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Challenges before the Fifteenth Finance Commission

V Bhaskar ( was Special Chief Secretary Finance to the Government of Andhra Pradesh, and Joint Secretary, Thirteenth Finance Commission.

The terms of reference of the Fifteenth Finance Commission are significantly different from those of earlier finance commissions. Some of these changes are within the mandate of the Constitution. Some do not appear to be so. Others appear extraneous. Some appear to urge the commission to asymmetrically treat a group of states. This article examines the challenges the XV-FC will face while addressing these changes.

The author is grateful to Indira Rajaraman for her insightful comments on an earlier version of this article.

The Fifteenth Finance Commission (XV-FC) has been appointed with the terms of reference (ToR) notified in a presidential order dated 27 November 2017. The ToR is significantly different from those of earlier finance commissions. We examine the issues arising out of these changes and review the challenges the XV-FC will face while addressing them.

Clause 3(b) of Article 280 of the Constitution is usually merged with part of Article 275 (1) and included in the ToR of a finance commission. The ToRs of the last 12 finance commissions over the past 60 sixty years did so. The words “[state] which are in need of assistance,” however, do not find place in the ToR of the XV-FC. It is not clear why this phrase has been excluded. This can be interpreted as a deliberate signal to the XV-FC to provide grants to states on grounds other than need. This exclusion meshes with two other references encountered subsequently in the ToR—one, relating to the removal of revenue deficit grants to states in need, and the other, relating to providing incentive grants to states which may not be in need.

Revenue Deficit Grants

The ToR states that the commission may also examine if revenue deficit grants are to be provided at all. Critics argue that this is an unwarranted invitation to the XV-FC to discontinue the provision of revenue deficit grants. They argue that this inducement in the ToR can be interpreted as mandatory rather than directory. Such a directive untenably interferes in the working of the finance commission. This intrusion can be seen to be in violation of Article 280(4) of the Constitution and Section 8 of the Finance Commission (Miscellaneous Provisions) Act, 1951, both of which empower finance commissions to independently determine their procedure and work plan, including the issue of whether it should provide any grants at all.

The theology for the provision of revenue deficit grants is well established. Recurring revenue expenditure is not seen as growth inducing. Revenue expenditure should therefore never exceed revenue receipts. All borrowings should be deployed exclusively for capital expenditure to accelerate growth. States with revenue deficits should be supported to the extent of such deficits. This will ensure that all their borrowings are exclusively channelled towards growth-inducing capital expenditure.

Prima facie, such a reference seems unimpeachable. All states have passed their versions of the Fiscal Responsibility and Budget Management (FRBM) Act, 2003. A cornerstone of all these FRBM acts is compliance with the golden rule: revenue deficit should be zero.1 There should, thus, be no reason for the XV-FC to provide revenue deficit grants at all.

The reality is somewhat different. The 17 states listed in Table 1 (p 40) include 11 states that were provided revenue deficit grants by the Fourteenth Finance Commission (XIV-FC). The XIV-FC projected revenue deficits for each of the years between 2015 and 2020 and provided gap-filling grants for each year. Column 3 of Table 1 gives the aggregate grant provided by the XIV-FC for 2015–20 and Column 4 gives the grant it projected for 2017–18. Columns 5, 6, and 7 list the revenue deficits reported by the state governments in their respective budget documents.

There are significant variations between the projections for revenue deficit made by the XIV-FC in their report and the numbers reported by the state governments in their budget documents. For Kerala, the XIV-FC projected an allocation of `1,529 crore as revenue deficit grant for 2017–18. In its budget for 2017–18, the Kerala government projected a revenue deficit of `16,043 crore, more than 10 times the XIV-FC projection. West Bengal was allocated `3,311 crore as revenue deficit for 2016–17 by the XIV-FC. It reported a revenue deficit of nearly three times this projection, `9,469 crore for that year. The Kerala and West Bengal governments clearly feel that the XIV-FC has underestimated their need for revenue deficit grants.

Jammu and Kashmir (J&K) was expected to incur a revenue deficit of `10,831 crore and `11,849 crore for 2016–17 and 2017–18, respectively. Accordingly, the XIV-FC provided matching revenue deficit grants. The revenue deficit should have been zero after receipt of the grant. However, after accounting for these grants, the J&K government showed a surplus in its accounts of `7,606 crore and `9,349 crore, respectively. Mizoram was expected to require a revenue deficit grant of `2,446 crore in 2017–18. Its budget documents project it to generate a revenue surplus of `1,787 crore in this period. The J&K and Mizoram governments through their budget documents indicate that the XIV-FC has overestimated their need for revenue deficit grants.

There is a third category of states who could claim that the XIV-FC has overlooked their claims for revenue deficit grants. These are the states of Haryana, Maharashtra, Punjab, Rajasthan, Tamil Nadu, and Uttarakhand. These six states have been reporting significant revenue deficits over the last three years. For 2017–18 it is projected to be `95,485 crore.2 It is noteworthy that five of the six large revenue deficit states are not poor states. They have a per capita income above the all-India average.

Substantial Deviations

The XIV-FC did its work meticulously. It followed the procedure adopted by previous commissions while making revenue and expenditure projections. And yet, its projections went significantly awry.3 There could be two reasons for such substantial deviations:

(i) Finance commission projections are based on snapshot data and all relevant parameters including the impact of future uncertain developments cannot be incorporated into their assessment. The finance commission can assimilate, to some extent, risk into their projections, but they cannot incorporate uncertainty. It is this uncertainty4 that is the cause of such significant deviations that often make nugatory its revenue deficit recommendations.

(ii) Finance commissions face information asymmetry problem. States know more about their finances and reveal less to the finance commissions. In this situation, states are incentivised to game the system. The framework adopted by successive finance commissions sent a signal to the states that revenue deficits would be bridged with matching grants. The XIV-FC removed the reward to states for being fiscally disciplined, compounding this problem.

The argument that the FRBM law will compel the states to constrain their revenue deficits is not corroborated by actual behaviour. States and even the centre blithely transgress their commitments under the FRBM act and seek to rectify the situation by either amending the FRBM act or exploiting its escape clauses. The Tamil Nadu government passed its FRBM act in 2003. It subsequently amended its FRBM act in 2004, 2005, 2010 (twice), and 2016. In each amendment, the goal of reaching zero revenue deficit was pushed back further. The 2016 amendment commits the state to reduce this ratio to 5% by 31 March 2019 and eliminate revenue deficit by 2019–20.

Other states are more circumspect. They violate the revenue deficit threshold without amending the FRBM act.5 The government of Haryana in its Statement of Fiscal Policy and Disclosure for the year 2017–18 recognised the breach and promised that necessary amendment in the Haryana FRBM Act, 2005 would be made on receipt of the requisite guidelines from the union government.6

Figure 1 shows the number of states that reported revenue deficit in their accounts between 1980–81 and 2017–18 (budget estimate or BE). FRBM acts were passed by the state governments in a staggered manner. Between 2002 and 2007, 26 states passed the FRBM act. Of the 28 states in India then, 24 reported a revenue deficit in 2002–03. This number reduced to four in 2007–08, possibly attributable to the FRBM acts that they legislated.7 It gradually built up to 15 in 2014–15 before slightly reducing to 12 in 2015–16, 10 in 2016–17 (revised estimates or RE) and eight in 2017–18 (BE). After 2010, states8 had no fresh incentive to adhere to the FRBM prescription since they had exhausted all the debt write-off that came with its enactment.

Despite the fact that states embarked on a fiscal consolidation path since 2002–03, at no time have all the 29 states simultaneously reported zero revenue deficit. Kerala, Punjab, and West Bengal have incurred revenue deficits every year since 1990–91 (RBI 2017: Chart 120). Worryingly, in the recent past, states like Andhra Pradesh (since 2014–15), Haryana (since 2008–09), Himachal Pradesh (since 2012–13), Rajasthan and Tamil Nadu (both since 2013–14) have joined this club.

Two lessons can be gleaned from the analysis presented so far. First, the passage of fiscal responsibility act by a state government is not adequate comfort that the government will conform to it. Second, the Government of India’s instruments of compellance in this regard— monitoring the release of finance commission grants or restricting borrowing consent under Article 2939 to errant states have either not been applied at all, or applied only selectively so that some states were enabled to deviate from the requirements of their own FRBM acts.

Options before the XV-FC

What are the options available to the XV-FC on the provision of revenue deficit grants? If it wants to continue on the well-trodden path and continue providing such grants to states, it has to strengthen the credibility of its projections so that it can make more accurate estimations of fiscal need.

In the power sector, regulators use the concept of a “true up” to modify the cost and revenue projections of a previous year, which may have gone astray. In a multi-year tariff scenario, the tariff for the second year is modulated by the variances between actual costs and revenues from the projections made in the previous year, so long as they can be justified by the distribution company. If it cannot justify these deviations, it is not allowed to pass them on in the form of increased tariff to consumers.

Perhaps a similar approach can be adopted by the XV-FC for revenue deficit grants. Its projections of revenue and expenditure for all state governments could be compared to actuals the next year, and revenue deficit grants released only if the state has not veered significantly and of its own volition from its commitments in the FRBM act. Which agency should undertake such a review? The proposed Fiscal Council would be the ideal institution.

The other option for the XV-FC is to follow the suggestion in the ToR and discontinue the provision of revenue deficit grants. The number of states reporting revenue deficits is increasing. The aggregate revenue deficit for BE 2017–18 reported by the nine states in Table 1 is `1,13,121 crore. The revenue deficit grant requirement could work out to more than `6,00,000 crore during 2020–25. This will absorb a significant portion of the divisible pool to the detriment of the fiscally restrained states. A case can be made that due to the moral hazard faced by states, the revenue deficit grant should be discontinued.

Base Year or Terminal Year

Earlier finance commissions were required to assess these resources for the required five-year period based on the revenues likely to be reached during the year prior to this period. This prior year is termed as the base year, and is the jumping-off year for the finance commissions to make projections into the future. It is assumed that the finance commission would have available to it reasonably credible figures for parameters like growth, inflation, and revenue for the base year and these figures could then be used as the basis for making projections for the future five-year period. Table 2 shows the base year indicated in the ToRs of earlier finance commissions.

The Tenth Finance Commission (X-FC) used 1993–94 data on revenue and expenditure that was available to it, as a basis to project revenues for 1995–2000. Similarly, all succeeding commissions were asked to use a base year that was before the period covered by its recommendations. The ToR of the XV-FC requires it to use the revenues likely to be reached by 2024–25, the terminal year of its recommendations as the basis for the projections for the five-year period starting 2020–21 and 2024–25. This is challenging to say the least.

Potential and Fiscal Capacity

The ToR of the XV-FC states that for both tax and non-tax revenues, the commission would also take into account the potential and fiscal capacity of the central and state governments. “Fiscal capacity” is susceptible to multiple interpretations. A study commissioned by the XIV-FC posits that fiscal capacity of a state is estimated by its tax to gross state domestic product (GSDP) ratio (Raychaudhuri 2013). A second study10 brings the expenditure side into the concept by defining fiscal capacity as a measure of a government’s ability to raise revenues for provision of services, relative to its costs of service responsibilities. A third studyhas pointed to the inadequacy of using revenues for measuring fiscal capacity and emphasises the need to simultaneously look at tax effort (Vazquez and Boex 1997).

The XIV-FC did not compute fiscal capacity. Instead it used a proxy of fiscal capacity for computing inter se state shares in the horizontal devolution exercise. This was the difference between per capita income of a state and the state with the highest per capita income.

Which approach should the XV-FC follow? It could be argued that the XV-FC should scrutinise three distinct parameters. First, the entire exploitable revenue base of a state government to assess its potential fiscal capacity; second, the base actually exploited to determine fiscal capacity; and third, the efficiency in exploiting this base to determine tax effort. It is debatable whether state-level data required for making such a comprehensive assessment is available. Such a determination will indeed be a challenge for the XV-FC unless it takes the path laid out by the earlier commissions.

Recommendations of the XIV-FC

The XV-FC is required11 to have regard to impact on the fiscal situation of the union government of the substantially enhanced tax devolution, following the recommendations of the XIV-FC, while making its recommendations. The reference to the impact of the increase in devolution brought about by the XIV-FC on the fiscal situation of the union appears both superfluous and irrelevant. The ToR already enjoins the XV-FC to estimate the resources of the union government by projecting revenue and expenditure commitments on the basis of values reached during the base year.12 The impact of the enhanced devolution award of the XIV-FC will last only till the financial year ending 31 March 2020. Till that date, the devolution of 42% of the divisible pool remains an inescapable commitment of the central government. No reference to it is necessary for the XV-FC to incorporate it into its examination of the finances of the central government between 2015 and 2020.

For 2020–25, the period of consideration of the XV-FC, the award of the XIV-FC is irrelevant. The XV-FC is required to make an ab initio assessment of revenue projections and expenditure commitments of both levels of governments for 2020–25. Based on the surplus it determines for the union for 2020–25, it decides on the quantum of the divisible pool that needs to be shared with states. The 42% award of the XIV-FC is not relevant to this exercise. The XV-FC may increase, decrease or maintain the devolution share at 42%. Determining this is the sole privilege of the XV-FC, to be exercised after its consultations and deliberations.

This reference is at best misplaced, and at worst, a leading suggestion on the possibilities of adopting a recidivist path.

New India 2022

The ToR requires the XV-FC to also examine the impact of the “continuing imperative of the national development program including New India-2022” on union government finances. “New India 2022” is an ambitious movement initiated by the central government. It has six components: (i) poverty-free India; (ii) dirt- and squalor-free India; (iii) corruption-free India; (iv) terrorism-free India; (v) casteism-free India; and (vi) communalism-free India.13 Each of these components has subcomponents. For example, the first component—poverty-free India—includes nine subcomponents, including promoting inclusive growth, doubling farmers’ income, and improving health, education, and gender outcomes.

Three questions arise about the direction to the XV-FC to consider the impact of New India 2022 on the finances of the union government:

(i) India 2022, as it is presently framed, appears to be a vision set against a background of sectoral aspirations. For achieving New India 2022, a number of sectoral departments in both the state and central governments will have to implement a number of programmes. How these schemes/programmes will be dovetailed with the existing government programmes in the corresponding sectors does not appear to have been clarified. The additional financial commitment of the central and state governments under this programme also does not appear to have been firmed up.

(ii) Most of these sectors are operational areas of the state governments rather than the union government. These include agriculture, public health, housing, sanitation, and public order. Education, electricity, and forests are in the concurrent list, but states are responsible for most of the expenditure in these sectors.

(iii) New India 2022 can also be seen as a political commitment of the union government that will have to be implemented mainly through the state governments. Why the XV-FC should examine its impact on the finances of only the union government and not the state government remains unspecified.

Critics argue that this reference seeks to gerrymander the XV-FC mandate. This reference ostensibly enables the XV-FC to underwrite the proposed central
government schemes under Article 282 for India 2022 rather than providing grants directly to states under Article 275. Though the provision of grants under Article 282 is prima facie permissible,14 the finance commissions have always been urged to confine their attention to providing grants under Article 275, rather than underwriting grants by central/state governments under Article 282.

Impact of GST

The commission is required to examine the impact of goods and services tax (GST) on the finance of the centre and the state governments. This is to include the payment of compensations for a possible loss of revenue for five years and the abolition of a number of cesses.

The GST was introduced in July 2017 with the express agreement that it would be tailored to be revenue neutral. One of the reasons for putting in place a multiple number of rates, one as high as 28%, was so that the finances of both levels of government should not suffer. The central GST rules and the state GST rules were subsequently amended to increase the maximum rate to 20% for each tax, an aggregate tax of 40%. This is a far cry from the pre-GST average rate of 26.5%.15

Both the centre and the state governments wanted the GST to be revenue neutral and clothed themselves legally accordingly. Compensation required to be paid, can be met from the special compensation cess exclusively levied to fund it. In this scenario, there appears to be little case to ask the XV-FC to examine the impact of GST on the finances of the centre and the states.

It is possible that the present scenario is far removed from the expected scenario. It is also possible that aggregate GST revenues are not reaching expectations16while the states are making significant claims for compensation. If so, the remedy lies in the reform of the GST structure, and not in burdening the XV-FC, with yet another objective to meet with its extremely limited arsenal.

Consent to States for Borrowing

The ToR directs the XV-FC to consider the conditions that the union government may impose on the states while providing consent under Article 293(3) of the Constitution. This reference seems driven by the report of the XIV-FC which states:

We were alerted to the possibility that, in future, no State may have debt outstanding to the Union Government, due to discontinuance of intermediation of loans as recommended by FC-XII. It was further pointed out that, in such an event, the Union would be deprived of its ability to enforce fiscal rules on the States under Article 293 (3) of the Constitution. (Finance Commission 2014: 200)

The specific provision for examining the use of conditionality in the grant of permission to state governments to borrow appears to be driven by the apprehension that “the Union would be deprived of its ability to enforce fiscal rules on the states” and this power must not be infringed or diluted in anyway. This dictate in the ToR seems inapt and should perhaps be ignored by the XV-FC for the following reasons.

As pointed out earlier, the union has been unable to enforce fiscal rules on the states even when it is empowered to do so under Article 293(3). The nine states have projected revenue deficits in their budgets for 2017–18 and were all required to take the centre’s consent for borrowing under Article 293(3) and they have presumably done so. Some of these states are in dire fiscal straits incurring revenue deficits for significantly long periods of time. The centre has been either unwilling or unable to discipline these states fiscally. Putting in place additional conditionalities for borrowing even when they have no dues to the centre may serve little purpose.

The Twelfth Finance Commission (XII-FC) recommended that central loans to states be disintermediated and states borrow directly from the market. However loans taken from external development agencies could not be disintermediated by the centre as states cannot borrow directly from foreign agencies. The centre commenced giving back-to-back loans to state governments matching foreign assistance.

Table 3 lists the maturity profile of central government’s back-to-back loans to state governments as at end-September 2013 arising from externally aided projects. The list of states has been arranged in order of earliest maturity. As will be seen, of the 17 listed states, only Chhattisgarh will repay its back-to-back loans between 2023 and 2033. The other 16 states will repay their loans after 2033. These 16 states will not become independent of centre’s borrowing during 2020–25, the period of consideration of the XV-FC. The central government could encourage Chhattisgarh and such of the other 12 states not listed above, who are likely to pay off their outstanding loan to the centre to avail external development assistance on back-to-back basis. This would be a better way to ensure control on states’ lending in the medium term than any proposed amendment to Article 293(3).

Provision of Incentives

The XV-FC is encouraged to provide incentives to induce states to prioritise certain developmental goals. Such incentives can be put in place through two modes: (i) use of indicators of past performance to determine up front the eligibility of a state for a predetermined grant amount for the future five-year period; (ii) use of forward-looking indicators (FLIs) to determine at a future date a particular state’s share of a lump sum provision made, depending upon that state’s relative performance in respect of those indicators on that future date.

If the object of the incentive exercise is to change the behaviour of states, then the XV-FC will have to use FLIs. While FLIs can induce behaviour change, states apprehend that the centre, being an interested party, may not objectively determine eligibility for grants based on the use of FLIs. However, grants based on past performance will not induce behavioural change. Thus, determining what type of incentive to deploy—a backward looking or a forward looking incentive grant will be a challenge for the XV-FC.

Expansion of the Tax Net

The GST is a cooperative enterprise between the centre and the states. For the first time since the formation of the Indian federation, both the union and the states have been sharing the same tax base. Expansion and deepening of such a tax base under the GST is the joint responsibility of both the centre and the states. It is possible that in some states, the tax base may have been extensively trawled. In some states, this may not be the case. States alone cannot be given full credit for good performance nor can they be held accountable for lethargy in widening this tax base.

Under the Goods and Services Tax (Compensation to States) Act, 2017, state governments are guaranteed a compounded annual growth rate of 14% over 2015–16 (base year). Any shortfall in their collections will be met by compensation grants from the union government to the extent of 100% of the notional loss for the next five years.

There could be two categories of states once the GST gets fully underway. The first category will be the states that reach a revenue growth rate above 14%.17 These states will require neither the compensation nor the proposed incentive.

The second category of states are those that report a revenue growth rate below 14%. The compensation act significantly dilutes any incentive such states may have to widen and deepen the GST tax base. For the next five years, these states are guaranteed a 14% nominal growth in their GST revenues without making any effort. Under the value added tax (VAT) regime, the centre provided states with a graded compensation for losses incurred: 100% in the first year, 75% in the second, successively stepping down to zero percent in the fifth year.

Such a provision gradually but inexorably built up a stake of the state governments in the success of the VAT regime. Some state governments, seeing the writing on the wall, grew out of VAT compensation during the first year itself. Will a similar experience be seen for GST? It will, for the first category of states. It is not clear whether it will also be so for the second category of states. The centre recently amended the GST compensation act increasing the cess on some motor vehicles from 15% to 25%. Evidently, the GST Council anticipates demands for compensation from states to exceed original estimations. This enhances the concerns highlighted here.

It is therefore ironic that the XV-FC is being asked to incentivise states for good performance in GST, when the design of the compensation scheme promoted by the central government makes them indifferent to the success of the GST for the next five years.

Population Growth

The ToR asks the XV-FC to incentivise “efforts and progress made in moving towards replacement rate of population growth.” Two issues arise. First, the conflation of efforts and progress may not be a substitute for achieving good outcomes. Outcomes alone may need to be the decisive parameter for computing eligibility for incentives.

Second, this reference will impact states asymmetrically. The Population Division of the United Nations defines a total fertility rate (TFR) of 2.1 as the replacement level fertility rate. Out of the 29 states in India, 18 have already reached replacement rate.Table 4 lists the states that are above and below this replacement rate.

There are 11 states that have a replacement rate above 2.1. Of these, Assam and Chhattisgarh are fast approaching the replacement rate of 2.1. The four north-eastern states may not see this as a priority given their low population counts. This effectively leaves only five states that need to focus on their TFR to reach a replacement rate of 2.1. The XV-FC is thus being directed to selectively provide incentives to these five states for reducing their TFR to 2.1.

The 18 states that have already reached the replacement rate of 2.1 may feel such a pointed reference in the ToR penalises them for their past performance. This asymmetry is further biased by the XV-FC being asked to use 2011 population figures in their computations. As seen in Table 5, the five states that stand to gain18 by the use of 2011 population figures are the same five high population states whose TFR is above the replacement rate of 2.1. Thus, the low replacement rate states feel that they are being disadvantaged twice over, by the inclusion of this direction.


Expenditure on Populist Measures

The ToR presumably encourages the XV-FC, through a framework of incentives and deterrents, to reward states that control expenditure on populist measures and deter states that do not exercise such controls. Implementing such a direction will be a challenge for two reasons.

First, the definition of a populist measure may not stand the test of time. Tamil Nadu’s Mid-day Meal Scheme and Andhra Pradesh’s `2 rice schemes were originally branded populist when they were first introduced. Today, they have been deeply integrated into entitlement-based programmes being implemented by the central government. They are no longer populist programmes but official policy.

Second, it may be inappropriate for the XV-FC to deter populist programmes introduced and implemented by a state government in the exercise of its sovereign functions. If a programme is “wasteful” or “unnecessary,” the proper authority to take deterrent action may be the electorate, not the finance commission.

The Supreme Court has stated:

The court can strike down a law or scheme only based on its vires or unconstitutionality but not on the basis of its viability. When a regime of accountability is available within the Scheme, it is not proper for the Court to strike it down, unless it violates any constitutional principle. (Bhim Singh v Union of India and Others. Para 76(3), Supreme Court of India (2010), INSC 358, 6 May 2010)

The judgment of the United States Supreme Court on the Affordable Care Act (Obamacare) is also relevant:

We do not consider whether the Act embodies sound policies. That judgment is entrusted to the Nation’s elected leaders. We ask only whether Congress has the power under the Constitution to enact the challenged provisions. Members of this Court are vested with the authority to interpret the law; we possess neither the expertise nor the prerogative to make policy judgments. Those decisions are entrusted to our Nation’s elected leaders, who can be thrown out of office if the people disagree with them. It is not our job to protect the people from the consequences of their political choices. (US 576 2012: 6)

Two supreme courts have given clear and unambiguous findings about the legality of the so-called populist schemes. The XV-FC also may need to evaluate whether it is its job to protect people from the consequences of their political choices. It may therefore find it difficult to deter states from embarking on such schemes despite the exhortation to do so in its ToR.

Additional Matters

The ToR encourages the XV-FC to incentivise state governments to accelerate implementation of the flagship schemes of Government of India—develop infrastructure, improve fiscal sustainability and quality of expenditure, improve the ease of doing business, improve sanitation, including the aim to end open defecation.

This is a smorgasbord of targets that the XV-FC is asked to incentivise presumably through the use of grants under Section 275 linked to the imposition of conditionalities. There are two challenges that the XV-FC will face here:

(i) To encourage the state to change course to “desired” directions, they must be incentivised by grants of significant value. The nine subsections of paragraph 7 of the ToR draw attention of the XV-FC to more than nine targets. These goals will require substantial outlays to be earmarked as incentives to command the commitment of state governments. Such large grants will cut into the fiscal space available for rule-based devolution that should be the preferred mode of operation for a finance commission.

(ii) The conditionalities imposed must be achievable. Only then will states be able to reach the goals and draw down their incentives. The Thirteenth Finance Commission (XIII-FC) had provided a water sector grant to all states. It required, amongst other conditions, that states successively increase their recovery rates for irrigation. Few states drew down this grant. The political cost of increasing water recovery charges evidently exceeded the financial benefit of receiving the grant. The challenge before the XV-FC is not to overestimate both the capacity and willingness of the state governments to undertake reform while proving sufficiently significant incentives to induce them to reform.

Census 2011 for Computations

The use of population figures from 2011 masks a paradigm shift in the determination of the shares of states in the devolved pool of taxes. Over the last 40 years, starting from the Seventh Finance Commission till the XIV-FC, eight finance commissions have been mandated to use the 1971 population for the purpose of computing state shares (Bhaskar and Subrahmanyam 2014).

Population is an important criterion that significantly affects a state’s share of the devolution pool. This is because it enters the computation of state shares both directly and indirectly. The XIV-FC allotted a weight of 17.5% to 1971 population. Directly, 17.5% of a state’s share in the divisible pool was determined on this basis. Indirectly, the 1971 population figure was also used to scale the income distance criterion (to which it had allotted a weight of 50%). The explicit and implicit use of population in finance commission computations has a marked effect on state shares of the devolution pool. To demonstrate, Table 5 lists the states and the amounts they would have gained or lost over their presently allocated share if the XIV-FC had used 2011 population both in its 17.5% population criterion as well as for scaling the income distance criterion.

Table 5 is instructive from the equity as well as political economy point of view. All the five southern states would have been the biggest losers, along with West Bengal, Odisha, Assam and Punjab. The quantum of these contingent losses for 2015–20 are significant. The five biggest potential gainers, Uttar Pradesh, Bihar, Rajasthan, Madhya Pradesh, and J&K account for 90% of the total gains. The above list of contingent losers and gainers for 2015–20 will possibly become the actual list of losers and winners for 2020–25 with the XV-FC having been explicitly mandated to use the 2011 population figures.

The direction to the XV-FC to use the 2011 population figures is not appropriate for three reasons.

First, over the last four decades, the 1971 population has been used as a criterion for determining the states’ share of the divisible pool by successive finance commissions even though subsequent census figures were available to it. The direction to the XV-FC to use the 2011 Census figures militates against the Revised Policy Statement on the Family Welfare Programme placed before Parliament in June 1977, which guaranteed that the 1971 population figures will be used as the parameter for computing state devolution shares. This assurance was confirmed by the National Development Council (NDC) in its meeting in 1979 and reiterated in the National Population Policy in 2000.

The drastic change in population base from 1971 to 2011 proposed in the ToR should have been made after consultation with the NDC or at least the NITI Aayog, which has accepted cooperative federalism as one of its operational tenets. One of the basic canons of cooperative federalism is the need for all federating members to provide credible commitments to each other. This change belies the commitment given by the centre to the states in 1977, 1979, and 2000 and weakens its capacity to make credible commitments in future.

Second, income distance has been used as a criterion for horizontal devolution over the last seven finance commissions. The XV-FC may find it difficult to discard or substantially modify this criterion. This criterion represents the commission’s attempt to ensure states have the fiscal capacity to provide comparable levels of public services to their residents at comparable levels of taxation. This parameter provides greater weightage to poorer states depending upon the distance of their per capita GSDP from that of a rich state (Haryana in the case of the XIV-FC). Placing high importance on equity, the XIV-FC provided a weightage of 50% to the income distance criterion.

If the 2011 population had been used for computations, the five states of Uttar Pradesh, Bihar, Madhya Pradesh, West Bengal, and Rajasthan would have an aggregate weightage of 32.48% out of the 50% weight accorded to income distance to all the 29 states. Thus, nearly 65% of the income distance criterion would have been pre-empted by these five states. While it is not this author’s case that the income distance criterion should not be utilised, the use of the 1971 population would have moderated the impact of this double whammy on the “non-poor” states.

Third, as noted in Bhaskar (2017), trust between the federating members is another essential component of a vibrant federation. Trust endures when changes from the norm are discussed between federating members in advance, and the approach to be adopted is agreed upon if not unanimously, then at least by majority. This does not appear to have been done while preparing the ToR of the XV-FC.19 The centre has already belied the trust of the state governments in the case of CGST compensation (Bhaskar 2017), and now the unilateral adoption of the 2011 population figures may further dilute this trust.

The XV-FC may therefore need to carefully craft its approach while providing adequate ballast to this ToR.


The ToR of the XV-FC is significantly different from those of earlier finance commissions. Some of these changes are within the mandate of the Constitution. Some do not appear to be so. Others appear extraneous. Some appear to urge the commission to asymmetrically treat a group of states. The XV-FC needs to take a considered view on how it will approach its work. The chairperson of the Fourth Finance Commission, P V Rajamannar in his minute attached to the report stated:

In respect of such an important matter as the determination of resources which will be available to each state as a result of a scheme of devolution, there should not be a gamble on the personal view of five persons, or a majority of them. (Minutes by P V Rajamannar, Report of the Fourth Finance Commission 1965: 93)

All the previous finance commissions have belied his apprehensions, and one can confidently say, so will the XV-FC.


1 Some states like Tamil Nadu have additionally defined this requirement in terms of limiting the ratio of revenue deficit to revenue receipts.

2 Excluding Uttarakhand, which projected a small surplus for 2017–18.

3 It is not to make a case to say that only the projections of the XIV-FC went awry. It occurred with respect to previous finance commissions as well. See, Bhaskar (2013).

4 Uncertainty includes additional welfare programmes implemented in future, like loan waiver or imposition of prohibition.

5 This is true of the centre as well. The Comptroller and Auditor General reported that effective revenue deficit targets and fiscal deficit targets were deferred by the government in Union Budget 2016–17 and 2017–18 without corresponding amendments to the act. See, CAG (2017).


7 Or more likely, the powerful incentive that the XII-FC provided to states that legislated and complied with the FRBM act—the write-off of their loans from the centre.

8 Except Sikkim and West Bengal, which passed their FRBM acts in 2010 responding to incentives offered by the XIII-FC.

9 It can be argued that grant of consent under Article 293 has so far been linked only to state governments remaining within the permissible fiscal deficit “authorised” by the finance commission and revenue deficit has not been a factor in determining consent at all. The Government of India may not have so far imposed zero revenue deficit as a condition, but given its powers under Article 293(3), nothing prevented it from doing so.


11 The word “shall” is used in para 6(1) of the ToR.

12 The reference here to the base year points to the use of 2018–19 and not 2024–25 as mentioned in the ToR.


14 Bhim Singh v Union of India and Others. Para 76(3), Supreme Court of India (2010), INSC 358, 6 May 2010.

15 The sum of standard rate of state value added tax at 14.5% and central excise rate at 12% is 26.5%. The maximum rate of 40% has not yet been levied, but the GST Council has now been empowered to do so.

. The press release dated 27 November 2017 notes a downward trend in GST revenue over the five months since its implementation.

17 Telangana has reportedly achieved a tax collection growth rate of 26.69% in November 2017 compared to November 2016 (Times of India 2017).

18 Ignoring Jammu and Kashmir.

19 A formal consultation would imply seeking views on specific issues like the use of the 2011 population. This is in contrast to a general request made by the centre to the state governments seeking suggestions on the ToR. This is a routine exercise initiated before every new finance commission is constituted.


Bhaskar, V (2013): “Issues before the Fourteenth Finance Commission,” Economic & Political Weekly, Vol 48, No 17, pp 31–36.

— (2017): “Goods and Service Tax: A Saga of Cooperative and Contesting Fiscal Federalism,” Aarthika Charche. FPI Journal of Economics and Governance, Vol 2, No 1.

Bhaskar, V and P S Subrahmanyam (2014): “Population as a Criterion for Horizontal Devolution by the 14th Finance Commission,” Economic & Political Weekly, Vol 49, No 5, pp 20–23.

CAG (2017): Report of the Comptroller and Auditor General of India on Compliance of the Fiscal Responsibility and Budgetary Management Act, 2003 for the Year 2015–16, Comptroller and Auditor General of India.

Finance Commission (2014): Report of the Fourteenth Finance Commission, December.

Raychaudhuri, Ajitava (2013): “Estimating True Fiscal Capacity of States and Devising a Suitable Rule for Granting Debt Relief based on Optimal Growth Requirement,” Report prepared for the Fourteenth Finance Commission.

RBI (2017): Handbook of Statistics on Indian States, Reserve Bank of India.

Times of India (2017): “Telangana Beats GST Glitch Blues, State Coffers Brim Over,” 24 December.

US 567 (2012): Opinion of Roberts C J, 567 US,

Vazquez, J M and L F J Boex (1997): “Fiscal Capacity: An Overview of the Concepts and Measurement Issues and Their Applicability in the Russian Federation,” Working Paper 97-3, Andrew Young School of Policy Studies, Georgia State University.

Updated On : 13th Mar, 2018


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