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The Role of Finance Commissions in Intergovernmental Fiscal Management
Fiscal imbalances, both vertical and horizontal, are common to federations and India is no exception. The Indian Constitution provides for instruments—shared taxes and grants-in-aid—to address such imbalances and an institutional mechanism—the finance commissions with specified terms of reference—to negotiate such imbalances. The paper addresses how 14 different FCs have dealt with their constitutionally assigned roles and strengthened the fabric of fiscal federalism in India. It further examines how the role of FCs were enlarged with additional terms in the interest of sound finance. It discusses, as an illustration, how FCs have addressed one of the major fiscal concerns, restoring budgetary balance and maintaining macroeconomic stability in the economy.
The authors are grateful to the anonymous referee whose comments have greatly benefited this paper as also to Smriti Mehra for excellent research assistance.
Fiscal federalism relates to the assignment of functions to different levels of government and of appropriate revenue instruments to carry out these functions based on comparative advantage. In India, the nationwide base and redistributive taxes, money supply, and borrowing powers are assigned to the federal government, while subnational governments, being closer to people, are better placed in local service provisioning. The social and economic sectors, involving large expenditures, thus, become the responsibility of subnational governments. This eventually results in a vertical imbalance. Such imbalances are common to most federations and India is no exception. Further, the gap between capacity to collect revenue and expenditure needs varies across states depending upon initial endowments, historical backgrounds, and the levels of development. This gives rise to a horizontal imbalance. The Constitution-makers foresaw these imbalances and provided for instruments in the form of taxes to be shared and grants-in-aid. They also provided for an institutional mechanism in the form of finance commissions (FCs) to facilitate such transfers.
The commission’s terms of reference (ToR) are specified in the Constitution under Article 280(3). They include (i) distribution and allocation of the net proceeds of shareable taxes between the union and states (prior to the 80th constitutional amendment in 2000, this included personal income tax compulsorily and union excise duties, if needed, and thereafter, all taxes) and (ii) principles governing the grants-in-aid of the revenues of states out of the Consolidated Fund of India. Subsequently, the 73rd and 74th constitutional amendments in 1992 added two subclauses, which required the FC to recommend measures needed to augment the Consolidated Fund of a state to supplement the resources of panchayats and municipalities therein on the basis of the recommendations of the state finance commission. Finally, the President can refer any other matter to the FC in the interest of sound finance. The First FC was constituted in November 1951 and covered the five-year period 1952–57. Since then, there have been 14 FCs. The FC-XV, which submitted its report in November 2020, covered the period 2020–26.
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