The Finance Commission and the Fiscal Federalism Challenges

In the next months, the government plans to form a Finance Commission to address the critical issue of sharing the Centre’s tax money among the states. This article discusses the Finance Commission’s role in India’s fiscal federalism, focusing on the changing dynamics following reforms and the attendant discussions over the horizontal distribution formula.

Evolution of the Finance Commission

  • Constitutional Provision: The Finance Commission is a constitutional body established under Article 280 of the Indian Constitution. It was first constituted in 1951.
  • The major goal of the Finance Commission is to recommend the allocation of financial resources between the Union (Centre) and the States.
  • The Finance Commission is appointed every five years, or as directed by the President of India. The Commission’s recommendations are valid for five years.
  • The Commission is made up of a Chairman and other members chosen by the President. Typically, the Chairman has a background in economics, finance, or public administration.
  • Terms of Reference: The President establishes the terms of reference for each Finance Commission, which serve as a guide for the Commission’s deliberations and recommendations.

The Finance Commission’s Importance in India’s Fiscal Federalism

  • Distribution (vertical and horizontal): The Finance Commission decides the vertical share, which is the proportion of the Centre’s tax revenue that should be distributed to the states to ensure equitable resource allocation. It also develops the horizontal sharing formula, which dictates how revenue is dispersed across states.
  • Addressing Fiscal gaps: The Finance Commission plays a critical role in addressing these gaps by making financial transfers to less developed countries. The Commission bridges the budgetary gap and assists states with low revenue-raising capabilities through revenue shortfall grants and other ways.
  • Promoting Cooperative Federalism: By facilitating intergovernmental budgetary transfers, the Finance Commission operates as an institutional tool that encourages cooperative federalism. It promotes collaboration and coordination between the Centre and the States, establishing a sense of shared fiscal responsibility.
  • Article 280 of the Indian Constitution establishes the Finance Commission as a constitutional body. Its existence and operation are explicitly stated in the constitution, ensuring its independence and impartiality in providing recommendations.
  • Five-Year assessment Cycle: The Finance Commission’s regular appointment every five years assures a periodic assessment of the fiscal arrangements between the Centre and the States. This enables modifications and revisions in response to changing economic and social conditions, ensuring that fiscal transfers stay relevant and effective.
  • Expertise and Suggestions: The Finance Commission is made up of professionals in economics, finance, and public administration. Its suggestions are based on extensive research, consultations, and assessments of numerous criteria such as population, budgetary capability, and development requirements. These proposals provide useful insights and direction to the Centre and States in making fiscal decisions.
  • Resolving budgetary Conflicts: The Finance Commission assists in resolving budgetary conflicts and disputes between the Centre and the States. It creates a sense of fairness and openness in budgetary resource allocation by providing an independent and objective venue for negotiation and deliberation.
  • Increasing budgetary Discipline: The Finance Commission promotes budgetary discipline and accountability. It fosters responsible fiscal behaviour and discourages wasteful spending by monitoring the fiscal performance and requirements of the states.

Changes in dynamics following reforms

  • Reduced Role of Plan funding: Prior to reform, the Centre could compensate states through plan funding. However, following the reforms, there has been a decrease in new investments in public sector enterprises (PSUs), as well as the elimination of the Planning Commission in 2014. As a result, the Finance Commission has become the principal instrument for vertical and horizontal resource distribution, increasing the importance of its position.
  • Transfer of Tax Revenues: States were awarded a part of the Centre’s tax income pool when the Constitution was amended in 2000. The devolution of tax revenues has strengthened the importance of the Finance Commission in allocating monies between the Centre and the States.
  • Shift in Population statistics: The usage of population statistics in evaluating resource distribution has shifted from utilising 1971 census data to considering 2011 census data. This trend has sparked discussions and disputes, especially among states that have effectively managed population growth rates, because it may damage their share of devolution.
  • Deepening Faultlines: Faultlines between states have widened in recent years along political, economic, and fiscal dimensions. Election results and regional variations in infrastructure, corporate investment, social indices, and the rule of law have increased the north-south divide and highlighted regional inequities. The Finance Commission faces difficulty in managing these faultlines while ensuring equitable distribution.
  • Concerns about Fiscal Incapacity vs. Fiscal Irresponsibility: The Finance Commission must determine whether a state’s deficit is the result of fiscal incapacity or fiscal irresponsibility. Striking a balance between aiding deficit-ridden states and penalising fiscally responsible ones is a difficult undertaking, as greater assistance to one state would imply less assistance to others.
  • Changing Economic Environment: The post-reform period in India’s economic landscape has seen adjustments, with certain states seeing faster growth rates and greater budgetary capacity than others. This dynamic necessitates the Finance Commission taking into account shifting economic realities and ensuring that the distribution formula represents the current situation.

Addressing concerns about cesses and surcharges

  • Clear Directions: The Finance Commission should establish clear instructions for when and under what conditions cesses and surcharges can be imposed. Cessations and surcharges should not be employed as routine measures, but rather as extraordinary instruments to address special requirements or issues, according to these guidelines.
  • The Finance Commission may propose a formula or procedure to limit the amount that can be raised through cesses and surcharges. This would prevent over-reliance on these mechanisms and ensure that they do not constitute a significant component of the Centre’s total tax revenue.
  • Transparency and Accountability: The government should improve transparency and accountability in the use of proceeds from cesses and levies. It should issue frequent reports on how these monies are being used, illustrating how they contribute to the intended purposes and benefit states and the wider economy.
  • Consultation with States: When developing rules for cesses and surcharges, the Finance Commission should communicate extensively with states. States should be able to provide feedback, express their concerns, and propose solutions to establish a balance between the Centre’s income requirements and the states’ financial autonomy.
  • Alignment with Fiscal Responsibility: Any cesses and surcharges should be consistent with fiscal responsibility and budget management standards. The Finance Commission can guarantee that these mechanisms are used wisely and do not contradict the FRBM Act’s fiscal discipline goals.
  • Review and Evaluation: The effects of cesses and surcharges should be reviewed and evaluated on a regular basis to determine their effectiveness in accomplishing the desired goals. The Finance Commission can play an important role in monitoring the use of these instruments and recommending required changes depending on the results of the evaluation.

Implementing freebie restrictions

  • Simple Definition: To avoid uncertainty and resource exploitation, a clear definition of what constitutes a freebie must be established. It should include non-essential handouts or subsidies as well as actions that go beyond vital public services and infrastructure development.
  • The Finance Commission can emphasise the necessity of following to fiscal responsibility principles and operating within financial restrictions. This guarantees that resources are used wisely and sustainably, avoiding the building of unsustainable debt.
  • Essential Services Prioritisation: Encourage governments to prioritise critical public services above non-essential freebies, such as healthcare, education, and infrastructure. This guarantees that resources are directed towards areas that will have a greater and longer-term impact on the population’s overall well-being and development.
  • Evaluation of Impact: It is critical to assess the impact of freebies on the economy, fiscal health, and the intended beneficiaries on a regular basis. This assessment can assist in identifying any unexpected implications, potential resource waste, or negative effects on economic growth.
  • Public knowledge and Discourse: Raising public knowledge about the consequences of excessive freebies and the significance of budgetary responsibility. Citizens, governments, and professionals can gain a better understanding of the long-term effects of unsustainable handouts by encouraging open speech and dialogue.
  • The Finance Commission’s role: The Finance Commission can play a critical role in developing rules and suggestions for limiting freebies. This involves advising on prudent fiscal management and ensuring that resource allocation is consistent with long-term development objectives.

@the end

The Finance Commission is critical to India’s fiscal federalism. Concerns about cesses, surcharges, and freebies must be addressed by the Commission, which must offer clear principles, promote transparency, and emphasise long-term fiscal sustainability. Stakeholder consultation, frequent evaluation, and public awareness are critical to striking a balance between satisfying welfare requirements and encouraging fiscal responsibility.

And get notified everytime we publish a new blog post.