Important Finance Commissions and their recommendations

14th Aug, 2021

Since 1951, eight Finance Commissions have so far been appointed.

First Finance Commission

The President of India appointed a Finance Commission on 1st December 1951.

Important recommendations of this commission:

  • The States’ share in the proceeds of the income tax should be 55 percent of the net proceeds.
  • As regards the distribution among states, the basis should be as follows: 20 percent should be distributed on the basis of the relative collection of states and 80 percent on the basis of the relative population according to the census of 1951.
  • Of the net proceeds of the duty levied on tobacco, matches, and vegetable products, 40 percent should be distributed to the states.
  • The Centre should make conditional and unconditional grants to the states. Considerations in fixing the amounts of these grants should be the budgetary needs of the states, the standard of social services, and special burdens, which are due to floods and famines.

Second Finance Commission

The Second Finance Commission was set up in June 1956.

Important recommendations of this commission:

  • The share of the states in the net proceeds of income tax should be increased to 60 percent.
  • The actual distribution of shares assigned to the states should be on the basis of population. Thus, 90 percent of the amount of the divisible pool should be distributed on the basis of population and only 10 percent on the criterion of sources of collection.
  • The number of excise duties to be shared by the Union with the states is increased from 3 to 8, but the shares of the states in these duties are reduced from 40 percent to 25 percent. Even then, there was an increase in the absolute amount of revenue accruing to the states.
  • Unlike the First Finance Commission, the Second Finance Commission recommended unconditional grants.
  • On the whole, the distribution made by the Second Commission was fair and just.

Third Finance Commission

The Third Finance Commission was set up in December 1960.

Important recommendations of this commission:

  • Of the net proceeds of income tax, 66 2/3 percent should be distributed among the states.
  • The distribution of the states’ share should be to the extent of 80 percent on the basis of population and 20 percent on the basis of the collection.
  • The number of excisable commodities in the divisible pool of proceeds is raised from 8 to 35. However, the percentage of states’ shares is reduced from 25 to 20.
  • In order to remove the wide disparity in the development of the different regions, Special Purpose Grants for the improvement of communication should be given to the backward states.
  • Grants-in-aid should be given for meeting the planned revenue expenditure of the states.
  • It was however felt that in view of the rapid increase in the expenditures of state governments the commission did not properly adjust their requirements. Nevertheless, the commission was more generous and quite fair.

Fourth Finance Commission

The Fourth Finance Commission was constituted by the President in 1964.

Important recommendations of this commission:

  • Of the net proceeds of income tax, 75 percent should be distributed among the states.
  • For the Union Territories, 2.5 percent of the net proceeds of the income tax should be allocated.
  • The excise duties on all commodities should be shared by the Union with the states. The share of the individual states should be determined on the basis of 80% on population and 20% on relative economic backwardness.
  • Liberal grants-in-aid of Rs. 140 crores per annum (as against Rs. 64 crores in the Third Finance Commission) should be made to the state governments.
  • A competent body should be formed to study in detail the entire problem of indebtedness of states and allied matters.
  • The Planning Commission should be made a statutory body independent of the government and the relative scope and the function of the Finance Commission and the Planning Commission should be clearly defined by amending the Constitution.
  • The Government of India has accepted the recommendations of the Commission with some modifications.

Fifth Finance Commission

The Fifth Finance Commission was appointed in February 1968 under Article 280 of the Indian Constitution. Shri Mahavir Tyagi was its chairman. The financial report of the Commission was submitted on 31st July 1969.

Important recommendations of this commission:

  • Of the net proceeds from income tax, 75 percent should be distributed among the states. But 90 percent is to be distributed on the basis of population and the rest on the basis of the collection. It thus revived the scheme suggested by the Second Finance Commission.
  • The states’ share in the Union excise should be continued at 20 percent of the actual collection. The criterion of distribution should be 80 percent on the basis of population and 20 percent on the basis of social and economic backwardness.
  • In considering the question of grants, emphasis should be shifted from budgetary needs to the broad fiscal needs of the state.
  • A tax on newspaper advertisements should be imposed.
  • There should be resource mobilization in the agricultural sector through the imposition of agricultural income tax.
  • The state should not indulge in deficit financing.
  • Balanced budgets and expenditure control should be the basis of fiscal policy.
  • The Centre should urge the states to clear their overdrafts and achieve fiscal discipline.
  • In this way, the Fifth Finance Commission tried to make keen efforts to solve the problem of allocation of financial resources between the center and the states.

But, it could not make an appreciable headway because:

  • The role of the Finance Commission vis-a-vis the Planning Commission was not clearly defined;
  • The Finance Commission could not pay due attention and devote sufficient time to the issue of the use of Centre- state transfer of resources in an optimum manner.
  • Moreover, the commission assigned less importance to grants vis- a-vis devolution of taxes.
  • While rewarding backwardness, the Commission overlooked the obstacles in the way of progress and improvement of advanced regions.
  • It has unduly shifted large resources from the more developed states to the less developed ones.

Sixth Finance Commission

On 28th June 1972, the Sixth Finance Commission was appointed.

Apart from the usual terms of reference regarding the distribution and allocation of tax proceeds and grants-in-aid, it had the following additional terms of reference:

1. To assess the non-plan capital gap of the various states for the period 1974-79.

2. To review the policy and arrangement relating to the financing of relief expenditure by the states.

3. To examine the possibility of establishing a national fund for financing relief expenditure.

4. To review the indebtedness of the state governments to the Centre, and suggest a suitable debt relief scheme.

By the end of 1973, the commission submitted its report. Its recommendations have been fully accepted by the government.

Important recommendations of this commission:

  • The share of states in the divisible pool of revenue from income tax should be revised to 80 percent. (The Fifth Finance Commission had suggested 75 percent).
  • While allocating the share of each state in this pool of income tax proceeds, 90 per should be distributed on the basis of population and 10 percent on the basis of the collection. It, thus, retained the scheme as suggested by the Fifth Commission.
  • Seven rich states — Maharashtra, Gujarat, Haryana, Punjab, M.P., Karnataka, and Tamil Nadu — were not recommended for grants-in-aid by the Commission.
  • In its recommendations, the Commission had adopted fair play and tried to reduce the regional imbalances in state finance to some extent.
  • Further, the commission in its report also chalked out the norms for improving the standard of administration and social services,
  • The commission estimated that the aggregate indebtedness of the states to the Centre will be to the tune of Rs. 8,400 crores by March 1974. It, thus, suggested that the repayment process should be consolidated and spread out over 15 years to 30 years.
  • The Commission, however, did not favor the establishment of the national funds for financing the relief outlays. It suggested that instead of providing an ad hoc relief fund, provision must be made on a wide scale for the development of drought and flood-prone areas under the plan scheme.
  • Compared to the previous commission, the Sixth Commission appeared to be more fair and just, though it has been criticized for having discouraged the states to be self-reliant, by enhancing the transfer of resources from the Centre to the states.

The Seventh Finance Commission

The Seventh Finance Commission was appointed in 1977, under the chairmanship of Shri J.M. Shelat, with the following terms of reference:

1. To consider the requirements of resources for upgrading the administration in the non-developmental sectors in the backward states on par with the levels of advanced states.

2. To ensure a reasonable return on investments in capital projects such as irrigation and power works, transport undertakings, industrial and business enterprises.

In specific terms, the Commission’s task was to examine:

  • The share and allocation of income-tax and central excise duties;
  • The distribution of additional excise duties;
  • The distribution of estate duty;
  • Sanctioning of grants in view of the Railway Passenger Fares Act of 1957, and on account of wealth tax on agricultural property;
  • The assessment of the debt position of the states, and suggestions for appropriate measures to lighten their burden;
  • The financing of relief expenditures.
  • The Seventh Finance Commission has to make the recommendations in view of a clamor for autonomy and fiscal sovereignty from the states.

Important recommendations of this commission:

  • It coincided with the states’ demand for a larger share, raising it from 10 percent to 15 percent of the proceeds of the non-sharable surcharge on the income- tax.
  • The Commission states that the surcharge should be treated as additional income tax which should be sharable along with income-tax revenue.
  • The Commission also held that population is the indicator of the needs of a state; hence, for inter-state distribution of the states’ share, the 90:10 ratio should be retained.
  • The Commission also subscribed to the states’ view that the corporation tax should be distributed in the same fashion as the income tax.
  • With regard to the distribution of the proceeds from excise duties, the Commission doubled the share of the states from 20 percent to 40 percent. This 40 percent share of the states must have inter-state distribution, by giving equal weightage to four factors, namely,

(i) population;

(ii) the inverse of the per capita State Domestic Product;

(iii) the poverty ratio; and

(iv) a revenue equalization formula.

  • As regards grants-in-aid, the Commission recommended that:

(a) General grants can be given to the states to cover their budgetary deficits,

(b) To upgrade the administration and basic service standards of a state up to a minimum national standard and conditional grants may be given,

(c) For some specific reason of national concern, such as loss of revenue due to implementation of prohibition, special grants may be given.

  • Regarding debt relief, the commission suggested that:

(i) loans for productive purposes should be repaid over 15 years and unproductive loans are repaid over 30 years;

(ii) There should be consolidation of the small savings loans in perpetuity. Thus, only interest be paid, with no repayment of the principal;

(iii) There should be consolidation of the rest of the central loans into one loan, which is to be recovered over 15 to 30 installments paid yearly;

(iv) Interest rate charged should be around 4.75 to 5 percent.

  • The Commission turned down the demand for a permanent Finance Commission, stating that “it would be unhealthy from the point of view of the Commission’s function vis-a-vis the state governments.” Instead, it suggested instituting an ‘expert non-political agency’ as an advisory body that will play the role of a watchdog.

The Eighth Finance Commission

  • The Eighth Finance Commission was appointed in 1982 under the chairmanship of Shri Chavan. Its Final Report was placed in 1984.
  • The 8th FC, despite realizing the increasing fiscal needs of the states, did not increase their shares in the divisible pool of income tax. It, however, increased the share of states in excise revenue from 40% to 45%.
  • The 8th FC’s approach was to reduce the inter­state disparities through progressive distribution/allocation of resources. It also favored tax sharing rather than grants as the mode of resource transfer.
  • It laid down that grants should reflect the states’ efforts in their fiscal/financial management and should not merely be a gap-filling phenomenon.

Ninth Finance Commission

  • The Ninth Finance Commission was constituted in June 1987. It was chaired by Shri Salve. It submitted the first report in July 1988 and the second report in December 1989.
  • The Commission was asked to adopt a normative approach and look into the desirability of expenditure and also to deal with the problem of revenue deficits.
  • The 9th FC suggested that the fiscal needs of the states showed be judged through tax efforts and expenditure economy. Secondly, there should be equalization of the standards of social services provided by the states.
  • In short, it recommended grants on the basis of normative gaps rather than fiscal gaps in state finance.

Tenth Finance Commission

  • The Tenth Finance Commission was appointed in June 1992 under the chairmanship of Shri К. C. Pant, Its report was submitted in November 1994, covering the period 1995-2000.
  • There was no binding on the 10th FC to adopt a normative approach. It was, however, to look into the targets for additional resource mobilization by the states, the potential for raising additional tax revenue, and strives for better fiscal management.
  • The 10th FC took note of the growing revenue expenditure and deficit on revenue account as well as growing inter-regional disparities in the country’s finance both at the Centre and State levels.
  • The Commission recommended that the share of State in the divisible pool income-tax revenue should be 77.5% and that of Union Territories should be 0.927%.
  • It enhanced the States’ share in excise revenue to 47.5% of the net divisible pool.
  • Regarding the debt problem of the States’ the 10th FC opined that states should make prudent use of borrowed money and loans should not be written off. Incentives for better fiscal management should be provided.
  • The commission provided a broader definition to the pool of divisible tax revenue covering income-tax, Corporation Tax, Union excise duties, additional duties on excise on excise, and grants in lieu of tax on railway passenger fares.
  • 10th FC laid down that fiscal discipline requires avoiding deficit on revenue account and expenditure control.
  • Table 1 entails a nutshell review of the shares of states in net proceeds from income tax provided under different finance commissions.

Table 1 Finance Commissions Division for Shares of States in Net Proceeds for Income Tax:

Finance CommissionShare (in %)
First55
Second60
Third66.6
Fourth75
Fifth75
Sixth80
Seventh85
Eighth85
Ninth85
Tenth77.5

Eleventh Finance Commission

  • It was appointed in July 1998 with A. M. Khusro as the chairman. Its report was submitted in July 2000, covering the period 2000-2005.
  • Its term of reference is confined to:

i. Distribution of tax proceeds between the Centre and the states.

ii. Grants-in-aid principles.

iii. Measures towards consolidation of funds.

  • 11th FC recommended that the share of states in the net proceeds of all central taxes, and duties be fixed at 28 percent. Besides, 1.5 percent of all taxed revenue be allocated to the states separately.
  • This means the states’ share is totally up to 29.5 percent.

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 FC 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.

The Thirteenth Finance Commission has submitted its report to President in December 2009. The main task of the Finance Commission is to make recommendations on sharing tax revenues between centre and states.

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.

Forteenth 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).

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