Context: The Finance Commission is a constitutionally mandated body that determines the method and formula for distributing the tax proceeds between the Centre and states
About Finance Commission
- Under Article 280 of the Constitution, the President of India is required to constitute a Finance Commission at an interval of five years or earlier.
- Composition: It has a chairman and four members appointed by the President.
- NK Singh was appointed as its chairman in November, 2017.
Function of Finance Commission
- Makes recommendations to the President of India on the distribution of tax proceeds between the Union and the States and the share of each state.
- Decides the principles that govern the payment of grants-in-aid to states from the Consolidated Fund of India.
- Recommends ways of strengthening the economic health of the country by suggesting ways to increase revenue, bridge gaps in income and expenditure, and handle debt.
- Evaluate the state of finance of the Union and State Government
- The President of India can also refer any other matter to the Finance Commission in the interest of building a sound financial system.
- Some mandatory functions regarding distributing the tax proceeds:
- equitable distribution among various states based on population
- how much is needed to pull up lagging states
- how much productive value each is adding
- In India’s quasi-federal structure, most of the taxes are collected by the Centre, but, much of the expenditure needs to be done by the state.
- As a federal nation, India suffers from both vertical and horizontal fiscal imbalances.
- Vertical Imbalance: Between State and centre, resulting from states incurring expenditures disproportionate to their sources of revenue.
- Horizontal Imbalance: Among the states resulting differing historic backgrounds or resources endowments, and can widen over time.
How has Finance Commission recommendations changed over the years?
- The first commission was appointed in 1952.
- Each of them faced its own unique set of challenges.
- So far, 15 Finance Commissions have been appointed at intervals of every five years.
- Since the 1st Finance Commission, the nature of India's economy and macro-economic policy has changed dramatically.
In response to changing policies
Which central tax revenues are to be shared
Initially Constitution provided only two central taxes with states — income tax and excise duties
80th constitutional amendment in 2000 provided for sharing of proceeds of all the Union taxes & duties with the states (except: central sales tax, consignment ) It was recommended in 10th FC (1992)
Share of income tax proceeds to state
From 1st to 9th FC jumped from 55% to 80%
At the time of the seventh commission: 40% was given to states
10th FC lowered the state’s share from 55%-80% to 77.5%
73rd and 74th amendments to the Constitution in 1992
The Governor of a state is required to constitute a Finance Commission to decide the resource allocation between the state government and the Panchayati Raj Institutions.
In response to Changing Needs
First seven commissions assigned 80-90% weightage to it. The eighth FC introduced measures of equity for the first time, including per capita state income and the gap between state and highest per capita state income, as factors. The 12th FC increased the population parameter to 25%, reducing the backwardness criterion to 50%.
Grants for states
The commission also prescribes how much of grants is to be given to states. Considering the capital expenditure needs of states in these sectors.
Implementation of the Recommendation:
- Implemented by an order of the President
- Traditionally, the Centre accepts the recommendations.
- But 3rd FC-recommendations about “how to share five-year Plan resources”, was not accepted by the government.
- The crucial recommendations relating to sharing of revenues from taxes, duties and grants-in-aid are implemented by an order of the President.
Present FC & its Recommendations:
Constituted on 27 November, 2017.
15th FC: Chairman is NK Singh.
As per the terms of reference (ToR), the Commission was mandated to give its recommendations for five years from 2021-22 to 2025-26.
- Commission was asked to:
- Recommend performance incentives for States in many areas like power sector, adoption of DBT, solid waste management etc
- Apart from the vertical and horizontal tax devolution, local government grants, disaster management grants.
- To examine whether a separate mechanism for funding of defence and internal security ought to be set up and if so how such a mechanism could be operationalised.
- Terms of Reference (TOR)
- Population data from 2011census should be used to make the recommendations.
- The ToR of the Finance Commission requires it to recommend grants-in-aid to the States. These grants include: (i) revenue deficit grants, (ii) grants to local bodies, and (iii) disaster management grants.
- States to be given 41% of the divisible tax pool of the Centre during the period 2021-22 to 2025-26.
- Reason given: to accommodate the funds for Jammu and Kashmir and Ladakh, which were carved out as Union Territories by Parliament.
14th FC had recommended 42% tax devolution to the states.
- Performance Based Incentives and Grants to States:These grants revolve around four main themes.
- health and education:The first is the social sector, where it has focused on health and education.
- Rural Sector: Second is the rural economy, where it has focused on agriculture and the maintenance of rural roads.
- Governance and administration: Third, governance and administrative reforms under which it has recommended grants for judiciary, statistics and aspirational districts and blocks.
- Power Sector: Fourth is for the power sector, which is not linked to grants but provides an important, additional borrowing window for States.
- Grants-in-aid to all tiers of the Panchayati Raj including the Traditional Bodies of Fifth and Sixth Schedule areas, in 28 States, in two parts, namely,
- Basic Grant: 50 % will be Basic Grant.These are untied and can be used by RLBs for location-specific felt needs, except for salary or other establishment expenditure.
- Tied Grant: 50 % will be the Tied Grant.The These are to be used for the basic services of (a) sanitation and maintenance of open-defecation free (ODF) status and (b) supply of drinking water,rain water harvesting and water recycling.
- Vertical Devolution (Devolution of Taxes of the Union to States):
- It has recommended maintaining the vertical devolution at 41% - the same as in its interim report for 2020-21.
- It is at the same level of 42% of the divisible pool as recommended by the 14th Finance Commission.
- It has made the required adjustment of about 1% due to the changed status of the erstwhile State of Jammu and Kashmir into the new Union Territories of Ladakh and Jammu and Kashmir.
- Horizontal Devolution (Allocation Between the States):
- For horizontal devolution, it has suggested 12.5% weightage to demographic performance, 45% to income, 15% each to population and area, 10% to forest and ecology and 2.5% to tax and fiscal efforts.