Role Of Finance Commission In India

This article has been written by Shristi S. from Maharashtra National Law University, Aurangabad

Table of Contents

ABSTRACT

India’s Finance Commission is a constitutional authority that plays a crucial part in the management of the country’s finances. It was created in accordance with Article 280 of the Indian Constitution, and its main duty is to suggest how money should be split between the federal and state governments.

An overview of the pivotal role the Finance Commission has played in advancing fiscal federalism, economic fairness, and cooperative fiscal management in India is given in this abstract. The Finance Commission evaluates the financial needs and resources of both the national and state governments using a methodical approach, often in five-year cycles. The recommendations include a wide range of financial topics, including debt management, tax devolution, grants-in-aid, and fiscal restraint.

The Commission assures a just and equitable distribution of resources while taking into consideration the changing economic and social dynamics of the nation through a collaborative and data-driven process. The reduction of state budget disparities is one of the Finance Commission’s main goals.

It accomplishes this by allocating resources based on a number of factors, including population, income distance, and fiscal capability. By ensuring that states with different degrees of development receive an equitable amount of federal funding, this strategy promotes economic justice and lessens regional inequalities.

The Finance Commission is also crucial in promoting budgetary restraint among the federal and provincial governments. It evaluates the fiscal health of the states and offers incentives for responsible financial management. At both levels of government, this contributes to ensuring fiscal stability and accountability. The Finance Commission deals with new fiscal problems and issues that the nation is confronting in addition to resource distribution.

It offers advice on issues like the Goods and Services Tax (GST) compensation to states, local government budget, and disaster relief. These proposals offer the government insightful advice on important fiscal issues. By serving as a link between the federal government and the states, the Finance Commission also supports cooperative federalism.

It encourages discussion, cooperation, and the establishment of consensus on budgetary issues, all of which are crucial for the nation’s overall economic growth and development.

INTRODUCTION

Brief Overview

An important and active organisation that is crucial to India’s fiscal landscape is the Finance Commission. It is a physical representation of India’s dedication to federalism, fair resource distribution, and economic growth.

The Finance Commission was established under Article 280 of the Indian Constitution, and its main responsibility is to determine how money should be split between the federal government and the states in order to maintain fiscal stability and socioeconomic advancement. This organisation, which has roots in the early years of the Republic, has developed into a key component of fiscal federalism in India.

Due to India’s unusual political structure, which consists of a union of states, a system must be in place to divide resources between the federal government and individual states in a fair and effective manner. The Finance Commission was designed with this objective in mind, embracing the values of fairness, effectiveness, and accountability in the allocation of resources. In addition to addressing economic imbalances over time, it fostered cooperative federalism by encouraging cooperation between the federal government and the states.

The duties of the Finance Commission span a wide range of duties, including the distribution of central taxes to states, grants-in-aid, and the evaluation of states’ financial health. The central and state governments’ budgetary allocations are impacted by its recommendations, which have an impact on important industries including education, healthcare, infrastructure, and rural development.

Since Indian federalism has complex dynamics and ramifications for the country’s economic development, understanding the role of the Finance Commission is crucial.

In this research, we explore the historical development, makeup, purposes, and guiding principles of the Finance Commission. We consider its implications for fiscal federalism, weigh the weight of its suggestions, and carefully consider the difficulties it faces. In order to fully comprehend the crucial role played by the Finance Commission in India’s governance and growth, we will look at how it shaped the country’s economic landscape.

Importance of Fiscal Federalism

Fiscal federalism is a critical concept in the field of public finance and governance, particularly in federal systems of government like that of India, the United States, Canada, and many others. It refers to the allocation of fiscal responsibilities and financial resources between different levels of government within a federal or decentralized system. The importance of fiscal federalism lies in several key aspects:

Balancing Centralization and Decentralization:

A balance between national leadership and local sovereignty can be achieved with the aid of fiscal federalism. It enables the separation of duties and authority between the federal government and subnational organisations (states, provinces, regions, etc.), ensuring that each level has the power and resources necessary to carry out its duties successfully.

Efficiency in Resource Allocation:

Allocating resources effectively is encouraged by fiscal federalism. The interests and priorities of the local community are frequently better understood by subnational administrations. The distribution of resources according to local conditions and preferences is made possible by the decentralisation of fiscal authority, which can result in a more efficient and productive use of resources.

Reduction of Regional Disparities:

By granting fiscal autonomy to subnational governments, fiscal federalism facilitates the reduction of regional disparities in economic growth and public service delivery. It allows regions with varying levels of development to allocate and allocate resources in a manner that is appropriate to their specific circumstances.

Enhancing Accountability:

Accountability is encouraged at both levels of government thanks to fiscal federalism. The central government is in charge of ensuring that subnational governments follow fiscal discipline and conform to specified standards, while subnational governments are held accountable for the use of resources allotted to them.

Innovation and Experimentation:

The delivery of services and the development of new policies are encouraged by fiscal decentralisation. As successful practises are followed by others, different governments or regions can implement policies that are specifically suited to their needs, fostering policy innovation and education.

Fiscal federalism is critical to fostering effective governance, lowering regional inequities, strengthening accountability, and balancing a variety of interests in federal systems of government. It is a key idea in the area of public finance and governance because it supports political stability, economic growth, and efficient public service delivery.

Purpose and Objectives of This Article

To educate and inform the audience about the existence and importance of the Finance Commission in India.
To trace the historical evolution of the Finance Commission, highlighting key milestones and amendments.
To understand how the Finance Commission’s role and functions have evolved over time in response to changing fiscal and economic circumstances.
To explore the composition and appointment process of the Finance Commission.
To examine how the Finance Commission operates, conducts its inquiries, and makes recommendations.

Ultimately, the primary objective of a project on the role of the Finance Commission in India is to provide a holistic understanding of this institution’s role and its impact on the Indian federal system, thereby contributing to informed discussions and decision-making in matters of fiscal federalism and resource allocation.

Historical Evolution of the Finance Commission

1.Genesis (1950–1951): On January 26, 1950, the Indian Constitution’s Article 280, which established the Finance Commission, went into effect. Its main goal was to address India’s fiscal imbalances and problems with financial integration at the time of independence. K.C. Neogi, who served as the commission’s head, established the first finance panel in 1951.

2.Early Phases (1950s–1960s): In the beginning, the Finance Commission’s main objectives were to suggest guidelines and standards for how tax income should be allocated between the federal government and state governments. It was designed to make sure that each state got a fair portion of the available funds. This work was continued by the second and third Finance Commissions, respectively led by C.D. Deshmukh and Mahavir Tyagi.

3.Transition to a Growing Economy (1970s-1980s): As India’s economy began to grow, the Finance Commission’s role evolved. It started addressing issues related to grants-in-aid to states, especially those with resource constraints. The fourth and fifth Finance Commissions, led by K. Brahmananda Reddy and N. Kaldor, played a crucial role in this transition.

4.Addressing Economic Reforms (1990s): The economic reforms of the early 1990s had a significant impact on India’s fiscal federalism. The Finance Commissions during this period, such as the eighth and ninth under the chairmanship of N.K. Singh, focused on adapting the fiscal framework to accommodate market-oriented reforms.

5.Integration of Local Government Finances (2000s-2010s): With the enactment of the 73rd and 74th Amendments to the Indian Constitution in 1992, the Finance Commission’s role expanded to include recommendations on sharing central revenues with local governments (Panchayats and Municipalities). The 10th and 11th Finance Commissions, led by A.M. Khusro and C. Rangarajan, respectively, played a key role in this integration

6.Tax devolution recommendations for the twenty-first century: The 21st-century Finance Commissions have concentrated on a number of important subjects, including:

advocating tax devolution between the federal government and the states while taking into account variables like population, economic disparity, and financial restraint.
offering suggestions for grants-in-aid while assessing the quality of each state’s finances.
addressing matters relating to the stabilisation, consolidation, and sustainability of the budget.
taking into account catastrophe relief needs and those of states in special categories.

7. Present-day difficulties and reforms: To address current issues with India’s fiscal federalism, the Finance Commission is constantly changing. It must take into account matters such as the Goods and Services Tax (GST) rollout, the effect of the COVID-19 epidemic on state budgets, and the requirement for equitable and sustainable resource allocation, to name a few.

8.15th Finance Commission (2020-2025): N.K. Singh served as the head of the 15th Finance Commission, which recommended grants-in-aid, tax devolution on both the horizontal and vertical axes, as well as other fiscal changes. It aimed to maintain fiscal restraint while achieving a balance between the demands of the states and the needs of the federal government.

Overall, the historical development of the Finance Commission demonstrates its capacity to adjust to shifting political and economic conditions in India. It is essential to encouraging fiscal federalism and a fair distribution of resources among the federal government, the states, and local governments. This promotes political and economic stability in India.

KEY AMENDMENTS AND REFORMS

The Finance Commission in India has undergone several key amendments and reforms over the years to adapt to changing economic, fiscal, and political circumstances. Here are some of the notable amendments and reforms related to the Finance Commission:

42nd Amendment Act (1976): This amendment made several changes related to the Finance Commission:

It extended the term of the Finance Commission from five to six years.
It allowed the Finance Commission to recommend the principles governing grants-in-aid to states out of the Consolidated Fund of India (CFI).

80th Amendment Act (2000): This amendment addressed the issue of sharing of revenues from the Central Sales Tax (CST):

It allowed the Finance Commission to recommend the principles for sharing CST proceeds between the center and states.
This amendment was crucial in the context of economic reforms and the phasing out of CST.

84th Amendment Act (2001): This amendment related to the panchayats and municipalities and had implications for the Finance Commission’s role:

It mandated that the Finance Commission would also make recommendations on the sharing of central revenues with local governments (panchayats and municipalities).
It extended the term of the Finance Commission to five years.

One Hundredth Amendment Act (2016): This amendment was related to the Goods and Services Tax (GST):

It allowed for the creation of a Goods and Services Tax Council to make recommendations on GST-related issues.
It specified that the recommendations of the GST Council would be considered by the Finance Commission when determining the revenue-sharing formula between the center and states.

Constitution (One Hundred and First Amendment) Act (2016): This was a significant amendment related to GST:

It introduced the Goods and Services Tax (GST) and abolished various indirect taxes. The Finance Commission had to adapt its recommendations in light of this major tax reform.

Change in Population Data: The Finance Commission has periodically adjusted its criteria for tax devolution based on population data. For instance, it shifted from using 1971 census data to 2011 census data for population-related factors in the 14th Finance Commission.

Performance-Based Grants: In recent commissions, there has been an increasing emphasis on performance-based grants, rewarding states for implementing key reforms in areas like education, health, and local governance.

Recommendations on Disaster Relief: The Finance Commission has taken into account the need for states to receive assistance in the wake of natural disasters and has recommended provisions for disaster relief funds.

Sustainability and Fiscal Responsibility: In the context of increasing fiscal deficits and debt levels in some states, the Finance Commission has focused on encouraging fiscal responsibility and sustainability.

Special Category States: The criteria for identifying special category states and determining the allocation of funds to these states have been subjects of reform and debate in recent Finance Commissions.

Composition and Appointment of the Finance Commission

The composition and appointment of the Finance Commission in India are specified in the Indian Constitution, primarily in Article 280. The Finance Commission is a constitutional body, and its composition and appointment process are as follows:

Composition of the Finance Commission:

The Finance Commission typically consists of the following members:

Chairperson: The Finance Commission is headed by a Chairperson, who is appointed by the President of India. The Chairperson is often an individual with a strong background in economics, finance, or public administration.

Four Other Members: In addition to the Chairperson, the Finance Commission includes four other members. These members are also appointed by the President.

Secretary: The Finance Commission is assisted by a Secretary, who is typically a senior officer from the Indian Administrative Service (IAS).

Appointment of the Members:

The appointment of the Chairperson and members of the Finance Commission follows a specific process:

Appointment by the President: The President of India appoints both the Chairperson and the other members of the Finance Commission. These appointments are typically made based on the recommendations of the Prime Minister.

Consultation with State Governments: Before appointing the members of the Finance Commission, the President consults with the Governor of each state. This consultation is aimed at ensuring representation and cooperation between the center and the states in matters related to fiscal federalism.

Tenure and Eligibility Criteria:

The tenure of the Finance Commission is specified in the Indian Constitution. According to Article 280:

The Finance Commission is typically appointed every five years. Its recommendations cover a five-year period known as the “award period.”
Members of the Finance Commission can be reappointed for subsequent terms, but they cannot be members of more than one Finance Commission.
There are no strict eligibility criteria specified in the Constitution for the Chairperson or members of the Finance Commission. However, they are usually individuals with expertise in economics, finance, or public administration.

Independence of the Finance Commission:

To ensure its independence, the Finance Commission is not subject to the direct control or influence of the central government. It operates autonomously and makes its recommendations based on objective criteria and principles laid out in the Constitution.

The Finance Commission plays a crucial role in the allocation of financial resources between the central government and state governments in India. Its recommendations on the distribution of tax revenues, grants-in-aid, and other fiscal matters are instrumental in promoting fiscal federalism and equitable resource allocation across the country.

Functions and Responsibilities of the Finance Commission

The Finance Commission in India has several important functions and responsibilities as outlined in Article 280 of the Indian Constitution. Its primary role is to address the fiscal imbalances and allocate financial resources between the central government and state governments. Here are the key functions and responsibilities of the Finance Commission:

Distribution of Tax Revenues: The Finance Commission recommends the principles and criteria for the distribution of certain taxes between the central government and state governments. These taxes include income tax, excise duty, and customs duties.
Grants-in-Aid to States: The Commission recommends grants-in-aid to states from the Consolidated Fund of India (CFI). These grants are provided to states with revenue deficits or those facing special circumstances that warrant additional financial assistance.
Review of State Finances: The Finance Commission examines the financial positions of state governments. It assesses factors such as revenue generation, debt levels, and fiscal management to determine the need for grants and financial support.
Assessment of Resources: It assesses the total revenue and expenditure requirements of the central government. This assessment helps in determining the resources available for allocation to states.
Resource Allocation: The Finance Commission makes recommendations on the distribution of net proceeds of taxes between the center and states, as well as among the states themselves. It uses various criteria like population, income distance, and fiscal capacity to allocate resources equitably.
Local Government Funding: The Finance Commission recommends the principles for sharing central revenues with local governments, including panchayats and municipalities. This is in line with the provisions of the 73rd and 74th Amendments to the Indian Constitution.
Advisory Role: While the Commission’s recommendations are not binding on the government, they hold significant weight and are usually accepted by the government with minor modifications. The Commission’s advisory role contributes to fiscal federalism and cooperative federalism in India.

The Finance Commission plays a critical role in ensuring the equitable distribution of financial resources, reducing inter-state disparities, and promoting fiscal responsibility across various levels of government in India. Its recommendations are crucial in maintaining the balance of powers and resources between the central government and state governments in the country’s federal system.

CHALLENGES AND CRITICISMS

The role of the Finance Commission in India has been subject to various challenges and criticisms over the years. These challenges and criticisms highlight certain areas where the functioning of the Finance Commission may face scrutiny or require reform. Some of the key challenges and criticisms include:

Political Interference: One common criticism is the potential for political interference in the functioning of the Finance Commission. There have been instances where the central government has influenced the Commission’s recommendations to favour certain states or political interests. This can undermine the Commission’s independence and objective decision-making.
Data Accuracy and Reliability: The Finance Commission relies on various data sources to make its recommendations, including population data, fiscal data, and socio-economic indicators. Critics argue that data accuracy and reliability can be compromised, leading to inaccuracies in resource allocation. Ensuring the availability of accurate and up-to-date data is a challenge.
Discontent Among States: States often express dissatisfaction with the Finance Commission’s recommendations, especially when they believe they are not receiving a fair share of financial resources. This discontent can lead to inter-state disputes and strains in the center-state relationship.
Criteria for Resource Allocation: The criteria used by the Finance Commission for resource allocation, such as population, income distance, and fiscal capacity, have faced criticism. Some argue that these criteria do not adequately account for the needs and priorities of states, leading to inequitable distribution.
Fiscal Responsibility: While the Finance Commission encourages fiscal discipline among states, there are concerns that some states continue to have high levels of debt and fiscal deficits. Critics argue that the Commission should take a more assertive role in ensuring fiscal responsibility.
Resource Constraints: Given the growing demand for resources at both the central and state levels, there may be limitations in meeting the financial requirements of all states. This can lead to competition and disputes over resource allocation.
Challenges of GST Implementation: The Goods and Services Tax (GST) has introduced complexities in tax revenue sharing between the center and states. The Finance Commission has had to adapt its recommendations to accommodate the new tax regime, which has presented challenges.
Economic Changes and Uncertainties: Economic fluctuations, global economic crises, and unforeseen events like the COVID-19 pandemic can disrupt fiscal planning and resource allocation. The Finance Commission may need to address such challenges in its recommendations.

To address these challenges and criticisms, there have been ongoing discussions and debates on reforms to improve the functioning of the Finance Commission. Reforms may include revisiting criteria for resource allocation, enhancing data accuracy, ensuring greater transparency, and strengthening the Commission’s independence from political interference. Additionally, the Commission itself can take steps to engage with states more effectively and consider their specific needs and circumstances when making recommendations.

The 15th Finance Commission and Recent Developments^[1]

Vertical Devolution (Devolution of Taxes of the Union to States):
It has recommended maintaining the vertical devolution at 41% – the same as in its interim report for 2020-21.
It is at the same level of 42% of the divisible pool as recommended by the 14th Finance Commission.
It has made the required adjustment of about 1% due to the changed status of the erstwhile State of Jammu and Kashmir into the new Union Territories of Ladakh and Jammu and Kashmir.
Horizontal Devolution (Allocation Between the States):
For horizontal devolution, it has suggested 12.5% weightage to demographic performance, 45% to income, 15% each to population and area, 10% to forest and ecology and 2.5% to tax and fiscal efforts
Revenue Deficit Grants to States:
Revenue deficit grants emanate from the requirement to meet the fiscal needs of the States on their revenue accounts that remain to be met, even after considering their own tax and non-tax resources and tax devolution to them.
Revenue Deficit is defined as the difference between revenue or current expenditure and revenue receipts, that includes tax and non-tax.
It has recommended post-devolution revenue deficit grants amounting to about Rs. 3 trillion over the five-year period ending FY26.

The number of states qualifying for the revenue deficit grants decreases from 17 in FY22, the first year of the award period to 6 in FY26, the last year.

Performance Based Incentives and Grants to States:

These grants revolve around four main themes.

The first is the social sector, where it has focused on health and education.

Second is the rural economy, where it has focused on agriculture and the maintenance of rural roads. The rural economy plays a significant role in the country as it encompasses two-thirds of the country’s population, 70% of the total workforce and 46% of national income.

Third, governance and administrative reforms under which it has recommended grants for judiciary, statistics and aspirational districts and blocks.

Fourth, it has developed a performance-based incentive system for the power sector, which is not linked to grants but provides an important, additional borrowing window for States.

Fiscal Space for Centre:

Total 15th Finance Commission transfers (devolution + grants) constitutes about 34% of estimated Gross Revenue Receipts to the Union, leaving adequate fiscal space to meet its resource requirements and spending obligations on national development priorities.

Grants to Local Governments:

Along with grants for municipal services and local government bodies, it includes performance-based grants for incubation of new cities and health grants to local governments.

In grants for Urban local bodies, basic grants are proposed only for cities/towns having a population of less than a million. For Million-Plus cities, 100% of the grants are performance-linked through the Million-Plus Cities Challenge Fund (MCF).

MCF amount is linked to the performance of these cities in improving their air quality and meeting the service level benchmarks for urban drinking water supply, sanitation and solid waste management.

Criticism

Performance based incentives disincentivizes independent decision-making. Any conditions on the state’s ability to borrow will have an adverse effect on the spending by the state, particularly on development thus, undermines cooperative fiscal federalism. It does not hold the Union government accountable for its own fiscal prudence and dilutes the joint responsibility that the Union and States have.

CONCLUSION

In conclusion, the Finance Commission plays a pivotal role in India’s federal system by addressing fiscal imbalances and allocating financial resources among the central government, state governments, and local governments. Its significance lies in promoting fiscal federalism, ensuring equitable distribution of resources, and contributing to economic equity and stability.

The Finance Commission’s functions and responsibilities encompass tax revenue distribution, grants-in-aid, fiscal discipline, assessment of state finances, and recommendations on resource allocation. It adapts to changing economic and political contexts, making it a dynamic institution in India’s governance.

While the Finance Commission has been instrumental in reducing inter-state disparities, promoting fiscal responsibility, and enhancing cooperative federalism, it also faces challenges and criticisms, including concerns about political interference, data accuracy, and the criteria for resource allocation. These challenges underline the need for ongoing reforms and improvements in the Commission’s functioning.

Despite these challenges, the Finance Commission remains a crucial institution in India’s democratic and federal framework. Its role in addressing fiscal disparities, ensuring accountability, and fostering cooperative governance is integral to India’s economic development and political stability. As India continues to evolve and face new fiscal challenges, the Finance Commission’s role remains indispensable in shaping the nation’s fiscal landscape.