The Finance Commission : Its Role in Adjustment of

Union-State Financial Relations

Alice Jacob*

THE CONSTITUTION OF INDIA has laid down elaborate and

detailed provisions for the division of financial resources between the
Union and the states. In the distribution of resources, the Union retained
customs duties, excise duties other than on medicinal, toilet and alcoholic
preparations, corporation tax and a share of income tax and also the right
to impose a surcharge for its own purposes on income tax and those taxes
which, although allocated to the states, are levied and collected by the
Union. 1 The main sources of the revenue of the states remained land
revenue, excise on alcoholic preparations, sales tax and a share of income
tax.2 Thus, the scheme of division of resources makes a clear bifurcation
of taxes to be levied by the Union and the states. Consequently, there
is no overlapping tax jurisdiction as is common in most of the older
federations.

The above scheme of distribution has tended to give the Union more
flexible sources of revenue and, as a result, created a gap between the
needs and resources of the states. It is an important problem of federal
finance to bridge this gap between functions and resources. In India, the
Constitution has attempted a three-fold scheme to bridge this gap. Firstly,
the states are entitled to a share in federal taxes, namely, taxes on income
(other than corporation tax) and Union excise duties on some commodities.
Secondly, the states are assigned the entire proceeds of certain taxes levied
by the Union, namely, estate duty, the tax on railway fares and additional

* LL.M. (Delhi), LL.M., J.S.D. (Yale), Research Professor, The Indian Law
Institute, New Delhi.
1. Articles 268, 270, 171, entries 82, 83, 84, 85, 86, List I, Seventh Schedule, The
Constitution of India.
2. Article 269, 270; entries 45, 46, 47, 48, 49, 50, 51, 52, 53, 54, 55, 56, 57, List II
Seventh Schedule,
318 Constitutional Developments Since Independence

excise duties levied in lieu of sales tax. Finally, the Constitution provides
a system of grants-in-aid of revenues.
Having made provisions for federal assistance to the states, both as
grants-in-aid and as a share of specified taxes, the Constitution visualised
the necessity for a machinery independent of Union Government to deter­
mine the measure of assistance that should be afforded and also the
principles on which this assistance should be made available. This
machinery was created in the form of Finance Commission to be appointed
by the President every five years so that such periodical adjustments can
be made in the union-state financial relationship as are needed in the
light of the emerging situation. The Finance Commission is a unique
experiment in the Indian federal system. Tt has been envisaged by the
framers of the Indian Constitution as "a quasi-arbitral body whose funtion
is to do justice between the centre and the states". 3 It is an authority
without parallel in other federations. The only other body which, bears
some resemblance to it is the Commonwealth Grants Commission of
Australia. However, there are significant differences between the two institu­
tions as regards their status and the scope of their competence. The Indian
Finance Commission is created by the Constitution and it is not a standing
body. It sits only once in five years. On the other hand, the Common­
wealth Grants Commission was set up in 1933 by the Commonwealth
Parliament and it is a standing body and recommends fiscal-need grants
to the deficit states of Western Australia and Tasmania.4 While in Australia,
members are appointed for three years, in India they are appointed for
nearly a year and after the Commission has completed its assigned task, it
becomes functus officio. Thus, there is no continuity in the commission's
work in India. Further, the Indian Finance Commission has larger
functions to discharge than its Australian counterpart in that the former
has to recommend tax-sharing between the Union and the states as well as
fiscal-need grants to states. In addition, other questions of inter­
governmental financial relationship are also referred to it from time to
time. The provision of Finance Commission is intended to assure the
states that the scheme of distribution will be made not by the Union
arbitrarily but will be based on the recommendations of an independent
commission, which will assess the changing needs of the states in making
them.

Article 280 of the Constitution which provides for the constitution of

the Finance Commission authorized Parliament to determine the qualifi­
cations required for appointment as members of the commission, the
3. See the observations of Dr. Ambedkar in the Constituent Assembly, 9 Constituent
Assembly Debates 260. See also B.N. Rau, Indian Constitution In The Making
384-85(1960).
4. See, Else-Mitchell (ed.) Essays on the Australian Constitution 256-58 (1961).
 The Finance Commission 319

manner in which they should be selected and to prescribe the powers of

the commission for the performance of their functions. Accordingly, the
Finance Commission (Miscellaneous Provisions) Act, 1951, was enacted by
Parliament. Under the Act, the commission is to consist of Chairman and
four other members. As for qualifications, the chairman is required to be
a person who has had experience of public affairs and its members should
be persons who (a) are, or have been, or are qualified to be, appointed
as judges of a High Court, or (b) have special knowledge of the
finances and accounts of the government; or (<■) have had wide experience
in financial matters and in administration; or (<l) have special knowledge of
economics.

Article 280 (3) of the Constitution lays down the functions of the
Finance Commission. The commission is required to make recommenda­
tions to the President as to (a) the distribution between the Union and the
states of the net proceeds of taxes which are to be or may be divided
between them and the allocation between the states of the respective shares
of such proceeds, (b) the principles which should govern the grants-in-aid
of the revenues of the states out of the Consolidated Fund of India, and
(c) any other matter referred to the commission by the President in the
interests of sound finance. Under the Constitution, the decisions on the
commission's recommendations with respect to income tax is taken by the
President and with respect to other taxes, grants-in-aid, etc., by
Parliament.

The commission is empowered to determine its own procedure of

business, and has been given the powers of a civil court in the matter of
summoning and enforcing the attendance of witnesses, requiring the produc­
tion of any documents and requisitioning any public record from any
court or office. The commission is also authorized to require any person
to furnish information on such points or matters, as in the opinion of the
commission, may be useful for or relevant to in the matter under its
consideration.

Todate six Finance Commissions have been constituted. All the Finance
Commissions have followed the practice of visiting the states, holding
consultations with ministers and senior officials of the Union and state
governments, members and officials of the Planning Commission and
receiving memoranda and oral evidence from individuals and representa­
tives of interested organizations before formulating their recommendations
to the President of India.

The Finance Commission is an advisory body and in terms of strict

law, the commission's recommendations are not binding on the President.
320 Constitutional Developments Since Independence

However, it was recognized by the framers of the Constitution that the

creation of such an institution in a federal set-up would have little meaning
if its recommendations were not accepted by the President except, of
course, where considerations of overriding importance justified departure
therefrom. For instance, Dr. Ambedkar was of the view that "in the
action to be taken by the President he should be guided by the recommen­
dations of the Fiscal Commission and should not act arbitrarily." 5 The
attitude of the Union Government towards the recommendations of the
Finance Commissions confirms the view of the framers that their recom­
mendations have been treated with utmost respect by the Union.

As instances of the recommendations which were not accepted by the

Union Government, one of them concerned the Second Finance Commis­
sion's recommendations regarding the consolidation of Union loans to the
states and the revision of interest rates on those loans. Though the
commission's recommendations themselves were not accepted, the Union
Government did, however, make important modifications on interest rates
in the light of the commission's recommendations. Consequently, the
object for which the recommendations were made was more or less achieved.
The net result of the changes introduced by the Union Government was
"to reduce by Rs. 4 crores per annum (as against Rs. 5 crores estimated
by the Finance Commission) the interest burden on the states on account
of loans taken between August 15, 1947 and March 31, 1958." 6 Another
recommendation not agreed upon by the Union Government related to
the majority recommendation of the Third Finance Commission as regards
grants under article 275 to the states. The commission had recommended
that the total amount of grants-in-aid should be of an order which along
with any surplus from devolution of taxes would enable the states to meet
75 per cent of the revenue component of state plans.7 The government
seemed to have been influenced by the dissenting note of the member-
secretary who felt that :

[Tjhere will be no real advantage to the States in receiving assistance

towards the plans partly by way of statutory grants-in-aid on the
basis of the Finance Commission's recommendations and partly on
the basis of the annual reviews made by the Planning Commission. 8

5. 9 Constituent Assembly Debates, 261. B.N. Ran was equally emphatic in his view
that except in the case of a patent error, "no Ministry should advise the President
to depart from the recommendations of the Commission." Supra note 3 at 384.
6. Reserve Bank of India : The Report on Currency and Finance for the Year
1957-58, 91 (Bombay 1958).
7. The Report of the Finance Commission (Third) 1961, 32.
8. Ibid,
 The Finance Commission 321

It may be pointed out that despite the member-secretary's dissent, the

Union Government accepted the Third Finance Commission's recommen­
dation in respect of special-purpose grants to certain states for the
improvement of road communications.

The six Finance Commissions constituted since the commencement of the

Constitution submitted their reports to the President in 1952, 1957, 1961,
1965, 1969 and 1973 respectively. The significant role played by them in
moulding the union-state financial relations may be examined with reference
to (a) sharing of taxes (b) statutory grants-in-aid.

II

The Constitution provides for obligatory participation of the states

in the proceeds of income-tax. The Finance Commission has the duty of
deciding the percentage of the net proceeds of income-tax to be assigned
to the states as well as Union territories and to recommend the manner of
distribution among the states of their share. As a result of the recom­
mendations, the states' share of the proceeds of income-tax has been
steadily increasing. From 50 per cent under the Niemeyer's award before
the First Finance Commission, it has been raised progressively to 80 per
cent at present. The gradual increase in the share by the Third, Fourth,
Fifth and Sixth Finance Commissions was to off-set the diminution in
the divisible pool of income-tax proceeds consequent on the ^classifica­
tion of income-tax on companies as corporation tax by the Finance Act,
1959, and also generally to augment the resources of the states to make
them commensurate with their responsibilities in a welfare state.

Apart from deciding the shares of the states in the divisible pool of
income-tax, the Finance Commission evolves the principles of distribution
of the states' share among the states inter se. The two principles vying for
recognition as the decisive factor in the determination of states' shares
are population and collection. Whereas the most populous and economi­
cally backward states have urged that population be considered as the sole
principle of distribution, the industrialised states have argued for increased
weightage to be given to the factor of collection. The controversy of
population versus collection is rekindled before successive Finance
Commissions.

The First Finance Commission recommended that the distribution

should be made 80 per cent on the basis of population and 20 per cent on
the basis of collection. The Third and Fourth Finance Commissions had
also adopted the same principles, but the Second Finance Commission felt
that the principle of collection was not an equitable basis of distribution
322 Constitutional Developments Since Independence

and should be completely eliminated in favour of population. The reason

was that the income tax was paid by a small portion of the population
and the bulk of the proceeds arose out of business incomes which in
the context of economic integration of the country and disappearance of
inter-state trade barriers, was derived from the country as a whole.
However, in order to have continuity with recommendations of the First
Finance Commission, the second commission, recommended that the
states' share should be distributed 90 per cent on the basis of population
and 10 per cent on the basis of collection. The Fifth Finance Commission
enlarged the divisible pool by adding advance income-tax collections and
having regard to considerations of equity and objective of securing a more
balanced correspondence between needs and resources of states in widely
varying circumstances, it raised the percentage assigned to the factor of
population to the same level as recommended by the Second Finance
Commission. In its view, population was a general measure of need. The
Fifth Finance Commission has made a significant departure from
the previous commissions in that it has adopted assessments as a
measure of contribution in place of collection adopted by the previous
Finance Commissions. In its view, collection as an index of contribution has
several shortcomings. For instance, it fails to make any allowance for
incomes originating outside the states; moreover, in view of deductions of
tax at source in respect of dividends, interest income, etc., adoption of
collection as a basis tends to favour states having metropolitan and indust­
rial centres. Therefore, on a balanced consideration of all the relevant
issues, the commission had adopted figures of income tax assessment in
each state after allowing for reductions on account of appellate orders,
references, revisions, rectifications, etc., as a measure of contribution. The
Sixth Finance Commission adopted the above formula earlier enunciated
by the fifth commission.
Thus, by giving weightage to 'papulation' and allowing 'collection'
only a small part to play in the principles for distribution of income tax
proceeds, the Finance Commissions have tried to rectify regional imbalances
by giving larger amounts to populous and economically backward states
as compared to the economically advanced states.9
The Constitution provides only for permissive participation by the
states in the proceeds of Union excise duties. Nonetheless, since inception
the states have been getting a share in the proceeds of Union excises in
accordance with the recommendations of the Finance Commissions. The
9. The Report of the Finance Commission (First) 1952, 64-78; the Report of the
Finance Commission (Second) 1957, 40; the Report of the Finance Commission
{Third) 1961, 16-19; the Report of the Finance Commission (Fourth) 1965, 17-20;
the Report of the Finance Commission, (Fifth) 1969, 19-30; the Report of the
Finance Commission (Sixth) 1973, 11-13.
 The Finance Commission 323
purpose was to widen the field of devolution by having more than one
divisible tax and, thus, to allocate more resources to the states to meet
their increasing expenditure towards implementation of national plans of
development. The First Finance Commission recommended the distribu­
tion among the states of 40 per cent of the duties on three items, namely,
matches, tobacco and vegetable oil products. The Second Finance
Commission added five more items, namely, sugar, tea, coffee, paper and
vegetable non-essential oils and reduced the states' share to 25 per cent.
The Third Finance Commission extended the coverage to all duties which
were then being levied and reduced the share to 20 per cent. It excluded
those items of which the yield was then below Rs. 50 lakhs a year. The
Fourth Finance Commission further extended the coverage to all excise
duties including even those of which the yield was less than Rs. 50 lakhs
and also all duties which may be levied in the future. However, it excluded
from sharing special excise duties levied since 1963 as surcharges on basic
duties on certain items and regulatory duties. The Fifth Finance Com­
mission recommended continuance of the states' share in Union excise
duties at 20 per cent. Simultaneously, it somewhat enlarged the size
of the divisible pool by recommending inclusion of the proceeds of special
excise duties in the divisible pool for the two years 1972-73 and 1973-74.
The Sixth Finance Commission has recommended that the states' share of
all basic excise duties should be retained at 20 per cent. It has recom­
mended enlargement of the divisible pool by including 20 per cent of the
proceeds of auxiliary duties of excise from 1976-1977 onwards.

In considering the question of distribution among the states, all the

Finance Commissions have been giving weightage to 'population' as opposed
to 'consumption' because the factor of 'population' reflects generally the
needs of the states. On the other hand, adoption of 'consumption' as the
basis of distribution would operate to the disadvantage of less urbanised
states.10 The Fifth Finance Commission recommended that the divisible share
of Union excises (20 per cent) should be distributed 80 per cent on the basis
of population and two-thirds of the remaining 20 per cent be distributed
among states whose per capita income is below the average per capita
income of all the states. The balance of one-third should be distributed
on an integrated index of backwardness. For working out the index of
backwardness, the commission had considered six factors, namely,
(i) population of scheduled tribes, (ii) numberof factory workers per lakh of
population, (Hi) net irrigated area per cultivator, (iv) length of railways and
surfaced roads per 100 square kilometres, (v) short-fall in the number of
school going children as compared to those of school-going age, and (vi)

10. The Report of the Finanace Commission (Second) 1957, 41-44.

 324 Constitutional Developments Since Independence

number of hospital beds per 1,000 population. 11 The Sixth Finance

Commission felt that the principles of 'population' and 'relative economic
backwardness of the state' are relevant for distribution of Union excise
duties among the states. Accordingly, it recommended that 75 per cent
of the states' share of the divisible pool should; be distributed on the basis
of population of the states according to 1971 census and the balance of
25 per cent be distributed on the basis of "relation to the 'distance' of a
State's per capita income from that of the State with the highest per capita
income multiplied by the population of the state concerned according to
1971 census." 12
The Constitution does not prohibit the Union and the states agreeing
to an arrangement—'tax rental agreement'—by which the Union will
levy additional duties of excise in lieu of state sales tax on selected commodi­
ties. The present arrangement, under which the states do not levy any
sales tax on mill-made textiles, sugar, tobacco, woollen fabrics and silk
fabrics was introduced by the Additional Duties of Excise (Goods of
Special Importance) Act, 1957, which was enacted in pursuance of the
decision of the National Development Council in December, 1956. The
Act does not debar the states from levying sales tax on the specified
commodities, but it provides that if in any year a state levies a tax on the
sale or purchse of such commodities, no sums shall be paid to that state in
that year unless the Union Government otherwise directs. The role of the
Finance Commission in this respect is limited only to the purpose of
determining the principles of distribution of the net proceeds. The Second
Finance Commission recommended that the share of each state should not
be less than the revenue realised from the levy of sales tax on these items
for the financial year 1956-57 in that state. On working out the estimates
of recipts of sales tax for the relevant year, the commission arrived at
guaranteed shares for each state. The surplus, if any, from the additional
duty also accrues to the states. This had been continued by the Third,
Fourth and Fifth Finance Commissions. The Fifth Finance Commission
recommended that 50 per cent of the surplus should be distributed on the
basis of population and the remaining 50 per cent on the basis of collection
of the sales tax revenue of each state.

The present scheme has some advantages in that the chances for evasion
are minimised and it is convenient for traders to have the levy at the point
of production. However, the states have been constantly complaining
about the scheme because it had deprived them of a potential source of
revenue. In view of the opposition of the states, the Fifth Finance
Commission had suggested that it would not be desirable to continue the

11. The Report af the Finance Commission (Fifth) 1969, 36.

12. The Report of the Finance Commission, {Sixth) 1973, 14-17.
 The Finance Commission 325
scheme unless the Union Government, in consultation with the state
governments, can arrive at a general agreement for its continuance
with suitable modifications. Therefore, it did not recommend the extension
of the scheme to other commodities.13 To reduce the grievances of states
the Fifth Finance Commission had recommended that the rates of duties
may be made ad valorem as far as possible and may be revised periodi­
cally to keep the rates on par with the rates of sales tax on similar items
levied by the states.14 Consequent on the recommendations of the Fifth
Finance Commission, the whole issue was considered by a group of central
and state government officials and in the light of the proposals made by
that group, the National Development Council in 1970 agreed to the
continuance of the existing system subject to the condition that the incidence
of the duties should be increased within a period of two or three years.
It may be pointed out in this connection that the Union Government has
accepted these recommendations and implemented them through successive
Finance Acts.
The Sixth Finance Commission departed from the views of the previous
commissions in that it expressed the view that there is no need to set
apart any guaranteed amounts to the states, as there is no risk of the share
of any state in the net proceeds of such duties falling short of the revenue
realised from the levy of sales-tax on the commodities subject to additional
duties of excise in lieu of sales tax for the financial year 1956-57. The
commission, while examining afresh the principles for allocation of proceeds
among the states, recommended that 70 per cent weightage for population,
20 per cent for State Domestic Products at state current prices and 10 per
cent for production would seem to be the most equitable formula for such
allocation.15
Of the taxes which the Union is empowered under article 269 of the
Constitution to levy and collect for assignment to the states, estate duty
on property other than agricultural land is being levied. The basis of
distribution recommended by the Second Finance Commission has been
followed by the successive commissions. The formula for allocation of
this revenue among the states inter se is that the estate duty relating to
immovable property is divided among the states in proportion to the gross
value of the immovable property located in each state and the duty on
movable property is divided on the basis of population.16
13. Supra note 11 at 44.
14. Id. at 44-45.
15. Supra note 12 at 21.
16. The Report of the Finance Commission (Second) 1957, 50-51; the Third Commis-
sion Report (1961) 13-15; the Fourth Commission Report (1965) 12-13; the Interim
Report of the Fifth Finance Commission (1968) appearing as annexure to the Final
Report (1969) 236-38; the Report of the Finance Commission (Sixth) 1973, 25-26.
326 Constitutional Developments Since Independence

The proceeds of the tax on railway fares are assigned to the states
under article 269. Initially the Union levied the tax in 1957 and the
Second Finance Commission recommended the basis for allocation of the
passenger earnings on the basis of route mileage within each state, making
due allowances for the variations of density of traffic between the various
gauges in each zone. However, the Union Parliament repealed the tax in 1961
and merged it with the railway fares and guaranteed to the states a fixed
amount of grant on the basis of the average of the actual collection of the
tax during the previous two years (1958-1960). Subsequently, while the
basis for allocation remained the same, the fourth commission calculated
the share on the basis of statistics for three years ending 1966-67. The
fifth commission did not recommend any change in the existing principles
for distribution of the grant.17 The states are aggrieved about the repla­
cement of this tax by a fixed grant because they feel that they are being
deprived of their share of the growing revenues of the railways. The
Sixth Finance Commission which examined this matter, agreed with the
view-point of the states and recommended that the Union Government
should redetermine the amount of grant payable in lieu of this tax, in
terms of what the states could have got, if the tax had continued in its
original form. The Commission remarked :

We., .feel that the repeal of the passenger tax and its replacement
by a fixed grant was not quite in accordance with the spirit, if not
the letter, of the provisions of Article 269 of the Constitution. It
will be in the larger interests of healthy development of cooperative
federalism in the country if the point of view of the States is given
due recognition in taking decisions on issues of this nature. 18

Ill

Article 275 requires the Union to give grants-in-aid to the states in

need of assistance. Article 280 requires the Finance Commission to recom­
mend principles which should govern grants-in-aid. In other words, the
commissions are required to evolve principles first and then determine the
amounts to be paid as grants-in-aid by applying these principles to indivi­
dual cases. The First Finance Commission considered the principles of
grants-in-aid in detail and recommended that budgetary needs of the states
should be an important criterion for determining the assistance required
by the states, but that in arriving at the needs, appropriate allowances
are to be made based on a number of considerations. First, the budgets

17. See, the Interim Report of the Fifth Finance Commission appearing as annexure to
the Final Report, 233-35.
18. Supra note 12 at 24.
 The Finance Commission 327
should be reduced to a standard form by eliminating non-repetitive items,
second, due consideration should be given to the tax-effort by the state
and the extent to which the state itself made efforts to raise resources in
relation to its tax potential. Third, allowance should be made for the
scope for economy in expenditure. Fourth, grants-in-aid should be used
for raising the level of administration and improve the standard of basic
social services in the states. Fifth, grants should be made to help indivi­
dual states to meet their special burdens or obligation of national concern,
though falling within the states' spheres. Independently of budgetary
criterion, the commission recommended that grants should be given to
further any beneficent service of primary importance for assisting the less
advanced states to march ahead.19
The second commission considered these principles salutary. However,
it realized that the concept of needs had undergone a change in the trans­
formation of the state into a welfare state. The committed expenditure
of the first five-year plan schemes and liabilities arising out of the second
plan had also become part of the states' estimates. Though one of the
main functions of grants-in-aid is to reduce inequalities in the standard
of basic social services in the states, with the planning process under way
under the aegis of the Planning Commission, the commission felt that the
equalization of basic social services in the states is the main concern of
the plans and that it would be incorrect for the commission to go beyond
the plan and make separate allotments for broad purpose of national
importance. On this analysis, the commission recommended only two
broad principles to govern grants-in-aid. First, the eligibility of a state
for grants-in-aid and the amount of such aid should depend upon its fiscal
need in a comprehensive sense. The commission also felt that the gap
between the ordinary revenue of a state and its normal revenue expendi­
ture should as far as possible be met by devolution of taxes and that
grants-in-aid should be the residuary form of assistance.

The commission had been asked to take into account the requirements
of the second plan in making recommendations for grants-in-aid. In
bridging the uncovered revenue gap, the commission took into account the
resources to be raised by the additional tax efforts of the states, plan grants
recommended by the Planning Commission under article 282 of the
Constitution and also the grants-in-aid to be recommended by the commis­
sion itself. Thus, during the term of the Second Finance Commission
the changing pattern of financial relations between the Union and the
states was coming to the surface. The plan grants under article 282, outside
the recommendations of the Finance Commission, were already greater

19. The Report of the Finance Commission (First) 1952, 90-104.

328 Constitutional Developments Since Independence

than the grants made under article 275 as a result of their recommenda­
tions, and this disparity was likely to increase in the future.20

The Third Finance Commission also was in agreement with the general
principles enunciated by the earlier commissions. The commission was
also required to determine the amount of grants-in-aid having regard to
the requirements of the third five-year plan. The commission felt that the
fiscal needs of the states as assessed by the commission should take into
account not only non-plan expenditure but also plan expenditure. In
other words, the commission felt that they had overall responsibility for
devising a scheme of devolution and grants-in-aid, which would take note
of fiscal needs in their totality. On this basis the commission recommended
that the total amount of grants-in-aid should be such which, along with
any surplus from devolution, would enable the states to meet 75 per cent
of the uncovered revenue component of their plans. The commission also
felt it would be advisable to attach strict conditions of utlization to any
grants-in-aid given for activities meant to serve national purpose, but that
states should have freedom to re-appropriate funds from one allocation to
another in respect of grants meant generally to strengthen the state sector.
The commission revived the principle of first commission that they
could recommend special-purpose grants, and had in fact recommended
grants for development of communications more extensively. The commis­
sion also pointed out the subsidiary role of the Finance Commission
brought out by the invasion of the field of financial planning by the
Planning Commission.

The Fourth and Fifth Finance Commissions were not required to

consider the requirements of the five-year plans in assessing grants-in-aid.
Accordingly, they did not recommend the inclusion of plan grants and
specific-purpose grants in grants-in-aid. However, beginning with the fourth
commission, the terms of reference to the commissions required them to
have due regard to certain special consideration in working out grants-in-
aid. Among these considerations are, the expenditure devolving on the
states for servicing of their debt, the creation of a fund out of part of the
proceeds of estate duty, and the scope for economy consistent with efficiency
which may be effected by the states in their administrative expenditure
(fourth commission); in addition to the above considerations, transfer of
funds to local bodies and aided institutions (fifth commission); further,
the existing practice in regard to determination and distribution of central
assistance for financing state plans, expenditure on administration taking
into account such provision for emoluments of government employees,
teachers and local body employees, adequate maintenance and upkeep of

20. Chanda, Federalism in India 214-16 (1965).

 The Finance Commission 329

capital assets and maintenance of plan schemes completed by the end of

1973-74 and the requirements of backward states to upgrade their
administration with a view to bringing it to the levels obtaining
in the more advanced states (sixth commission). In calculating the
grants-in-aid in the context of the fiscal needs of the states, the Sixth
Finance Commission has taken into consideration all these factors.
Particularly significant are the commission's recommendations aimed
at eliminating the disparities among the states in the standards of
essential administrative and social services. Among such services, the
commission has identified primary education, medical and public health
and welfare of Scheduled Castes, Scheduled Tribes and other backward
classes to be of crucial importance for the well-being of the people. The
idea is that the states whose per capita expenditure is below the all-states'
average in these areas of administration, should be enabled to come up to
such an average by the grants-in-aid. Further, the commission has suggest­
ed a method to prevent diversion of funds provided for the improvement
of these services. It is that the concerned Union ministry and the Planning
Commission should, at the time of scrutiny of the annual plans of the states,
verify whether the funds provided for these services have been utilised on
them. Only such expenditure on these services in excess of what has been
provided for by the Finance Commission should be considered as plan
expenditure qualifying for central assistance. This method will ensure
equality of treatment between surplus states and states qualifying for
grants-in-aid and subject all states to some amount of fiscal discipline.21

The recommendations of the successive Finance Commissions have

resulted in a progressive increase in the amount of Union grants to the
states under article 275. The First Finance Commission recommended
the payment of a little over Rs. 5 crores a year. The Second Finance
Commission raised the amount to Rs. 37 crores a year. Under the recom­
mendations of the Third Finance Commission, the states received over
Rs. 52 crores annually as statutory grants. The Fourth and Fifth Finance
Commissions increased the amount annually to a little over Rs. 121 and
Rs. 127 crores respectively. Under the award of the Sixth Finance
Commission, there has been a substantial increase of grants-in-aid to
Rs. 502 crores annually and fourteen states will be the recipient of such
grants.22

21. Supra note 12 at 68-70.

22. Andhra Pradesh, Assam, Bihar, Himaohal Pradesh, Jammu & Kashmir, Kerala,
Manipur, Meghalaya, Nagaland, Orissa, Rajasthan, Tripura, Uttar Pradesh, and
West Bengal.
330 Constitutional Developments Since Independence

IV
The above appraisal of the recommendations of the successive Finance
Commissions reveal that while their basic approach has been that "the
prosperity of the states must rest on the solid foundation of a reasonably
strong and financially stable centre," 23 they have shown a strong awareness
of the growing needs of the states "in fulfilling a complementary role in
the devlopment of national economy and in the provision of a higher level
of social services."24 The commissions have recognized the inadequacy
of the resources of the states and their increasing dependence on the
Centre. Consequently, under their recommendations, there has been a
steady increase in the transfer of funds from the Union to the states.
They have striven to strengthen the resources of the poor states much more
than those of the rich states. The basic idea is to reduce the disparity in
resources among the states and to ensure, as far as possible, a national mini­
mum of social services in all the states of the Union. By giving weightage
to the principle of 'population' in the devolution of taxes, the commissions
have tried to achieve equalisation among the states. Substantial amounts
distributed among states on the basis of population tend, to some extent,
to reduce disparities between their resources. But in the matter of grants-
in-aid under article 275, the commissions have been working under certain
limitations, which arose as a result of centralised planning in the country.
Article 275 of the Constitution had been designed to help the states, which
are less developed and have less capacity to raise resources of their own.
But with the emergence of the Planning Commission, which looks after the
developmental needs of the states and recommends plan grants to the states,
which are made by the Union under article 282 of the Constitution, the
Finance Commissions have gradually ceased to examine the fiscal needs of
states in their totality. They merely scrutinise the budgets of the states,
forecast of receipts and non-plan expenditure for a quinquennium and
recommend grants-in-aid to cover the revenue deficit. In terms of article
275, there is nothing to exclude from its purview the grants for meeting
revenue expenditure on plan schemes, nor is there any express bar against
grants for capital purposes. In assessing the fiscal needs of the states, the
approach of the Finance Commissions has varied with regard to plan
expenditure. During the term of the first commission, planning had not
assumed much importance and it dealt with the revenue requirements of
the states as a whole. The second commission considered the plan
revenue expenditure (other than the capital expenditure) in fixing grants-
in-aid. The third commission by a majority, recommended grants-in-aid
of such surplus out of tax devolutions, to cover 75 per cent of the revenue

23. The Report of the Finance Commission (First) 1952, 7.

24. The Report of the Finance Commission (Third) 1961, 20.
 The Finance Commission 331
portion of their plan outlay. However, this recommendation was not
accepted by the Union Government. The fourth and fifth commissions
completely excluded the plan expenditure in fixing the grants. Further,
the second, fourth and fifth commissions, unlike the first and" third commi­
ssions, had refused to recommend special-purpose grants outside the plan.
The fourth and fifth commissions expressly acquiesced in a restricted role
for the Finance Commission in the matter of statutory grants, owing to the
existence of the Planning Commission.25 The Sixth Finance Commission
has also recognised the "closefinancialinterdependence between the Centre
and the States", brought about by the advent of economic planning. In the
words of the commission :

[I]t is by no means an exaggeration to say that the Centre can be

financially only as strong as the States and vice versa. The task of
a Finance Commission, in this changed context, ought to be one of
settling the optimal distribution of the resources of the public sector
between the Centre and the States.26

The sixth commission has laid down guidelines for central assistance for
state plans in sectors such as construction of roads, irrigation and flood
protection works and administrative and social services such as primary
education, medical and public health and welfare of Scheduled Castes, etc.
Further, the commission has made specific-purpose grants-in-aid to states
for improvement of these services and has suggested a method in order
that the states may purposefully utilise the grants and not divert them to
other heads of expenditure.

The Finance Commissions have repeatedly pointed out that the financial
weakness of the states is due in part at least to 'inadequate expenditure
control' and 'inadequate mobilization of available resources'. The third
commission noted that the states "are tending to develop an allergy to tap
resources in the rural sector."27 The Fifth Finance Commission, which was
asked to recommend on the scope for raising additional revenue by the states
from their sources of revenue, also noted that the efforts of the states to
mobilise resources in the agriculture sector had not been satisfactory:

Many states do not levy tax on agricultural income... [l]t is a fact

that the prosperous part of the agricultural sector is now definitely
undertaxed. In the last few years, several states have taken measures

25. See, the Report of the Finance Commission {Fourth) 1965, 9 and the Report of
the Finance Commission (Fifth) 1969, 12.
26. Supra note 12 at 7.
27. Supra note 24 at 38.
332 Constitutional Developments Since Independence

to exempt small landholdings from land revenue and have given up

land revenue income, wholly or partially.28

This shows that the states themselves are to some extent responsible
for their financial weakness. The Sixth Finance Commission has also
emphasized the need for improvement of fiscal administration in many of
the states.29 Unless the states impose financial discipline on themselves
by reducing expenditure on non-plan schemes and simultaneously tap all
resources available to them, it may prove difficult for the Finance Commis­
sions to meet their deficits.

As pointed out already, successive Finance Commissions have drawn

attention to the fact that the transfer of funds on the recommendations of
the Planning Commission has encroached on the functioning of the Finance
Commission. The Third Finance Commission suggested two alternatives
to provide a solution. One was to enlarge the functions of the finance
commission to embrace the total financial assistance to the states whether
by way of loans or devolution of revenues. This, in the opinion of the
third commission, would be in conformity with the spirit and express
provisions of the Constitution. The second alternative was to transform
the Planning Commission into the Finance Commission at the appropriate
time.

The Study Team of the Administrative Reforms Commission in its

Report on Centre-State Relationships has, after examining various
alternatives to avoid overlap of functions between the Finance Commission
and the Planning Commission, recommended that the Planning Commission
should be entrusted with the entire work of determining budgetary needs
and that the Finance Commission should deal only with the sharing and
distribution of divisible central taxes and the Planning Commission should
determine plan as well as non-plan grants.30 The Administrative Reforms
Commission has, however, recommended that the Finance Commission
should be asked to make recommendations on the principles which should
govern the distribution of plan grants to states and in order that the
Finance Commission may be able to make such recommendations, it should
have before it an outline of the five-year plan as prepared by the Planning
Commission. While the principles relating to the distribution of the plan
grants will be set out by the Finance Commission, the application of these
principles from year to year will be left to the Planning Commission and

28. Supra note 1] at 82-85.

29. Supra note 12 at 52-62.
30. The Report of the Study Team of the Administrative Reforms Commission On
Centre-State Relationships Vol. I, 38-39 (1967).
 The Finance Commission 333

the Union Government. Further, in order to secure effective coordination

of the Finance Commission's recommendations and the plan, a member
of the Planning Commission may be appointed to the Finance Commission.31

The recommendations of the Administrative Reforms Commission have

been acted upon by the Union Government in constituting the Sixth
Finance Commission. For the first time, one of the members of the
Planning Commission was appointed as a member of the Sixth Finance
Commission.32 Further, the sixth commission was asked in recommending
statutory grants to give consideration to the existing practice in regard to
determination and distribution of central assistance for state plans. How­
ever, the commission in fixing the statutory grants-in-aid did not have the
benefit of information either on the quantum of central assistance or its
apportionment between grants and loans to states for the fifth plan
period. 33

Despite the existence of another channel for the flow of funds from the
Union to the states, the financial assistance, whether by way of devolution
or grants, which the states receive on the basis of the recommendations of
the Finance Commission, is of a statutory character and does not involve
control over its utilization. These are 'assured devolutions' which do not
affect the autonomy of the states. The successive Finance Commissions
have been augmenting the resources of the states. Further, the Union
Government has been referring varied questions of central-state financial
relations to the commissions. For instance, the fifth commission was
asked to recommend on the scope for raising revenue from the taxes under
article 269 of the Constitution, which were not levied then and more
importantly on the scope for raising additional revenue by the states from
their own sources of revenue. 31 Now that the Union is levying wealth tax
on agricultural property, the sixth commission was asked to recommend
the principles governing the distribution among the states of the proceeds
of this tax.35 Though the Union Government is not bound to accept the
recommendations of the Finance Commission, there is an established conven­
tion that the commission's recommendations should be given due weight
and not departed from except for overriding reasons. The states also

31. The Report of the Administrative Reforms Commission on Centre-State Relationships

(1969) 17.
32. B.S. Minhas, Member, Planning Commission, was made a member of the
Sixth Finance Commission and he was required to render part-time service to the
commission. Supra note 12 at 1. Minhas has since resigned from the Planning
Commission.
33. Supra note 12 at 71.
34. Supra note 11 at 80-92.
35. See the terms of reference to the Sixth Finance Commission, 4(f), supra note 12
at 2.
334 Constitutional Developments Since Independence

have reposed confidence in the commission's objective adjudgment of their

competing claims. No greater tribute to the work of the Finance Commis­
sions can be paid than the one paid by the Centre-State Relations Inquiry
Committee set up by the Government of Tamil Nadu. It said :
Every Finance Commission has been flooded by. the States with
grievances of one sort or other. It must be said to the credit
of the Commission that it has dealt with each one of those
grievances objectively and has suggested remedies and offered solu­
tions for the most intricate problems. The confidence that the
states have reposed in it is due entirely to its independence and
impartiality and its ability to hold the scales even as between compe­
ting claims.36
The Finance Commissions thus have been and will continue to be a vital
link between the Union and the states in the adjustment of their mutual
financial relationships. Finance being the core of a good government, the
role of an impartial body as that of the Finance Commission, is invaluable
to the Indian federal system.

36. The Report of the Centre-State Relations Inquiry Committee (popularly known as
the Rajamannar Committee) 95 (1971).