The Fourteenth Finance Commission: FAQs

1.       What is a Finance Commission?

The Finance Commission is a body set up by the President of India every 5 years under Article 280 of the Constitution.  It consists of a Chairman and four members. The main task of the Commission is to make recommendations about the distribution of tax revenues between the Centre and states. For doing so, it consults with various ministries and departments, as well as stake holders and policy makers at the state and local government level. 

2.       What is the Fourteenth Finance Commission?

The Fourteenth Finance Commission (FC-14) was constituted by the President on 2 January 2013. Dr.  Y. V. Reddy was appointed as the Chairman.  Three full time members (Ms. Sushama Nath, Dr. M. Govinda Rao and Dr. Sudipto Mundle) and one part-time member (Prof. Abhijit Sen) were also appointed. The recommendations of FC-14 cover the five year period from 2015-16 to 2019-20. The final report was submitted in December 2014, and made public in February 2015[1].

3.       What does the Finance Commission do?

The finance commission makes recommendations on the following:

(i)   Vertical Devolution: How gross tax revenues should be distributed between the Centre and States

(ii)   Horizontal Devolution: How the states’ tax quota should be apportioned between different states

(iii)  The principles on which states should be given grants in aid from the Consolidated fund of India.

(iv)  How to augment the Consolidated Funds of States to add to the resources of Panchayats and Municipalities

(v)   Review the state of finances and debt levels of the Union and States and review the fiscal consolidation process.

Of these recommendations, (i) and (ii) usually receive the most media attention since they have an important  bearing on the Centre’s fiscal position as well as the flow of funds to states.

4.       Why do we need a Finance Commission?

In most federal systems, there are vertical and horizontal fiscal imbalances. Vertical imbalances occur because the central government has the power to levy and/or appropriate more taxes than the states. As a result states do not have sufficient tax revenues to fund their expenditures. This is resolved by allocating some taxes from a common divisible tax pool to states.

Horizontal imbalances occur because states have different levels of development, income and expenditure. Some states have high incomes, and can deliver public services such as roads, schools, and hospitals from their own revenues. Others may struggle to even pay salaries of civil servants. The aim of the Finance Commission is to ensure that all states have enough resources to fund a minimum level of expenditure each year.

5.       How did the Fourteenth Finance Commission allocate union taxes to states?

The Finance commission transfers funds to states in two ways: (i) through devolution of taxes from the common divisible pool and (ii) through grants.  Grants form a small part of FC transfers; the bulk is through tax devolution.

FC-14 recommended that the share of states in taxes be increased from the existing 32 per cent to 42 per cent of the divisible tax pool. This is the highest increase ever by any finance commission. In 2014-15; states received Rs 3.82 trillion as share of taxes; in 2015-16, they will receive Rs.5.79 trillion. By 2019-20, their share is expected to rise to over Rs.10 trillion.

The central and state governments have opposing views when it comes to vertical devolution. The Centre was keen to stick to the old devolution rate of 32% in order to retain more fiscal space. Caught between the conflicting goals of keeping the fiscal deficit within target and simultaneously increasing capital expenditure on infrastructure projects, the central government needs all the resources it can get[2]. On the other hand, most state governments want more devolution, with some states arguing for a share in those centrally levied surcharges and cess that are not normally shared with states.

6.       How did the Fourteenth Finance Commission allocate taxes among states?

The distribution of taxes among states will be based on six criteria, each appropriately weighted to reflect its importance, as shown below.

Pic 1: Horizontal Devolution

Source: Fourteenth Finance Commission Report

The highest weight is assigned to income distance, which is defined as the distance of actual per capita income of a state from the state with the highest per capita income[3]. The farther a state is from the highest per capita state, the more transfers it will get from tax devolutions.   Population ranks second in importance, since states with a higher population tend to have higher expenditure needs. The population of a state is based on the 1971 census. In order to take into account changes in the structure of population due to demographic shifts, changing fertility rates or migration, an additional 10% weight is assigned to the population according to the 2011 census.  Area has a 15% weight in devolution, because a state with a larger area needs more resources to deliver the same facilities to its residents as compared to a smaller state.  Finally, forest cover is viewed as being critical to maintain ecological balance, but the trade off is that the land is not available for any economic activity. Hence forest cover has a moderate weight of 7.5%.

7.       So how does the divisible pool of taxes get divided between the states?

This table shows the share of the tax pool that will devolve to each state between 2015 and 2020.

Pic 2 State-wise Share of Tax Pool

Source: Fourteenth Finance Commission Report

The highest share goes to Uttar Pradesh (17.9%), simply because of its population (highest), and low per capital state domestic product (the lowest was Bihar, UP was the second from the bottom). Bihar also gets a high portion of union taxes (9.7%) as its income is quite far from all-states average per capita income. The north-eastern states receive a very low share of union taxes, because they are covered by special unconditional central aid that covers their expenditures.

8.       Is the distribution of taxes fair?

The distribution of taxes may seem unfair because there is no provision to reward states for fiscal discipline, or sound revenue management, or even progress on human indicators. The existing criteria actually reward poorly performing states:  the lower they are on the per capita income scale; the more they get from the union tax pool.  Many states had suggested that the length of time for which they maintain fiscal discipline should also be given a significant weight to encourage consistent fiscal prudence; but FC-14 has dropped fiscal performance altogether as a criterion for horizontal devolution.

It must be noted that the finance commission is not a body that rewards economic performance; its aim is to ensure that distribution among states creates more equitable resources. Poorer states, or states with larger populations and large areas need more funds to compete with those that have advantages in these areas. 

9.       What will be the impact of FC-14 recommendations?

States are keen that the bulk of transfers from the centre flow as tax devolutions or untied grants. There has been an increase in grants for Centrally Sponsored Schemes in recent years. Such grants require states to make matching contributions and do not give them the autonomy to design or implement the schemes. They are also “one-size-fits-all” schemes;  as they are not tailored to the specific ground level requirements of each state. FC-14 strongly recommends that the centre reduce the number of Centrally Sponsored Schemes, and instead move the resources directly to the states so that they can design, implement and monitor the end use of funds at the state and local level.

Co-operative federalism- the aim of the present government- is best served through formula based, non-discretionary transfers such as tax devolution. The increase in tax devolution rate, therefore, may be an important step towards shifting the institutional mechanism towards transfers that promote states’ fiscal autonomy.