1. What is a Finance Commission?
2. What is the Fourteenth Finance Commission?
3. What does the Finance Commission do?
4. Why do we need a Finance Commission?
5. How did the Fourteenth Finance Commission allocate union taxes to states?
6. How did the Fourteenth Finance Commission allocate taxes among states?
7. So how does the divisible pool of taxes get divided between the states?
8. Is the distribution of taxes fair?
9. What will be the impact of FC-14 recommendations?
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.
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.
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.
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%.
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.
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.
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.