Finance Commission and their Formulae for Sharing Taxes 

A distinguishing feature of Union-State financial relationship in India is the explicit recognition in the Constitution of the varying nature of the need and the provision of a periodical review of the situation by a quasi-judicial body. Article 280 of the Constitution provides for the appointment of a Finance Commission by the President. It is with respect to the obligatory sharing of Union taxes and grants that the provision for a Finance Commission has been made in Article 280. It is appointed after every five years or earlier to makerecommendations to the President regarding the distribution of shared taxes, grants-in-aid and any other matter referred to the Commission. The Commission is to consist of a Chairman and four other members. 
The commission is charged with tremendous responsibilities of making requisite recommendations to the president of India. The Finance Commission consists of a chairman and four members to be appointed by the president.

Functions of Finance Commission
There are two important functions – Suggestive functions and making
recommendations – to be performed by the Finance Commission.
Suggestive Functions
1. To suggest the criteria of distribution between union and States of net proceeds which are to be, or may be divided between them.
2. It determines the allocation of net proceeds between different states according to their respective shares of proceeds.
3. Any modification or continuance of the term of any agreement entered in to by the union government with the government of any State in part B of the First schedule under clause (v) of Article 178 or Article 306
4. The principle which should govern the grants – in –aid of the revenue of different states out of the consolidated fund of India.
5. Any other matter referred to the commission by the President of India.
Making Recommendations
1. The percentage of net proceeds of the Taxes which may be divided between Centre and States.
2. The allocation of shares of the proceeds of such taxes in percentages between different States.
3. To determine the principle to govern the grants – in aid of the revenue out of the consolidated fund of government of India between States.
4. The modification of continuances of the term of agreement regarding the levy of International customs and duties with part B States.
5. Grants- in- aids in tribal areas and
6. Special grants for any particular state.

Article 280(3) of the Constitution requires the Finance Commission to make recommendations:

(a) as to the distribution of the net proceeds of shareable taxes between Union and the States, and the allocation between the States of their shares in such proceeds.  Formulation of principles that should guide the assignment of share to the States and the determination of individual share of each State constitutes a central task of the Commission,

(b) the principles which should govern the grants-in-aid of the revenues of the states out of the Consolidated Fund of India. In addition, the sub-sections (b)(b) and (b)(c) inserted by the 73rd and 74th amendments require it to recommend measures needed to augment the resources of panchayats and municipalities in the states. And most importantly, sub-section (b)(d) requires the commission to look into any other matter referred to it by the president ‘in the interests of sound finance’.

Accordingly, it is customary that the presidential order appointing the Finance Commission contains two parts: the first part contains the substantive matters relating to the (a) and (b) above, and the second part contains certain other considerations that the commission might keep in mind while making its recommendations in the interests of sound finance. The considerations to be kept in view ‘in the interests of sound finance’ have differed from commission to commission depending upon the economic exigencies prevailing at that time.

A comprehensive list of the considerations included in the terms of reference given to all the finance commissions so far, are enumerated in Vithal and Sastry (2001). They include:

(1) Plan requirements;

(2) additional resource mobilisation efforts by states;

(3) requirements of committed expenditure;

(4) scope for economy consistent with efficiency;

(5) central assistance to state plans;

(6) emoluments of Government employees, teachers, etc;

(7) maintenance of capital assets;

(8) upgradation of standards of administration;

(9) resources of the centre and demands thereon;

(10) requirements of states to meet non-Plan liabilities;

(11) debt servicing;

(12) adoption of a normative approach;

(13) adequate incentives for better resource mobilisation and financial discipline;

(14) need for speed, efficiency and effectiveness of Government functioning and delivery systems; and

(15) need for generating surpluses for capital investment.

The Finance Commission is entrusted with periodic review and resolution of Central-State fiscal problems. It was the clear intention of the fathers of the Indian Constitution that all matters pertaining to normal Central-State financial adjustments should be scrutinised by the Finance Commission, which was given a pre-eminent role in the resolution of problems in fiscal federalism. An incidental and by no means insignificant advantage of the appointment of a Finance Commission has generally been to rekindle interest in issues pertaining to financial relations between the Centre and the States and to promote an enlightened national debate on the several facets of India’s federal fiscal set-up. The role of the Indian Finance Commission is unique in many ways. It is one of few commissions provided in the constitution. It has no parallel in established federal Constitutions. The First Finance Commission was appointed in 1951 and twelve Finance Commissions have reported so far.

The following Table presents details regarding years of establishment and reporting of various Finance Commissions.

Chronology of Finance Commission

Why is there a need for a Finance Commission?

The Indian federal system allows for the division of power and responsibilities between the centre and states.  Correspondingly, the taxation powers are also broadly divided between the centre and states (Table 1).  State legislatures may devolve some of their taxation powers to local bodies.

The centre collects majority of the tax revenue as it enjoys scale economies in the collection of certain taxes.  States have the responsibility of delivering public goods in their areas due to their proximity to local issues and needs.

Sometimes, this leads to states incurring expenditures higher than the revenue generated by them.  Further, due to vast regional disparities some states are unable to raise adequate resources as compared to others.  To address these imbalances, the Finance Commission recommends the extent of central funds to be shared with states.  Prior to 2000, only revenue income tax and union excise duty on certain goods was shared by the centre with states.  A Constitution amendment in 2000 allowed for all central taxes to be shared with states.

Several other federal countries, such as Pakistan, Malaysia, and Australia have similar bodies which recommend the manner in which central funds will be shared with states.

Reports of Finance Commission

Under Article 281 of the Constitution, the President of India is required to cause laying of the Finance Commission report before each House of Parliament along with an explanatory note and the action taken by the government on the Commission’s recommendations.

The 12th Finance Commission

The 12th Finance Commission was constituted by the President of India, in November 2002 under the chairmanship of former RBI governor and noted economist Dr C Rangarajan. The Commission submitted its recommendation in November 2004 and recommended states’ share to be kept at 30.5% of the divisible pool of central taxes. Its recommendations covered the period of April 2005 to March 2010.

The 13th Finance Commission

The 13th Finance Commission was appointed by the President of India on November 13, 2007, under the chairmanship of Dr Vijay Kelkar. It recommended an increase in states’ share in the divisible pool of central taxes to 32%, an increase of 1.5% over the previous Commission’s recommendation and its recommendation covered the period of April 2010 to March 2015.

The 14th Finance Commission

The 14th Finance Commission was constituted by the President of India on January 02, 2013 under the chairmanship of former RBI governor Dr YV Reddy. The Commission submitted its report in December 2014. The Commission increased the share of states in the divisible pool (central taxes) from 32% to 42% which was accepted by the Union government. Recommendations are applicable for a period of five years from April 2015 to March 2020.

The 15th Finance Commission

The 15th Finance Commission was constituted by the President of India in November 2017, under the chairmanship of NK Singh, a former member of the Planning Commission. This Commission is expected to submit its report by October 2019. Its recommendations will cover a period of five years from April 2020 to March 2025.

Composition of transfers:  

The central taxes devolved to states are untied funds, and states can spend them according to their discretion.  Over the years, tax devolved to states has constituted over 80% of the total central transfers to states (Figure 1).  The centre also provides grants to states and local bodies which must be used for specified purposes.  These grants have ranged between 12% to 19% of the total transfers.

Over the years the core mandate of the Commission has remained unchanged, though it has been given the additional responsibility of examining various issues.  For instance, the 12th Finance Commission evaluated the fiscal position of states and offered relief to those that enacted their Fiscal Responsibility and Budget Management laws.  The 13th and the 14th Finance Commissionassessed the impact of GST on the economy.  The 13th Finance Commission also incentivised states to increase forest cover by providing additional grants.

Formula used for distribution:

The share in central taxes is distributed among states based on a formula.  Previous Finance Commissions have considered various factors to determine the criteria such as the population and income needs of states, their area and infrastructure, etc.  Further, the weightage assigned to each criterion has varied with each Finance Commission. 

The 14th Finance Commission considerably increased the devolution of taxes from the centre to states from 32% to 42%.  The Commission had recommended that tax devolution should be the primary source of transfer of funds to states.  This would increase the flow of unconditional transfers and give states more flexibility in their spending.

The share in central taxes is distributed among states based on a formula.   Previous Finance Commissions have considered various factors to determine the criteria such as the population and income needs of states, their area and infrastructure, etc.  Further, the weightage assigned to each criterion has varied with each Finance Commission.

The criteria used by the 11th to 14thFinance Commissions are given in Table , along with the weight assigned to them. 

The criteria used by the 11th to 14thFinance Commissions are:

Population is an indicator of the expenditure needs of a state. Over the years, Finance Commissions have used population data of the 1971 Census.  The 14th Finance Commission used the 2011 population data, in addition to the 1971 data.  The 15th Finance Commission has been mandated to use data from the 2011 Census.

Area is used as a criterion as a state with larger area has to incur additional administrative costs to deliver services.

Income distance is the difference between the per capita income of a state with the average per capita income of all states. States with lower per capita income may be given a higher share to maintain equity among states.

Forest cover indicates that states with large forest covers bear the cost of not having area available for other economic activities. Therefore, the rationale is that these states may be given a higher share.

• Devolution of taxes to states: The share of states in the centre’s taxes is recommended to be decreased from 42% during the 2015-20 period to 41% for 2020-21.  The 1% decrease is to provide for the newly formed union territories of Jammu and Kashmir, and Ladakh from the resources of the central government.

Criteria for devolution

• Income distance: Income distance is the distance of the state’s income from the state with the highest income.  The income of a state 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: The Terms of Reference (ToR) of the Commission required it to use the population data of 2011 while making recommendations.   Accordingly, the Commission used only 2011 population data for its recommendations.The 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.   States with a lower fertility ratio will be scored higher on this criterion.  The total fertility ratio in a specific year is defined as the total number of children that would be born to each woman if she were to live to the end of her child-bearing years and give birth to children in alignment with the prevailing age-specific fertility rates.
• Forest and ecology: This criterion has been arrived at by calculating the share of dense forest of each state in the aggregate dense forest of all the states.
• Tax effort: This criterion 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 GDP during the three-year period between 2014-15 and 2016-17.

Grants-in-aid

In 2020-21, the following grants will be provided to states: (i) revenue deficit grants, (ii) grants to local bodies, and (iii) disaster management grants.  The Commission has also proposed a framework for sector-specific and performance-based grants.  State-specific grants will be provided in the final report.

• Revenue deficit grants: In 2020-21, 14 states are estimated to have an aggregate revenue deficit of Rs 74,340 crore post-devolution.  The Commission recommended revenue deficit grants for these states (see Table 4 in the annexure).
• Special grants: In case of three states, the sum of devolution and revenue deficit grants is estimated to decline in 2020-21 as compared to 2019-20.  These states are Karnataka, Mizoram, and Telangana.  The Commission has recommended special grants to these states aggregating to Rs 6,764 crore.
• Sector-specific grants: The Commission has recommended a grant of Rs 7,375 crore for nutrition in 2020-21.  Sector-specific grants for the following sectors will be provided in the final report: (i) nutrition, (ii) health, (iii) pre-primary education, (iv) judiciary, (v) rural connectivity, (vi) railways, (vii) police training, and (viii) housing.
• Performance-based grants: Guidelines for performance-based grants include: (i) implementation of agricultural reforms, (ii) development of aspirational districts and blocks, (iii) power sector reforms, (iv) enhancing trade including exports, (v) incentives for education, and (vi) promotion of domestic and international tourism.  The grant amount will be provided in the final report.  
• Grants to local bodies: The total grants to local bodies for 2020-21 has been fixed at Rs 90,000 crore, of which Rs 60,750 crore is recommended for rural local bodies (67.5%) and Rs 29,250 crore for urban local bodies (32.5%).  This allocation is 4.31% of the divisible pool.   This is an increase over the grants for local bodies in 2019-20, which amounted to 3.54% of the divisible pool (Rs 87,352 crore).  The grants will be divided between states based on population and area in the ratio 90:10. The grants will be made available to all three tiers of Panchayat- village, block, and district.
• Disaster risk management:  The Commission recommended setting up National and State Disaster Management Funds (NDMF and SDMF) for the promotion of local-level mitigation activities.  The Commission has recommended retaining the existing cost-sharing patterns between the centre and states to fund the SDMF (new) and the SDRF (existing).  The cost-sharing pattern between centre and states is (i) 75:25 for all states, and (ii) 90:10 for north-eastern and Himalayan states.

For 2020-21, State Disaster Risk Management Funds have been allocated Rs 28,983 crore, out of which the share of the union is Rs 22,184 crore.  The National Disaster Risk Management Funds has been allocated Rs 12,390 crore.

Share of states in the centre’s taxes

 

Some of the grants-in-aid for FY 2020-21 (in Rs crore)

Recommendations on fiscal roadmap

• Fiscal deficit and debt levels: The Commission noted that recommending a credible fiscal and debt trajectory roadmap remains problematic due to uncertainty around the economy.  It recommended that both central and state governments should focus on debt consolidation and comply with the fiscal deficit and debt levels as per their respective Fiscal Responsibility and Budget Management (FRBM) Acts.
• Off-budget borrowings: 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.
• Statutory framework for public financial management: The Commission recommended forming an expert group to draft legislation to provide for a statutory framework for sound public financial management system.  It observed that an overarching legal fiscal framework is required which will provide for budgeting, accounting, and audit standards to be followed at all levels of government.

• Tax capacity: In 2018-19, the tax revenue of state governments and central government together stood at around 17.5% of GDP.  The Commission noted that tax revenue is far below the estimated tax capacity of the country.  Further, India’s tax capacity has largely remained unchanged since the early 1990s.   In contrast, tax revenue has been rising in other emerging markets.  The Commission recommended: (i) broadening the tax base, (ii) streamlining tax rates, (iii) and increasing capacity and expertise of tax administration in all tiers of the government.

• GST implementation: The Commission highlighted some challenges with the implementation of the Goods and Services Tax (GST).  These include: (i) large shortfall in collections as compared to original forecast, (ii) high volatility in collections, (iii) accumulation of large integrated GST credit, (iv) glitches in invoice and input tax matching, and (v) delay in refunds.  The Commission observed that the continuing dependence of states on compensation from the central government (21 states out of 29 states in 2018-19) for making up for the shortfall in revenue is a concern.  It suggested that the structural implications of GST for low consumption states need to be considered.

Other recommendations

• Financing of security-related expenditure: The ToR of the Commission required it to examine whether a separate funding mechanism for defence and internal security should be set up and if so, how it can be operationalised.  In this regard, the Commission intends to constitute an expert group comprising representatives of the Ministries of Defence, Home Affairs, and Finance.  
• The Commission noted that the Ministry of Defence proposed following measures for this purpose:

(i) setting up of a non-lapsable fund,

(ii) levy of a cess,

(iii) monetisation of surplus land and other assets,

(iv) tax-free defence bonds, and

(v) utilising proceeds of disinvestment of defence public sector undertakings.  

The expert group is expected to examine these proposals or alternative funding mechanisms.