Finance Commission 101 – Blog by Tickertape

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Imagine delegating responsibilities and powers among the members of a joint family. That’s a tricky business, right? But at the same time, it is vital for all resources including finances to be fairly distributed among the members, just to ensure the smooth functioning of the family. And this duty of delegating powers and responsibilities is mostly entrusted to the elders and the most experienced members of the family. That’s what a Finance Commission does at the national level.

India is a federal state, meaning we have a 2-tier government. One for the entire country, which is called the central/union government and the other for each state, called the state governments. As of today, we have 29 state governments in addition to the Union. That’s one complex structure, a joint family that is next-level 😛 So the distribution of the national financial revenue between the centre and the states may not be free of complexities. Thankfully, we have a written constitution that allows for the division of powers between the union and the state governments.

And so, our constitution provides for a Finance Commission, a constitutional body responsible for balancing financial resources among the centre and the states. More on this in today’s article.

What does the article cover?

What is Finance Commission?

History of the Finance Commission of India

List of Finance Commissions

What is the provision for sharing the tax proceeds in the Constitution?

Need for a Finance Commission

Who forms the Finance Commission of India?

Who constitutes the Finance Commission?

Prerequisites for the Finance Commission chairman and other members

When can a member of the Finance Commission be disqualified?

Scope of the Finance Commission of India

Functions and responsibilities of the Finance Commission

Reports of the Finance Commission

On what basis does the Finance Commission make recommendations?

Are the recommendations made by the Finance Commission binding on the government?

Some recommendations of the 14th Finance Commission

The 15th Finance Commission

Members of the 15th Finance Commission of India

Reports of the 15th Finance Commission

Recommendations of the 15th Finance Commission

Criteria for distributing the centre’s tax proceeds for 2020-21

States’ share in the centre’s tax revenue

Recommendations on fiscal plan

Recommendations made by the 15th Finance Commission on grants

73rd Constitutional Amendment Act and State Finance Commission

What is Finance Commission?

Also known as the Vitta Aayog, the Finance Commission is a constitutional body that defines financial relations between the union and state governments of India. In other words, the Financial Commission of India is entrusted with the responsibility of recommending how financial resources are to be shared between the governments with an aim to reduce the imbalance in transferring such resources.

History of the Finance Commission of India

The Finance Commission was established in 1951 by Dr B R Ambedkar. So far, we have had 15 Finance Commissions in India. Here are the details.

List of Finance Commissions

  Year of establishment Chairman Operational duration
1st 1956 K. C. Neogy 1952-57
2nd 1956 K. Santhanam 1957–62
3rd 1960 A. K. Chanda 1962–66
4th 1964 P. V. Rajamannar 1966–69
5th 1968 Mahaveer Tyagi 1969–74
6th 1972 K. Brahmananda Reddy 1974–79 
7th 1977 J. M. Shelat 1979–84
8th 1983 Y. B. Chavan 1984–89
9th 1987 N. K. P. Salve 1989–95
10th 1992 K. C. Pant 1995–00 
11th 1998 A. M. Khusro 2000–05
12th 2002 C. Rangarajan 2005–2010
13th 2007 Dr Vijay L. Kelkar 2010–2015 
14th 2013 Dr Y. V Reddy 2015–2020
15th 2017 N. K. Singh 2020–2025

Source: Jagran Josh

What is the provision for sharing the tax proceeds in the Constitution?

The centre enjoys most of the powers of collecting big tax revenues such as income tax. The reason? It enjoys economies of scale in collecting certain taxes. On the other hand, states are responsible to deliver public goods and services in their areas because they enjoy proximity to local requirements and issues. This is why, sometimes states incur higher expenditures than they generate revenue.

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Further, due to vast regional disparities, some states are unable to raise adequate resources as compared to others. Moreover, the states are also entitled to distribute their tax revenue among the respective Panchayati Raj institutions at all levels.

Need for a Finance Commission

Clearly, there is a disparity in the revenue generated by the centre and the states. And there has to be a way to balance this out. Meaning, the centre’s tax proceeds are required to be shared between the union, the states, and the local governments. That is why the need to establish a Finance Commission was felt by the makers of our constitution.

Who forms the Finance Commission of India?

Finance Commission is a constitutional body that is formed by the President under Article 280 of the Constitution, at the interval of 5 yrs.

Who constitutes the Finance Commission?

The Finance Commission consists of a chairman and 4 members. In addition, the government of India also appoints a secretary to the Finance Commission as support and manpower to aid in facilitating its work.

Prerequisites for the Finance Commission chairman and other members

The President constituted the 15th Finance Commission of India in Nov 2017 and appointed the former Planning Commission member N. K. Singh was appointed as the chairman. The Chairman of the Finance Commission is required to be experienced in public affairs.

The other 4 members should have been appointed or have had experience or knowledge in:

  • A Judge of a High Court or
  • Financial matters and administration
  • Finances and accounts of the Government or
  • Economics

When can a member of the Finance Commission be disqualified?

  • They are mentally unsound
  • They are undischarged insolvent
  • They are convicted of an immoral offence
  • Their financial and other interests hinder the commission’s smooth functioning

Scope of the Finance Commission of India

Article 280 of the Indian Constitution Act defines the scope of the Finance Commission as follows:

  • The Finance Commission is empowered to determine a procedure that allows it to discharge its responsibilities in an effective manner.
  • The Finance Commission is responsible to recommend the President about the distribution of the net proceeds of taxes, duties, and fees between the centre and the states.
  • The commission also recommends the allocation of the tax proceeds that the states receive among the local governments.
  • The Commission also defined the financial relations between the centre and the states.
  • Deal with the delegation of unplanned revenue resources between them.

Functions and responsibilities of the Finance Commission

With the scope of the Finance Commission as a premise, let’s look at the responsibilities of the constitutional body. The Finance Commission makes recommendations to the President on the following subjects:

  • Distribution of net tax proceeds between the centre and the States. The state’s share in the centre’s tax revenue depends on how much it contributed to the same.
  • Determination of the factors that govern grants and aids and its quantum to be offered by the centre to the deserving states.
  • Measures to augment the Consolidated Fund of a State to enhance the resources of Panchayats and Municipalities based on the State Finance Commission.
  • Determine the proportion in which Finance Commission Grants is to be offered to local bodies in the states. The Finance Commission Grants, which is a part of the Union budget, is a share of tax proceeds received by the centre.
  • Any other matter required to build a sound financial system in the country.
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Reports of the Finance Commission

Article 281 of the Constitution requires the President to present the Finance Commission report before each House of Parliament. The report should also mention an explanatory note and all the actions that the government has to take on the Commission’s recommendations to build a sound financial system in the country.

On what basis does the Finance Commission make recommendations?

The Finance Commission makes its recommendations based on the reference points that are to be used to formulate them. These reference points are decided by the centre and include factors such as the census to be used to factor in the population of states.

The Finance Commission then finalises the formula to distribute the tax proceeds for 5 yrs after consulting with all the stakeholders including the ministries and departments of the centre, state governments, banks and industry, and trade bodies.

Are the recommendations made by the Finance Commission binding on the government?

The Finance Commission’s recommendations are not binding on the government. However, there’s a strong probability that the Union government accepts the recommendations and acts on it.

Some recommendations of the 14th Finance Commission

The 14th Finance Commission had made the following recommendations:

  • The 13th Finance Commission had recommended that states get 32% of the share of the net proceeds of central Taxes. The 14th Finance Commission increased it to 42%
  • Fiscal deficit was to be reduced to 3% progressively and eliminated ultimately
  • The centre and the state governments were to conclude their bargain to implement GST Act

The 15th Finance Commission

Currently, we have the 15th Finance Commission in force. Initially, the duration of the Finance Commission was decided to be from 1st Apr 2020 to 31st Mar 2025 but the tenure starts from 2021 till 2026 for the full set of recommendations.

The 15th Finance Commission was required to submit 2 reports. The first report with the recommendations for the financial year 2020-21. And the second and final report would have the recommendations for the period of 2021-26, which is due for submission by 30th Oct 2020.

Members of the 15th Finance Commission of India

Chairman:

N. K. Singh: he was the former Member of Parliament (MP) and the former Secretary to the Government of India

Members:

  • Ajay Narayan Jha: he was the former Finance Secretary to the Government of India
  • Dr. Anoop Singh: he was the Adjunct Professor at Georgetown University, USA
  • Dr. Ashok Lahiri: he was the former Chief Economic Adviser, Ministry of Finance, Government of India and the former Chairman (Non-executive) Bandhan Bank

Part-time Member:

  • Dr. Ramesh Chand: Member, NITI Aayog

Secretary:

Reports of the 15th Finance Commission

The 1st report of the 15th Finance Commission for FY2020-21 was presented on 1st Feb 2020. One of the key recommendations was to reduce the share of states in the centre’s tax proceeds to 41% from 42% recommended by the 14th Finance Commission. The difference of 1% is to offer financial support to the newly-created UT of Ladakh and Jammu & Kashmir.

Recommendations of the 15th Finance Commission

In addition to recommending on the transfer of Centre’s tax proceeds to the states, the 15th Finance Commission is also entrusted to:

  • Analyse the impact of the recommendations made by the 14th Finance Commission on Centre’s fiscal position
  • Appraise the Centre’s and States’ level of debt and recommend a plan
  • Review the impact of GST on the economy
  • Recommend incentives for states based on their performance in controlling the population, promoting the ease of doing business, and other areas

Criteria for distributing the centre’s tax proceeds for 2020-21

Following are the criteria and the basis of their weights, which the share of the states in the centre’s tax proceeds is determined by the 15th Finance Commission of India.

1. Income distance: 45.0

The distance of the state’s income (average per capita GSDP during the period 2015-16 to 2017-18) from the average per capita income of all states. Meaning, the difference between both. Here, states with lower per capita income would receive a higher share in Union’s tax proceeds to maintain equity.

2. Population according to 2011 census: 15.0

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As mentioned earlier, the government decides the reference points based on which the Commission is to make recommendations. For the 15th FC, the 2011 census was the reference point to be used to collect population data. This criterion rewards states with controlled population growth, which is computed using the reciprocal of the Total Fertility Ratio (TFR) of each state, scaled by the 1971 census. By virtue of this, states with a lower fertility ratio score higher on this criterion.

3. Area: 15.0

A state with a larger area incurs additional administrative costs to deliver public goods and services.

4. Forest and Ecology: 10.0

This criterion calculates the states’ share of the dense forest in the combined dense forest of all the states.

5. Demographic Performance: 12.5

6. Tax Effort: 2.5

This criterion rewards states with higher tax collection efficiency computed as the ratio of the average per capita own tax revenue and the average per capita SGDP of 2014, 2015, and 2016.

Share of States in Centre’s taxes

State Devolution for FY 2020-2021 (Rs cr)
Uttar Pradesh 1,53,342 
Bihar 86,039
Madhya Pradesh 67,439
West Bengal 64,301
Maharashtra 52,465
Rajasthan 51,131
Odisha 39,586
Tamil Nadu 35,823
Andhra Pradesh 35,156
Karnataka 31,180
Chhattisgarh 29,230
Gujarat 29,059
Jharkhand 28,332
Assam 26,776
Telangana 18,241
Kerala 16,616
Punjab 15,291
Arunachal Pradesh 15,051
Uttarakhand 9,441
Haryana 9,253
Himachal Pradesh 6,833
Meghalaya 6,542
Manipur 6,140
Tripura 6,063
Nagaland 4,900
Mizoram 4,327
Sikkim 3,318
Goa 3,301
Total  8,55,176 

Source: PRS

Recommendations on the fiscal plan

  • The Commission recommended that Centre and States focus on debt consolidation and abide by the fiscal deficit and levels of debt as per their respective Fiscal Responsibility and Budget Management (FRBM) Acts
  • The Commission also recommended that Centre and States fully disclose their off-budgetary borrowings and eliminate the same timely
  • The Commission pointed out that India’s tax revenue is below its estimated tax capacity and that it has remained the same since the 1990s. Therefore, it recommended expanding the tax base, streamlining tax rates, and enhancing the capacity and expertise of the tax administrations at all levels
  • On analysing the impact of GST, the Commission revealed concerns including a huge shortfall in collections vis-à-vis the forecast, glitches in the invoice, high volatility in collections, and delay in refunds. Ergo, the Commission recommended considering the structural implications of GST for low-consumption states

Recommendations made by the 15th Finance Commission on grants

The 15th FC has recommended the following grants:

Revenue grants

As per the devolution/delegation of Union taxes between Centre and States based on the recommendations of the 15th Finance Commission, 14 out of 29 states are estimated to face a revenue deficit after the devolution. Therefore, the Commission has recommended offering a revenue deficit grants worth Rs 74,341 cr to these states to make up for the loss.

Special grants

Karnataka, Telangana, and Mizoram are recommended to be offered special grants of Rs 6,674 cr to compensate a decline in the sum of revenue deficit grants and tax devolution they received in 2020-21 compared to 2019-20.

Grants to local bodies

The Commission has also recommended Rs 90,000 cr as grants to the local bodies in 2020-21 as compared to Rs 87,352 cr in 2019-20. The new allocation is 4.31% of the divisible pool. While rural local bodies have been recommended to receive Rs 60,750 cr of the sum, urban local bodies would receive Rs 29,250 cr.

Disaster management grants

To encourage local-level disaster management, the Commission has recommended setting the National Disaster Management Funds (NDMF) and State Disaster Management Funds (SDMF). While NDMF Fund is recommended to be allotted Rs 12,390 cr, SDMFs could receive Rs 28,983 cr.

Sector-specific grants

The Commission has also recommended offering performance-based and sector-specific grants. Nutrition as a sector could receive Rs 7,375 cr in 2020-21.  The other sectors earmarked for grants include nutrition, pre-primary education, health, and railways.

Based on these criteria, the 15th Finance Commission has recommended to delegating Rs 8,55,176 cr of total tax proceeds to the states for 2020-21

Source: Jagran Josh

73rd Constitutional Amendment Act and the State Finance Commission 

The 73rd amendment made to the constitution of India in 1992 laid the basic structural framework for decentralised governance at the district and lower levels. This framework and its rules aimed at helping the districts and lower levels of our democratic system in sustaining themselves against external interferences.

The 73rd Constitutional Amendment Act mandates every state to establish a 3-tier Panchayat system, at the village, intermediate (with some exceptions), and district levels. Further, the 73rd Amendment also mandates the state to have a State Finance Commission, which overlooks the finances of the Panchayat and makes recommendations for the distribution of the Centre’s tax proceeds among various tiers of the Panchayati Raj Institutions and the state. State Finance Commission are also constituted every 5 yrs but by their respective state governments.

Aradhana Gotur

Content Writer at Tickertape

Lives in both, own and parallel universes and loves nature, music, and words (that turn into actions)

Aradhana Gotur

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