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Upholding Fiscal Federalism

Terms of Reference of the Fifteenth Finance Commission

G R Reddy ( is a former official of the Indian Economic Service and currently adviser to the Government of Telangana.

The appointment of the Fifteenth Finance Commission has come at a time of momentous changes in Indian fiscal federalism. The XV-FC has a challenging task in addressing these developments. A number of considerations in the terms of reference of the XV-FC, however, point to a bias in theToR towards the union government.

Views expressed are personal.

The appointment of the Fifteenth Finance Commission (XV-FC) by a presidential order on 27 November 2017 has come at a time of momentous changes in Indian fiscal federalism. The replacement of the Planning Commission by the National Institution for Transforming India (NITI) Aayog in January 2015, the removal of the distinction between plan and non-plan expenditure in the budgets of the union and the states from 2017–18, and the 101st constitutional amendment resulting in the introduction of the long-awaited goods and services tax (GST) from 1 July 2017 across the country are game changers in the area of fiscal federalism. Perhaps, such game changing developments did not take place in the period immediately preceding the appointment of any other commission.

The Impact of the Changes

The replacement of the Planning Commission—a parallel channel of resource transfers to states not envisaged under the Constitution—by NITI Aayog—which does not have an allocative role—is expected to address the problem of multiple channels of resource transfers that bedevilled fiscal federalism in the country so far. The main functions of NITI Aayog, among others, are to provide a shared vision of national development priorities, and to foster cooperative federalism through struc­tured support initiatives and mechanisms with the states on a continuous basis.

The Fourteenth Finance Commission (XIV-FC) considered the entire revenue account. Its terms of reference (ToR) did not bind it to look at only non-plan revenue account. The replacement of the Planning Commission, with the removal of the practice of classifying expenditure into plan and non-plan, has conferred full freedom to the XV-FC to look at the entire revenue expenditure in totality, instead of a fragmented view of resource allocations. As observed by the High Level Committee on “Efficient Management of Public Expenditure” (Rangarajan Committee, 2011), the non-plan and plan distinction in the budget was neither able to provide developmental and non-developmental dimensions of public expenditure, nor was it an appropriate budgetary framework.

The introduction of the GST marks a watershed in the reforms of indirect taxation in the country. It has ushered in an era of sharing a common tax base by the union and the states in place of exclusive jurisdiction over certain taxes based on the principle of total separation. Furthermore, the GST being a destination-based tax has shifted the tax base from production to consumption. This may impact revenue yield from indirect taxes as between the predominantly producing and consuming states. As the revenue impact of the GST across the states is not yet known, the XV-FC will have the challenging task of addressing this issue as its recommendations are applicable till 2024–25, beyond the five-year duration of compensation scheme for states that may suffer revenue loss, following the introduction of GST.

Besides these major changes, there is a slowdown in the growth of the economy since last year and pressures building up on both the union and state finances. There are incipient signs of states, which so far, by and large, adhered to the Fiscal Responsibility and Budget Management (FRBM) limits, slipping on them.

Functions of Finance Commission

The XV-FC has a major task on hand in putting in place a transfer system consistent with the recent changes in fiscal federalism, promoting cooperative fiscal federalism and ensuring fiscal stability. The main intent of this article is to analyse whether theToR of the XV-FC reflect the above imperatives in letter and spirit.

The main function of a finance commission as mandated in Article 280 of the Constitution is to make recommendations on (i) the distribution of net proceeds of divisible pool of taxes between the union and the states; (ii) inter se allocation of states’ share; (iii) principles which should govern the grants-in-aid to states by the finance commission; and (iv) measures to augment the Consolidated Fund of a state to supplement the resources of panchayats and municipalities.

These constitutionally mandated functions are reproduced as such in theToR of all the finance commissions. In terms of clause (d) of Article 280, any other matter can be referred to a finance commission in the interest of sound finance. It has become a practice to specify in theToR certain considerations that a finance commission shall have regard to, among others, while making its recommendations. While the considerations related to only grants till the Sixth Finance Commission, from the seventh onwards, the considerations covered both grants as well as tax devolution. These considerations have become a source of friction between the union and the states.

Additional Matters

As in the case of the previous commission, XV-FC is mandated to review the current status of finance, deficit, debt levels, and fiscal discipline efforts of the union and the states and recommend a fiscal consolidation road map for sound fiscal management. The important additional items included in theToR of XV-FC relate to the review of cash balances and examination of whether revenue deficit grants should be provided at all.

The deficit grants have been criticised mainly on the ground that they create perverse incentives to states to remain profligate and not exploit their revenue resources to their full potential. This is in the hope that the finance commission will recommend grants to bridge the estimated differential between the revenue requirement and their revenue realisation. This criticism, though still valid to a limited extent, has lost much of the ground following the adoption of a normative approach by the finance commissions for forecasting the revenue and expenditure of states. This coupled with the progressivity in the formulae for tax devolution as well increase in the vertical share of the states in the divisible pool of union taxes has resulted in a drastic reduction in the number of states getting deficit grants.

The number of states receiving revenue deficit grants has come down from 15 in the case of Eleventh Finance Commission (XI-FC) to 11 in the case of XIV-FC. Among the 11 states assessed to be revenue deficit, as many as eight are special category states. What is significant to note is that the share of the revenue deficit grants in total grants recommended by the finance commissions has witnessed a significant reduction from 60.4% in the case of XI-FC to 36.3% in the case of XIV-FC. This is despite the fact that the latter considered the entire revenue account as compared with the previous commissions which considered only the non-plan revenue account.

The question that arises is, how do we address the post-tax devolution revenue deficits of states in the absence of deficit grants? There are limits beyond which the tax devolution formula cannot be made progressive enough to ensure that no state is left with a deficit. This is neither desirable nor feasible as it will drastically cut down tax devolution to performing states, whose average per capita income is above the national average. This will amount to disincentivising development and making states weaker. Besides, the fundamental issue is that such a course of action will breach the constitutional provision for giving grants-in-aid to states under Article 275 (Rao 2017).

Compression of Fiscal Space?

The XV-FC has been mandated to take into consideration, among others, the impact of the fiscal situation of the central government of substantially enhanced tax devolution, following the recommendations of XIV-FC. The XIV-FC while explicitly stating that there was little scope for increasing the aggregate transfers to states strongly expressed the desirability of a compositional shift in transfers from grants to tax devolution. This would enhance the share of the states in unconditional transfers without imposing any additional fiscal burden on the centre. In this context, the XIV-FC observed that aggregate transfers to states, as a percentage of gross revenue receipts of the union, went up from 49.9% in 2010–11 to 53.7% in 2011–12 before coming down to 49% in 2012–13. Keeping these trends in view, the commission expected that the union would maintain the prevailing level of aggregate transfers at about 49% of its gross revenue receipts (Finance Commission 2014).

Following the increase in tax devolution, the union government dispensed with the formula-based normal plan assistance to states and terminated a number of schemes like Backward Regions Grant Fund and increased the matching contribution of states in respect of a number of centrally-sponsored schemes (CSSs). In the first three years of the XIV-FC award period, aggregate transfers hovered around 48% of centre’s gross revenue receipts.

Thus, the impression that the increase in tax devolution resulted in the compression in the fiscal space of the centre is fallacious and not borne out by facts. In such a situation, inclusion of the consideration regarding the fiscal position of the union following the enhanced tax devolution is not in the spirit of cooperative fiscal federalism. It creates an impression that inclusion of this consideration amounts to indirectly asking the XV-FC to reduce tax devolution to states.

Raising Loans

Another consideration relates to the conditions that the union may impose on the states while providing consent under Article 293 (3) of the Constitution. Under this article, a state cannot raise any loan without the consent of the union, if there is any part of an outstanding loan from the union to the state. Under clause (4) of this article, consent can be granted subject to such conditions, as the Government of India may think fit to impose.

This consideration seems to have been included in theToR for the first time, presumably because the share of the loans from the union in the outstanding debt of the states has been coming down significantly following the termination of central government loans to states from 2005–06 onwards. This was on the advice of the Twelfth Finance Commission that the centre should dispense with the practice of acting as an intermediary and instead allow the states to approach the market directly.

At the end of 2016–17, loans from the centre constituted less than 5% of the total outstanding debt of all states. It is likely that over the next few years, many states may liquidate all their borrowings from the centre, thus freeing themselves from the condition of seeking consent for raising loans internally. However, states are still bound by the FRBM legislation to contain their debt levels and maintaining a surplus on their revenue account. Therefore, the idea of imposing conditionalities on states’ borrowings is not in the spirit of cooperative federalism.

Other Considerations

The XV-FC has been asked to consider proposing measurable performance-based incentives for states in the areas, such as, deepening the tax net under GST, achievements in the implementation of flagship programmes of Government of India, progress made in increasing capital expenditure, progress made in improving tax and non-tax revenues, efforts in promoting ease of doing business, provision of grants to local bodies, progress made in sanitation and control or lack of control in incurring expenditure on populist measures.

Asking the finance commission to follow an incentive-based approach in recommending transfers to states and absence of any such considerations for nudging the union to perform better is indicative of the lopsidedness of the considerations listed in theToR. Fiscal prudence is a joint responsibility of the union and the states in a federation. Leaving out the union from such a responsibility will not result in fiscal prudence, and restricting them to states that have, by and large, adhered to FRBM stipulations, goes against the spirit of cooperative fiscal federalism. More importantly, the consideration relating to populist measures is highly subjective. What constitutes a populist measure differs widely across states. The centre is also equally guilty of populist measures.

Population Data

All the finance commissions since the seventh were asked to use population data of 1971 in all cases where population was regarded as a factor for determination of devolution of taxes, duties, and grants-in-aid. This was in consonance with the National Family Welfare Policy, 1977, which stipulated use of 1971 population figures till 2001 where population was a factor in the transfer of resources from the union to states.

This was done to ensure that states take effective measures to moderate the growth of their population (Reddy 2007). The XV-FC has been mandated to use the population data of 2011 while making its recommendations. This is a welcome development. As observed by the XIV-FC, migration is an important factor in the growth of a state’s population, apart from factors like fertility and mortality rates. Migration imposes a burden on the destination states and taking dated population for the purpose of central transfers is a double whammy for such states. In fact, the requirements of states depend on the current levels of population, and therefore, the XV-FC should have been mandated to take into account the latest available mid-year population as estimated by the Registrar General and Census Commissioner of India.

To sum up, the XV-FC has a challenging task on hand in addressing the game- changing developments in Indian fiscal federalism and in making cooperative fiscal federalism a reality. Going by the track record of the previous commissions, it is hoped that the XV-FC will not be constrained in its working by the considerations given to it that appear to be biased in favour of the centre.


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

Rao, Govinda M (2017): “The Fifteenth Finance Commission, Redefining the Commission’s Mandate?” Financial Express, 5 December.

Reddy, G R (2007): “Imbalance in Agenda of Finance Commission, Economic & Political Weekly, Vol 42, No 51, pp 8–10.


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