Finance Commission

Constitutional Bodies are those bodies whose formation is provided by the Constitution. These bodies help the Government to run efficiently and effectively. Each of these organizations is responsible for the administration of specific functions. Some additional bodies help them by providing advisory functions.

Finance Commission

The Finance Commission of India came into existence in 1951. Since the institution of the first finance commission, stark changes have occurred in the Indian economy causing changes in the macroeconomic scenario.

• It was established under Article 280 of the Indian Constitution by the President of India. It was formed to define the financial relations between the centre and the state. As per the Constitution, the commission is appointed every five years and consists of a chairman and four other members to be appointed by President.
• Further, the Constitution empowered the Parliament by law to determine the requisite qualifications for appointment as members of the commission and the procedure of selection. As a result the Finance Commission Act of 1951 was enacted which states the terms of qualification, appointment and disqualification, the term, eligibility and powers of the Finance Commission.

Qualifications and Manner of Selection

The Chairman of the Commission shall be selected from among persons who have had experience in public affairs, and the four other members shall be selected from among persons who—

• are, or have been, or are qualified to be appointed as Judges of a High Court; or
• have special knowledge of the finances and accounts of Government; or
• have had wide experience in financial matters and in administration; or
• have special knowledge of economies.

Functions of Finance Commission

It shall be the duty of the Commission to make recommendations to the President as to—

• The distribution between the Union and the States of the net proceeds of taxes and the allocation between the States of the respective shares of such proceeds.
• The principles which should govern the grants in aid of the revenues of the States out of the Consolidated Fund of India.
• Any other matter referred to the Commission by the President in the interests of sound finance.

15th Finance Commission

The 15th Finance Commission (Chair: Mr. N. K. Singh) was required to submit two reports. The first report, consisting of recommendations for the financial year 2020-21, was tabled in Parliament in February 2020. The final report with recommendations for the 2021-26 period was tabled in Parliament on February 1, 2021.

Key Recommendation in the First Report

• Devolution of Taxes to States: The share of states in the centre’s taxes is recommended to be decreased from 42% during the 2015-20 period to 41% for 2020-21. The 1% decrease is to provide for the newly formed union territories of Jammu and Kashmir, and Ladakh from the resources of the central government.

Terminology in Criteria

• Income Distance: Income distance is the distance of the state’s income from the state with the highest income. The income of a state has been computed as average per capita GSDP during the three-year period between 2015-16 and 2017-18. States with lower per capita income would be given a higher share to maintain equity among states.
• Demographic Performance: The Terms of Reference (ToR) of the Commission required it to use the population data of 2011 while making recommendations. Accordingly, the Commission used only 2011 population data for its recommendations.
• The Demographic Performance criterion has been introduced to reward efforts made by states in controlling their population. It will be computed by using the reciprocal of the total fertility ratio of each state, scaled by 1971 population data. States with a lower fertility ratio will be scored higher on this criterion. The total fertility ratio in a specific year is defined as the total number of children that would be born to each woman if she were to live to the end of her child-bearing years and give birth to children in alignment with the prevailing age-specific fertility rates.
• Forest and Ecology: This criterion has been arrived at by calculating the share of dense forest of each state in the aggregate dense forest of all the states.
• Tax Effort: This criterion has been used to reward states with higher tax collection efficiency. It has been computed as the ratio of the average per capita own tax revenue and the average per capita state GDP during the three-year period between 2014-15 and 2016-17.

Other Important Recommendation

• Grant-in Aids: In 2020-21, the following grants will be provided to states: (i) revenue deficit grants, (ii) grants to local bodies, and (iii) disaster management grants. The Commission has also proposed a framework for sector-specific grants, state-specific grants and performance-based grants.
• Fiscal Deficit and Debt Levels: The Commission noted that recommending a credible fiscal and debt trajectory roadmap remains problematic due to uncertainty around the economy. It recommended that both central and state governments should focus on debt consolidation and comply with the fiscal deficit and debt levels as per their respective Fiscal Responsibility and Budget Management (FRBM) Acts.
• Off-budget Borrowings: The Commission observed that financing capital expenditure through off-budget borrowings detracts from compliance with the FRBM Act. It recommended that both the central and state governments should make full disclosure of extra-budgetary borrowings. The outstanding extra-budgetary liabilities should be clearly identified and eliminated in a time-bound manner.
• Statutory Framework for Public Financial Management: The Commission recommended forming an expert group to draft legislation to provide for a statutory framework for sound public financial management system. It observed that an overarching legal fiscal framework is required which will provide for budgeting, accounting, and audit standards to be followed at all levels of government.
• Tax Capacity: In 2018-19, the tax revenue of state governments and central government together stood at around 17.5% of GDP. The Commission noted that tax revenue is far below the estimated tax capacity of the country. Further, India’s tax capacity has largely remained unchanged since the early 1990s. In contrast, tax revenue has been rising in other emerging markets. The Commission recommended: (i) broadening the tax base, (ii) streamlining tax rates, (iii) and increasing capacity and expertise of tax administration in all tiers of the government.
• GST Implementation: The Commission highlighted some challenges with the implementation of the Goods and Services Tax (GST). These include: (i) large shortfall in collections as compared to original forecast, (ii) high volatility in collections, (iii) accumulation of large integrated GST credit, (iv)Glitches in invoice and input tax matching, and (v) delay in refunds. The Commission observed that the continuing dependence of states on compensation from the central government (21 states out of 29 states in 2018-19) for making up for the shortfall in revenue is a concern. It suggested that the structural implications of GST for low consumption states need to be considered.
• Financing of Security-related Expenditure: The Terms of Reference of the Commission required it to examine whether a separate funding mechanism for defence and internal security should be set up and if so, how it can be operationalized. In this regard, the Commission intends to constitute an expert group comprising representatives of the Ministries of Defence, Home Affairs, and Finance. The Commission noted that the Ministry of Defence proposed following measures for this purpose: (i) setting up of a non-lapsable fund, (ii) levy of a cess, (iii) monetization of surplus land and other assets, (iv)Tax-free defence bonds, and (v) utilizing proceeds of disinvestment of defence public sector undertakings. The expert group is expected to examine these proposals or alternative funding mechanisms.

Key Recommendations in the Second Report

• Devolution of Taxes to States: The share of states in the central taxes for the 2021-26 period is recommended to be 41%, same as that for 2020-21. The adjustment of 1% is to provide for the newly formed union territories of Jammu and Kashmir, and Ladakh from the resources of the centre.
• Criteria for Devolution: The criteria for distribution of central taxes among states for 2021-26 period is same as that for 2020-21. However, the reference period for computing income distance and tax efforts are different (2015-18 for 2020-21 and 2016-19 for 2021-26), hence, the individual share of states may still change.

• Grants: Over the 2021-26 period, the following grants will be provided from the centre’s resources: (i) revenue deficit grants, (ii) grants to local bodies, and (iii) disaster management grants. The Commission has also proposed a framework for state-specific grants and performance-based grants. Sector-specific grants have been recommended in sectors such as health, education, and agriculture.
• Fiscal Deficit and Debt Levels: The Commission provided range for fiscal deficit and debt path of both the Union and States and an additional borrowing room to States based on performance in power sector reforms.
• Centrally-sponsored Schemes (CSS): A threshold should be fixed for annual allocation to CSS below which the funding for a CSS should be stopped.
• Revenue Mobilisation: Income and asset-based taxation should be strengthened by expanding the coverage of provisions related to tax deduction and collection at source (TDS/TCS); tapping potential of stamp duty and registration fees at the state level; integrating computerised property records with the registration of transactions, and capturing the market value of properties.
• GST: There is a need to: (a) resolve the inverted duty structure between intermediate inputs and final outputs present in GST; (b) restoring revenue neutrality of GST rate; (c) rationalizing rate structure by merging the rates of 12% and 18%.
• Public Financial Management: A comprehensive framework for public financial management should be developed. An independent Fiscal Council should be established with powers to assess records from the centre as well as states. States may form an independent debt management cell to manage their borrowing programmes efficiently. The centre as well as states should not resort to off-budget financing or any other non-transparent means of financing for any expenditure. A standardised framework for reporting of contingent liabilities should be devised. Both centre and states should strive to improve the accuracy and consistency of macroeconomic and fiscal forecasting. States should have more avenues for short-term borrowings other than the ways and means advances, and overdraft facility from the Reserve Bank of India.
• Health: The commission recommended that states should increase spending on health to more than 8% of their budget by 2022. Also due to inter-State disparity in the availability of medical doctors, it is essential to constitute an All India Medical and Health Service.
• Funding of Defence and Internal Security: Considering the extant strategic requirements for national defence in the global context, The Union Government may constitute in the Public Account of India, a dedicated non-lapsable fund called Modernisation Fund for Defence and Internal Security (MFDIS).