Finance Commission – Issues related to devolution of resources

Finance Commission – Issues related to devolution of resources

Needed, greater decentralisation of power

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Federal system.

Mains level : Paper 2-Why it is said that there is a paradox in the federal system of India? Covid-19 has highlighted the need for decentralisation in India.


Context

Even as States have taken up positions of leadership in the pandemic response, federal limitations are becoming hurdles.

State governments at the position of leadership

  • In the fight against the pandemic, one of the striking features of governance has been the signal role played by State Chief Ministers across India.
  • Proactive measures: Even before the Union government invoked the Disaster Management Act, 2005, many State governments triggered the Epidemic Diseases Act, 1897, and installed a series of measures to combat what was then an oncoming onslaught of COVID-19.
  • These actions have not always been perfect. Some of them have even disproportionately trenched upon basic civil liberties.
  • But, by and large, they have been tailored to the reality faced on the ground by the respective governments.
  • Policies to address local concerns: States such as Maharashtra, Kerala, Tamil Nadu, Rajasthan, and Karnataka have shaped their policies to address their direct, local concerns.
  • They have communicated these decisions to the public with clarity and consideration, helping, in the process, to lay out a broad framework for the nation.
  • Not just the laboratories of democracy: In doing so, they have acted not merely as “laboratories of democracy”, to paraphrase the former U.S. Supreme Court Justice Louis Brandeis, but also as founts of reasoned authority.

Federal arrangements placing limitations on the states

  • Equally, though, as much as State governments have taken up positions of leadership, they have repeatedly found themselves throttled by the limitations of the extant federal arrangement.
  • The Centre for Policy Research has pointed out at least three specific limitations.
  • Funds and structuring own package: The inability of States to access funds and thereby structure their own welfare packages.
  • Curbs imposed by PFMS: The curbs imposed by a public finance management system (PFMS) that is mired in officialdom.
  • This has prevented States from easily and swiftly making payments for the purchase of health-care apparatus such as ventilators and personal protective equipment.
  • Disruption of supply chains: Three, the colossal disruption of supply chains not only of essential goods and services but also of other systems of production and distribution, which has placed States in a position of grave economic uncertainty.
  • Need to decentralise: As these limitations demonstrate an urgent need to decentralise administration, where States — and local bodies acting through such governments — are allowed greater managerial freedom.
  • Under such a model, the Union government will command less but coordinate more.

Indian federalism-two distinct levels

  • There are varying accounts of what Indian federalism truly demands.
  • Two levels: What is manifest from a reading of the Constitution is that it creates two distinct levels of government: one at the Centre and the other at each of the States.
  • The Seventh Schedule to the Constitution divides responsibilities between these two layers.
  • The Union government is tasked with matters of national importance, such as foreign affairs, defence, and airways.
  • But the responsibilities vested with the States are no less important. Issues concerning public health and sanitation, agriculture, public order, and police, among other things, have each been assigned to State governments.
  • In these domains, the States’ power is plenary.
  • This federal architecture is fortified by a bicameral Parliament.
  • Significantly, this bicameralism is not achieved through a simple demarcation of two separate houses, but through a creation of two distinct chambers that choose their members differently-
  • A House of the People [Lok Sabha] comprising directly elected representatives and a Council of States [Rajya Sabha] comprising members elected by the legislatures of the States.

Financial autonomy of the states

  • Ensuring financial autonomy: In formulating this scheme of equal partnership, the framers were also conscious of a need to make States financially autonomous.
  • No overlap: To that end, when they divided the power to tax between the two layers of government they took care to ensure that the authority of the Union and the States did not overlap.
  • Therefore, while the Centre, for example, was accorded the power to tax all income other than agricultural income and to levy indirect taxes in the form of customs and excise duties, the sole power to tax the sale of goods and the entry of goods into a State was vested in the State governments.
  • The underlying rationale was simple: States had to be guaranteed fiscal dominion to enable them to mould their policies according to the needs of their people.

History of paradox in federal system of India

  • Despite this plainly drawn arrangement, the history of our constitutional practice has been something of a paradox.
  • It is invariably at the level of the States that real development has fructified.
  • But the Union has repeatedly displayed a desire to treat States, as the Supreme Court said in R. Bommai v. Union of India, as mere “appendages of the Centre”.
  • Time and again, efforts have been made to centralise financial and administrative power, to take away from the States their ability to act independently and freely.
  • Following five examples demonstrated that the point made here.

1 Matters of finance-what was expected in theory did not realise

  • Consider the widely hailed decision to accept the 14th Finance Commission’s recommendation for an increase in the share of the States in total tax revenues from 32% to 42%.
  • While, in theory, this ought to have enabled the States to significantly increase their own spending, in reality, as a paper authored by Amar Nath H.K. and Alka Singh of the National Institute of Public Finance and Policy suggests, this has not happened.
  • What went wrong? Gains made by the States, as the paper underlines, have been entirely offset by a simultaneous decline in share of grants and by a concomitant increase in the States’ own contribution towards expenditures on centrally sponsored schemes.

2. Goods and Service Tax

  • The decline in the sovereignty of the states: Notably, the creation of a Goods and Services Tax regime, which far from achieving its core purpose of uniformity has rendered nugatory the internal sovereignty vested in the States.
  • By striking at the Constitution’s federal edifice, it has made the very survival of the States dependent on the grace of the Union.
  • The tension today is so palpable that a number of the States are reported to have written to the Union Finance Ministry.
  • More than four months’ worth of Goods and Services Tax compensation to the States — reportedly totalling about a sum of ₹40,000 crore — remains unreleased.

3. Passing a bill as a money bill

  • The Union government’s centralising instinct, though, has not been restricted to matters of finance.
  • It has also introduced a slew of legislation as money bills, in a bid to bypass the Rajya Sabha’s sanction, even though these laws scarcely fit the constitutional definition.

4. Role of the Governors

  • Similarly, the role of the Governors has been weaponised to consolidate political power.

5. Article 370

  • But perhaps most egregious among the moves made is the gutting of Article 370 and the division of Jammu and Kashmir into two Union Territories.
  • It was done without securing consent from the State Legislative Assembly.

Conclusion

Perhaps a crisis of the kind that COVID-19 has wrought will show us that India needs greater decentralisation of power; that administration through a single central executive unit is unsuited to its diverse and heterogeneous polity. We cannot continue to regard the intricate niceties of our federal structure as a nettlesome trifle. In seeing it thus, we are reducing the promise of Article 1 of the Constitution, of an India that is a Union of States, to an illusory dream.

Finance Commission – Issues related to devolution of resources

Why has Kerala sought a relaxation of FRBM rules?Priority 1

Note4Students

From UPSC perspective, the following things are important :

Prelims level : FRBM Act

Mains level : Read the attached story


Kerala CM has urged the Centre to provide Kerala with flexibility under the Fiscal Responsibility and Budget Management (FRBM) Act so as to ensure that the State’s finances are not adversely impacted.

FRBM Act

  • The FRBM is an act of the parliament that set targets for the Government of India to establish financial discipline, improve the management of public funds, strengthen fiscal prudence and reduce its fiscal deficits.
  • It was first introduced in the parliament of India in the year 2000 by Vajpayee Government for providing legal backing to the fiscal discipline to be institutionalized in the country.
  • Subsequently, the FRBM Act was passed in the year 2003.

Features of the FRBM Act

  • It was mandated by the act that the following must be placed along with the Budget documents annually in the Parliament:
  1. Macroeconomic Framework Statement
  2. Medium Term Fiscal Policy Statement and
  3. Fiscal Policy Strategy Statement

Fiscal Indicators

It was proposed that the four fiscal indicators be projected in the medium-term fiscal policy statement viz.

  1. Revenue deficit as a percentage of GDP,
  2. Fiscal deficit as a percentage of GDP,
  3. Tax revenue as a percentage of GDP and
  4. Total outstanding liabilities as a percentage of GDP

Why is Kerala seeking flexibility under the FRBM?

  • Kerala was one of the earliest States to announce an economic package of ₹20,000 crore to mitigate the impact on livelihoods and overall economic activity.
  • Kerala’s current fiscal position means that it can borrow about ₹25,000 crore during the financial year 2020-21.
  • However the State government is understandably concerned that the stringent borrowing cap under the fiscal responsibility laws should not constrain its borrowing and spending ability over the remaining 11 months.
  • This is a crucial period when the state would have to meet other expenditure for routine affairs related to the running of the State’s socio-economic programmes as well as the post pandemic recovery.

How does a relaxation of the FRBM work?

  • The law does contain what is commonly referred to as an ‘escape clause’.
  • Under Section 4(2) of the Act, the Centre can exceed the annual fiscal deficit target citing grounds that include national security, war, national calamity, collapse of agriculture, structural reforms and decline in real output growth of a quarter by at least three percentage points below the average of the previous four quarters.
  • The ongoing pandemic could be considered as a national calamity.
  • This would allow both the Union government and States including Kerala to undertake the much-needed increases in expenditure to meet the extraordinary circumstances.

When have the FRBM norms been relaxed in the past?

  • There have been several instances of the FRBM goals being reset.
  • But the most significant FRBM deviation happened in 2008-09, in the wake of the global financial crisis, when the Centre resorted to a focused fiscal stimulus: tax relief to boost demand and increased expenditure on public projects.
  • This was aimed to create employment and public assets, to counter the fallout of the global slowdown.
  • This led to the fiscal deficit climbing to 6.2%, from a budgeted goal of 2.7%.
  • Simultaneously, the deficit goals for the States too were relaxed to 3.5% of GSDP for 2008-09 and 4% of GSDP for fiscal 2009-10.

Finance Commission – Issues related to devolution of resources

Private: Recommendations of the 15th Finance CommissionDOMRPriority 1

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Finance Commission

Mains level : Recommendations of the Finance Commissions


The Fifteenth Finance Commission (FC) has considered the 2011 population along with forest cover, tax effort, area of the state, and “demographic performance” to arrive at the states’ share in the divisible pool of taxes.

Quick recap: Finance Commission (FC)

  • The FC is a constitutionally mandated body that decides, among other things, the sharing of taxes between the Centre and the states.
  • Article 280 (1) requires the President to constitute, “within two years from the commencement of this Constitution.
  • And thereafter constitute FC at the expiration of every fifth year or at such earlier time as the President considers necessary.
  • An FC “which shall consist of a Chairman and four other members”.

Divisible Pool of Taxes

  • Under Article 280(3) (a) the FC must make recommendations to the President “as the distribution between the Union and the States of the net proceeds of taxes which are to be, or may be, divided between them under this Chapter and the allocation between the States of the respective shares of such proceeds”.
  • Accordingly, the FC determines a formula for tax-sharing between the states, which is a weighted sum of the states’ population, area, forest cover, tax capacity, tax effort and demographic performance, with the weights expressed in percentages.
  • This crucial role of the Commission makes it instrumental in the implementation of fiscal federalism.

Major recommendations of 15th FC

  • The report of the 15th FC, along with an Action Taken Report, was tabled in Parliament on Saturday.
  • The Commission has reduced the vertical devolution — the share of tax revenues that the Centre shares with the states — from 42% to 41%.
  • The 1 per cent decrease in the vertical devolution is roughly equal to the share of the erstwhile state of J&K, which would have been 0.85% as per the formula described by the Commission.
  • The Commission has said that it intends to set up an expert group to initiate a non-lapsable fund for defence expenditure.
  • The terms of reference of the Commission included considering the Centre’s demand for funds for defence and national security.
  • It may do so by creating a separate fund from the gross tax revenue before computing the divisible pool — which means that states would get a smaller share of the taxes.

The new parameter: 2011 census Population

  • As had been widely anticipated, shares of the southern states, except Tamil Nadu, have fallen — with Karnataka losing the most.
  • The population parameter used by the Commission has been criticised by the governments of the southern states.
  • The previous FC used both the 1971 and the 2011 populations to calculate the states’ shares, giving greater weight to the 1971 population (17.5%) as compared to the 2011 population (10%).

Why 2011 census was used?

  • The 15th FC has reasoned that the terms of reference leave it with no choice but to use the 2011 population; it has also argued that in the interest of fiscal equalization, it is necessary to use the latest Census figures.
  • The use of 2011 population figures has resulted in states with larger populations like UP and Bihar getting larger shares, while smaller states with lower fertility rates have lost out.
  • The combined population of the Bihar, Uttar Pradesh, Madhya Pradesh, Rajasthan and Jharkhand is 47.8 crore.
  • This is over 39.48% of India’s total population, and is spread over 32.4% of the country’s area, as per the 2011 Census.
  • On the other hand, the southern states of Tamil Nadu, Kerala, Karnataka and undivided Andhra Pradesh are home to only 20.75% of the population living in 19.34% of the area, with a 13.89% share of the taxes.
  • This means that the terms decided by the Commission are loaded against the more progressive (and prosperous) southern states.

Various criteria used

  • In order to reward population control efforts by states, the Commission developed a criterion for demographic effort — which is essentially the ratio of the state’s population in 1971 to its fertility rate in 2011 — with a weight of 12.5%.
  • The total area of states, the area under forest cover, and “income distance” were also used by the FC to arrive at the tax-sharing formula.
  • Income distance is calculated as the difference between the per capita gross state domestic product (GSDP) of the state from that of the state with the highest per capita GSDP, with states with less income getting a higher share in order to allow them to provide services comparable to those provided by the richer ones.
  • The Commission used the per capita GSDP of Haryana as the reference for calculating the income distance, and gave it a weight of 45%, down from the 50% assigned by the 14th FC.
  • The weight assigned to state area was unchanged at 15%, and that of forest cover was increased from 7.5% to 10%.

Ambiguity over the criterion

  • The effect of the demographic effort in increasing states’ devolution is not clear.
  • Shares of states like Maharashtra, Himachal Pradesh and Punjab, along with Tamil Nadu, all of which have fertility rates below the replacement level, have increased slightly.
  • On the other hand, Andhra Pradesh, Kerala, Karnataka, and West Bengal’s shares have fallen, even though their fertility rates are also low.
  • Incidentally, Karnataka, the biggest loser in this exercise, also had the highest tax-GSDP ratio in 2017-18, as per an RBI report on state finances.
  • Tax effort was also used by the Commission to decide the states’ shares, with a weight of 2.5%.
Finance Commission – Issues related to devolution of resources

Finance CommissionPriority 1

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Finance Commission

Mains level : Finance Commission, Its evolving role in fiscal federalism


  • The report of the Fifteenth Finance Commission, along with an Action Taken Report, was tabled in Parliament.
  • The Commission, headed by N K Singh, had submitted its Report to the President in December 2019.
  • The government had accepted the recommendations of the Commission “in substantial measure a/c to FM.

The Finance Commission and its purpose

  • Article 280 of the Constitution requires that a Finance Commission be constituted to recommend the distribution of the net proceeds of taxes between the Centre and states, and among the states.
  • Much has changed since the First Commission was set up in November 1951 under the Chairmanship of K C Neogy, a former member of the Constituent Assembly and diwan of a princely state.
  • The President has appointed 14 more Commissions since then.

Why need Finance Commission?

  • The framers of the Constitution were seeking to address the vertical imbalance between the taxation powers and expenditure and responsibilities of the federal government and the states, and the horizontal imbalance, or inequality, between states that were at different stages of development.
  • Ensuring inclusiveness is, therefore, a key mandate of the Finance Commission.
  • That means assigning weights to things like population, the fiscal distance between the top ranked states and the others, etc.
  • It is not that the best-performing state will be allocated the highest share — even if delivery execution and governance are better — rather, the effort will be to narrow the development gap between states.

Constitution of the Finance Commission

  • The Finance Commission Rules, 1951, lay down the criteria for being members of the constitutional body.
  • Members:
  1. those having special knowledge of finance and accounts of government with wide knowledge and experience in financial matters and in administration,
  2. or with special knowledge of economics, and
  3. those who have been qualified to be appointed as a judge of a High Court

Notable members

  • In the years following the reforms of the 1990s, Commissions have been headed by reputed economists and administrators — from A M Khusro, who headed the Eleventh Finance Commission, to Chakravarthi Rangarajan, Vijay Kelkar, and Y V Reddy, who were Chairmen of subsequent Commissions.
  • Senior politicians like K Brahmananda Reddy, Y B Chavan and N K P Salve had helmed earlier Commissions.
  • Before N K Singh, an economist and career administrator who subsequently joined politics, the last politician in this role was K C Pant, who then went on to be Deputy Chairman of the Planning Commission.

Changing role of the Finance Commission

  • What has changed dramatically since the 1950s, when the First Commission presented its recommendations on the transfer of resources between the Centre and the states, is the scale of distribution of tax proceeds.
  • From 10% of the total tax receipts of the Centre in 1950, it rose to a record 42% after the recommendations of the Fourteenth FC headed by Y V Reddy — a share that made previous awards look conservative, and sat well with the spirit of cooperative federalism.
  • The Fifteenth FC has recommended that this allocation be reduced by a percentage point to 41% in order to meet the security and special needs of the erstwhile state of Jammu and Kashmir.
  • The other significant change has been in the equation between the central and state governments as a result of the recommendations of the Twelfth FC which reshaped lending by the federal government to states.
  • The Fourteenth Commission recommended the creation of a Fiscal Council; the Thirteenth had set out detailed measures on implementing GST with a grand bargain for states.
Finance Commission – Issues related to devolution of resources

[oped of the day] Over to the statesop-ed snap

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Nothing much

Mains level : Role of states in the economic development story


Context

In the World Bank’s Ease of Doing Business index released last month, India ranked 63. It is a jump from its lowly rank of 142 in 2014. 

Challenges remain – with the states:

    • 15th FC ToR – When the government amended the terms of reference asking that allocations for defence and internal security be carved out upfront, states accused Centre’s highhandedness.
    • Land acquisition – government attempted to reform the land acquisition law by tweaking the balance in favour of investors many states objected to this. This happened despite the land being on the concurrent list in the Constitution.

Importance of states in India’s economic management

    • Early federalism – In the early years of our republic, the Centre dominated across all domains — political, economic and administrative — and states acquiesced to this unequal arrangement. 
    • Reaction to dominance – The reaction to central dominance came in the early 1980s when strong regional leaders started agitating against “the hegemony of the Centre”. Leaders like N T Rama Rao built their political careers on an “anti-Centre” platform.
    • Centre yielded – subsequently, the Centre yielded to the states largely in the political space. 
    • Economic policy spaceMuch of the economic policy control stayed with the Centre. It decided public investment and private investment through its industrial and import licensing policies. It left the states on the margins of economic management.

Economic reforms – change in relation: Three trends

    • The arrangement started to change with the onset of reforms from 1991.
    • Three trends have shifted the economic centre of gravity from the Centre to the states.

Trend # 1: Change in the content of the reform agenda

    • 1991 reforms – Centre could push through the reforms of the 1990s without even informing the states because they all pertained to subjects such as industrial licencing, import permits, exchange rate and the financial sector, which were entirely within its domain. 
    • Second-generation reforms – shift the emphasis from product to factor markets like land, labour and taxation, which often need the consent of states.
    • GST – it illustrates the increased clout of the states in driving reforms more than the GST negotiations. There was a clash of interests between the Centre and states, producer and consumer states, large and small states and coastal and inland states. The deal could not be finalised until the Centre guaranteed to fill the revenue gap of states according to an agreed formula.

Trend # 2: Fiscal federalism

    • Revenue – expenditure gap – estimates suggest that the Centre collects about 60% of the combined revenue, but gets to spend only about 40% of the combined expenditure. 
    • States collect 40% of the combined revenue but spend as much as 60% of the combined expenditure.
    • States autonomy – states now enjoy greater autonomy in determining their expenditure. Planning Commission is no more. The states get a larger quantum of central transfers and decide on how to spend that larger quantum.
    • Management of state financesThe RBI in its latest annual report on state finances raised several red flags
      • states’ increasing weakness in raising revenue
      • their unsustainable debt burden
      • the tendency to retrench capital expenditures in order to accommodate fiscal shocks such as farm loan waivers, power sector loans under UDAY and a host of income transfer schemes
    • Impact of state finances – As the RBI pointed out, the quality of expenditure at the state level has a multiplier effect on overall development outcomes.
    • Market response – The market will penalise the mismanagement of public finances. Even if it is the Centre or the states, for an unsustainable debt burden, market penalises.

Trend # 3: Economic federalism

    • Investments – There is states’ growing importance in economic federalism. They play a critical role in creating a conducive investment climate in the country. 
    • Ease of Doing Business – Much of the responsibility for improving the ease of doing business rests not with Delhi but with the states.

Conclusion

    • India’s prospects and aspiration for a $5 trillion economy depend on the Centre and the states working together.
    • If ever there was an opportune moment for a big push on cooperative federalism, it is now.
Finance Commission – Issues related to devolution of resources

[oped of the day] Beyond the mandateop-ed snap

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Nothing much

Mains level : 15th Finance Commission - ToRs - challenges


Context

Recent amendments to the Terms of Reference (ToR) of the 15th Finance Commission (FFC) are examined here. 

Amendments

    • First – requires the FFC to examine “whether a separate mechanism for funding of defence and internal security ought to be set up and how such a mechanism should be operationalised”. 
    • Second – from Section 83 of the Jammu and Kashmir Reorganisation Act 2019. It requires the President to “make a reference to the 15th Finance Commission to include the UT of J&K in its ToR and make an award for the successor UT of Jammu and Kashmir.

A new funding mechanism

    • Separate mechanism – The use of the words “separate mechanism” points to creating a mechanism distinct from the existing one. 
    • Constitutional position 
      • The Constitution requires that estimates relating to voted expenditure in the Annual Financial Statement be submitted in the form of demands for grants to the Lok Sabha.
      • The Government of India submits demands for grants to the Lok Sabha under the defence and home ministries for defence and deployment of armed forces in states.
    • New mechanism – The separate mechanism could be the creation of defence and internal security fund in the public account to which their annual budgetary allocations could be credited and spent over a multi-year time-frame without the threat of lapse. 
    • Already existing model – Such an arrangement already exists for a number of funds in the public account, like the National Disaster Relief Fund.

Challenges with this model

    • The extent of sum – The budget provision for 2019-20 for defence and the police grant of the home ministry is about Rs 5,30,000 crore. 
    • Huge amounts – It will be inappropriate to take away one-fifth of the GoI’s budget allocations into the public account. 
    • Budgetary management – escrowing such a large amount from its resources will constrain the GoI’s budgetary management.
    • Other ministries – similar demands could arise from other critical ministries like infrastructure and health, which will further emasculate budgetary flexibility. 
    • Lax budgeting – it will lead to lazy budgeting by the beneficiary ministries. 
    • Violation of rules – it violates the Government Accounting Rules 1990 (GAR), which allow for creating a fund in the public account only for the implementation of specified schemes of ministries and not for entire budgetary allocations of departments. 
    • Canons of budgeting – it violates the fundamental canons of annual budgeting mandated in the Constitution — providing for lapse of money budgeted but unspent during a year and obtaining Parliament’s approval every year for the Annual Financial Statement.
    • Ambiguity – The use of the words “internal security” creates ambiguity. 
      • Internal security means maintaining public order and peace by tackling internal threats and upholding the law. 
      • Public order and police are part of the state’s responsibility. 
      • Internal security is as much a concern of states as it is of the centre. 
    • Sharing with states – there would be a further challenge if such a fund is created in the GoI’s public account. It will have to decide how it will be shared with states.

J&K amendment

    • The phrase “include UT of JnK in its Terms of Reference” is indeterminate. 
    • No place for states – ToR of the FFC has 15 clauses. In which clause and where should it be included remains a question. The names of no state or UT find a place in any of these 15 clauses.
    • Treat as a state – this amendment requires the FFC to treat the UT of JnK as a state for the purposes of its award. 
    • No awards for UTs – No Finance Commission has ever made an award for any UT. It is not clear how the FFC can now make an award treating the UT of J&K as a state.
    • Competition with other UTs – the claims of the two other UTs with a legislature — Delhi and Puducherry demanding that FCs award a share of the divisible pool to them can’t be ignored.
    • The challenge from states – States argue that the impact of such a provision would increase the number of claimants to the divisible pool and reduce their individual share. 

Conclusion

    • Some state governments have complained about its perceived inequities to the President.
    • These two amendments unnecessarily raise more challenges for the FFC.
Finance Commission – Issues related to devolution of resources

[oped of the day] Firm steps to ease the fiscal federalism tensionop-ed snap

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Nothing much

Mains level : Fiscal federalism in India


Context

A “camel’s nose” is a metaphor to describe a situation where one permits a small entry to an outsider into one’s territory, only to be soon pushed out entirely. The fiscal relationship between the Centre and the States is fast turning into a “camel’s nose” syndrome for the States. 

Gaining entry to pushing out

  • Centre gained an entry through the GST into the territory of taxation powers of States.
  • It is now arming itself to elbow the States out entirely of its fiscal powers. 

Federalism

  • India is a union of States. Citizens of every State elect their government independently. 
  • The primary responsibility of such an elected government is efficient governance and accountability to its voters. 
  • An elected government is typically granted the powers to be able to raise revenues through taxation of its citizens and incur appropriate expenditure for their benefit.
  • Over the past five years, democratically elected State governments have been stripped of almost all powers of taxation.
  • There is an attempt to palm off the Centre’s expenditure obligation to the States and there is talk of even limiting expenditure powers of the States.

Lessons from the past : Meal scheme

  • In 1982, the newly elected Chief Minister of Tamil Nadu, MG Ramachandran (MGR) wanted to expand the midday meal programme to all 70 lakh children across 52,000 government schools to improve student enrolment. 
  • This entailed an additional expenditure of ₹150 crore, which the government did not have. 
  • MGR decided to levy an additional sales tax on goods sold in Tamil Nadu to cough up the amount needed. 
  • The programme was then further expanded by successive governments under the DMK. 
  • It catapulted Tamil Nadu’s literacy rate from 54% in 1981 to 83% in 2011. In just three decades, Tamil Nadu was counted as one of India’s most literate States.
  • MGR and other Chief Ministers of Tamil Nadu did not have to rush to New Delhi to make the decision to implement a midday meal programme and impose additional sales taxes to fund it. It was decided and approved in Chennai. 
  • In today’s India, MGR would have had to dash to Delhi and seek approval.

Fiscal federalism – goes against states

  • More than 80% of government’s revenues come from taxes, primarily from income tax (direct tax) and sales taxes (indirect tax). 
  • State governments in India do not have powers to levy income taxes. 
  • With GST, the Centre stuck its nose into the indirect taxes of State governments. States lost their sole powers to levy indirect taxes. 
  • Instead, they depend on a GST Council to determine tax rates and revenues.
  • A democratically elected State government in India can neither levy income tax nor sales tax. Effectively, it’s a representation without taxation.

Extending the intrusion into states’ domain – Defence

  • The Centre is now stretching its arms and legs to capture more. 
  • It has now proposed that there should be a permanent expenditure fund created for defence spending out of the total tax revenue pool. 
  • The Centre keeps 52% of the total tax revenue pool and distributes 48% to all the States and Union Territories. 
  • Instead of using its 52% share to spend on defence, the present government wants to palm off this expenditure to all the States. 
  • This will likely further reduce the tax revenues distributed to States for their own expenditure. 

Expenditure Council

  • There is now talk of constituting an Expenditure Council, similar to the GST Council. 
  • Not only did States lose their taxation powers but with this idea, they will lose its sole spending powers too. 
  • An elected Chief Minister of a State with no discretionary powers to earn or spend for the people of the State can virtually hand over the reins of governance to Delhi. 

Challenges

  • There is huge economic and cultural diversity among the various States. It is a terrible mistake to presume that all of India can be governed from Delhi.
  • Elected State governments and leaders cannot be made dummies without any fiscal powers for long. 
  • This fiscal federalism tension between the Centre and States can erupt into something more dangerous and spread wide.

Way ahead

  • Grant State governments the powers to levy income taxes. In large federal democracies such as the United States, State governments and even local governments have the right to levy income taxes. 
  • State governments should be given powers to raise revenues and incur expenditure in accordance with each State’s needs and priorities.
  • Amend the Constitution to grant States the powers to levy income taxes as they deem fit.

Conclusion

There is a distinction between unity and uniformity. Uniformity is not an essential condition for unity. On the contrary, a celebration of plurality may foster greater unity in a nation such as ours. The days of imperialistic London are over. It is the era of Gandhinagar, Chennai, Lucknow and Kolkata.

Finance Commission – Issues related to devolution of resources

[op-ed snap] Share of the stateMains Onlyop-ed snap

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Nothing Much

Mains level : Maintaining Fiscal Federalism


CONTEXT

Last week, the Union cabinet passed an amendment to widen the terms of reference of the 15th Finance Commission.

Background

  • The Commission has now been asked to examine the possibility of setting up a mechanism for funding defence and internal security.
  • As capital spending on defence continues to fall well short of what is required, it is difficult to contest the premise that it needs to be bolstered.
  • But, as the creation of “secure and non-lapsable funds for defence and internal security” may end up reducing the divisible tax pool further, the move could face resistance from states, especially when several of them are arguing for a greater share in tax revenues.
  • While the commission is yet to spell out its views on the subject, this request raises fundamental questions over the spending priorities of different levels of government and the framework that governs Centre-state fiscal relations.
  • The Seventh Schedule of the Indian Constitution specifies the separate as well as concurrent responsibilities of the Centre and state governments, with defence falling in the Union list.
  • The inability of the Centre to ramp up its spending on defence indicates the limited fiscal space available to it.
  • In large part, this is due to an increase in spending on items in the state and concurrent list, and a corresponding decline in spending on items in the Union list.
  • In 2015-16 alone, the Centre spent 16 per cent of its revenue expenditure on items in the state list, and another 16.4 per cent on items in the concurrent list.

Reduced Fiscal space for states –

  • In a federal structure, the Centre must address regional imbalances in the delivery of public services.
  • But the bulk of this spending is routed through sector-specific transfers or centrally sponsored schemes that curb the autonomy of the states in deciding their own expenditure priorities.
  • The added fiscal pressures on the Centre have, in turn, contributed to reduced fiscal space for states.
  • Over the years, the Centre has begun to rely increasingly on taxes collected through cesses and surcharges to meet its expenditure priorities.
  • But revenue from these sources does not form part of the divisible tax pool, it is not shared with states — squeezing them from both ends.

Conclusion

While the compulsions of the political economy have ensured greater central government spending on items in the state and concurrent lists, the current juncture may well be an opportune moment to rethink the spending priorities of different levels of the government. There is a need, particularly, to address legitimate concerns of states about increasing encroachment by the Centre.

Finance Commission – Issues related to devolution of resources

Time to have institutional mechanism like Fiscal Council to enforce rules: NK SinghPriority 1


Note4students

Mains Paper 2: Polity | Appointment to various Constitutional posts, powers, functions and responsibilities of various Constitutional Bodies

From UPSC perspective, the following things are important:

Prelims level: Fiscal Council

Mains level: Mandate of the finance commission


News

  • Stressing on the need to have uniform rules for fiscal consolidation of States and Centre 15th Finance Commission’s Chairman NK Singh called for institutional mechanism like a ‘Fiscal Council’ to enforce fiscal rules and keep a check on Centre’s fiscal consolidation.

A check over borrowings

  • For state government liabilities, Article 293 (3) provides a constitutional check over borrowings.
  • But there is no such restriction on the Centre.
  • It is time we have an alternative institutional mechanism like Fiscal Council to enforce fiscal rules and keep a check on Centre’s fiscal consolidation.
  • Singh had earlier proposed creation of an autonomous Fiscal Council with representatives from both states and Centre, but the recommendation was not implemented.

Why need Fiscal Council?

  • Various cesses and surcharges are becoming disproportionate proportion of overall divisible revenue.
  • There should be some mechanism to ensure that the basic spirit of the devolution process should not be undercut by clever financial engineering or taking recourse to traditions.
  • There is a need for coordination between the finance commission as well as the GST Council, which he termed as the only federal institution in the country.
  • There’s need for coordination between Finance Commission and GST council.
  • GST Council has no clue of what the Finance Commission is doing and Finance Commission has even lesser clue of what the GST Council is doing.

The municipal example

  • It is very clear that successful economic growth, successful good quality employment depends on agglomerations that work.
  • That in turn is going to depend on whether municipalities have enough revenue.
  • What the municipalities get today in terms of revenue is one per cent of GDP whereas on comparative basis, looking at other emerging market countries, it really ought to be 5 per cent of GDP.
Finance Commission – Issues related to devolution of resources

[op-ed snap] Another look at fiscal transfersop-ed snap


Note4students

Mains Paper 2: Polity | Functions & responsibilities of the Union & the States, issues & challenges pertaining to the federal structure

From UPSC perspective, the following things are important:

Prelims level: State Finance Commission (SFC)

Mains level: Role of finance commissions in fiscal federalism and changes proposed


NEWS

CONTEXT

Concept of federalism

  • Federalism is an old concept.
  • It is well known that the efficiency of a government depends on, among other factors, its structure.
  • In large countries, it has been felt that only a federal structure can efficiently meet the requirements of people from different regions.

The reason behind the existence of the present form of federalism

  • In our country during the independence struggle, provincial autonomy was regarded as an integral part of the freedom movement.
  • However, after Independence, several compulsions, which included defence and internal security, led to a scheme of federalism in which the Centre assumed greater importance.
  • Also in the immediate period following Independence, when the Centre and all States were ruled by the same party and when many of the powerful provincial leaders migrated to the Centre, the process of centralisation gathered further momentum.
  • Economic planning at a nation-wide level helped this centralising process.

What is Fiscal Federalism?

  • Fiscal federalism is the economic counterpart to political federalism.
  • Fiscal federalism is concerned with the assignment on the one hand of functions to different levels of government, and with appropriate fiscal instruments for carrying out these functions on the other.
  • The Central government must provide national public goods that render services to the entire population.
  • A typical example cited is defence.
  • Sub-national governments are expected to provide goods and services whose consumption is limited to their own jurisdictions.

Determinations of Raising of Taxes by different units of government

  • An equally important question in fiscal federalism is the determination of the specific fiscal instruments that would enable the different levels of government to carry out their functions.
  • This is the ‘tax-assignment problem’ .
  • In determining the taxes that are best suited for use at different levels of government, one basic consideration is in relation to the mobility of economic agents, goods and resources.
  • It is generally argued that the de-centralised levels of government should avoid non-benefit taxes and taxes on mobile units.
  • This implies that the Central government should have the responsibility to levy non-benefit taxes and taxes on mobile units or resources.

Problems in assigning different  taxing responsibilities  to different levels of government

  • Different Constitutions interpret differently what is mobile and what is purely a benefit tax.
  • For example, in the United States and Canada, both Federal and State governments have concurrent powers to levy income tax.
  • On the contrary, in India, income tax is levied only by the Central government though shared with the States.
  • Recognising the possibility of imbalance between resources and responsibilities, many countries have a system of inter-governmental transfers.

The provision in Indian Constitution regarding the division of taxes

  • The Indian Constitution lays down the functions as well as taxing powers of the Centre and States.
  • It is against this background that the issues relating to the correction of vertical and horizontal imbalances have been addressed by every Finance Commission, taking into account the prevailing set of circumstances.
  • However, Central transfers to States are not confined to the recommendations of the Finance Commissions.
  • There are other channels such as those through the Planning Commission until recently as well the discretionary grants of the Central government.

Recent changes in the division of tax proceeds

  • The Fourteenth Finance Commission has broken new ground in terms of allocation of resources.
  • One of its major recommendations has been to increase the share of tax devolution to 42% of the divisible pool.
  • This is a substantial increase by almost 10 percentage points.
  • The commission has argued that this does not necessarily affect the overall transfers but only enhances the share of unconditional transfers.
  • Over years, the performance of the Central government is judged not only on the basis of actions taken which fall strictly in its jurisdiction but also on initiatives undertaken in the areas which fall in the Concurrent and even State lists.
  • Today, the Central government is held responsible for everything that happens, including, for example, agrarian distress.
  • The Planning Commission was replaced by the NITI Aayog, which was simply a think-tank with no powers of resource allocation.

Way Forward

  • The Constitution should be amended and the proportion of shareable taxes that should go to the States fixed at the desired level.
  • The shareable tax pool must also include cesses and surcharges as these have sharply increased in recent years.
  • Fixing the ratio at 42% of shareable taxes, including cesses and surcharges, seems appropriate.
  • Another possible route is to follow the practice in the U.S. and Canada: of allowing the States to levy tax on personal income, with some limitations.
  • Also once this power is given to the States, the transfers from the Centre need adjustment.
  • There are issues relating to horizontal distribution. An appropriate balancing of criteria is needed particularly in the context of the rise in unconditional transfers.
Finance Commission – Issues related to devolution of resources

RBI governor bats for permanent status to Finance CommissionPriority 1


Note4students

Mains Paper 2: Polity | Functions & responsibilities of the Union & the States, issues & challenges pertaining to the federal structure

From UPSC perspective, the following things are important:

Prelims level: Finance Commission

Mains level: Read the attached story


News

  • The 15th Finance Commission, constituted in November 2017, will give recommendations for devolution of taxes and other fiscal matters for five fiscal years, commencing April 1, 2020.
  • RBI Governor Shaktikanta Das has said increasingly it is felt that there is a need to give permanent status to the Finance Commission and constitution of State Finance Commissions every five years.

Addressing various challenges

  • According to Das, there is now general agreement in the country about the importance of fiscal consolidation roadmap both at national and sub-national levels.
  • Successive finance commissions have made efforts to address the emerging issues and challenges, but in a democracy like India, the debate goes on.
  • Geopolitical risks have necessitated higher expenditure on defence and internal security.
  • Natural calamities and disasters have called for higher expenditure on relief and rehabilitation.
  • In parallel, aspirations of people and the country as a whole have required that the government spends more on developmental programmes.

Why such move?

  • The Commission can function as a leaner entity in the intervening period till the next Finance Commission is set up in a full-fledged manner.
  • Over past several decades, Finance Commissions have adopted different approaches with regard to principles of tax devolution, grants to be given to states and fiscal consolidation issues.
  • There is a need to ensure broad consistency between Finance Commissions so that there is some degree of certainty in the flow of funds, especially to the states.
  • This has become even more critical in the post GST scenario.

Imbibing Continuity

  • According to Das, finance commissions have over the past several decades adopted different approaches with regard to principles of tax devolution, grants to be given to states and fiscal consolidation issues.
  • In other words, there has to be continuity and change between finance commissions.
  • Increasingly, therefore, it is felt that there is a need to give permanent status to the finance commission.
  • A commission can function lean till the next finance commission is set up in a full-fledged manner.
  • During the intervening period, it can also address issues arising from implementation of the recommendations of the finance commission.

Other recommendations

  • The principle of decentralisation works better when powers and functions are delegated based on which tier of governance is best suited to fulfill that responsibility.
  • The constitution has already provided for delegation of certain functions to the urban and rural local bodies; but it is seen that there is still good distance to traverse when it comes to devolution of funds to these local bodies.
  • It is essential that State Finance Commissions are constituted every five years as per the mandate in Article 243I of the Constitution and arrangements are made for their robust functioning.

Back2Basics

Finance Commission

Finance Commission of India: Powers, Functions and Responsibilities

Finance Commission – Issues related to devolution of resources

[op-ed snap] Strengthening the federal linkop-ed snap


Note4students

Mains Paper 2: Polity | Functions & responsibilities of the Union & the States, issues & challenges pertaining to the federal structure

From UPSC perspective, the following things are important:

Prelims level: State Finance Commission (SFC), 73rd and 74th Constitutional Amendments (CAs), Article 243I of the Constitution,

Mains level: Role of finance commissions in fiscal federalism


Context

State finance commissions

  1. The State Finance Commission (SFC) is a unique institution created by the 73rd and 74th Constitutional Amendments (CAs) to rationalise and systematise State/sub-State-level fiscal relations in India
  2. Its primary task is to rectify growing horizontal imbalances in the delivery of essential public services to citizens
  3. But there has been inadequate appreciation of the significance of this institution by the Union, States as well as the professional community

Delays in the formation of SFCs

  1. Article 243I of the Constitution mandated the State Governor to constitute a Finance Commission within one year of the CAs (before April 24, 1994) and thereafter every five years
  2. This means fifth generation SFCs ought to have submitted reports by now but till date, only Assam, Himachal Pradesh, Tamil Nadu and Kerala have submitted their fifth SFC reports
  3. Many States are yet to cross the third SFC stage
  4. The seriousness, regularity, acceptance of recommendations and their implementation which characterise the Union Finance Commissions (UFCs) are conspicuously absent when it comes to SFCs

Problems being faced by SFCs

  • For historical reasons, UFCs, particularly from the third, have chosen a restrictive role of staying away from plan and investment allocations
  1. SFCs normally could not do this although some have chosen the UFC path
  2. Now that the Planning Commission has been dismantled, the 15th UFC has to spell out its decision-making domain
  • It is important to disabuse the notion among several politicians, policymakers and even experts that SFCs and the local governments they deal with have an inferior constitutional status when compared to the UFC
  1. The SFC is undoubtedly modelled on the UFC created under Article 280 and exemplified in Articles 243I and 243Y
  2. While the UFC is tasked with rectifying vertical and horizontal imbalances at the Union-State level, the SFC has to perform the same with reference to State/sub-State-level institutions
  3. The Constitution treats a local government on a par with a State government, especially when it comes to sharing of financial resources
  • SFCs face a crucial problem of reliable data
  1. The financial reporting system of the Union and States is well laid down
  2. On the other hand, local governments with no proper budgetary system are in deep disarray

Importance of SFCs

  • The task of the SFC to correct horizontal imbalances is extremely onerous when compared with the UFC as SFCs have to consider nearly 2.5 lakh local governments to promote minimum essential services in rural and urban areas
  1.  An SFC is the institutional agency to implement the golden rule of cooperative federalism that every citizen should be assured minimum public goods irrespective of her choice of residence
  • Article 280(3) has been amended to add clauses (bb) and (c) in order to take measures to augment the resources of panchayats and municipalities on the basis of the recommendations “made by the finance commission of the state”
  1. These sub-clauses affirm the organic link between local governments and SFCs to fiscal federalism
  • The federalist development state of India can grow only through a process of evolutionary policy making which works towards cherished goals
  1. Articles 243G and 243W give mandate of planning “for economic development and social justice”

Failure of UFC to address local level challenges

  1. UFCs have failed to play a hand-holding role in placing decentralised governance properly in the cooperative federal map of India
  2. No UFC has done its homework in reading and analysing SFC reports
  3. Without presenting a consolidated account of the reality at the sub-State level or highlighting which report went wrong, no UFC can legitimately guide States or contribute to improving the goals of constitutional amendments

Way Forward

  1. SFCs have not been provided with the necessary environment to play their rightful role in Indian fiscal federalism
  2. A great opportunity to build regional equity in India has been undermined
Finance Commission – Issues related to devolution of resources

Row over terms of reference: 15th Finance Commission forms panel to quell controversy


Note4students

Mains Paper 2: Polity | Appointment to various Constitutional posts, powers, functions and responsibilities of various Constitutional Bodies

From UPSC perspective, the following things are important:

Prelims level: Particulars of the Finance Commission

Mains level: Complement this newscard with our previous newscards on the same issue.


News

15th Finance Commission (FC) is seeking to quell the controversy

  1. The commission has set up a six-member council to “advise and assist” it on the ToR and “help in broadening the commission’s ambit and understanding”

More about the panel

  1. It will help prepare any research study which would enhance the commission’s understanding on the issues containing in its ToR;
  2. and to help broaden the commission’s ambit and understanding to seek best national and international practices on matters pertaining to fiscal devolution and improve the quality, reach and enforcement of its recommendations.
  3. The council’s role is advisory in nature, and it can’t tweak on its own the ToR of the commission
  4. Any change in the ToR has to be made by the Centre with the assent of the President
  5. The setting up of the council by the commission will also serve to ease pressure on the Centre, which has been accused of sabotaging cooperative federalism through “faulty” ToR

Bacground

  1. Some states have claimed that the progressive ones stand to lose if the commission follows its ToR
  2. and takes the 2011 census as the basis for the devolution of central funds, instead of 1971, that was adopted earlier
Finance Commission – Issues related to devolution of resources

[op-ed snap] The southern alliance and the 15th Finance Commissionop-ed snap


Note4students

Mains Paper 2: Polity | Appointment to various Constitutional posts, powers, functions and responsibilities of various Constitutional Bodies

From UPSC perspective, the following things are important:

Prelims level: Particulars of the Finance Commission

Mains level: Complement this newscard with our previous newscards on the same issue.


News

Context

  1. The finance ministers of three southern states and Puducherry (a Union territory) met at Thiruvananthapuram to protest the terms of reference (ToR) of the 15th Finance Commission (FC-15)
  2. Southern states are finalizing a formal protest to be lodged with the president of India, who appoints every finance commission
  3. The principal concern centres on the direction in the ToR to use population figures from the 2011 census in place of the 1971 census in the formula for determining state shares

Some of the contentious issues

  1. First, the state shares of a divisible pool has risen from roughly 24% of the Centre’s tax revenue at the start of reform in 1991, to a peak of 42% prescribed by FC-14 for the period 2015-20
  2. The suggestion in the ToR that FC-15 might consider a reduction of this divisible pool has led to widespread state disaffection, and not just in the south
  3. Second, to prevent population size from becoming a perverse incentive for states to neglect population control, seven finance commissions over a span of 35 years were explicitly directed in their ToR to freeze population shares of states at the 1971 census levels
  4. But FC-15 is re-considering it now

How can the GST help?

  1. With the GST, we now have for the first time a closer approximation to the true relative taxable base in different states
  2. Since the coverage of the GST tax base is uniform across states, and since the GST can be presumed to have imposed a uniform tax effort across states within its coverage,
  3. state-wise collections give us a better handle on the relative taxable capacity of states than the domestic product proxy that has been used until now
    (Background:  A common tax effort percentage is currently being applied to variations in state domestic product per capita, which is used to proxy differences across states in the taxable base)

What is the main issue with the southern states?

  1. A legitimate grievance of the southern states, however, is population migration to these states from the slower growing states of the north
  2. In the Economic Survey (ES) for 2016-17, an excellent chapter estimated inter-state economic migration between the censuses of 2001 and 2011 at roughly 5.5 million per year

No cause of worry for Kerala

  1. Kerala may be a host state for domestic migration, but it has been an exporter of prized manpower to the rest of the world
  2. As a major recipient of international remittances, the income accruing to Kerala far outpaces the income originating in the state
  3. Since finance commissions have so far been compelled to use state domestic product as a measure of relative tax capacity, which excludes remittance income,\
  4. Kerala has on that account actually been getting a top-up higher than was due
Finance Commission – Issues related to devolution of resources

[op-ed snap] Mandate and allocations: The 15th Finance Commissionop-ed snap


Image Source

Note4students

Mains Paper 2: Polity | Appointment to various Constitutional posts, powers, functions and responsibilities of various Constitutional Bodies

Prelims level: Various article so the constitution discussed in the newscard and particulars of the finance commission.

Mains level: Many states have raised questions against the directive to use population data of the 2011 Census. The newscard discusses some important points related to it.


News

Context

  1. The presidential terms of reference (ToR) of the Fifteenth Finance Commission have raised questions
  2. Why: The concerns are over the directive to use population data in the ToR from the 2011 Census, and not the 1971 Census that was used earlier, is an exaggeration
  3. For the southern States the issue of population is a point of concern
    (ToR: Terms of reference (TOR) define the purpose and structures of a project, committee, meeting, negotiation, or any similar collection of people who have agreed to work together to accomplish a shared goal)

Some important contentious issues
States need to debate a number of contentious issues in the ToR which affect the very structure of fiscal federalism
These include: asking the Commission

  1. “to examine whether revenue deficit grants be provided at all”;
  2. considering “the impact of [the] fiscal situation of the Union government of substantially enhanced devolution by the Fourteenth Finance Commission, coupled with continuing imperative of the national development programme including New India 2022”;
  3. looking at the conditions that may be imposed by the Central government while providing consent to States when they borrow under Article 293(3);
  4. asking the Commission to propose measurable performance-based incentives to States
  5. and finally, promoting ease of doing business

 The ToR of the Fifteenth Commission raise questions about constitutional propriety 

  1. Take, for example, the suggestion that the Commission may examine whether the revenue deficit grants should be given at all
  2. The very objective of Article 275 is to enable the Commission to give grants to offset post-devolution gaps between normatively assessed revenues and expenditures
  3. If the Commission takes this suggestion seriously, it will have serious ramifications for States with genuinely large resource gaps
  4. The ToR seek to reduce the role of Article 275, which is a legitimate channel for grants,
  5. and asks the Commission to leave it more fiscal space to expand grants under Article 282, which is questionable

Central government is interfering with the state subjects

  1. Asking the Commission to take into account the performances in implementation of various Central schemes is equally contentious
  2. The Seventh Schedule of the Constitution assigns the respective functions in terms of Union, State and Concurrent subjects
  3. It is ironical that the Union government has been intruding into State subjects through Central schemes by forcibly using fiscal space
  4. Performances must be built into the implementation of schemes and not into the tax devolution formula
  5. It must be noted that devolution of taxes to States is not a charity; it is their right

The way forward

  1. The ToR of the present Commission raise serious issues of constitutional propriety
  2. Hopefully, States will safeguard their turf to preserve the federal fabric of the country

Back2basics

Finance commission

  1. The first Finance Commission was established by the President of India in 1951 under Article 280 of the Indian Constitution
  2. It was formed to define the financial relations between the central government of India and the individual state governments
  3. The Finance Commission (Miscellaneous Provisions) Act, 1951 additionally defines the terms of qualification, appointment and disqualification, the term, eligibility and powers of the finance commission
  4. As per the Constitution, the Commission is appointed every five years and consists of a chairman and four other members
  5. Since the institution of the first finance commission, stark changes in the macroeconomic situation of the Indian economy have led to major changes in the finance commission’s recommendations over the years
  6. There have been fifteen commissions to date
  7. The most recent was constituted in 2017 and is chaired by N. K.Singh, a former member of the Planning Commission
Finance Commission – Issues related to devolution of resources

15th Finance Commission: Is it just a South India vs North India debate?op-ed snap


Note4students

Mains Paper 3: Economy | Indian Economy Issues relating to planning

From UPSC perspective, the following things are important:

Prelims level: Fifteenth Finance Commission, Article 270 of the Indian Constitution

Mains level: Debate on the effect of 15th Finance commission’s changed terms of reference


Context

Fifteenth Finance Commission’s terms of reference (ToR)

  1. The Fifteenth Finance Commission’s terms of reference (ToR) have evoked a sharp response from southern states
  2. The ToR mandates the Commission to use 2011 population for tax sharing and devolution of resources instead of 1971 population as was the practice in the past
  3. Between 1971 and 2011, except Telangana, population shares of four southern states in total declined from 22.01% to 18.16%
  4. Use of 2011 population for sharing resources means a decline in the flow of resources to these states

Beyond southern states

  1. Between 1971 and 2011, population share has declined in 10 states other than the four southern states
  2. These are Assam, Goa, Himachal Pradesh, Odisha, Punjab and West Bengal
  3. Thus, use of 2011 population would also affect economically less prosperous states like Assam, Odisha and West Bengal

Tax-sharing formula

  1. In the past, the tax-sharing formula was a combination of factors reflecting equity, need and efficiency
  2. Population being a neutral indicator of need has been used by all 14 finance commissions

Fundamental question about the use of population

  1. Any finance commission is required to assess fiscal needs of states for tax sharing and grants
  2. Binding Commission’s work to a particular reference population is arbitrary and unfair to all the stakeholders including the Commission

Policy on resource sharing

  1. The policy on resource sharing needs to make a distinction between tax sharing and grants
  2. Tax sharing is to correct the vertical and horizontal imbalances arising due to constitutional assignment of tax powers and expenditure responsibilities between the Union and states
  3. Also, as per the Article 270 of the Indian Constitution, tax share recommended by the Finance Commission does not form part of the consolidated fund of the Union government, implying this is not a component of Union budget

Way forward

  1. Any incentive or reward should be done through a grant mechanism instead of horizontal tax sharing
  2. It is too early to conclude the outcome of the use of 2011 population on resource sharing
  3. The ultimate outcome would depend on how the Commission treats various factors in the horizontal allocation of resources
Finance Commission – Issues related to devolution of resources

Why South India states are objecting to Finance Commission’s mandate


Note4students

Mains Paper 2: Polity | Functions & responsibilities of the Union & the States, issues & challenges pertaining to the federal structure

From UPSC perspective, the following things are important:

Prelims level: 15th Finance Commission

Mains level: Issues related to the distribution of resources between states


Opposing 15th Finance Commission

  1. A political storm is brewing in South India over the determination of how India distributes its pooled tax revenues among its many states
  2. Several chief ministers and opposition leaders of southern states have expressed vehement opposition to one particular mandate of the present Fifteenth Finance Commission: to use 2011 census population figures instead of 1971 for the purpose of tax devolution

Why such opposition

  1. The Indian union made a compact with all its states in the mid-1970s to freeze federal allocations based on population size at 1971
  2. This was done to ensure states which had managed to tackle their population growth were not penalized by way of lower allocations
  3. The growth rate in population dropped uniformly across all states, but the fall in South India was rapid, creating a distinct divergence between the number of people in the North versus the South
  4. Since the present finance commission has the mandate to use newer population figures, which brings both economic and demographic divisions into the picture, the fear among southern states is that the degree of redistribution would increase

Back2Basics

Fifteenth Finance Commission

  1. The Fifteenth Finance Commission of India is a finance commission constituted in November 2017
  2. The commission was set up to give recommendations for five fiscal years commencing on 1 April 2020
  3. The main tasks of the commission were to “strengthen cooperative federalism, improve the quality of public spending and help protect fiscal stability”
  4. Finance Commission is established by the President of India under Article 280 of the Indian Constitution
  5. The Finance Commission (Miscellaneous Provisions) Act, 1951 additionally defines the terms of qualification, appointment, and disqualification, the term, eligibility and powers of the finance commission
  6. As per the Constitution, the Commission is appointed every five years and consists of a chairman and four other members
Finance Commission – Issues related to devolution of resources

Northern states may benefit under 15th Finance Commission


Note4students

Mains Paper 2: Polity | Functions and responsibilities of the Union and the States, issues and challenges pertaining to the federal structure, devolution of powers and finances up to local levels and challenges therein.

From UPSC perspective, the following things are important:

Prelims level: Particulars of the finance commission(read with B2B)

Mains level: The decision will have a long lasting positive affect on the Economies of particular states.


What is the news?

  1. North Indian states like Bihar and Chhattisgarh with higher rates of population growth may get more funds under the 15th Finance Commission
  2. Why: The government is asking the commission to use the latest census data of 2011 for allocation of resources, against 1971 census data used earlier

Particulars of the 15th Finance Commission

  1. The Commission, has been asked to submit its report by 30 October 2019
  2. Its recommendations will be in force for the five years starting 1 April 2020

Why this decision?

  1. Many analysts consider the earlier practice of not referring to the current population while providing resources to the state governments was archaic and distortionary
  2. This practice was sometimes justified by some as disincentivizing states from letting their population proliferate, although there was no evidence that any state did follow such a policy
  3. However, it resulted in lower standards of services provided by the state governments to its citizens
  4. Such a static provision also did not take into account the effect of net migration on the state population

Other directions given to the Commission

  1. The Commission has also been asked to propose measurable performance-based incentives in areas such as GST
  2. And efforts and progress made in moving towards replacement rate of population growth
    (which refers to the total fertility rate that will result in a stable population without increasing or decreasing it)
  3. FFC will also consider achievements made by states in implementation of flagship central schemes and building disaster resilient infrastructure, reaching sustainable development goals, and quality of expenditure
  4. Progress made in increasing capital expenditure, improving the quality of such expenditure and promoting labour-intensive growth have also been included in the ToR(terms of reference) for the Commission

Back2basics

Finance Commission of India: Powers, Functions and Responsibilities

Finance Commission – Issues related to devolution of resources

Finance Commission’s changing roles, challenges over the years


Note4Students

Mains Paper 2: Powers, functions and responsibilities of various Constitutional Bodies.

The following things are important from UPSC perspective:

Prelims level: Finance Commission

Mains level: This article is important for mains as it talks about the challenges the upcoming Fifteenth Finance Commission will face and how has Finance Commission changed over the years. It also highlights the contribution of the Finance Commission in reshaping the Center- State relations and in giving impetus to the cooperative federalism.


News

Context

  • The government will soon constitute the Fifteenth Finance Commission, as per normal practice, a couple of years before the end of the five-year period during which the Commission’s recommendations are valid.

The Finance Commission

    1. Article 280 of the Constitution requires that a Finance Commission be constituted to recommend the distribution of the net proceeds of taxes between the Centre and states, and among the states.
  • The framers of the Constitution were seeking to address the vertical imbalance between the taxation powers and expenditure and responsibilities of the federal government and the states, and the horizontal imbalance, or inequality, between states that were at different stages of development.
    1. Ensuring inclusiveness is, therefore, a key mandate of the Finance Commission.
  • That means assigning weights to things like population, the fiscal distance between the top ranked states and the others, etc. It is not that the best-performing state will be allocated the highest share – even if delivery execution and governance are better – rather, the effort will be to narrow the development gap between states.
  1. The First Commission was set up in November 1951 under the Chairmanship of K C Neogy.
  2. The President has appointed 13 more Commissions since then.
  3. The Finance Commission Rules, 1951, lay down the criteria for being members of the constitutional body: those having special knowledge of finance and accounts of government with wide knowledge and experience in financial matters and in administration, or with special knowledge of economics, and those who have been qualified to be appointed as a judge of a High Court.

Convention regarding composition of the Finance Commission

    1. In the years following the reforms of the 1990s, Commissions have been headed by reputed economists and administrators  from A M Khusro, who headed the Eleventh Finance Commission, to Chakravarthi Rangarajan, Vijay Kelkar, and Y V Reddy, who were Chairmen of subsequent Commissions.
    2. Senior politicians like K Brahmananda Reddy, Y B Chavan and N K P Salve had helmed earlier Commissions; the last politician in this role was K C Pant, who then went on to be Deputy Chairman of the Planning Commission.
    3. The approach the government adopts on the composition of the Fifteenth Finance Commission and whether it will follow what has been a convention, since the Twelfth Finance Commission (2002), of having a member of the (erstwhile) Planning Commission as a part-time member will be interesting to watch.
    4. The Planning Commission in its old structure and form has been dismantled, and has been replaced with the Niti Aayog.
  • The Twelfth Commission, had suggested to the government that it could alternate between an economist and a political figure such as a former state Finance Minister to be the Chairman.

How has responsibilities and scope of the Finance Commission increased over the years?

  1. The scale of distribution of tax proceeds has changed dramatically since the 1950s since the First Commission presented its recommendations on the transfer of resources between the Centre and the states.
  2. From 10% of the total tax receipts of the Centre in 1950, it has now risen to a record 42% after the recommendations of the Fourteenth Finance Commission, a share that makes previous awards look conservative, and sits well with the spirit of cooperative federalism.
  3. Along with these changes has been the widening of the terms of reference of the Commissionthe Thirteenth Commission was told-
  • To assess the impact of the proposed GST from April 1, 2010;
  • The need to improve the quality of public expenditure, to review the finances of both the Centre and the states;
  • To suggest measures to maintain a stable fiscal environment consistent with equitable growth;
  • To suggest a revised roadmap to maintain the gains of fiscal consolidation through 2015.
  1. Also the equation between the central and state governments has changed as a result of the recommendations of the Twelfth Finance Commission which-
    • Reshaped lending by the federal government to states that is, rather than the Centre borrowing and then lending to states, it recommended that states be allowed to borrow directly.
    • Since then, the debt obligation of states to the Centre has come down significantly, giving rise to questions over whether states that have repaid all borrowings from the Centre need to take Delhi’s approval at all for their future borrowings.
  • Also recommended that if states were to be given debt relief over and above the distribution of tax proceeds, conditions of fiscal discipline should be enforced.
  • Grants that were recommended by the Commission are however conditional  which may also have been criticised, but the counter-argument has been that it was aimed ultimately at improving governance.
  • It has also been pointed out that other federal structures too have equalisation grants.
  1. The Fourteenth Commission recommended the creation of a Fiscal Council; the Thirteenth had set out detailed measures on implementing GST with a grand bargain for states.

Challenges ahead of Fifteenth Finance commission

  1. As the Fifteenth Commission is set to be appointed, the criteria for distribution will be reviewed.
  2. The question is whether the commission will take into account the level of collections by each state after the roll out of the GST or not?
  3. The challenge this time will be the fact that unlike in the past, the share of net tax proceeds between the central government and states is almost equal.
  4. After the last Commission’s recommendation to distribute 42%, raising the bar on higher transfer of resources will have a much bigger impact on the federal government.
  5. The twelfth Finance Commission had suggested that it was time now to perhaps look at a Constitutional amendment to fix a ceiling on the distribution of the net tax proceeds, with the Finance Commission arbitrating on distributing tax proceeds among states.                                                                                             
  6. The Commission itself reckons that its biggest role has been to uphold the country’s federal structure, and to be an architect of fiscal restructuring – from being mainly an arbitrator between the Centre and states.
Finance Commission – Issues related to devolution of resources

How can the 14th Finance Commission advance cooperative federalism?


  1. The overall increase in the amount of financial resources will make state financially strong. Financial stability lends to a strong federation.
  2. The state will have more autonomy as there will no conditional transfers, states can decide expenditure on basis of their own priorities.
  3. Implementation of GST will also bring centre and state closer to each other on economic platform.
  4. Although, there is no clear direction on how to evaluate performance of Panchayats which is going to affect their financial stability.

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