tax Act in 1959, which introduced separate tax on corporations. This led to exclusion of income tax on corporate entities from the divisible pool. This has continued to be major cause of complaint among the States.

The States have contended that the annual grants given to compensate the States for the loss of revenue arising from the exclusion of income tax on corporate entities during 1959 to 1962 was inadequate and, more importantly that the amendment meant the exclusion of more buoyant source of revenue from the divisible pool. The latter conten tion implicitly assumes that with the inclusion of more buoyant source of revenue in the divisible pool, the Finance Commission would not have reduced the percentage shares of the divisible taxes going td the States.

The second important issue relates to the high proportion of non-corporate income tax and excise duty transferred to the States and its alleged incentive effects on Centre's effort in raising revenue from these divisible taxes. The Eighth and the Ninth Finance Commissions, for example, have recommended the transfer of 85 per cent of non-cor porate income tax and 45 per cent of Union excise duty to the States. The consequence of this is alleged to be the lack of inerest on the part of the Centre in revenue productivity of income tax and its resorting to frequent administered price increases instead of raising excise duties on the products of public monopolies to raise revenues. One solution to this is said to be broadening ihe divisible pool itself to include the proceeds from all Central taxes and sharing fixed proportion of it with the States, but the Sarkaria Commission did not consider this suggestion favourably (India, 1988-2).

2. Grants-in-Aid
The States’ tax-heads are such that they would not make them financially independent. Accordingly, provision has been made for grants-in-aid of revenue in article 275(i) of the constitution. Federalism is not only a unifying but also a leveling up force. Federal grants-in-aid to the Constituent units have been necessary and this exists in all federations. The simple reason behind this is that no system of distribution of financial sources between the federation and the units can possibly meet the needs of national development and social services which are usually the responsibility of the units. By this device financially weaker States can be assisted in bettering their economic conditions. Different clauses of Article 275 make both general and specific provision for grants-in-aid to the States in need of assistance. This is a discretionary provision. But its inclusion in the Constitution makes it obligatory on the part of the Central Government to make grants-in-aid towards the costs of schemes undertaken by the States, with the approval of the Centre, for promoting the welfare of the Scheduled Tribes and for raising the level of administration of Scheduled areas. Article 282 also provides for grants to the States. This article empowers the Union Government to make grants for a public purpose even though the purpose is one concerning which Parliament cannot normally legislate.

Vertical imbalance caused by the assignments of responsibilities and revenue sources continued to persis\t till today. In the year 2000-01 States could finance only about 43 per cent of the expenditure from their own revenue sources13. Inadequacy of this magnitude is not made up even after the devolution of tax share. Therefore constitution provided for various kinds of grants. The most important amongst the grants is the one that come under article 275, and to be given only on the recommendation of the Finance Commission. The purpose of article 275 is to give grants-in-aid of revenue to such States that are adjudged to be in need of assistance. A practice of the successive Finance Commissions has been that such grants have been assigned the resolving role under the scheme of fiscal devolution. That means such grants are given to those States whose resources are inadequate even after the tax devolution. The First Finance Commission said: “In assessing the needs of the States and formulating our recommendations in regards to the sum to be paid as grants-in-aid, we have considered the budgetary position of the States and the probable amount which would accrue to them under our plan for the devolution of income tax and union excise”. Thus, grants (article 275) have been used, generally, to cover the non-plan revenue gap of the states. Significance of the grants can be gauged from the fact that it constituted 18.87 of the Finance Commission recommended devolution under the Twelfth Finance Commission which was higher by 5.4 percentage point from such devolution under Eleventh Finance Commission.

Grants- in-aid of revenues have been traditionally recommended by the Finance Com missions for two distinct purposes: First, to fill the estimated postdevolution gaps in the non-Plan revenue accounts of the States and second, to enhance the levels of specified public services in the States where these services are deficient. The former is general purpose transfer, whereas the latter is in the nature of close-ended specific purpose non- matching grant. Thus, the grants given to the States under Article 275 were not designed to offset the fiscal disadvantages of the States per se but to help them to overcome their projected budgetary difficulties and to raise the levels of certain specified ser vices to the 'bench mark' level. Even in the latter case, the design of the transfer schemes did not take into account the responsiveness of expenditures on aided functions to the specific purpose non-matching transfers, nor did it ensure suitable monitoring mechanism to make the grants effective.
 

3. Borrowings

Articles 292 and 293 define the borrowing powers of the Union and the States, respectively. Under Article 292, the executive power of the Union extends to borrowing upon the security of the Consolidated Fund of India within such limits, if any, as may from time-to-time be fixed by Parliament by law. This power extends to giving guarantees. Article 293 empowers a State to borrow within the territory of India upon the security of the Consolidated Fund of the State. Thus, States can borrow only within the territory of India. Clause (2) of Article 293 imposes the condition that a State may not raise any loan if any part of the loan extended by the Government of India remains outstanding. In such cases, the permission of the Government of India is required for a State to raise a loan.

Article 292 of the Constitution empowers the Government of India to borrow upon the security of the Consolidated Fund of India, i.e., the resources of the Union, subject only to such limitations as Parliament by law may impose. The Government of India can borrow internally as well as externally. States too are empowered to borrow under Article 293. According to this Article, a State cannot borrow outside India. The borrowing powers of the States are limited. Furthermore, if a State is indebted to the Union (as every State is now), it may not resort to further borrowing without the prior consent of the Central Government. However, the State governments do not regard this provision as putting them unduly in the grip of the Union. It does not appear that the working of this Article has been detrimental to the interest of the State. The scheme of distribution of resources and of functions just described makes the State governments inevitably dependent upon the Central financial transfers, for which the balancing devices have already been provided. The Constitutional provisions have avoided rigidity in these balancing devices by leaving undefined the exact quantum of devolution and its distribution among the States. Basically, the working of Centre-State financial relations can be seen from the overall result of financial operations on State finances. The relationship can also be seen in terms of various elements of fiscal federalism such as sharing of taxes, statutory and discretionary grants-in-aid, Central loans to States, performance under Article 269 and so on.

Evaluation of Finance Commission transfers

The gapfilling approach outlined above has been subject to severe criticism for four important reasons. First, none of the Finance Commissions as sessed the overall resource position of the Centre and the proportion of the resources required to meet its commitments on any objective basis, although the terms of reference explicitly required them to do so. They merely made judgments about the shareable proportions of non-corporate income tax and Union excise duty Gulati, 1987, p.7). While, this criticism is too sweeping, it is fact that the Commissions have found it difficult to evolve objective criteria for evaluating the Centre's needs. On the other hand, continuously raising the percent ages of the yield of the taxes to be shared implicitly meant that the Centre had more resources than its needs warranted or that it was the Centre which should or could raise more resources. Second, the transfers made by the Finance Commissions were not designed to meet the major objective of unconditional transfers, name ly, offsetting fiscal disadvantages of the States. The tax devolutions were decided on different considerations from those of the grants in aid, and, even in the use of the former, the criteria used for distribution among the States of income tax were different from those of the excise duties, although since the Eighth Finance Commission they were substantially the same for the two shareable taxes. The earlier Com missions recommended tax devolution mainly on the basis of popula tion but greater weight was assigned to the backwardness factor by the later Commissions. The tax devolution, which formed the predominant proportion of Finance Commission transfers, is made on the basis of general economic indicators and is not geared to offset fiscal disadvantages of the States as such.

Third, the use of grants-in-aid given mainly to fill te projected budgetary gaps of the States after tax devolution, has been criticised virtually by every study on the subject. First, it is pointed out that such an approach has implicit in it strong disincentive to tax effort and to economy in xpenditure (Lakdawala, 1967, Sastry, 1966, Gulati, 1973, Chelliah et.al, 1981). Second, this methodology does not enable the States with lower resource bases to provide reasonable standards of services as the emphasis would be on meeting budgetary gaps arising from the existing relatively low levels of services in these States (Grewal, 1975). Third, as grants-in-aid were taken to be residuary form of assistance, the methodology of scrutinising the budgets had relevance only to the States with post-devolution gaps in their non-Plan revenue accounts (Chelliah, et.al., 1981). It has been argued that the overall effect of the approach adopted by the Commission is to render the scheme of transfers inequitous (Gulati and George, 1978).

This is because, in the distribution of shareable taxes, predominant weight is assigned to the population factor either explicitly or implicitly in scaling other variables (Datta, 1979). And given that budgetary needs formed the basis of determin ing the grants-in- aid, the low expenditure levels of many of the poorer States could not qualify them to receive grants-in-aid under Article 275. The more recent Finance Commissions have modified the above approach and methodology in response to the criticism in three impor tant ways. First, they introduced norms selectively by targeting the rates of growth of revenues and expenditures, assuming certain rates of interest and dividends on the loans given and investments made by the governments (Sarma and Kalyani, 1987).

Second, tax devolution was enhanced substantially so that very few States were left with gaps after tax devolution. This was done particularly by the Seventh Finance Commission by doubling the proportion of excise duty shares ofthe States from 20 percent to 40 per cent. As consequence, virtually all major States except Orissa, and in some years West Bengal and Rajasthan, were left with surpluses in their non-Plan revenue accounts after tax devolution. As the States' shares of divisible taxes were enhanced, significantly larger weight was assigned to the backward ness criterion to make the transfers more progressive. In the event, as already mentioned, the transfers came to be related largely to general economic indicators of backwardness and population and not specifi cally to fiscal disadvantages of the States. Further, the assessment of receipts and expenditures in respect of the States with post-devolution surpluses had no bearing on the transfers received and as most of the major States had surpluses, the elaborate exercise of making assess ment was largely irrelevant. Besides, the disincentive effects on tax effort and expenditure economy continued and as the States were left with significant variations in per capita surpluses in their non-Plan revenue accounts after tax devolution, the resources available for the Plans varied substantially leading to an inequitous growth pattern. The third important change the more recent Commissions brought about was to recommend upgradation grants to equalise standards of some specific services.

Although the first Finance Commission India, 1952) made such grant to equalise primary educational levels and the third Finance Commission, for improvement in Communications (India, 1959), sizeable amounts of upgradation grants were given only since the sixth Finance Commission's award (1973). This has been argued as way of making the transfer schemes more progressive (Gulati, 1978). But the objective of specific purpose transfers has to be to raise the levels of services in all the States to the normative levels and not 'equity' perse. However, none of the Finance Commissions paid adequate attention to the proper designing of the specific purpose transfers in order to achieve the objective of raising the services in the States to the required normative levels, nor did they examine thesuitability of non-matching transfers recommended by the Finance Com missions to undertake such task (Rao and Aggarwal V., 1990). In the light of the above, the attempt by the Ninth Finance Commission to link thetransfers to fiscal disadvantages more closely is noteworthy.