Finance Commissions – A Historical Perspective

Vertical and horizontal imbalances are common features of most federations and India is no exception to this. The Constitution assigned taxes with a nation-wide base to the Union to make the country one common economic space unhindered by internal barriers to the extent possible. States being closer to people and more sensitive to the local needs have been assigned functional responsibilities involving expenditure disproportionate to their assigned sources of revenue resulting in vertical imbalances. Horizontal imbalances across States are on account of factors, which include historical backgrounds, differential endowment of resources, and capacity to raise resources. Unlike in most other federations, differences in the developmental levels in Indian States are very sharp. In an explicit recognition of vertical and horizontal imbalances, the Indian Constitution embodies the following enabling and mandatory provisions to address them through the transfer of resources from the Centre to the States
- Levy of duties by the Centre but collected and retained by the States (Article 268)
- Taxes and duties levied and collected by the Centre but assigned in whole to the States (Article 269).
- Sharing of the proceeds of all Union taxes between the Centre and the States under Article 270. (Effective from April 1, 1996, following the eightieth amendment to the Constitution replacing the earlier provisions relating to mandatory sharing of income tax under Article 270 and permissive sharing of Union excise duties under Article 272).
- Statutory grants-in-aid of the revenues of States (Article 275)
- Grants for any public purpose (Article 282).
- Loans for any public purpose (Article 293).
In addition to provisions enabling transfer of resources from the Centre to the States, a distinguishing feature of the Indian Constitution is that it provides for an institutional mechanism to facilitate such transfers. The institution assigned with such a task under Article 280 of the Constitution is the Finance Commission, which is to be appointed at the expiration of every five years or earlier. Under the Constitution, the main responsibilities of a Finance Commission are the following.
- The distribution between the Union and the States of the net proceeds of taxes which are to be divided between them and the allocation between the States of the respective shares of such proceeds.
- Determination of principles and quantum of grants-in-aid to States which are in need of such assistance.
- Measures needed to augment the Consolidated Fund of a State to supplement the resources of the Panchayats and Municipalities in the State on the basis of the recommendations made by the Finance Commission of the State.
The last function was added following the 73rd and 74th amendments to the Constitution in 1992 conferring statutory status to the Panchayats and Municipalities. These Constitutionally mandated functions are the same for all the Finance Commissions and mentioned as such in the terms of reference (ToR) of different Finance Commissions. To enable the Finance Commission to discharge its responsibilities in an effective manner, the Constitution vests the Finance Commission with power to determine its procedures. Under the Constitution, the President shall cause every recommendation made by the Finance Commission together with an explanatory memorandum as to the action taken thereon to be laid before each House of Parliament. So far, twelve Finance Commissions have given their reports. The Thirteenth Finance Commission is expected to give its report in October, 2009. The Union government has always been accepting the recommendations of the Finance Commissions, exception being the recommendations of the Third Commission relating to Plan grants. There have been major changes in the public finances of the Union and the States during the period of over 55 years covered by the Finance Commissions. A number of new matters have been refereed to the Commissions in consonance with these developments. How the different Finance Commissions have discharged their responsibilities in the ever changing fiscal situation is covered in the following sections under different heads.

Vertical Distribution

Initially, the Constitution provided for the sharing of only two Central taxes with States. Article 270 permitted mandatory sharing of the net proceeds of income tax levied and collected by the Union with the States. Such proceeds assigned to States did not form part of the Consolidated Fund of India. Article 272 provided for sharing of Union excise duties, if Parliament by law so provided. The shares of the States in Union excise duties were to be paid from the Consolidated Fund of India. This position continued till the 80th amendment of the Constitution in 2000 which provided for sharing of the proceeds of all Union taxes and duties with the States, except the Central sales tax, consignment taxes, surcharges on Central taxes and earmarked cesses. This was done taking into account the recommendation of the Tenth Finance Commission to enable the States to derive the advantage of sharing the buoyancy of all Central taxes, to ensure greater certainty in the resource flows to the States and to facilitate increased flexibility in tax reforms.
As per the then Constitutional provisions, tax sharing recommended by the first ten Finance Commissions was restricted to the proceeds of income tax and Union excise duties. The share of States in the proceeds of income tax as recommended by the Finance Commission witnessed a significant jump from 55 per cent (the First Commission) to 85 per cent (the Ninth Commission). For the first time, the Tenth Commission lowered the shares of States to 77.5 per cent on the ground that the authority that levied and administered the tax should have a significant and tangible interest in its yield. The higher share of States in income tax recommended by the Commissions was partly due to historical reasons and partly on account of the Constitution providing for compulsory sharing of income tax proceeds with States.
As far as the distribution of the proceeds of Union excise duties was concerned, initially the share of States was restricted to certain specified commodities. From the Fourth Commission onwards, States were being given a share in the proceeds of the tax on all the commodities. The shares of States in the Union excise duties as recommended by the First, Second and Third Finance Commissions were 40 per cent of the proceeds of the tax on three commodities, 25 per cent of the proceeds of the tax on eight commodities and 20 per cent of the proceeds of the tax on 35 commodities, respectively. During the periods covered by the Fourth to Sixth Commissions, the shares of States remained static at 20 per cent of the net proceeds of the tax on all commodities. The Seventh Commission made a major departure by recommending an increase in the share of the States from 20 per cent to 40 per cent. That Commission felt that the Union excise duties should have a predominant role in the transfer of financial resources to States, considering the size of the proceeds. Another factor that prompted the Commission to increase the share of the States was to effect bulk of the transfers through tax devolution, reducing the grants to a residual on the one hand and to leaving surpluses on revenue accounts with as large a number of States as possible on the other hand.
The system of recommending shares of States in the proceeds of income tax and Union excise duties gave way to recommending shares of States in the total net proceeds of all taxes, heralding a new phase in tax devolution to States. This was facilitated by the eightieth amendment of the Constitution in 2000, which was done on the recommendation of the Tenth Finance Commission. The Eleventh Finance Commission was the first Commission to make recommendations on tax shares under the new dispensation. The Eleventh Finance Commission recommended that the States’ share in Central taxes be fixed at 29 per cent. Of this, 2 percent share was on account of additional excise duties levied by the Centre on man made textiles, tobacco and sugar in lieu of sales tax by States under a tax rental agreement between the Centre and the States. The Twelfth Commission increased the shares of the States to 30.5 per cent.
The Eleventh Finance Commission, for the first time, introduced the concept of overall ceiling on total Central transfers to States from all channels on the revenue account. The indicative ceiling recommended by the Commission was 37.5 per cent of the gross revenue receipts of the Centre. This was raised to 38 per cent by the Twelfth Finance Commission. This indicative ceiling was based on the then prevailing level of transfers on the revenue account. The recommendation of the indicative ceiling seems to have been prompted by considerations relating to macro-economic and fiscal stability. This has prompted States to demand that the total revenue account transfers might be fixed at 50 per cent of the gross revenue receipts of the Centre on the ground that this was the level reached in the year 1999-2000.
Broadly, the needs of the States guided the recommendations of the first three Commissions on vertical distribution of resources. The Fourth Commission, for the first time, took the view that in determining the overall share of States, due regard was to be given to the requirements of States on the one hand and the needs of the Union on the other. This was partly because of the reason that no reference was made to the resources of the Centre and the demands thereon in the ToR of the first four Commissions. Appreciation of the need for applying more or less uniform norms for assessing the resources and requirements of the Centre and the States and their adoption started taking shape from the Sixth Commission onwards.
The shares of States in tax devolution had gone up from about 10 per cent of the total tax receipts of the Centre in the 1950s to 30.5 per cent during the period of 2005-10 covered by the recommendations of the Twelfth Finance Commission. This was mainly facilitated by the higher buoyancy of Central taxes as compared with the State taxes, reforms and broadbasing of Central taxes and the levy of taxes on services by the Centre from the year 1994. The tax devolution recommended by the successive Finance Commissions was without much controversy. The States, however, have been demanding the fixation of their share in Central taxes at a higher level.
The current arrangement regarding tax devolution may undergo changes with the proposal to introduce the unified Goods and Services tax (GST) from April, 2010. The Thirteenth Finance Commission has been asked to analyse the impact of the proposed introduction of GST from 2010.

Horizontal Distribution

After making recommendations regarding tax devolution, it is the task of the Finance Commissions to recommend its interse distribution amongst States. Three phases are discernible in the interse distribution of tax shares among States. In the first phase which lasted till the Seventh Finance Commission, separate formulae were recommended for the distribution of interse shares of States in income tax and Union excise duties. Separate Constitutional provisions governing the sharing of income tax and Union excise duties with States seem to have prompted the first seven Finance Commissions to follow this approach. Recommendation of a uniform formula for the inter se distribution of income tax (excluding the percentage of tax proceeds earmarked for distribution on the basis of origin) and Union excise duties by the Eighth Finance Commission marked the beginning of the second phase which lasted till the Tenth Finance Commission. The Eleventh Finance Commission marked the beginning of the third phase with full convergence in the distribution formula when all the Union taxes became shareable with States.
In the interse distribution of income tax, the first seven Commissions assigned an overwhelming weightage to population ranging from 80 to 90 per cent and the residual weightage ranging from 10 to 20 per cent was assigned to contribution. It was for the first time that considerations relating to equity gained prominence in the formula for interse distribution of income tax proceeds in the recommendation of the Eighth Commission. This Commission assigned a weight of 22.5 per cent to the inverse of per capita income of States and 45 per cent weightage to the distance of the per capita income of a State from the highest per capita income while reducing the weightage to population from 90 per cent to 22.5 per cent and retaining the weightage to contribution at 10 per cent. The Eighth Commission, again for the first time, adopted a common formula for the distribution of 90 per cent share of States in income tax proceeds and the States’ share of Union excise duties. The shift in the different components in the formula for interse distribution in favour of equity was carried forward by the subsequent Commissions. The Tenth Finance Commission had done away with the weightage given to the contribution in the interse distribution of States’ share of income tax on the ground that the States’ efforts in collecting their own taxes was more relevant rather than its contribution to the collection of Central taxes.
The introduction of elements of equity in the formula for the interse distribution of Union excise duties took place much earlier. The Second Finance Commission while giving 90 per cent weightage to population assigned the remaining weightage of 10 per cent to certain adjustments. This marked the introduction of a factor which was intended to correct the large weightage given to population. All the subsequent Commissions assigned small weightages to factors like index of backwardness, distance of per capita income, income adjusted total population, etc. The Seventh Finance Commission reduced drastically the weightage assigned to population to 25 per cent and increased the weightages assigned to equity. The principle of the same formula governing the interse distribution of income tax and Union excise duties introduced by the Eighth Commission was followed by the Ninth and Tenth Commissions. The Tenth Finance Commission for the first time assigned weights to efficiency parameters in the distribution formula. That Commission assigned a weight of 10 per cent to fiscal self reliance as measured by the share of own revenues in total revenue expenditure of a State. The Tenth Commission also inducted disability factors represented by area and infrastructure distance into the distribution formula for the first time. The Commission assigned a weight of 5 per cent each to these factors. Since then, the successive Commissions have been assigning weights to area. The Twelfth Commission did not assign any weight to infrastructure distance. The introduction of elements of equity in the distribution formula was by and large welcomed.
The Eleventh Finance Commissions carried forward the shift in favour of equity considerations in the formula for the interse distribution of States’ share in all Union taxes. The recommendation of the Commission to reduce the weightage given to population to 10 per cent and to assign a weightage of 62.5 per cent to per capita income distance had resulted in the reduction of shares of high income and middle-income States in tax devolution. This evoked a sharp reaction from these States, despite the fact that the Commission assigned a combined weightage of 12.5 per cent to tax effort and fiscal discipline. The contention of these States was that the better performing States were being penalized under the dispensation of the Finance Commissions and that this was creating a moral hazard for States to remain profligate and not to improve their fiscal situation. Though a need was felt to reward the States for better performance, it gathered momentum in the wake of the recommendation of the Eleventh Finance Commission according higher weightage to equity. The Twelfth Finance Commission increased the weight to population from 10 to 25 per cent and reduced the weight assigned to distance of per capita income from 62.5 per cent to 50 per cent. Furthermore, the Commission doubled the weightage assigned to efficiency parameters like tax effort and fiscal self sufficiency.
The criteria used by the Finance Commissions for the interse distribution of tax shares across States can be broadly grouped under, a) factors reflecting needs, such as population and income measured either as distance from the highest income or as inverse, b) cost disability indicators, such as area and infrastructure distance and c) fiscal efficiency indicators, such as tax effort and fiscal discipline. While the weightage assigned to population has declined considerably, weightage assigned to income distance and efficiency factors has increased considerably in recent years.
A major change in tax devolution took place when the Eighth Finance Commission recommended earmarking 5 per cent of the net proceeds of Union excise duties to those States which had a deficit in their non-plan revenue accounts after taking into account their shares in devolution of all taxes including their share in the 40 per cent of Union excise duties earmarked for all States. This earmarking of a specified portion of States’ share in Union excise duties was continued by the Ninth and Tenth Finance Commissions. Thus the problem of non-plan deficit on the revenue account of States which had hitherto been addressed by Article 275 grants had come to be partly addressed by tax devolutions. This also had the effect of moderating the post-devolution revenue account surpluses of certain States.
It has been argued in some quarters that there has been an accentuation of inequalities across States and that the Finance Commission transfers failed to arrest this trend. But one cannot look at the Finance Commission transfers in isolation. While transfers designed by the Finance Commissions in recent years have laid considerable emphasis on equity, transfers effected through other channels may not necessarily be guided by equity considerations. Besides, private investment plays a major role in explaining growth differentials across States. By and large, Finance Commission transfers remained more progressive relative to other transfers. The initial imbalances were too large to be addressed by the Finance Commission transfers alone. Compared with tax devolution, grants have a greater redistributive role. Grants have ranged between 7 per cent and 27 per cent of the total transfers recommended by the Finance Commissions. Surprisingly, even backward States have expressed a preference for tax devolution as a major channel of transfer because of its buoyancy as compared with grants which are fixed.

Grants-in-Aid

Horizontal imbalances are addressed by the Finance Commission through the system of tax devolution and grants-in-aid, the former instrument used more predominantly. Under Article 275 of the Constitution, Finance Commissions are mandated to recommend the principles as well as the quantum of grants to those States which are in need of assistance and that different sums may be fixed for different States. Thus one of the pre-requisites for grants is the assessment of the needs of the States. The First Commission had laid down five broad principles for determining the eligibility of a State for grants. The first was that the Budget of a State was the starting point for examination of a need. The second was the efforts made by States to realize the potential and the third was that the grants should help in equalizing the standards of basic services across States. Fourthly, any special burden or obligations of national concern, though within the State’s sphere, should also be taken into account. Fifthly, grants might be given to further any beneficent service of national interest to less advanced States. By and large, these principles have guided the grants recommended by all the Finance Commissions.
Grants recommended by the Finance Commissions are predominantly in the nature of general purpose grants meeting the difference between the assessed expenditure on the non-plan revenue account of each State and the projected revenue including the share of a State in Central taxes. These are often referred to as ‘gap filling grants’. The issues relating to non-plan deficit grants are discussed in detail in a separate section. Up to the Fifth Commission, grants were recommended only for covering the non-plan revenue deficits of States after tax devolution with only a few exceptions. The First Commission recommended grants for the expansion of primary education The Third Commission recommended grants to cover 75 per cent of the revenue component of State Plans. The Government of India did not agree with this recommendation on the ground that since Central assistance was specifically sanctioned for the Third Five-Year Plan, there was no need for grants for Plan purpose.
The position began to change with the Sixth Finance Commission when that Commission was asked to consider the requirements of States which were backward in standards of general administration with a view to bringing them to the levels obtaining in the more advanced States. It took the view that a Finance Commission was basically concerned with expenditure on revenue account and therefore recommended upgradation grants for meeting the revenue expenditure deficiencies of certain States in areas like general administration, administration of justice, jails, police, primary education, medical and public health and welfare of scheduled castes, scheduled tribes and other backward classes. The Seventh Commission was asked to consider upgradation of standards in non-developmental sectors and services. The Commission restricted the scope of grants to administration of taxes, treasury and accounts administration, judicial administration, general administration, police and jails. Like the Seventh, the Eighth and the Tenth Commissions were asked to consider non-developmental sectors. However, both these Commissions recommended grants for developmental sectors like education and health. As the ToR of the Ninth Commission did not specifically refer to the requirements of upgradation, that Commission did not recommend any grants in its report for the period 1990-95. The Commissions also recommended a mechanism to monitor the utilization of upgradation grants. The Eleventh and Twelfth Finance Commissions did not recommend any upgradation grants.
As indicated earlier, the Sixth Commission considered grants for meeting revenue expenditure alone. The Seventh took the view that there was no restriction imposed by Article 275 in making grants for capital expenditure. The Seventh Finance Commission took into account the requirements on capital account while recommending grants under upgradation and special problems. Even so, the scope of the Finance Commission grants remained grants-in-aid of the revenues to enable States to meet capital expenditure. These grants were by no means capital resource devolution.
Over the years, the scope of grants to States was extended further to cover special problems. The Eighth Finance Commission felt that one of the objectives of the grants-in-aid was to support States in their efforts to solve special problems facing them. Accordingly, it recommended grants for special problems in ten states. The Ninth Finance Commission too recommended special problem grants for the year 1989-90 but did not recommend any such grants for the period 1990-95 on the ground that such problems were meant to be dealt with by the Plan itself. The Tenth, Eleventh and Twelfth Finance Commissions also recommended grants for solving special problems.
Following the seventy third and seventy fourth amendments to the Constitutions, the Finance Commissions were charged with the additional responsibility of recommending measures to augment the Consolidated Fund of a State to supplement the resources of local bodies. This has resulted in further expansion in the scope of Finance Commission grants. The Tenth Commission was the first Commission to have recommended grants for rural and urban local bodies, though its ToR were not amended consequent to the Constitutional amendment. All the subsequent Commissions had recommended grants to rural and urban local bodies. Grants to local bodies constituted 17.5 per cent of the total grants recommended by the Twelfth Finance Commission.
The Twelfth Finance Commission further extended the scope of grants to achieve equalization of expenditure across different states. While full equalisation of expenditure would require a steep step up in the grants, the Commission restricted itself to partial equalization of services in two sectors, namely education and health. The Commission recommended grants under education to eight States and those under health to seven States, where the levels of revenue expenditure were lower relative to the average expenditure. The Commission adopted a new approach by recommending grants for the maintenance of roads and bridges and public buildings. These grants are in addition to the normal expenditure that the States would be incurring on the maintenance of these assets.
Thus, over the years, there has been considerable extension in the scope of grants-in-aid. Now the Finance Commission grants cover in addition to meeting the non-plan revenue deficits, requirements of States on account of special problems, and partial equalisation of certain basic services. They even cover the capital expenditure needs of States in these sectors. As a result, the share of the gap grants in total grants had come down to about 40 per cent during the period covered by the Twelfth Finance Commission.

Terms of Reference

As indicated earlier, the three constitutionally mandated responsibilities of a Finance Commission are the distribution between the Union and the States of the net proceeds of shareable Central taxes, determining the grants to States which are in need of assistance and recommending measures to augment the Consolidated Fund of a State to supplement the resources of local bodies. These are mentioned as such in the Presidential Order constituting a Finance Commission. In addition to the substantive functions, any other matter can be referred to a Finance Commission in the interest of sound finance under Article 280 (3) (d) of the Constitution. It has become customary to mention certain considerations in the Presidential Order appointing a Commission, which the Commission may consider, among others, while making its recommendations. The Presidential Order listing out the main functions, additional matters and considerations constitutes the ToR of a Finance Commission. In fact, the First Finance Commission was not given any ToR. It proceeded with its work based on the substantive duties enumerated in the Constitution.

Considerations

It has become customary for the Presidential Order to mention certain considerations that a Commission shall have regard, among others, while making its recommendations. These considerations by and large reflected the emerging developments in Centre-State finances. Up to the Sixth Commission, these considerations mostly related to Article 275 grants. The position changed with the Seventh Commission. In the case of the Seventh Commission, the considerations were listed out in a separate paragraph and these considerations related to both tax sharing and grants-in-aid. Since then, the practice is continuing. The Seventh Finance Commission was the first Commission to have been asked to take into account the resources of the Central government and the demands thereon on account of the expenditure on civil administration, defence and border security, debt servicing and other committed expenditure or liabilities. Earlier the considerations referred to only the resources of States and the demands thereon. States’ in their memoranda to the Seventh Finance Commission had contended that the considerations should not bind the Commission while making its recommendations on tax devolution. The Commission observed that, ‘The change in our terms of reference compared to those of the earlier Commissions is, in a sense, a purely formal one, recognizing the past practice. Further, tax shares and grants-in-aid under Article 275 have always been inextricably linked to the scheme of transfer of the past Commissions’. The Commission categorically stated in its report that the considerations specified in the Presidential Order did not constrain its functioning in any way.
The considerations specified for the Ninth Finance Commission stated that it shall adopt a normative approach in assessing the receipts and expenditure on the revenue account of the States and the Centre. This was in contrast to the terms of reference of the previous Commissions which were asked to take into account certain considerations, among others. The States, reacting to this change, contended that the Finance Commission derived its authority from the Constitution and that its powers could not be curtailed by a Presidential Order. There was a similar debate when there was specific reference to the needs of the Centre but no reference to the needs of the States for the first time in the case of the Twelfth Commission. The Twelfth Commission took the view that the omission of any specific reference to the needs of States might be due to the insertion of a separate consideration in the ToR regarding the realization of the objective of not only balancing the receipts and expenditure on revenue account of all States and the Union, but also generating surpluses for capital investment. Despite there being no specific consideration, it had assessed the needs of the States as comprehensively as in the case of the Centre.
The States felt that the considerations were biased in favour of the Centre. Their grievance was based on the point that the considerations specified for the Finance Commissions mentioned only guidelines for the assessment of resources and needs of States. In the case of the Centre, mention was made of its resources but in the case of the States mention was made of the efforts made to raise additional resources. The Commissions have by and large allayed these apprehensions by taking the stand that the considerations were no constraints on their working and by gradually adopting normative approach in their assessment of the resources and needs of the Centre and the States. If the considerations were more specific about the States, it could be because of the fact that whereas in the case of the Centre the Commissions had to consider merely the capacity to devolve a certain share of its revenue, they had to assess the needs of each State In the case of States, any additionality accruing to a State disproportionate to its need might lead to grievance on the part of other States.

Additional Matters

The important additional matters referred to the Finance Commissions are distribution of proceeds of additional excise duties in lieu of sales tax, distribution of grants to States in lieu of the tax under the repealed Railway Passenger Fares Act, 1957, modalities of financing relief expenditure, upgrdation of standards of administration, special problems and the assessment of the debt position of the States. In the backdrop of all round deterioration in the State as well as Central finances, for the first time, the Eleventh Finance Commission was asked, by way of an additional item, to review the state of the finances of the Union and the States and suggest ways and means by which the governments, collectively and severally, might bring about a restructuring of the public finances so as to restore budgetary balances and maintain macro-economic stability. In accordance with this additional item, the Eleventh Finance Commission recommended a restructuring plan aimed at bringing the revenue deficit of the Centre and the States to no more than 1 per cent of GDP, containing the combined fiscal deficit to less than 6.5 per cent of GDP and achieving a tax-GDP ratio of around 17 per cent. The strategy suggested to achieve the restructuring consisted of wide ranging reforms in tax and non-tax revenues, containing expenditure on subsidies and major restructuring of expenditure. A similar additional matter was referred to the Twelfth Finance Commission. The Twelfth Finance Commission was asked to suggest a restructuring plan to achieve debt reduction along with equitable growth in addition to macro-economic stability. In addition, the Commission was also asked to draw a monitorable fiscal reforms programme aimed at reduction of revenue deficit of States.
The Twelfth Finance Commission recommended a multi-dimensional restructuring aimed at both qualitative and quantitative aspects of managing government finances. The core strategy centered on raising the trend rate of growth by reducing government dissavings, which in turn required elimination of revenue deficit and reduction of fiscal deficit. Fiscal consolidation suggested by the Commission included elimination of revenue deficit by the Centre and the States by 2008-09, reducing fiscal deficit to 3 per cent of GSDP/ GDP by the States and the Centre and bringing down the combined debt-GDP ratio to 75 per cent by 2009-10. The long term goal for the Centre and the States as suggested by the Commission was to bring down and maintain the debt-GDP ratio at no more than 28 per cent each. To achieve these levels, the Commission recommended wide ranging reforms on tax, non-tax and expenditure fronts. The Twelfth Finance Commission was also asked to examine the issue whether non-tax income of profit petroleum to the Union, arising out of contractual provisions, should be shared with the States and if so, to what extent.
With eminent persons on its body and in consultations with the States and the Centre, the Finance Commissions have succeeded in resolving a number of vexatious issues. Finance Commissions in the past have streamlined the financing of relief expenditure and institutionalized the arrangements for calamity relief in the form of Calamity Relief Fund and National Calamity Contingency Fund. Growing and unsustainable debt position of the States and the Centre was a major issue in Centre-State fiscal relations. Periodic rescheduling of Central loans to States and debt relief linked to certain performance indicators were tried out by the Finance Commissions to extend relief to States. The Twelfth Finance Commission’s recommendation for the termination of Centre’s disintermediation in loans has eliminated the moral hazard of States expecting periodic bail outs. The Commission recommended a Debt Consolidation and Relief Facility aimed at providing debt write off and interest relief linked to revenue deficit reduction and reduction in interest burden. The Commission stipulated that the benefit under the Facility was conditional on each State enacting fiscal responsibility legislation. The enactment of fiscal responsibility legislation by almost all the States following the recommendation of the Twelfth Finance Commission resulted in rule-based management of public finances replacing the discretionary management of public finances which resulted in all round deterioration in public finances. This is a major landmark in the history of public finances in the country.

Plan and Non-Plan Conundrum

A major debate regarding the recommendations of Finance Commissions relates to Finance Commissions restricting their assessment of State finances to non-Plan revenue account. There is no distinction between the expenditure on the Plan and non-Plan account in the Constitution. The budgetary classification of expenditure into Plan and non-Plan came into vogue with the introduction of centralized planning in India. There were no specific ToR for the first Commission. The Second and the Third Commissions were asked to take into account the requirements on account of the Plan. The Second Commission recommended grants under Article275 to enable States to meet their entire revenue expenditure on Plan and non-Plan account along with Plan grants and additional resource mobilization. The Third Commission took into account 75 per cent of the estimated revenue component of the Plan while recommending tax devolution and grants-in-aid. The government did not accept the Plan grants recommended by the Commission on the ground that Central assistance was specifically granted for the Third Five-Year Plan and that there was no need for the Commission to again consider the question of Plan grants. The Fourth, Fifth and the Sixth Commissions were asked to take into account the requirements of States to meet the committed expenditure on the maintenance of Plan schemes completed. In addition to committed expenditure, the Fifth and the Sixth Commissions were asked to consider the requirements on revenue account of States to meet the expenditure on administration, interest charges, etc., which were basically in the nature of non-Plan expenditure. Though the ToR excluded specific reference to Plan revenue account, it was contended that no bar was placed on these Commissions to consider the entire revenue account. The Fourth Commissions decided not to deal with the Plan expenditure on the ground that the Planning Commission which had been specifically constituted should have unhampered authority in the domain of planning. The Fifth and Sixth Commissions did not recommend any grants for meeting Plan revenue expenditure. The Seventh and Eighth Finance Commissions were asked to take into account requirements of States on revenue account to meet non-Plan commitments. These Commissions did not take into account Plan expenditure by implication.
The Ninth Commission was asked to keep in view the objective of not only balancing the receipts and expenditure on revenue account of both the States and the Centre, but also generating surpluses for capital investment. The Commission took the stand that unless the entire revenue account was considered, it would not be possible to balance the revenue account. The Commission after obtaining a legal opinion took the stand that grants for Plan purposes were very much within the purview of the Finance Commissions and recommended Plan grants. In the case of the States having non-Plan surplus, the Commission assumed that 40 per cent of this surplus would be available for the Plan. If there was a deficit on the revenue account after this exercise, the Commission recommended grants equivalent to the assessed deficit on the Plan revenue account. Ultimately, the Plan grants recommended by the Ninth Commission were considered as the States’ own resources for the Plan and the normal formula based Central assistance for State plans was dispensed in the usual manner. The practical difficulties involved in making projections of Plan outlays by and large kept the subsequent Finance Commissions away from considering Plan revenue expenditure.
The Thirteenth Finance Commission, for the first time, has been asked to take into account the gross budgetary support to the Central and State Plans as a demand on the resources of the Centre.
The Finance Commissions have been facing certain practical problems as the periods covered by a Five-Year Plan and a Finance Commission were not coterminous. The Second Finance Commission pointed out the difficulties arising from the periods not being coterminous. States have a tendency to suppress their committed expenditure and over estimate revenue for the Plan resources. A few attempts had been in the past to make the periods coterminous. The Third Commission was asked to give its report covering the period of four years 1962-66, so that the Fourth Commission and the Fourth Plan could be coterminous (1966-71). But the Fourth plan could be finalized for the period 1969-74 because of the war with China. The second attempt at synchronization was made by curtailing the period covered by the Fourth Commission by two years. The Fifth Commission’s recommendations covered the period 1969-74 same as the Fourth Plan. This synchronization continued till the Fifth Commission. The third attempt at synchronization was made at the time of the Ninth Commission. The Ninth Commission was asked to give two reports, the first report covering the year 1989-90 and the second report covering the period 1990-95 to synchronize with the Eighth Five-year Plan. But the intended synchronization did not take place as the Eighth Plan commenced two years later. Following the recommendations of the Administrative Reforms Commission, a convention was established to appoint a member of the Planning Commission to the Finance Commission from the Sixth Commission onwards to ensure better coordination between these two institutions.

A Retrospect

There is a general consensus that the institution of the Finance Commission has acquitted itself well. There has been considerable expansion in the role of the Commissions from mainly being an arbitrator between the Centre and the States to being an architect of fiscal restructuring. There has been near stability in the share of States’ in the combined revenue expenditure at about 57 per cent. Centralisation of economic policy did not show up in any reduction in the share of States. It may be true that States’ expenditure has come to be more influenced by the Centre. There has been a decline in the revenue expenditure financed by own resources from 80 per cent in the early fifties to around 60 per cent now. This could be partly on account of the higher buoyancy of Central taxes and increase in their coverage. Finance Commission transfers still account for the bulk of the Central transfers.
Despite the changing fiscal environment and considerable expansion in its functions, the institution of the Finance Commission has ensured smooth functioning of Centre-State fiscal relations. If there has been no breakdown in the Centre-State relations, the credit for this entirely goes to the Finance Commissions. It also goes to the credit of the framers of the Indian Constitution that the provisions relating to Central- State fiscal relations have stood the test of time. They proved adequate even in meeting the changing environment. Fiscal federalism will always remain a work in progress and the institution of the Finance Commission, as in the past, will continue to deal with the changing environment and emerging challenges. The recent improvement in the fiscal situation can also be partly attributed to the focus that the recent Finance Commissions laid on fiscal restructuring. The global developments unfolding since September 2008, have cast shadow on the fiscal correction path undertaken by the Centre and the States. But these may be temporary blips and it is hoped that the fiscal consolidation will be back on track. The Thirteenth Finance Commission has a major task ahead in coping with the challenges posed by the global meltdown and in ushering in a new era in fiscal federalism with the proposed introduction of GST from April 2010.