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Imbalance in Agenda of Finance Commission

The terms of reference of the recently constituted Thirteenth Finance Commission are heavily loaded in favour of the central government. It is, perhaps, for the first time that a finance commission has been explicitly asked to take into account the gross budgetary support to the central and state plans as a demand on the resources of the centre. This may result in making the finance commission transfers residual flows.


Imbalance in Agenda of Finance Commission

G R Reddy

are equal partners and should serve the purpose of promoting a stable and sustainable fiscal environment. The purpose of this note is to examine whether the ToR of the TFC meet these requirements. The specification of considerations in the ToR is taken up first for discussion under

The terms of reference of the recently constituted Thirteenth Finance Commission are heavily loaded in favour of the central government. It is, perhaps, for the first time that a finance commission has been explicitly asked to take into account the gross budgetary support to the central and state plans as a demand on the resources of the centre. This may result in making the finance commission transfers residual flows.

I am grateful to C H Hanumantha Rao, B P R Vithal and Mahendra Dev for useful comments and suggestions. Errors and omissions that remain are my own.

G R Reddy (reddy_grr55@yahoo.co.in) is a former official of the Indian Economic Service.

he Thirteenth Finance Commission (TFC) has been constituted by a presidential order on November 13, 2007 [Government of India 2007]. The primary responsibilities of a finance commission, as spelt out in Article 280(3) of the Constitution, are to make recommendations regarding (i) the distribution between the union and the states of the net proceeds of taxes which are to be, or may be, divided between them, (ii) the principles which should govern the grants-in-aid of the revenues of the states out of the Consolidated Fund of India, and (iii) measures needed to augment the resources of panchayats and municipalities in the states.

These constitutionally mandated responsibilities are the same for all the commissions and spelt out as such in the terms of reference (ToR). Apart from these primary obligations, certain other matters are also referred to a finance commission under Article 280(3) (d) of the Constitution. It has become customary for the ToR to include some considerations, which the commissions may take into account while making their recommendations. Over the years, there has been an enlargement of these considerations. Up to the Sixth Finance Commission, these considerations related only to recommendations concerning grants-in-aid. From the Seventh Finance Commission onwards, these considerations were extended to cover even tax sharing.

By and large, additional matters referred to a commission and the specification of considerations which a finance commission may take into account while making its recommendations are intended to reflect the emerging trends and concerns in central-state fiscal relations. Ideally, the additional matters and the considerations specified in the ToR should be based on the premise that the centre and the states certain broad heads.

Demands on Central Resources

The ToR has stipulated that the TFC shall take into account the demands on the resources of the central government, in particular, on account of the projected gross budgetary support (GBS) to the central and state plans, expenditure on civil administration, defence, internal and border security, debt-servicing and other committed expenditure and liabilities. The consideration in the case of states is restricted to that of taking into account the resources and there is no reference to the needs except to the non-salary component of maintenance and upkeep of capital assets and the non-wage related expenditure on plan schemes to be completed by March 31, 2010. Expenditure on civil administration, debt-servicing and other committed liabilities is as much a demand on the resources of states as that of the centre. Not mentioning these demands on the resources of states is blatantly unfair.

Over the years, plan expenditure has shifted towards social sectors, resulting in a higher proportion of revenue expenditure in the total expenditure under the plan. In the case of social sectors like education and health, the bulk of the expenditure is under the revenue account. The reference made to the commitments of states relates only to non-wage maintenance expenditure on capital assets and on plan schemes to be completed by March 31, 2010. Under this consideration, there is an apprehension that the requirements on account of salary in respect of schemes to be completed under education and health sectors will not be taken into account.

As the terminal year of the Eleventh Plan is 2012, most of the ongoing schemes will continue till then. Therefore, 2012 should have been specified as the cut-off year. We may expect that the TFC will take

december 22, 2007 Economic & Political Weekly


the requirement of schemes to be completed at the end of the Eleventh Plan into account. In fact, the Twelfth Finance Commission had factored in the committed expenditure from 2007-08 onwards, coinciding with the new five-year plan, though the cut-off date prescribed for that commission was March 31, 2005.

The practice of not specifically mentioning the needs of the states in the ToR started with the Twelfth Finance Commission. As observed by that commission, the omission of any specific reference to the needs of states may be due to the insertion of a separate consideration in the ToR regarding 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 reference to the needs of states, one may expect that the TFC would assess the needs of the states with the same degree of comprehension as was done by its immediate predecessor commission.

Gross Budgetary Support

What is of more importance than the omission of needs of states in the ToR is the fact that a finance commission has been asked for the first time to take GBS for the central and state plans as a demand on the resources of the central government. The considerations for the Seventh and Eighth Finance Commissions included taking into account the existing practice in regard to the determination and distribution of central assistance for state plans.

However, this was a general consideration and not part of the consideration relating to the demands on the resources of the central government.

Both the Eleventh and Twelfth Finance Commissions have projected the plan expenditure of the centre as a residual keeping in view the targets laid down for deficit reduction and the projected nonplan expenditure including non-plan grants to states. By including the GBS in the needs of the centre, there is a danger that the finance commission transfers to states would become residual, given the deficit reduction targets mandated under the Fiscal Responsibility and Budget Management (FRBM) legislation and the indicative amount of overall transfers to

Economic & Political Weekly december 22, 2007

states to be fixed at 38 per cent of central gross revenue receipts as recommended by the Twelfth Finance Commission and accepted by the central government.

The finance commission is a constitutional body and as such cannot be bound by an estimate of GBS worked out by an extra-constitutional authority like the Planning Commission. The question is whether the TFC will make an independent assessment of the requirements on account of GBS, as it may upset the estimates of the plan already finalised. TFC will be failing in its duty if it binds itself by a given GBS. This will be a great decline in the role of a constitutional institution like the finance commission.

Another concern is the composition of GBS itself, which is in the nature of undermining the autonomy of states. The GBS of central government consists of central plan and central assistance to state and union territory (UT) plans. The GBS to central plan comprises central sector plan and centrally-sponsored schemes (CSS). Over the years, GBS to central plan has undergone a major shift with an increase in the number and funding to CSS, which are mainly in the areas falling under state subjects. This has happened despite a consensus on the need to reduce the number of CSS. Now, funding to CSS is nearly 50 per cent of the GBS to the central plan and over 400 per cent of normal central assistance.

A large proportion of the CSS fund bypasses the state budgets. The GBS to state plans, as it emerged since 1969 used to be mainly in the form of untied block grants referred to as normal central assistance. The nature of these grants has undergone a major dilution with the centre introducing specific schemes and labelling support to these schemes as additional central assistance. The nature of GBS has undergone further dilution with the introduction of discretionary grants under special plan assistance and special central assistance. As a result, normal central assistance is now around 40 per cent of the GBS for state plan [Garg 2006]. The consideration of GBS by the TFC will amount to perpetuating the increasing role of CSS and increasing the discretionary element of assistance to state plans.

Though there is no constitutional bar, all the commissions with the exception of the First, Second and the Ninth Finance Commissions looked at only the non-plan component of revenue expenditure of states as the plan component was supposed to be taken care of by the Planning Commission. In the case of the recent finance commissions including the TFC, there is no stipulation in the ToR that they should take into account only the non-plan revenue expenditure of states when considering their needs. In fact one of the considerations for the recent finance commissions is the need for balancing receipts and expenditure on revenue account of all states and the union.

Revenue Account

With no bifurcation of state plan outlays into revenue and capital components, and approved plan outlays often bearing no relationship with the state's resources and emphasis on social sectors, the revenue component of state plan outlays increased to about 50 per cent. Plan grants by the centre cover only a small proportion of the revenue component of the plan and there is no surplus in the non-plan revenue accounts of states to meet the revenue component of the plan. Maintenance of completed plan schemes and debt-servicing exert pressure on the non-plan revenue accounts of states. Thus, states will find it difficult to balance their revenue budgets. It is, therefore, necessary for the TFC to address this issue and take into account the entire revenue account. Such an approach will not make finance commission transfers a residual, as apprehended. The need for the removal of distinction between plan and non-plan revenue expenditure as well as the need for the finance commissions to look at the total revenue account is too well established to bear repetition here. Such an approach is required to balance receipts and expenditure on the entire revenue account, which is one of the considerations specified in the ToR.

It may be pertinent to mention here that the transfers recommended by the finance commissions are not entirely in the nature of meeting the non-plan revenue expenditure. Grants recommended by finance commissions under upgradation of


standards of administration and special problems and those recommended to local bodies are taken as a resource for the state plans and the expenditure met out of these grants is booked under plan revenue account.

Quality of Expenditure

One of the considerations, which the TFC is required to take into account, is the need to improve quality of public expenditure to obtain better outputs and outcomes. It is not clear as to how the commission is going to accomplish this task. One of the possibilities is that the TFC may consider some expenditure on certain activities as not meeting quality standards and scale it down in their forecasts of state expenditure. This will be at the expense of the state autonomy. The other way the commission could take this into account is by recommending specific grants to certain sectors, as was done by the Twelfth Finance Commission. That commission recommended specific grants to education, health and made additional provisions towards maintenance expenditure over and above the forecast of expenditure made by it. As the utilisation of these grants is subject to monitoring, one may expect some improvement in the quality of expenditure. But for this to happen, these special purpose grants have to be sizeable. This will increase the share of grants, more particularly of tied grants in total devolution.

The consideration regarding the need to manage ecology, environment and climate change consistent with sustainable development may also result in the finance commission recommending specific purpose grants. One can only hope that states that manage their ecology and environment relatively better and are not penalised. These grants are likely to be subjective in nature.

The practice of asking the finance commissions to take the 1971 population as the base in all cases where population is a factor for determination of devolution of taxes and duties and grants-in-aid started with the Seventh Finance Commission. This was in consonance with the National Family Welfare Policy, 1977, which stipulated the adoption of 1971 population figures till 2001 in all cases where population was a factor in the allocation of central transfers. This was done to ensure implementation of family planning programmes by states.

The growth of population of a state depends on the natural growth as well as migration into or out of a state. While effective implementation of the family planning programme can result in a lower natural growth of population, it may have no major effect on the overall growth of population because of migration flows. States like Bihar, Madhya Pradesh, Rajasthan, Uttar Pradesh, Uttarakhand and a large number of special category states are likely to lose with the adoption of 1971 population. If there is a case for freezing the population at its 1971 level for the purpose of central transfers, there is an equally compelling case for freezing the per capita income of states at a pre-determined level to reward states that have managed their economies well. Using the 1971 population may result in sacrificing equity with no major efficiency gain.

There are instances of finance commissions using the latest population figures in certain types of transfers. For instance, the Ninth and Tenth Finance Commissions used the latest population figures for distributing the states’ share in additional excise duties in lieu of sales tax on the plea that these were the result of a tax rental agreement between the centre and the states and were not in the nature of tax devolution or grants-in-aid. Similarly, the Twelfth Finance Commission used the 2001 population for the inter se distribution of grants recommended by it to rural and urban local bodies. One may hope that the present commission would follow the precedent set by its predecessor commissions by not using the 1971 population for certain types of transfers.

Review of Debt Position

Under the additional items, one of the tasks assigned to the TFC in the ToR relates to reviewing the state of finances of the union and the states, keeping in view, in particular, the operation of the states’ Debt Consolidation and Relief Facility, 2005-10, introduced by the central government on the basis of the recommendations of the Twelfth Finance Commission and suggest measures for maintaining a stable and sustainable fiscal environment consistent with equitable growth. This ToR is very much different from those of the previous commissions. The ToR of most of the previous commissions made reference to the review of the debt position of states and suggesting correctives. In contrast, the present TFC is just asked to take into account the operation of the Debt Consolidation and Relief Facility recommended by the previous commission.

As such, the scope for debt relief has become very limited, with the share of central loans in total outstanding debt of states coming down drastically with debt swap and the centre dispensing with the practice of extending plan loans to states. When the states are struggling to meet the deficit reduction targets, the centre has, in a way, pre-empted the commission in recommending relief to even acutely debt stressed states. One can only hope that the TFC will recommend debt relief in the interests of sustainable fiscal environment.


The ToR of the TFC seem to be heavily loaded in favour of the centre. One such glaring instance is the inclusion of GBS among the needs of the centre while not making any mention of the needs of the states. Uniform criteria should have been applied for the consideration of the expenditure needs of the centre and states. States are unlikely to get any debt relief under the dispensation of the ToR. The finance commission is technically free to take other considerations, based on its judgment, such options will be limited, as the other considerations will have to be in consonance with those mentioned in the ToR. Despite the bias in the ToR in favour of the centre, the TFC can still take into account the requirements of states in a comprehensive manner as one of the considerations relates to 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.


Government of India (2007): Gazette Notification No 1937(E), Ministry of Finance, November 13.

Garg, Subash Chandra (2006): ‘Transformation of Central Grants to States – Growing Conditionalities and Bypassing State Budgets’, Economic & Political Weekly, Vol 41, No 48, pp 4977-84, December 2.

december 22, 2007 Economic & Political Weekly

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