Finance Commission – Issues related to devolution of resources

Fifteenth Finance Commission has increased proportion of grants conditional on reforms


From UPSC perspective, the following things are important :

Prelims level: State Finance Commission

Mains level: Paper 2- Conditional grants to incentivise the states for reforms

The article highlights the crucial recommendations made by the 15th Finance Commission and also explains the importance of conditions for grants from the Centre to push the state for reforms.

Crucial recommendations by 15th Finance Commission

  • The Fifteenth Finance Commission’s report for the period 2021-22 to 2025-26 outlines some crucial recommendations for state governments.
  • These recommendations cover tax devolution, grants from the Centre, and the guidelines for the borrowings that they are permitted to incur over the medium-term.
  • The commission has recommended that 41 per cent of the government’s divisible pool of taxes be transferred to state governments.

Horizontal devolution formula

  • The horizontal devolution formula specifies each state’s share in the overall pie.
  • The 15th FC was required to use the states’ population as per the 2011 Census — a highly contentious change.
  • It has also introduced a demographic performance criterion.
  • Additionally, it has also introduced a new criterion –tax effort.
  • Tax effort is measured by the ratio of the three-year average of per-capita own tax revenues and per-capita gross state domestic product (GSDP).
  • The net result of the change in criteria is that the share of 10 states in the divisible pool has declined.
  • Karnataka is the biggest loser, while Maharashtra is the biggest gainer.

Grants from the Centre conditioned on reforms in states

  • Another major set of the commission’s recommendations pertain to grants from the Centre.
  • In a major shift, the 15th FC has sharply increased the proportion of grants whose receipt is conditional on specified reforms being undertaken.
  • 57 per cent of the 15th FC-recommended grants accepted so far by the GoI are conditional, relative to just 17 per cent for the 14th FC (including J&K).

What are the conditions

1) Setting up of State Finance Commission (SFC) and applicability of SFC’s recommendations for 5 years only

  • Constitution requires state governments to set up State Finance Commissions (SFC).
  • The 15th FC has asserted that the mandate of any given SFC is intended to be applicable only for five years.
  • It revealed that only 15 states have set up their fifth or sixth SFCs, whereas several states have not moved beyond their second or third SFC.
  • Accordingly, a staggering 84 per cent of the Rs 4.4 trillion grants for local bodies recommended by the 15th FC are conditional on the states setting up SFCs for the coming five-year period, and acting on their recommendations by March 2024.

2) Availability of online accounts

  • Another entry-level condition for availing grants by rural and urban local bodies pertains to the timely availability of their accounts online from 2021-22 onwards.

3) Notiflying floor rate for property tax

  • For the receipt of grants by the urban bodies, states are required to notify a floor rate for property tax by 2021-22, and demonstrate consistent year-wise improvement from 2022-23 onwards.
  • This will complement the conditions set previously by SEBI for ULBs to become eligible to raise municipal bonds.

Changes in limit on net borrowings of state governments

  • The commission has recommended that the normal limit for net borrowings of state governments be fixed at 4 per cent of GSDP in 2021-22.
  • This will ease to 3.5 per cent by 2022-23, thereafter reverting to the erstwhile 3 per cent limit till 2025-26.
  • The additional borrowing space of 0.5 per cent of GSDP for states is conditional on the completion of power sector reforms.

Prospect of huge gaps in states’ revenue in the future

  • The states’ fiscal arithmetic will alter in 2022-23 with the GST compensation set to cease at the end of June 2022 as things stand today.
  • The ensuing drop in grants, combined with the tapering of the front-loaded revenue deficit grants is likely to leave a big gap in some states’ revenues.

Consider the question “What are the conditions laid down by the 15th Finance Commission on the states for the central grants? How these conditions could benefit the states?”


The question is whether this revenue gaps will force the states to move on both the power sector reforms, which have proven challenging in the past, and the municipal reforms, so that their resource availability may be enhanced.

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