Finance Commission

Published on 21 Jan 2025

Finance Commission 

Article 280 of the Constitution provides for a Finance Commission as a quasi-judicial body to be constituted by the President of India every five years. The Constitution envisages the Finance Commission as the balancing wheel of fiscal federalism in India.

Powers and Functions of Finance Commission

• Vertical devolution: Determine the share of state in the divisible pool of central taxes.

• Example: The 15th Finance Commission recommended vertical devolution to be 41%.

• Horizontal distribution: Determine the allocation of resources among states based on criterias like income distance, population, area, forest & ecology, demographic performance and tax efforts.

• Example: The 15th FC introduced Tax effort and Demographic performance criterias to recommend horizontal distribution of resources.

• Grant in aid: Determine the grant to be provided by the Centre to the states and the local bodies out of the Consolidated Fund of India.

• Example: The 15th Finance Commission has recommended state specific grant of 49599 crore and local bodies to receive a grant of 4.36 lakh crore. 17 states will receive revenue deficit grant.

• Advisory function: The measures needed to augment the Consolidated fund of a state to supplement the resources of the local bodies of the state.

Latest Finance Commission recommendations

The 15th Finance Commission was constituted for a five-year period starting from 2021-22 to 2025-26. The following are some of the observable recommendations.

• Vertical devolution: The devolution between the Centre and the state shall be maintained at 41% just like the interim report.

• Horizontal devolution: This was done based on the given parameters - Population (15%), Area (15%), Forest and Ecology (10%), Income Distance (45%), Tax and Fiscal efforts (2.5%) and Demographic performance (12.5%).

• Revenue deficit grants to states: Recommended an amount of 3 trillion over the five year period. The number of states to receive the grant will be 17 in 2022 and shall decrease in 6 in 2026.

• Sector specific grants: Grants worth 1.3 lakh crore will be given to states based on performance in eight sectors namely, health, education, higher education, agricultural reforms, road maintenance, judiciary, statistics and aspirational districts.

• State specific grants: 44599 crore has been kept aside to meet social needs, administrative infrastructure, water and sanitation, tourism etc.

• Performance based grants to local government: For million plus cities, grants will be based on their performance in improving air quality, drinking water supply, sanitation and waste management.

• Disaster risk management: The cost sharing between the centre and state to be 90:10 for special category states and 75:25 for other states.

• Fiscal roadmap: Suggested the Centre to bring down the fiscal deficit to  4% by 2025-26 and 3% for the states.

• Defense and Internal Security: Acknowledging the crucial role played by states in defense and internal security, the Commission proposed specific grants for these purposes.

• Population Data: Utilizing the 2011 Census data rather than the earlier 1971 Census for resource allocation, aiming to reflect the current demographic realities more accurately.

• Income Distance: The Commission considered the income distance factor, focusing on states with lower per capita incomes to bridge the gap and promote balanced development.

• Off-budget borrowings: Commission had red-flagged the off-Budget funding of welfare schemes through public sector entities and had urged the Centre to come clean on these

Issues concerning the recommendations

• Use of 2011 census data: This has negatively affected the funds devolved to southern states whose population has declined considerably over the past 40 years.

• Example: Tamil Nadu receives only 29 paise for the one rupee it contributed as tax while Uttar Pradesh gets 2.79 rupees for its one rupee.

• Devolution in favour of Centre: The states demand vertical distribution to be in their favour as limitations have been imposed on the revenue deficit grants.

• Example: In FY 22, states had a combined capital expenditure of 10.5 trillion while the centre managed 8.4 trillion. Hence states are demanding more.

• Conditionality over state’s borrowing: The states were expected to perform certain power sector reforms for them to have extra borrowings.

• Example: States were mandated to reduce operational losses, revenue gap and tariff subsidy to avail the extra borrowing of 0.5% of GSDP.

• Conditional grants to local bodies: Tied nature of these grants has a negative impact on the independent functioning of the local bodies.

• Example: 60% of the fund granted to the local body has been tied to water and sanitation service.

• Recommending the fiscal roadmap: The Finance Commission is not empowered to dictate the fiscal deficit target for the centre and state, thus overstepping their authority.

• Not addressed the issue of cess and surcharge: The usage of these instruments, which are not devolved to the states, has been increasing. The commission failed to address this.

Way Forward

• Increase the state share: The states should be given more fiscal space so that they are not getting strained by fiscal shortage.

• More equitable distribution: The devolution should also take into account the contributions from each state for sound horizontal distribution.

• Fiscal freedom to local bodies: The tied nature of grants to the local government must be reduced for more autonomous development.

The concerns of the states must be addressed during the 16th Finance Commission so that states get enough finance to function efficiently and fiscal federalism gets maintained in the nation.

Tags:
Polity

Keywords:
Constitutional bodies Finance commission Article 280 Fiscal federalism

Syllabus:
General Studies Paper 2

Topics:
Indian Constitution