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.

Banking sector in India

Commercial Banks: Commercial Bank may be defined as the financial institutions that deals with deposit and advances of a business organization [RBI is not a commercial bank]. These are of three type:

• Public Sector Bank ( 19 GoI undertaking + 1 IDBI + 1 SBI + 5 SBI Associate)

• Private Sector Bank (ICICI,YES,AXIS etc whose head office is in India)

• Foreign Banks (HSBC,BANK OF AMERICA etc whose head office is overseas)

Assets and Liabilities: for a bank asset is advances (loans) and liabilities is deposits.

Types of deposit: 

• Term Deposit (That is open for a particular time period e.g. FD)

• Demand Deposit (Current Account Saving Account)

Repo Rate: Repo rate is a measure to control the flow of money supply in the market. It is a rate at which Central Bank (RBI) lends funds to commercial banks. Regulated by RBI.
Reverse Repo Rate: it is a rate at which banks parks their access money with RBI. Regulated by RBI.  (Repo Rate -1) 
CRR( Cash Reserve Ration): The portion of the bank’s net time and demand liabilities that is to be maintained with RBI is CRR. Regulated by RBI.
SLR (Statuary Liquidity Ration): The portion of the bank’s net time and demand liabilities that is to be maintained with Bank in the form of liquid (that is easily encashable like gold or government bond or securities) is SLR. Regulated by RBI.
How much a bank can lend for advances: Suppose total income =100. Than SLR =23 CRR =4 to be reserved. Rest 73 can be given as advances.

Note1: Reducing any rate means flowing the money in the market. Increasing any is vice versa.
Note2: Repo and Reverse repo are also called as liquidity adjustment facility (absorption and infusion of money; repo is infusion and reverse repo is absorption) If repo is increased bank will borrow money at high rate and also bank will lend the money to customer at higher rate and vice versa.

Supply of money:

RBI  --       <----Banks----Customer-----Market

RBI lends money to banks banks lends to customer, customer invests in market.
If supply of money is in access purchasing power will increase for customer (Because if you have money you will invest it somewhere or you will purchase any goods). Purchasing power increases means inflation increases. So RBI increases the rate. And vice versa.


Priority Sector Lending:
Priority sector refers to those sectors of the economy which may not get timely and adequate credit in the absence of this special dispensation. Typically, these are small value loans to farmers for agriculture and allied activities, micro and small enterprises, poor people for housing, students for education and other low income groups and weaker sections.

Priority Sector includes the following categories:
(i) Agriculture
(ii) Micro and Small Enterprises
(iii) Education
(iv) Housing
(v) Export Credit

Nostro and Vostro Account:  Nostro account is account maintained in a foreign bank by domestic bank. Vostro account is account maintained in domestic bank of a foreign bank.

Non Performing Assets (NPA):  Any bank asset(advance or loans) of which principal and interest amount is not repaid for a certain period of time is called Non Performing Assets. Generally if principal of an asset is not repaid in 90 days or interest is not repaid in 180 days the asset is classified as non performing asset (NPA).

Real time Gross Settlement(RTGS): The acronym 'RTGS' stands for Real Time Gross Settlement, which can be defined as the continuous (real-time) settlement of funds transfers individually on an order by order basis (without netting). 'Real Time' means the processing of instructions at the time they are received rather than at some later time; 'Gross Settlement' means the settlement of funds transfer instructions occurs individually (on an instruction by instruction basis). Considering that the funds settlement takes place in the books of the Reserve Bank of India, the payments are final and irrevocable.
National Electronic Fund Transfer: National Electronic Funds Transfer (NEFT) is a nation-wide payment system facilitating one-to-one funds transfer. Under this Scheme,  individuals, firms and corporates can electronically transfer funds from any bank branch to any individual, firm or corporate having an account with any other bank branch in the country participating in the Scheme.

Note1: For transferring the funds through RTGS and NEFT the bank branches should be RTGS and NEFT enabled as the case may be.
Note2: Limit for NEFT: no minimum or maximum limit however PAN card is mendatory for NEFT remittance for more than 50,000). For RTGS minimum limit is 2,00,000 but there is no upper limit.

Base Rate: It is a minimum interest rate below which bank can not lend [advances/loans] to customer. It is determined by banks themselves.

SWIFT: Society for Worldwide Inter-bank Financial Telecommunication is a messaging system through which financial messages pass from one financial institute to other financial institute. It is a internationally acceptable financial messaging system. For ant messaging through SWIFT a bank must have a SWIFT code. It is helpful in forex transaction.

IFSC: IFSC or Indian Financial System Code is an alpha-numeric code that uniquely identifies a bank-branch participating in the NEFT system. This is an 11 digit code with the first 4 alpha characters representing the bank, and the last 6 characters representing the branch. The 5th character is 0 (zero). IFSC is used by the NEFT system to identify the originating / destination banks / branches and also to route the messages appropriately to the concerned banks / branches. It is used for domestic transaction in India.

Electronic Clearing System (ECS): ECS is an electronic mode of payment / receipt for transactions that are repetitive and periodic in nature. ECS is used by institutions for making bulk payment of amounts towards distribution of dividend, interest, salary, pension, etc., or for bulk collection of amounts towards telephone / electricity / water dues, cess / tax collections, loan installment repayments, periodic investments in mutual funds, insurance premium etc. Essentially, ECS facilitates bulk transfer of monies from one bank account to many bank accounts or vice versa.
ECS Credit is used by an institution for affording credit to a large number of beneficiaries (for instance, employees, investors etc.) having accounts with bank branches at various locations within the jurisdiction of a ECS Centre by raising a single debit to the bank account of the user institution. ECS Credit enables payment of amounts towards distribution of dividend, interest, salary, pension, etc., of the user institution.
ECS Debit is used by an institution for raising debits to a large number of accounts (for instance, consumers of utility services, borrowers, investors in mutual funds etc.) maintained with bank branches at various locations within the jurisdiction of a ECS Centre for single credit to the bank account of the user institution. ECS Debit is useful for payment of telephone / electricity / water bills, cess / tax collections, loan installment repayments, periodic investments in mutual funds, insurance premium etc., that are periodic or repetitive in nature and payable to the user institution by large number of customers etc.
Functions of RBI :
Monetary Authority:

• Formulates, implements and monitors the monetary policy.

• Objective: maintaining price stability and ensuring adequate flow of credit to productive sectors.

Regulator and supervisor of the financial system:

• Prescribes broad parameters of banking operations within which the country''s banking and financial system functions.

• Objective: maintain public confidence in the system, protect depositors'' interest and provide cost-effective banking services to the public.

• Regulator and supervisor of the payment systems   

1. Authorises setting up of payment systems
2. Lays down standards for operation of the payment system
3. Issues direction, calls for returns/information from payment system operators.

Manager of Foreign Exchange

• Manages the Foreign Exchange Management Act, 1999.

• Objective: to facilitate external trade and payment and promote orderly development and maintenance of foreign exchange market in India.

Issuer of currency:

• Issues and exchanges or destroys currency and coins not fit for circulation.

• Objective: to give the public adequate quantity of supplies of currency notes and coins and in good quality.

Developmental role:

• Performs a wide range of promotional functions to support national objectives.

Related Functions:

• Banker to the Government: performs merchant banking function for the central and the state governments; also acts as their banker.

• Banker to banks: maintains banking accounts of all scheduled banks.

Other Name of RBI:
Banker’s Bank
Government’s bank
Lender of the last Resort
Central Bank
Manager of foreign exchange

RBI Guidelines for Issuing Licence to Nw banks in private sectors:

Following are the highlights of the Reserve Bank of India's guidelines for licensing of new banks in the private sector:

• Corporates, PSUs and NBFCs can set up a bank.

• No bar on entities in sectors like brokerage, realty Minimum paid-up equity capital to be Rs. 500 crore.

• New banks to get listed within 3 years of business.

• Foreign shareholding limited to per cent for first 5 years.

• RBI to seek feedback on applicants' background from other regulators, Income Tax, CBI and ED.

• Licence seeker should have 10 years of successful financial track record, sound credentials and integrity.

• To comply with priority sector lending targets; open at least 25 per cent branches in unbanked rural areas.

• Boards to have majority of independent directors.

• Business plan should be realistic, viable and address financial inclusion.            

Economic Survey of India 2014-15: Highlights

Union Finance Minister Arun Jaitely on 27 February 2015 presented Economic Survey of India 2014-15 in the Parliament. 

The Economic Survey reviews the developments in the Indian economy over the previous 12 months, summarises the performance on major development programmes and highlights the policy initiatives of the government and the prospects of the economy in the short to medium term.

Three pronged strategy suggested in Economic Survey 2014-15

• To improve the investment climate and reduce the backlog of stalled projects, Economic Survey 2014-15 suggested a three-pronged strategy, namely
• Revival of public investment in short term, to act as an engine of growth in infrastructure sector. It argues that public investment cannot be a substitute for private investment; but is required as a complement and to crowd it in.
• Need of creative solutions to strengthen institutions relating to bankruptcy. This will ensure that exit options are available. This will also ameliorate over-indebtedness that lowers the capacity to generate new investments. Towards this end, it contemplates setting up of a high-powered Independent Renegotiation Committee.
• Economic Survey highlights the need for reorientation and restructuring of the PPP model. This is expected to make them more viable in future.

Main Highlights of the Economic Survey 2014-15

General Highlights

• Using the new estimate for 2014-15 as the base, GDP growth at constant market prices is expected to accelerate to between 8.1 and 8.5 percent in 2015-16.
• Inflation declined by over 6 percentage points since late 2013 which is likely to remain in the 5-5.5 percent range in 2015-16, creating space for easing of monetary conditions.
• The current account deficit declined from a peak of 6.7 percent of GDP in Quarter 3 of 2012-13 to an estimated 1.0 percent in the fiscal year 2015-16.
• After a nearly 12-quarter phase of deceleration, real GDP has been growing at 7.2 percent on average since 2013-14, based on the new growth estimates of the Central Statistics Office.
• Foodgrains production for 2014-15 is estimated at 257.07 million tonnes, which will exceed average food grain production of last five years by 8.5 million tones
• Foreign portfolio flows have stabilized the rupee, exerting downward pressure on long-term interest rates which is reflected in yields on 10-year government securities and surge in equity prices.
• From a cross-country perspective, a Rational Investor Ratings Index (RIRI) which combines indicators of macro-stability with growth illustrates that India ranks amongst the most attractive investment destinations.
• It ranks well above the mean for its investment grade category (BBB), and also above the mean for the investment category above it (on the basis of the new growth estimates).
• In the short run, growth will receive a boost from the cumulative impact of reforms, lower oil prices, likely monetary policy easing facilitated by lower inflation and improved inflationary expectations, and forecasts of a normal monsoon in 2015-16.
• Growth in medium-term prospects will be conditioned the “balance sheet syndrome with Indian characteristics” that has the potential to hold back rapid increases in private sector investment.
• In the long-run, private investments will be the engine of growth. However, there is a case for reviving targeted public investment as an engine of growth in the short run to complement and crowd-in private investment.
• Expenditure control and expenditure switching from consumption to investment will be the key to growth in the short-run
• It calls for complementing Make in India initiative with Skill India initiative to enable a larger section of the population to benefit from the structural transformation that such sectors will facilitate.
• The Survey emphasizes on creation of a National Market for Agricultural Commodities in place of thousands of agricultural markets
• The Model APMC Act, 2003 should be amended along the lines of the Karnataka Model that has successfully introduced an integrated single licensing system.

Fiscal Framework

• The Survey calls for adhering to the medium-term fiscal deficit target of 3 percent of GDP. This will provide the fiscal space to insure against future shocks and also to move closer to the fiscal performance of its emerging market peers.
• It also calls for moving toward the golden rule of eliminating revenue deficits and ensuring that, over the cycle, borrowing is only for capital formation.
• Expenditure control combined with recovering growth and the introduction of the GST will ensure that medium term targets are comfortably met.
• In the short run, the need for accelerated fiscal consolidation will be conditioned by the recommendations of the Fourteenth Finance Commission (FFC).
• The quality of expenditure needs to be shifted from consumption, by reducing subsidies, towards investment.

Subsidies and the JAM Number Trinity Solution

• Food Subsidy Bill stands at 107823.75 crore rupees during 2014-15 (up to January 2015) which means an increase of 20 percent over previous year
• The direct fiscal cost of select subsidies is roughly 378,000 crore rupees or 4.2 percent of GDP in 2011-12.  
• 41 percent of subsidy given for the PDS kerosene is lost as leakage and only 46 percent of the remaining 59 percent is consumed by households that are poor.
• The JAM Number Trinity – Jan Dhan Yojana, Aadhaar, Mobile – can enable the State to transfer financial resources to the poor in a progressive manner without leakages and with minimal distorting effects.

Indian Railways and Public Investment

• The Indian Railways over the years has been plagued by host of issues. Some of them include underinvestment resulting in lack of capacity addition and network congestion; neglect of commercial objectives; poor service provision; and consequent financial weakness.  These have cumulated to below-potential contribution to economic growth.
• As a result, the competitiveness of Indian industry has been undermined. Calculations reveal that China carries thrice as much coal freight per hour compared to India. Coal is transported in India at more than twice the cost vis-à-vis China, and it takes 1.3 times longer to do so.
• The railways public investment multiplier (the effect of a 1 rupee increase in public investment in the railways on overall output) is around 5.
• In the long run, the railways must be commercially viable and public support must be linked to railway reforms. These include adoption of commercial practices, tariff rationalization, and technology overhaul.

Union Budget 2015-16

Union Budget 2015-16 Highlights:

 TAXATION
1. Abolition of Wealth Tax.
2. Additional 2% surcharge for the super rich with income of over Rs. 1 crore.
3. Rate of corporate tax to be reduced to 25% over next four years.
4. No change in tax slabs.
5. Total exemption of up to Rs. 4,44,200 can be achieved.
6. 100% exemption for contribution to Swachch Bharat, apart from CSR.
7. Service tax increased to14 percent.

AGRICULTURE
1. Rs. 25,000 crore for Rural Infrastructure Development Bank.
2. Rs. 5,300 crore to support Micro Irrigation Programme.
3. Farmers credit - target of 8.5 lakh crore.

INFRASTRUCTURE
1. Rs. 70,000 crores to Infrastructure sector.
2. Tax-free bonds for projects in rail road and irrigation
3. PPP model for infrastructure development to be revitalised and govt. to bear majority of the risk.
4. Atal Innovation Mission to be established to draw on expertise of entrepreneurs, and researchers to foster scientific innovations; allocation of Rs. 150 crore.
5. Govt. proposes to set up 5 ultra mega power projects, each of 4000MW.

EDUCATION
1. AIIMS in Jammu and Kashmir, Punjab, Tamil Nadu, Himachal Pradesh, Bihar and Assam.
2. IIT in Karnataka; Indian School of Mines in Dhanbad to be upgraded to IIT.
3. PG institute of Horticulture in Amritsar.
4. Kerala to have University of Disability Studies
5. Centre of film production, animation and gaming to come up in Arunachal Pradesh.
6. IIM for Jammu and Kashmir and Andhra Pradesh.

DEFENCE
1. Allocation of Rs. 2,46,726 crore; an increase of 9.87 per cent over last year.
2. Focus on Make in India for quick manufacturing of Defence equipment.

WELFARE SCHEMES
1. GST and JAM trinity (Jan Dhan Yojana, Aadhaar and Mobile) to improve quality of life and to pass benefits to common man.
2. Six crore toilets across the country under the Swachh Bharat Abhiyan.
3. MUDRA bank will refinance micro finance orgs. to encourage first generation SC/ST entrepreneurs.
4. Housing for all by 2020.
5. Upgradation 80,000 secondary schools.
6. DBT will be further be expanded from 1 crore to 10.3 crore.
7. For the Atal Pension Yojana, govt. will contribute 50% of the premium limited to Rs. 1,000 a year.
8. New scheme for physical aids and assisted living devices for people aged over 80 .
9. Govt. to use Rs. 9,000 crore unclaimed funds in PPF/EPF for Senior Citizens Fund.
10. Rs. 5,000 crore additional allocation for MGNREGA.
11. Govt. to create universal social security system for all Indians.

RENEWABLE ENERGY
1. Rs. 75 crore for electric cars production.
2. Renewable energy target for 2022: 100K MW in solar; 60K MW in wind; 10K MW in biomass and 5K MW in small hydro

TOURISM
1. Develpoment schemes for churches and convents in old Goa; Hampi, Elephanta caves, Forests of Rajasthan, Leh palace, Varanasi , Jallianwala Bagh, Qutb Shahi tombs at Hyderabad to be under the new toursim scheme.
2. Visa on Arrival for 150 countries.

GOLD
1. Sovereign Gold Bond, as an alternative to purchasing metal gold.
2. New scheme for depositors of gold to earn interest and jewellers to obtain loans on their metal accounts.
3. To develop an Indian gold voin, which will carry the Ashok Chakra on its face, to reduce the demand for foreign coins and recycle the gold available in the country.

FINANCIAL SECTOR
1. Forward Markets Commission to be merged with the Securities and Exchange Board of India
2. NBFCs registered with the RBI and having asset size of Rs 500 crore and above to be considered as ‘financial institution’ under Sarfaesi Act, 2002, enabling them to fund SME and mid-corporate businesses
3. Permanent Establishment norms to be modified to that mere presence of offshore fund managers in the country does not lead to “adverse tax consequences.”