Context (TH): The GoI appointed the 16th Finance Commission (FC) to determine the vertical distribution of revenue between the Centre and the States and the horizontal devolution between states.
About Finance Commission
TheFC is a constitutional body constituted by the President under Article 280 of the Constitution.
It is a Quasi-Judicial body constituted every 5th year or at such earlier time as the President deems necessary.
It consists of a chairman and 4 other members to be appointed by the President. They are eligible for re-appointment.
Qualifications of the members
Qualifications of the members are to be decided by the Parliament, as provided in the Constitution.
Accordingly, the Parliament has specified the following specifications:
The Chairman should be a person with experience in public affairs.
The members should be selected from amongst:
A Judge of the High Court or one qualified to be appointed as one.
A person who has specialized knowledge of finance and accounts of the government.
A person who has wide experience in financial matters and administration.
A person who has special knowledge of economics.
Recommendations
The Finance Commission makes recommendations to the President on
Distribution of net tax proceeds between the Centre and States and allocation between the states of respective shares of such proceeds.
Principles that govern grants-in-aid to the States by the Centre.
Measures needed to augment the Consolidated Fund of State to supplement resources of Panchayats and municipalities in the state.
Any other matter referred to it by the President in the interests of sound finance.
The Commission submits its report to the President, who lays it before both houses of the Parliament.
The recommendations made by the Finance Commission are only advisory in nature and not binding on the government.
State Finance Commission
Constitutional Basis: The SFC was established under the 73rd and 74th Constitutional Amendments in 1992 which aimed to strengthen local self-governance in India by providing constitutional status to panchayati raj institutions and municipalities.
Appointment: The Governor of each state is responsible for appointing the State Finance Commissioneveryfive years, as mandated by Article 243-I of the Constitution.
The Government of India has established the 16th Finance Commission under Article 280(1) of the Constitution. Dr. Arvind Panagariya is appointed as Chairman.
Terms of Reference for 16th Finance Commission
Distributing taxes between the Union and States and allocating State shares.
Principles governing grants-in-aid from the Consolidated Fund of India to States and grants under Article 275(empowers Parliament to make law to provide financial assistance to States in the form of grants-in-aid charged to the revenue of India) for specific purposes.
Measures to boost State Consolidated Funds for supporting Panchayats and Municipalities based on State Finance Commission recommendations.
Review current financing structures related to disaster management under the Disaster Management Act of 2005, proposing improvements or changes.
Issues in Financial Devolution
Firstly, cess and surcharge, estimated at around 23% of its gross tax receipts, are not shared with the States.
The total tax revenue for the years 2022-23 (actual), 2023-24 (revised estimates) and 2024-25 (Budget estimates) of the Union government is (₹30.5, ₹34.4, and ₹38.8 lakh crore), respectively.
The State’s share was (₹9.5, ₹11.0, and ₹12.2 lakh crore), respectively, which constitutes around 32% of the total tax receipts of the Centre. This is way less than the 41% recommended by the 15th FC.
Cess, like the GST compensation cess, is also used for centrally sponsored schemes that benefit the States. However, the States have no control over these components.
Secondly, the amount each State gets back for every rupee they contribute to Central taxes shows steep variation.
Industrially developed states received much less than a rupee for every rupee they contributed against states like Uttar Pradesh and Bihar.
This is because many corporations are headquartered in these state capitals, where they would remit their direct taxes, and there is a difference in GST collection among various states.
Thirdly, the percentage share in the divisible pool of taxes has been reducing for southern States over the last six FCs.
This is due to the higher weightage being given to equity (income gap) and needs (population, area, and forest) than efficiency (demographic performance and tax effort).
Finally, grants-in-aid varies among various States.
As per the 15th FC, there are revenue deficits, sector-specific and State-specific grants given to various States, and grants to local bodies. It is based on population and area of States.
Basis for allocation for Previous FC
The share of States from the divisible pool (vertical devolution) stands at 41% as per the recommendation of the 15th FC.
The distribution among the States (horizontal devolution) is based on various criteria. (See the figure below)
Vertical Fiscal Imbalance
Vertical Fiscal Imbalance (VFI) refers to the mismatch between revenue-raising powers and expenditure responsibilities of different levels of government in a federal system. For example, states incur about 61% of the revenue expenditure but collect only 38% of the revenue receipts.
The Indian Constitution divides financial duties between the Union government and the States. While the Union government is better positioned to collect certain taxes efficiently, the States are often best suited to provide public goods and services due to their proximity to citizens.
Importance of Reducing VFI
It enhances the efficiency of public spending by allowing States more autonomy in resource allocation.
It addresses the magnification of imbalances during crises, such as the COVID-19 pandemic.
It promotes a more equitable and responsive federal structure.
Role of the Finance Commission in Addressing VFI
The Finance Commission plays a pivotal role in addressing VFI through two main mechanisms:
Determining the distribution of taxes collected by the Union government to the States.
Recommending the allocation of these taxes across individual States.
Additionally, the Commission recommends grants under Article 275 of the Constitution, though these are typically short-term and purpose-specific.
Unconditional transfers from the Union government are primarily tax devolution from net proceeds, excluding cesses and surcharges.
Measuring Vertical Fiscal Imbalance
To measure VFI, the sum of Own Revenue Receipts (ORR) and tax devolution to Own Revenue Expenditure (ORE) for all states are calculated.
A ratio less than 1 indicates that the combined revenue receipts and tax devolution are insufficient to meet expenditure needs. The deficit in this ratio serves as a proxy for VFI after devolution.
To eliminate VFI, the average share of net proceeds devolved to States between 2015-16 and 2022-23 should have been 48.94%.
The 14th and 15th Finance Commissions recommended only 42% and 41%, respectively.
