FISCAL FEDERALISM

Contents on Fiscal Federalism:

1. Introduction

2. Govinda Rao’s Article

3. Reddy’s Article.

4. Recent developments in Indian Fiscal Federalism- Optional- 3 typed pages: For

students wishing to do extra.
Articles from business standard, livemint and TOR of 15th fc attached.
Introduction (Only for Understanding):

References:
1. Musgrave and Musgrave (2004): Public Finance in Theory and Practice, 5 th
Edition, Tata McGraw Hill.
2. Jha, Prakash Chandra (2012): Theory of Fiscal Federalism: An Analysis, MPRA
Paper No. 41769.
3. McLure, C.E. and Martinez-Vazquez. The Assignment of Revenues and
Expenditures in Intergovernmental fiscal relations.
4. Vo, D.H. The Economics of fiscal decentralization.
5. http://www.ciesin.columbia.edu/decentralization/English/Issues/Expenditure.html

I. What activities are carried out by Governments of Mixed Economies? (Musgrave and
Musgrave)
Modern so-called capitalist economies are in fact mixed economies, with substantial
government intervention in various areas of economic activity.
For instance, in US, over 20 percent of GDP is purchased by the government. Total
government expenditure including transfers equal 35 percent of GNP and tax revenues absorb
over 30 percent thereof.
In Western Europe, governmental share of economic activity is frequently over 50 percent.
Beyond the budgetary function (spending and taxes), public policy influences the course of
economic activity through monetary, regulatory and other devices.

Thus, governments perform three major functions:

1. Allocation function: Allocation of social goods (non-rival nature of consumption and
inapplicability of exclusion). Ensure that resources are used efficiently.
Social goods are both national, like defence, where benefits accrue nationwide, and local, like
street lighting, which benefits, local residents.
Thus, governments have also to decide the assignment of different social goods to various
levels of the government (Nation, State, Local).
2. Distribution Function: To achieve equitable distribution of income.
Adjustment in the state of distribution and wealth to achieve what society calls a fair or just
state of distribution.
3. Stabilization Function: The stabilization branch is to assure the achievement of high
employment and price stability.
Measures to deal with unemployment, inflation and inadequate economic growth (and also
trade and balance of payments).
There are two instruments of stabilization policy:
Monetary Instruments: Reserve requirements, discount rates, open market policy and so on.
Fiscal instruments: Taxes and Expenditures. Also, how the Government Deficit (Spending –
Taxes) is financed is equally important.

II. Fiscal Federalism: Theory and Concepts (MPRA Paper)

Theory of fiscal federalism lays out a general normative framework for the assignment of:
(i) Functions (the three functions listed above),
(ii) Expenditure responsibilities, and
(iii) Revenue responsibilities
to different vertical levels of government (Central: Centralized; State and Local:
Decentralized) in a federation.
It also suggests a revenue-sharing mechanism to correct fiscal imbalances through inter-
governmental transfers for ensuring equity and efficiency.

Assignment of Functions:

The three functions are assigned to the three levels of the government by considering the
advantages and disadvantages of each level.

1. Macroeconomic stabilisation and Income Redistribution: Theory favours

centralization of these two functions. So, these two functions assigned to the Central/
Federal/ National/Union Government.
This is because federal government always possesses a far greater capability to maintain high
levels of employment with stable prices than a sub-national government. Similarly, the scope
of redistributive programme is limited by the potential mobility of residents which tends to be
greater, the smaller is the jurisdiction.

2. Allocative Function: Theory favours the decentralisation of allocative function

(Decentralisation theorem--advanced by Wallace E. Oates). Each public service should
be provided by the jurisdiction having control over the minimum geographical area
that would internalize benefits and costs of such provision.
Oates provides strong rationale for decentralisation of public goods and services on following
grounds:
(i) The provision of public goods and services by federal government leads to
uniform level of consumption and utilisation of goods and services respectively
across all regions. Such uniformity may lead to inefficiencies.
(ii) Decentralised provision allows governments to cater better to the tastes and needs
of local residents.
(iii) The possibilities of welfare gains in case of decentralised provision of goods and
services are further enhanced by the phenomenon of consumer mobility. “Citizens
vote with their feet”. This implies that a consumer can to some extent select his
place of residence that provides a fiscal package best suited to his or her
preferences.
(iv) Decentralisation may also result in greater experimentation and innovation in
production of public goods and services. With a large number of independent
producers of public good, one may expect a variety of approaches that, in the long
run, promise greater progress in the modes of production of such goods and
services.
(v) Inter-jurisdictional competition as a result of decentralisation may also lead to
efficiency in the provision of public goods and services. This means that if one
jurisdiction, for example, discovers a particular effective way of providing certain
service, the governments of other jurisdictions are also likely to adopt similar
techniques, or even better techniques and methods.
(vi) Finally, it is argued that the decentralisation of allocative functions may lead to
more efficient levels of public output because expenditure decisions are tied more
closely to real resource cost. If a community is required to finance its own public
programme through local taxation, its members are more likely to weigh the
benefits of the programme against it actual cost.

Thus, in brief, normative theoretical considerations strongly support decentralisation on

the ground of efficiency, accountability, manageability, and autonomy principles.
Local public goods to States/local governments and national public goods to federal or
central governments (Vo Paper).
Examples of local public goods: law, order, public safety, education, health policy, local
issues like street lighting systems, local sewage, garbage collection, local paper
deliveries.

Assignment of Expenditure and Revenue Responsibilities Subservient to the Above

Functions:

Assignment of expenditure and revenue responsibilities subservient to the above three

functions to different levels of governments is the most fundamental issue in a federation.
Economies of administration and transactions costs lead to "grouping" of roughly congruent services
at local (e.g., street lighting, refuse removal), regional (rural-urban roads, refuse disposal), and
national (intercity highways, environmental policy) levels (last reference).

I. Assignment of Expenditure Responsibilities:

Federal Government:
 Carrying out services which relate to stabilisation of economy and redistribution of
income.
 Provision of National goods whose benefits are national in scope.
 Certain services which require service area larger than a local jurisdiction for cost-
effective provision. These include, for example, transportation services, water and
sewage, etc.
 Role in providing compensatory grants for spill-out of benefits from state level provision
of services.

State Government
A similar role for each state is in order for spill-out of benefits from local provision of
services within their jurisdictions.

Local Government
All other services could and should best be provided by the local governments with federal
and state/provincial governments having some role in defining minimum standard.

Table1.1 (below) from this paper shows the broad theoretical guidelines in expenditure
assignment.

II. Comments:
Thus, the theory favours a decentralized model for assignment of expenditure responsibilities
on account of efficiency, accountability, manageability and autonomy principles.

In most cases, it is desirable that the national government assume responsibility for national
public services, international affairs, monetary policy, regulation, transfers to persons and
businesses, fiscal policy coordination, regional equity, redistribution (in which all levels of
government may play a role), and preservation of an internal common market.

However, some central functions such as regulation of the financial sector, environment, etc.,
may be effectively shared with sub-national governments.

State governments may have dominant responsibility for education, health, social insurance,
intermunicipal issues, and oversight of local governments.
All local services should be assigned to local governments. In areas of shared responsibilities,
the roles should be clarified.

Generally, the central government should be involved with overall policy, setting standards,
and auditing; state governments should have an oversight function; and local governments
should be involved with the provision of infrastructure and services.

Assignment of public services to local or regional governments can be based on various

considerations such as economies of scale, economies of scope (appropriate bundling of public
services to improve efficiency through information and coordination economies and enhanced
accountability through voter participation and cost recovery), cost/benefit spillovers, proximity to
beneficiaries, consumer preferences, and flexibility in budgetary choices on composition of public
spending. Assignment of responsibilities to various local governments could be asymmetric based on
population size, rural/urban classification and fiscal capacity criteria. Thus large cities may have
responsibilities for some services which are provided directly by the center in other areas.
Table: Last source.
 Table: Last source.

II. Assignment of Revenue (Tax) Responsibilities:

 Expenditure assignment must precede tax assignment; but not necessarily as a rule . It is
so since tax assignment is, in general, guided by the expenditure assignment at different
levels; and this cannot be worked out in advance of expenditure assignment.

 Further, the theory does not favour a decentralised model for assignment of tax though
the decentralisation of expenditure responsibilities is widely accepted. Theory favours a
centralization of revenue responsibilities.

 Reasons:

(1) Lower level government will otherwise engage themselves in ‘beggar-thy-neighbour’

competition when tax is levied on mobile factors such as capital and labour. Such
interjurisdictional competition would turn out to be self-defeating and result in reduction
in taxation and in turn would lead to under-provision of public goods and services.
(2) Moreover, a decentralised tax system would hinder the functions of internal common
market, that is, free mobility of resources. (GST had this in mind)

Therefore, as opposed to expenditure responsibilities, a centralised tax system is often

preferred.

 Guidelines for tax assignment:

Musgrave (1983), on the basis of ‘equity’ and ‘efficiency’ criteria, enumerates which taxes
should be assigned to federal government and which should be placed at the sub-national
levels of government:
(i) Taxes suitable for economic stabilisation should be assigned to the federal
government;
(ii) Progressive redistributive (????) tax should be centralised; (Redistributive tax: a tax
intended to spread income more fairly among people, by taxing rich more and poor
less. Eg. Income tax in India).
(iii) Taxes on mobile factors of production are best administered at the central level;
(iv) Tax base highly unequally distributed between different jurisdictions (such as natural
resource taxes, Vo paper) should be centralised;
(v) Taxes on immobile factors of production are best suited for local levels;
(vi) Residence-based taxes such as sales of consumption goods to consumers or excise are
suitable for states;
(vii) Benefit taxes and user charges might appropriately be used at all levels of
government.
(viii) Taxes with cyclically stable revenue should be assigned to states (because of their
small size, state governments need stable revenues that help in continuity of public
service provision, Vo paper).

Table 1.2 below further elaborates the above guidelines and theoretical insights on tax
assignments.
III. Impact of Expenditure and Tax (Revenue) Assignments: Vertical Fiscal Imbalance
and Horizontal Fiscal Imbalance
From the preceding discussions, it is apparent that due to efficiency and equity
considerations, there is no reason to expect that the distribution of financial resources among
governments will correspond to the distribution of expenditure responsibilities.
Thus the federal government has more taxing powers, but comparatively less expenditure
responsibilities; and, on the other hand, sub-national governments generally have less taxing
authorities but more expenditure functions to perform.

This, in consequence, contributes to what is known as the vertical fiscal imbalance (VFI)
and horizontal fiscal imbalance (HFI).
Vertical Fiscal Imbalance:
Refers to inconsistency between revenue raising and fiscal needs of government at the
different level of the government in a federation.

Horizontal Fiscal Imbalance:

Unlike VFI, ‘horizontal fiscal imbalance’(HFI) refers to inconsistency between revenue
raising and fiscal needs of government at the same level. The different units of government
within a particular level cannot be expected to have equal fiscal capacity ( involving both
equality of revenue-raising capacity and equality in costs of providing comparable services)
except by chance.

Fiscal Imbalances (Horizontal and Vertical) in a federal system imply the existence of some
form of revenue-sharing arrangements or equalisation grants to remove the inequities. The
next sub-section examines this aspect further.

IV. Inter-governmental Transfers and Revenue-Sharing:

 A critical component of fiscal federalism is inter-governmental transfers and revenue-
sharing.
 Reasons for transfers:
Both the inter-governmental transfers and the revenue-sharing arrangement are employed to
fulfil a variety of objectives:

(i) VFI is generated invariably by the expenditure and revenue assignment among
different levels of government in a federation.
1. In most countries, the federal government retains the major tax bases, leaving insufficient
fiscal resources to the sub-national governments for covering their expenditure needs.
Inter-governmental transfer is, therefore, needed to balance the budget at the sub-national
level.
2. However, individual policy choices also play a significant role in determining the
resulting ex-post-vertical fiscal imbalance. If lower level of government chooses to
increase spending or not to raise assigned taxes, the VFI would increase. Thus, if transfers
were designed solely to close the VFI, there would be little incentive for lower levels of
government to raise own revenues or restrict or manage expenditures efficiently.
3. Thus, unless there are objective criteria for the determination of transfers, ‘gap-filling’ to
finance sub-national deficits is likely to lead to macro-economic difficulties as well as
indeterminate ’bargaining’ between the federal and sub-national levels of government.
4. Since VFI tends to favour the federal government, the size of transfers to sub-national
levels of government often may be function of macroeconomic stabilisation concerns.
(ii) HFI arises because of the fact that some sub-national governments may have better
access to natural resources or to other tax bases that are not available to others; they
may also have higher income levels than those in other jurisdictions. These are
commonly referred to as differences in fiscal capacities.
(iii) Some sub-national governments may have extraordinary expenditure needs because
they may have high proportions of poor, old, and young population. The net fiscal
benefit (NFB), measured by the gap between fiscal capacity and fiscal need, is often
caused by such uncontrollable factors and therefore should be addressed by federal
government transfers.
(iv) Inter-governmental transfers are used to address inter-jurisdictional spill-over
effects.
1. Some public services have spill-over effects (or externalities) on other jurisdictions.
2. Measures such as pollution control, inter-regional high-ways, higher education
(highly-educated people may leave for other jurisdictions), fire departments (may be
used by neighbour jurisdictions), etc.
3. Without reaping all the benefits of these projects, a local government may tend to
under-invest in such projects.
4. Therefore, it is essential for the central government to provide incentives or financial
resources to address such problems of under-provision of certain services.

 Categories of transfers:

1. Scholars of public finance and fiscal federalism broadly group the intergovernmental
transfers into the following two categories:

Conditional transfers (or specific purpose transfers); and

Unconditional transfers (or general-purpose transfers).
2. Conditional transfers may consist of matching transfers; non-matching transfers for
specific purposes; and block transfers.

(i) In case of conditional transfers, the federal government specifies the purposes for
which the recipient sub-national government can use the funds.

(ii) Such transfers are often used to address concerns that are highly important to the
federal government such as projects with inter-regional spill-over effects but
which might be considered less so by the sub-national governments.

(iii) As stated earlier, conditional transfers can be of several types -- matching

transfers, non-matching transfers for specific purposes, and block transfers.
 (iv) Further, each of these may be without a redistribution criterion or may be either
open-ended or closed-ended.
(v) In the case of matching open-ended transfers, a federal government contributes
the same amount to be spent by the subnational governments in an area.

(vi) In an open-ended matching transfer, the transfers of federal government depend

upon the recipient’s behaviour. If sub-national government’s expenditure is
vigorously stimulated by the programme, then the federal government’s
contributions may be quite large and vice versa.

(vii) Contrary to the above, in matching closed-ended transfers, the federal

government specifies some maximum amount that it will contribute in order to put
a ceiling on the cost borne by it. Such transfers are used in most countries because
of concern of budget control.

(viii) Different countries employ different mechanisms.

(ix) In non-matching block transfers, federal government contributes a fixed sum of

money with stipulation that grant be spent on specified public goods or services.
In this case, the recipient government is not required to match the contribution of
federal government.

3. Unconditional transfers, as the name suggests, is characterised by the absence of

restrictions over its use by the recipient governments.

The main justification for this grant is to equalise fiscal capacities of different sub-
national governments in order to ensure the provision of minimum or reasonable level of
public services.

Conclusion
Broadly speaking, theory of fiscal federalism lays out a general normative framework for the
assignment of expenditure responsibilities as well as revenue responsibilities to different
vertical levels of government in a federation and suggests a revenue-sharing mechanism to
correct fiscal imbalances.
Principal reasons for growing interest of scholars in fiscal federalism in the recent times are
as follows:
(1)
(i) Until the decade of 1980s, the issues of fiscal federalism used to receive fairly little
attention even in economics; and practically none in the disciplines of political science and
public administration.
(ii) Interest was also confined essentially to the specialists of the subject in the US (Tanzi,
1995: 229).
(iii) However, as the decade of 1990s advanced, several countries around the world—
developed and developing both—began to decentralise their economic powers.
(iv)The decentralisation trend is often believed to be largely as much a consequence of
economic globalisation as it is the result of the domestic regional pressures brought about by
the process of economic liberalisation.
(v) Consequently, roles and responsibilities of different levels of government not only in
federal systems but also in unitary polities have undergone a sea-change.
(vi) However, fiscal decentralisation, more importantly in developing countries including
India, has led to a host of fiscal problems, many of which the existing literature on fiscal
federalism fails to address.
(vii) Although many industrialised countries have had a long history with decentralised
governance, developing countries have recently begun to decentralise. Challenges facing
developed countries are often magnified in developing countries, where the institutions
necessary for successful decentralisation are weaker (Rodden, Eskeland, and Litvack 2003:
3).

(2)
(i) Besides, the debate and developments within EU with regard to creating a central entity
that would transcend the responsibilities of its member-states in some important economic
spheres opened up the question of how much power should be transferred to the central
entity.
(ii) Key issues in the debate are who should be responsible for economic redistribution and
which functions should be performed exclusively by EU? Thus developments in EU have
forced the economists and policy makers to critically look at the existing theoretical literature
of fiscal federalism.

(3)
(i) Another factor explaining the increasing interest in fiscal federalism is the growing
dissatisfaction with the role of public sector, especially in developing countries undergoing
structural adjustment programmes.
(ii) Most of the developing countries witnessed explosive growth of their public sector in
post-Second World War period. The role of federal governments in income maintenance,
income redistribution and stabilisation of economy has expanded.
(iii) Such developmental strategies also had found the support of economists on the grounds
of efficiency and equity (Keynes, 1964).
(iv) With the onset of economic globalisation and liberalisation however, ‘neo-
institutionalists’ or ‘neo-liberals’ started questioning some of the traditional or first
generation theory of fiscal federalism. They stated that greater reliance should be placed on
the market and less power should remain in the hands of federal government.
(v) By questioning the effectiveness of the federal government’s role in stabilising the
economy and improving the distribution of income for the purpose of reducing the poverty
and unemployment, some neo-liberal economists have reduced the legitimacy of federal
government’s greater role and have created a presumption in favour of reducing the size of
the public sector while giving more powers to both market and sub-national governments.
(vi) As part of the public sector reforms, many countries undergoing economic liberalisation
are now considering and undertaking devolution of some key functions to subnational-level
governments.
(vii) In terms of resource allocation, various arguments have been advanced to support the
view that privatisation and decentralisation would lead to greater efficiency.

(4)
(i) Further, mention must also be made here of international agencies such as World Bank,
International Monetary Fund (IMF) and Inter-American Development Bank (IADB) which
also encouraged research on fiscal federalism and decentralisation in order to persuade the
developing countries to decentralise their public sectors more often to legitimise their own
vested interests in market-oriented economic reforms.

(5)
(i) Furthermore, perception that the present-day institutional arrangements cannot be
explained by traditional theory, which had developed mainly in 50s and 60s, led to growing
scholary research to examine the new reality.
(ii) This is also perhaps the reason that interests in the subject has begun drawing more and
more attention both at academic and policy-planning levels in almost all countries, as they
have come to confront with new fiscal problems; and fiscal federalism has today thus
emerged as an important subject of study.
(iii) Theory of fiscal federalism has recently been divided into the first-generation theory and
the second-generation theory.

Note instead of taking the assignment of functions approach, we also have the assignment of
goods and services approach Rao and Singh Stanford Paper.
Site Index Contributor: World Bank
Main Page Author: Decentralization Thematic Team
Issues in Program Design Contact: Jennie Litvack
Expenditure Assignment
Fiscal decentralization involves shifting some responsibilities for
expenditures and/or revenues to lower levels of government. One
important factor in determining the type of fiscal decentralization is the
extent to which subnational entities are given autonomy to determine the
allocation of their expenditures. (The other important factor is their ability
to raise revenue.) This note outlines principles and best practice and
highlights how country specifics will ultimately be the best determinant of
expenditure assignments.

It is important to clarify where local governments can determine the

allocation of expenditures themselves versus those where the center
mandates expenditures and local levels simply execute those
expenditures. When statistics on subnational finance are available
(most notably in the IMF's Government Finance Statistics) these two
types of expenditures are usually aggregated and one figure is
provided on "percentage of subnational expenditures." Thus, analysts
must be very careful when using this as in indicator of local
autonomy, as autonomy will not be enhanced unless the funds are not
tied by the center. (Of course, some countries do derive the benefits
of local expenditure autonomy as a result of local governments'
ability to access the funds and circumvent the central mandates!)

Unitary and federal governments provide different opportunities for

fiscal decentralization. Unitary countries do not have sub-national
governments that are constitutionally empowered to make decisions
over a specified range of government functions and services; rather,
they have multiple subordinate levels of the same government (e.g.,
central, provincial, district). Federal governments, on the other hand,
have constitutionally protected sub-national governments and thus,
the possibilities for independent decision making are clearly stronger
under these systems. It is important to note that local governments (as
opposed to state or province) may not necessarily enjoy constitutional
protection under federal systems. In practice, however, the extent and
nature of decision-making power exercised by lower tiers varies
widely from country to country in both federal and unitary countries
and may change (in either direction) from time to time. At the
extremes, some nominally federal countries (e.g., Venezuela) may be
considerably less decentralized in reality than in nominally unitary
countries (e.g., Colombia).

Despite the complexity of the existing situation in many countries,

both theory and experience suggest strongly that it is important to
state expenditure responsibilities as clearly as possible in order to
enhance accountability and reduce unproductive overlap, duplication
of authority, and legal challenges. Many would argue that decision-
making should occur according to the principal of "subsidiarity" --
that is at the lowest level of government consistent with allocative
efficiency (e.g., the geographic area that internalizes the benefits and
costs of decision-making for a particular public service). The optimal
size of jurisdiction for each service could theoretically differ, but in
practice economies of administration and transactions costs lead to
"grouping" of roughly congruent services at local (e.g., street lighting,
refuse removal), regional (rural-urban roads, refuse disposal), and
national (intercity highways, environmental policy) levels.
Decentralized decision-making enlarges possibilities for local
participation in development. In addition, national allocative
objectives may be carried by local governments responding to
incentives created by national grants and regulations as well as
interlocal or interregional agreements. National governments have
obvious roles with respect to both stabilization and distribution, and
due attention must be paid to possible local conflicts with these
policies.

In most cases, it is desirable that the national government assume

responsibility for national public services, international affairs,
monetary policy, regulation, transfers to persons and businesses,
fiscal policy coordination, regional equity, redistribution (in which all
levels of government may play a role), and preservation of an internal
common market. However, some central functions such as regulation
of the financial sector, environment, etc., may be effectively shared
with sub-national governments. State governments may have
dominant responsibility for education, health, social insurance,
intermunicipal issues, and oversight of local governments. All local
services should be assigned to local governments. In areas of shared
responsibilities, the roles should be clarified. Generally, the central
government should be involved with overall policy, setting standards,
and auditing; state governments should have an oversight function;
and local governments should be involved with the provision of
infrastructure and services.

Assignment of public services to local or regional governments can

be based on various considerations such as economies of scale,
economies of scope (appropriate bundling of public services to
improve efficiency through information and coordination economies
and enhanced accountability through voter participation and cost
recovery), cost/benefit spillovers, proximity to beneficiaries,
consumer preferences, and flexibility in budgetary choices on
composition of public spending. Assignment of responsibilities to
various local governments could be asymmetric based on population
size, rural/urban classification and fiscal capacity criteria. Thus large
cities may have responsibilities for some services which are provided
directly by the center in other areas.

An illustrative representative assignment of expenditure

responsibilities is depicted in Table 1, taking into account also the
possible desirability in some instance of "decentralization" beyond
formal government to civil society. An additional important
consideration to be borne in mind is that accountability is often best
promoted by establishing a clear and close linkage between the costs
and benefits of public services, so that the overall amount of
expenditure responsibility to be assigned to a particular level of
government will ideally correspond to the amount of revenues that
level has at its potential command.

This table provides a guideline of expenditure assignments based on

the subsidiarity principal. In practice, it is unlikely that any country
would or should follow precisely the division set out in the table. In
many instances some functions should be shared between levels of
government in the sense that higher levels of government may
exercise a regulatory or policy role, while lower levels of government
are responsible for service delivery. Even within service delivery
though, there are aspects best conducted by different levels of
government. For example, with regard to infrastructure, the technical
specifications for bridge construction might come from a higher level
of government, construction and maintenance at the local level. In
health care, the center may continue to provide technical training for
staff, procurement of pharmaceuticals to benefit from economies of
scale and ensure quality, and fund public health services. Intermediate
levels might conduct supervision of local level personnel, provide
refresher training courses, and, together with the local level, decide
the appropriate mix of curative services to offer as well as ensure
adequate maintenance of facilities and satisfaction with the personnel.

In this connection, it should be emphasized that assigning

responsibility for the provision of service to a specific level does not
imply that the same government should be directly engaged in its
production. Collection, transport, and treatment services in solid
waste management, for example, can be assigned to different public
and private entities depending on economies of scale, commercial
viability, and externalities. Many other services can also be
"unbundled." Production decision should result from evaluation of
alternatives using efficiency and equity criteria.

Experience has clearly shown that effective decentralization requires

complementary adaptations in institutional arrangements for
intergovernmental coordination, planning, budgeting, financial
reporting, and implementation. Such arrangements may encompass
both specific rules (e.g., in the design of fiscal transfers) and
provision for regular intergovernmental meetings and periodic
reviews of intergovernmental arrangements. Detailed central control
over local use of funds is seldom appropriate. Instead, what is needed
is transparency and accountability to local constituencies supported
by strengthened higher level monitoring and reporting of local fiscal
performance.
Questions on Govinda Rao’s Paper (Section-Wise)

1. Discuss the evolution of Indian Federalism and the Assignment Problem.

2. Discuss the trends and issues in fiscal imbalances. Also discuss the major issues in
Federal Fiscal Arrangements.
3. With regards to Intergovernmental Transfers, discuss the following:
(a) Economic Rationale for Transfers.
(b) Design of Intergovernmental Transfers.
4. With regards to Intergovernmental Transfers, discuss the following:
(a) Intergovernmental Transfers in India.
(b) Shortcomings of Intergovernmental Transfers in India.
(c) Equalizing effects of Intergovernmental Transfers.
 Changing Contours of Federal Fiscal Arrangements in India
M. Govinda Rao

I. Introduction

 India is a classical federation with a constitutional division of functions between the

Union and States in terms of the Union (List I), State (List II) and Concurrent (List III)
lists.

 Although the country has the federal system with separate legislative, executive and
judicial wings at both central and State levels, in its functioning it is considered to be a
quasi-federal system because of the very high concentration of powers with the central
government.

 Besides, the residuary powers have been assigned to the central government.

(Residuary Powers: Legislation required on matters not mentioned in the three lists in
point one above. Residuary provisions in Article 248 of the Constitution and Entry 97 of
the Union List. Example, power of imposing a tax not mentioned in the Lists II and III,
making laws with respect to matters not covered in Lists II and III. The three lists are
discussed in the Seventh Schedule of the Constitution (Internet))

 The center also has over-riding powers in respect of the items placed in the concurrent
list.

 Above all, the Center, has powers even to alter the boundaries of a State and create new
States by dividing the existing ones by informing the State government.

 The concentration of powers got further strengthened with the adoption of centralized
planning in a mixed economy framework with the implementation of an item placed in
the concurrent list ‘economic and social planning” after 1951.

 The objective of this paper is to analyze the trends and major challenges faced by Indian
fiscal federalism in the context of a liberal and open economy environment.

 The analysis is important for a number of reasons.

1. First, India is the most populated federation and resolution of intergovernmental and
governance issues offer valuable lessons for other large multilevel fiscal systems.
 2. Second, the transition from to more liberalized and a more open economy involves
many difficult issues of designing the reforms, their co-ordination and sequencing.

3. Third, Indian experience shows how apparently contradictory features like

developmental planning, market economy and fiscal decentralisation can be combined
and with what consequences.

4. Finally, experience with asymmetrical federalism - of accommodating diverse social,

religious, linguistic and ethnic groups, protecting the interest of minorities and
catering to the needs of people in atypical regions can provide useful lessons in
accommodating diversities.

5. The important issues of democratic federal polity including the politics of the
coalition government, different political party rule at the center and states and
emergence of regional parties in power some of the other developments warranting
detailed analysis.

 The paper is organized in five sections.

1. Section II gives a brief account of the evolution and structure of Indian federalism.
2. Tax and expenditure assignments and their implications on vertical and horizontal
fiscal imbalances are analyzed in Section III.
3. Fiscal imbalances in Indian federalism are analyzed in Section IV.
4. The design of general purpose and specific purpose transfers from the Center to
the states are analyzed in Section V.
5. The salient features of intergovernmental transfer systems in India are
summarized in the last section.

II. Evolution of Indian Federalism:

1. Introduction and Union-Centre Decentralization

Para 1.
1. India is the largest democratic federal polity inhabited by a billion people spread over
28 States and 7 Centrally administered territories.
2. A separate legislative, executive and judicial arm of government are constituted at
both Central and State levels.
3. The upper house or Rajya Sabha in the Parliament is the Council of States.
4. The seventh schedule to the Constitution specifies the legislative domains of the
Central and State governments in terms of Union, State and Concurrent lists.
5. The Constitution also requires the President of India to appoint a Finance Commission
every five years to review the finances of the Center and the States and recommend
devolution of taxes and grant in aid for the ensuing five years.
Para 2.
1. Historical factors have played an important role in the adoption of a federal constitution
with strong unitary features in India.

(Unitary Constitution: There is only one Government, which is all powerful and rakes
decisions under all matters.

Federal Constitution: Three layers of the Government- Centre, State and Local. The
Federal set-up provides for a two-tier system of Government. The centre deals in national
and international matters like defence, external affairs, issuance of currency and so on,
while the rest of the activities come under the jurisdiction of the states. The functions,
resource areas and powers of the Centre and State Governments are defined under the
three Lists. Residual power belongs to the Centre (TR Jain))

2. The centralized governance under the colonial rule was combined with the bias towards a
unitary framework in the constitution.

3. There was also considerable fear that in the oligarchic power structure prevailing in rural
areas at the time of independence, significant decentralization could entail elite capture
public services.

4. The centralization inherent in the constitutional assignments was accentuated by the

adoption of a planned development strategy.

5. Centralized planning strategy required the Planning Commission to allocate resources

according to the envisaged priorities.

6. The most important centralization process was done when the major commercial banks
were nationalized in 1969 and along with the nationalization of financial institutions, the
Central government virtually acquired complete control over the financial system.

7. Recent economic and political events, however, have paved the way for a greater degree
of decentralisation.

8. In the economic sphere, the transition to a market-oriented liberalization and more open
economic environment has necessitated a greater degree of fiscal decentralisation.

9. On the political front, factors such as the end to single party rule, the emergence of
coalition of parties in power at the center and increasing importance of regional parties in
the political affairs of the country have provided a favorable environment for
decentralized governance.
2. Sub-State decentralization:
1. Although Indian federation was evolved as a two-tier structure until 1992, local
government units functioned both in urban and rural areas, but as agencies of the State
governments.

2. The statutory recognition to rural and urban local governments was accorded with the
73rd and 74th Constitutional amendments in 1992.

3. With this, each of the State governments was required to pass legislation appointing
Panchayat Raj institutions and urban local bodies.

4. It was stipulated that election to these local bodies should be held within the stipulated
period.

5. If the elected governments at local levels are superceded, elections should be held within
the six months.

6. A separate list of 29 functions for rural local bodies and 18 items for urban local bodies
were placed in the 11th and 12th Schedules respectively for the rural and urban local
governments to implement concurrently with the states.

7. The sources of finance were also identified for the local bodies.

8. Each State government was required to appoint a State Finance Commission to

recommend tax devolution and grants to the local governments.

3. The System:
1. Federalism in India is characterized by constitutional demarcation of revenue and
expenditure powers among the three levels of government.

2. The institutional structure of multilevel provision of public services is shown in Figure 1.

3. Thus, one billion people in the country are spread over twenty-eight States and seven
centrally administered territories.

4. The Seventh schedule to the Constitution specifies the legislative, executive, judicial and
fiscal domains of Union and State governments in terms of Union, State and concurrent
lists.
 (Kindly ignore the line “The centralisation….” In this figure)

5. The Constitution also requires the President to appoint a Finance Commission every five
years or earlier to review the finances of the Union and States and recommend devolution
of taxes and grants-in aid of revenues to them for the ensuing five years.

6. In addition, the Planning Commission also gives assistance to the States based on a
formula determined by the National Development Council

(This is called the 'Gadgil' formula after the name of the Deputy Chairman of the Planning
Commission (Prof. D. R. Gadgil) who introduced the formula for the first time in 1969) and
different central ministries give specific purpose transfers to States.
7. Below the States, there are over a quarter million local governments.

8. Of this about 3000 are in urban areas and the remaining in rural areas.

9. Rural local governments again are at three levels - district, Taluk (block) and village
levels.

10. The urban local governments consist of municipal corporations in large cities,
municipalities in smaller cities and towns and in notified area committees in smaller
towns.

11. Each of the State governments has devolved powers to levy certain taxes and fees to
village panchayats and urban local bodies.

12. The States have also instituted a system of sharing of States' revenues and giving grants to
urban and rural local bodies.

13. In addition, a number of Central sector and centrally sponsored schemes are implemented
by the local governments and the funds earmarked for the purpose are passed on to them
from the State governments for implementation.

III. The Assignment Question

1. Tax and Expenditure Assignments in India:

Functions:
1. The functions required for maintaining macroeconomic stability, international relations
and activities having significant scale economies have been assigned exclusively to the
Center or have to be carried out concurrently with the States.

2. The functions which have a State-wide jurisdiction are assigned to the States.

Taxes and Borrowings:

1. Most broad-based and progressive tax handles have been assigned to the Centre.

(itep.org : broad based tax is one that taxes most of the potential tax base. A broad based
sales tax is one that applies to all almost all purchases of goods and services. A narrow based
tax applies only to fewer items and has exemptions for things like food, housing and
medicine)
2. The Centre also has residual tax powers.
 3. A number of tax handles have been assigned to the States as well, but from the
viewpoint of revenue productivity (tax elasticity and tax buoyancy), only the sales tax
is important.

4. The States can borrow from the Central government. They have the powers to borrow
from the market as well, but if a State is indebted to the Central government, the
borrowing has to be approved by the Centre.

5. The tax powers are assigned on the basis of the principle of separation, exclusively
either to the Center or to the States. However, exclusivity is only in the legal sense
and this gives rise to anomalous situations.

Thus, the Center can levy taxes on production (excise duty) but the tax on the sale of
goods is leviable by the States.

Similarly, taxes on agricultural incomes and wealth are in States’ domain whereas
those on non-agricultural incomes and wealth are a Central prerogative. The States
find taxing agricultural incomes politically infeasible besides being administratively
difficult. In the event, this has provided an easy means to evade the income tax levied
by the Centre.

Pattern of expenditures of centre and states (Table 2)

1. Central government: Defense and provision of large physical infrastructure facilities.

2. States: Internal security, law and order, and social services and economic services like
agriculture, animal husbandry, forestry, fisheries, irrigation and power and public
works.

3. States: Share in expenditure on administrative services is about 68 per cent; on social

services they spend about 83 per cent and on economic services their share is about
two-thirds. Their role in providing social services like education, public health and
family is particularly predominant, close to 90 per cent.

Shares of Central and State Governments in Revenues and Expenditures (Tables 1 and 2)
1. The States, on an average, raise about 34 per cent of revenues and incur 57 per cent of
expenditures.

2. However, their manoeuvrability in implementing expenditures is lower; about 15 per

cent of total expenditures is incurred on items requiring matching requirements from
the States.
3. In fact, States’ expenditures on these schemes increased from 7 per cent of the total in
1985-86 to about 20 per cent in 2000-01.

Table 1
Table 2
Revenue Sharing

1. The Constitution also recognizes that the States’ tax powers are inadequate to meet
their expenditure needs and therefore, provides for the sharing of revenues from
central taxes.

2. Prior to the enactment of the Constitution (Eightieth Amendment) Act 2000, taxes
on incomes other than non-agricultural incomes and union excise duty were shared
with the States.

3. Considering the potential adverse incentives of sharing of taxes from individual

sources for the Central government, based on the recommendations of the Tenth
Finance Commission, the Constitution was amended (80th Amendment) to include
proceeds from all central taxes in the divisible pool.

(Explanation: The system prior to the Amendment provided incentives to the States to
remain indifferent to their developmental and fiscal performance (HL Bhatia, Public
Finance))

4. In addition to tax devolution, the Constitution provides for making grants in aid to
the states as well (Article 275).

5. Both tax devolution and grants in aid have to be determined by the Finance
Commission, an independent body appointed by the President every five years
(Article 280).
2. Assignment between State and Local Governments:
1. With the constitutional amendments in 1992, roles and responsibilities of rural and
urban local governments have been specified.

2. Accordingly, in separate schedules, a list of 29 functions to rural local bodies and

another list of 18 functions to urban local bodies have been specified.

3. However, these functions are concurrent with the States and the actual assignment of
specific revenue sources and expenditures depends on the extent to which the State is
willing to devolve.

4. Each state is required to appoint the state Finance commission every five years to
recommend the devolution of resources for carrying out the functions assigned.

5. In addition to State transfers, the local governments received funds for the
implementation of various central schemes.

6. The most important of them is for poverty alleviation, but there are also other
schemes on social and community services in which, the local governments have a
comparative advantage in implementation.

7. Analysis shows that local governments have very little flexibility in the use of funds
(Rao, Amar Nath and Vani, 2003).

8. After deductions of charges for electricity by the State government in the general
purpose transfers, very little is left.

9. A bulk of what is available is needed for administration and the local governments are
hardly in a position to execute any developmental schemes.
IV. Fiscal Imbalances: Trends and Issues.

1. Vertical Fiscal Imbalance in India:

1. The constitutional assignment and developments over the years have caused a high
degree vertical fiscal imbalance.

2. From Table 3, the State governments in 2000-01 collected only 38 per cent of total
current revenues (column 2), but their share in total current expenditure was 57 per
cent (column 3).
3. From the revenue sources assigned to them, they could finance only 48 per cent of
their current expenditures (column 4) and 43 per cent of their total expenditures
(column 6).

4. Thus, from the own sources assigned to them, the States raise only about 44 per cent
of expenditure requirements.

5. Over 55 per cent of States’ total expenditures are financed from transfers from the
Center and loans.

6. Interestingly, even when the States’ revenues grew at a rate faster than that of the
Center, their fiscal dependence on the latter increased.

7. Although the States’ share in raising revenue has marginally increased since mid
1980s, as their expenditure share increased at a faster rate (Table 3, column 5),
causing increase in fiscal dependence.

8. Thus, the proportion of States’ current expenditures financed from own revenues
declined from 59 per cent in 1995-96 to 49 per cent in 1998-99.

9. The States’ share in total expenditures too increased from 53 per cent in 1990-91 to
57 per cent in 2000-01.

10. However, this does not signify increase in decentralization for, the spending financed
by specific purpose transfer on which the states’ have little manoeuverability have
shown a sharp increase in recent years.
 Table 3

2. Horizontal Fiscal Imbalance:

1. An important feature of Indian fiscal federalism is the wide inter-State differences in
revenue capacity (ability to raise revenue to support public services) and
consequently, per capita expenditures.

2. There are 17 relatively more homogenous general category States, but even these
have wide differences in size, revenue raising capacities, efforts, expenditure levels
and fiscal dependence on the Centre.

3. In addition, in terms of economic characteristics the 11 mountainous States of the

north and the Northeast differ markedly from the rest and therefore are considered
‘special category’ States.

4. Of the 28, three States have been carved out from three large States. The three new
States are Jharkhand (carved out of Bihar), Chattisgarh (carved out of Madhya
Pradesh) and Uttaranchal (carved out of Uttar Pradesh.

5. While the first two states have continued as general category states, the last one is
considered to be a special category state.

6. Differences in per capita revenues and expenditures among the States shown in Table
bring out several important features.
 First, there are wide inter-state variations in revenues in both per capita terms and as a
ratio of Gross State Domestic Product (GSDP).

 Second, these variations indicate differences in revenue capacity, and partly,

differences in revenue efforts.

 Third, the tax-GSDP ratios in the special category States are lower than in the general
category States even when their per capita GSDP is higher.

(i) This is partly because, in these States there is not much production activity and the
government administration is the major determinant of the GSDP.

(ii) Further, size of their tax base is smaller than what is indicated by the GSDP, because
a significant proportion of government spending spills over the jurisdictions.

 Fourth, although the revenue bases in the special category States are low, their
average per capita current expenditure are higher than not only the all-State average
but also the average of high-income States.

(i) Of course, the higher than average per capita expenditures in special category States
cannot be entirely attributed to their inherent cost disability.

(ii) This may also be due to bad fiscal management.

 Fifth, in the case of general category States, the fiscal dependence on the Center is not
only high but also varies inversely with per capita income.

(i) It is seen that per capita expenditures in high income States was higher than the all
State average by 44 per cent and that of the low-income States is lower by 36 per cent.

(ii) The large differences in per capita expenditures exist despite significant equalization:
while the per capita revenues from own sources in low income States were about 29
per cent of those in high income States, per capita expenditure in the former was close
to 63 per cent.

7. The inter-state disparities in India even among the general category States are not
only high, but also have shown an increasing trend.

 In 1980-81, the per capita SDP in the richest State, Punjab (Rs 2674) was about 2.9
times that of the poorest, Bihar (Rs 919).

8. In 1998-99, this difference increased to 4.8 times with per capita SDPs of the two
States respectively at Rs 23254 and Rs 4813.
9. It is also seen that per capita income levels have tended to diverge sharply after
market-based reforms were initiated.
10. As inter-State differences in the ability to raise revenues increased over the years, and
as federal transfers did not entirely offset the fiscal disabilities of the poorer states, the
coefficient of variation in expenditures also increased over the time period (Rao,
1998).

Table 4
V Intergovernmental Transfers

1. Economic Rationale for Transfers:

1. Intergovernmental transfers have been employed to fulfil a variety of objectives and the
design of the transfer scheme depends on the purpose for which it is given.
2. In the literature, federal transfers are recommended for (i) closing the fiscal gap, (ii)
equalization, (iii) spillovers and merit good reasons. (In addition, transfers may also be
 given to carry out some agency functions for the central government Rao and Singh
(1998)).

[Extra (for understanding): U can quote portions from Rao and Singh
(1998) for your exams as well. State the full reference in the exam.
Sources:

1. INTERGOVERNMENTAL TRANSFERS: RATIONALE, DESIGN AND

INDIAN EXPERIENCE, M. Govinda Rao and Nirvikar Singh, December 1998)
2. Fiscal Federalism In India: Intergovernmental Transfers Explored
(https://www.ukessays.com/essays/economics/fiscal-fedaralism-in-india-
intergovernmental-transfers-explored-economics-essay.php)

3. Intergovernmental Transfers/Grants Design

http://www.ciesin.org/decentralization/English/Issues/Transfer.html (World
Bank)

(i) Offsetting fiscal imbalances or closing fiscal gaps:

Fiscal imbalances, as discussed earlier, are of two types, vertical or horizontal. Vertical
fiscal imbalance refers to the difference between expenditures and revenues at different
levels of government, while horizontal federalism refers to the differences between
revenue and expenditure levels within a particular level of government.

Vertical fiscal imbalances:

Vertical fiscal imbalances are a feature common to all multilevel governmental systems.
Even when assignments of functional responsibilities and revenue powers are efficient,
imbalances are bound to occur.

This is because the efficient expenditure assignment does not typically match with the
efficient tax assignment.

The central government has a comparative advantage in raising revenues and monitoring
intergovernmental competition to control “free-riding” whereas sub-central governments
are better placed to provide public services efficiently corresponding to varying
preferences of people of different jurisdictions (Breton, 1987, 1996).

Therefore, assignments according to comparative advantage necessarily result in vertical

fiscal imbalance.

Of course, actual assignments are the result of many non-economic considerations and
these can contribute to vertical fiscal imbalances as well.

Vertical fiscal imbalances can also be caused by factors other than assignments. At the
subnational level, intergovernmental tax competition can result in lower tax rates, but
competition to provide public services can enhance expenditure levels, thereby
accentuating vertical fiscal imbalance. In addition, variations in fiscal management in
 terms of tax effort and expenditure economy among different levels of government can
also contribute to the degree of vertical fiscal imbalance.

While there is clear evidence of increasing vertical fiscal imbalance in Indian federalism,
that by itself would not justify intergovernmental transfers.

In fact, the vertical fiscal imbalance rationale for intergovernmental transfers is

tautological because the growth of the vertical fiscal imbalance itself could be due to (i)
increases in revenue capacity at the state level lagging growing expenditure needs; and
(ii) slack fiscal management at the state level resulting in lower tax effort and increased
expenditure profligacy. Further, giving transfers to fill the gaps between actual revenues
and expenditures of the states can also create serious disincentives for states’ fiscal
management.
(Rao and Singh (1998)).

Horizontal Fiscal Imbalance:

The filling the “fiscal gap” rationale for intergovernmental transfers extends to horizontal
fiscal imbalances as well.

Horizontal fiscal imbalances refer to the mismatch between revenues and expenditures of
governmental units within a level of government.

In the Indian context, they refer to an excess of expenditures over revenues of different
state governments.

From the national point of view, the persistence of large horizontal imbalances has been
considered improper, and these imbalances have been sought to be corrected through
equalizing transfers from the center, which automatically implies the existence of some
degree of vertical imbalance as well.

Horizontal fiscal imbalances can arise due to revenue or expenditure differences between
the states. Revenue differences can be due to either differences in fiscal capacity or in
effort. Similarly, expenditure differences between states may be due to differences in the
quantity or quality of public services provided or differences in the unit cost. Again, cost
differences can be due to factors beyond the control of the states or due to differences in
fiscal management.

(ii) Equalization or Horizontal Equity Across the Federation:

Horizontal equity: “Equals must be treated equally”.

Taxation principle according to ability to pay calls for people with equal capacity to pay the
same and for people with greater ability to pay more. The former is called horizontal equity
and the latter is called vertical equity.

If income is used as an index of ability to pay, people with same income must pay the same
tax.
Equalization issues (Horizontal Equity):

A country which values horizontal equity (i.e., the equal treatment of all citizens nationwide)
will need to correct the fiscal inequity which naturally arises in a decentralized country.
Subnational governments with their own expenditure and taxation responsibilities will be
able to provide their residents different levels of services for the same fiscal effort owing to
their differing fiscal capacities. If desired, these differences may be reduced or eliminated if
the transfers to each jurisdiction depend upon its tax capacity relative to others, and upon the
relative need for and cost of providing public services (World Bank).

OR

The argument for intergovernmental transfers on equity grounds has been made either in
terms of ensuring horizontal equity of individuals across the states, or simply of ensuring
inter-regional equity (Musgrave, 1962). Both the approaches build a case for unconditional or
general purpose transfers from the centre to the states on a progressive scale so as to offset
the fiscal disabilities arising from low revenue capacity and high expenditure needs (Rao and
Singh (1998)).

(iii) Spillover and Merit Goods Reason:

Merit Goods: Merit goods are commodities or services that the public sector provides free or
cheaply because the government wishes to encourage their consumption. Examples:
Subsidized housing or social services (education) for helping the poor, health care services
for poor and elderly (Britannica.com).

Reasons for transfers:

In the mainstream literature, intergovernmental transfers are seen as a device to resolve the
problem of mismatch between benefit spans from various hierarchies of public goods and
exogenously given spatial jurisdictional domains. When the benefits of public services
provided by a state spill over its jurisdiction, the state ignores the benefits accruing to the
non-residents while deciding the amount of the service provided. The jurisdiction equates the
marginal benefits from the public service with the marginal cost of providing it, and as it
ignores the part of the benefit accruing to non-residents the result is non-optimal provision of
the public service. Optimal provision of the service in question can be ensured through
Coasian bribes or voluntary action of the jurisdictions to compensate for the spillovers.
However, such solutions are infeasible and therefore, spillovers have to be arbitrated through
central grants akin to ‘Pigovian’ subsidies to offset the spillovers. These transfers must
necessarily be specific-purpose, requiring matching contributions from the states and the
exact matching rate should depend upon the size of spillovers. This implies that the matching
rate should vary with the degree of externality generated by various public services. Further,
a uniform rate of matching transfers would have non-uniform responsiveness in different
states depending on their level of development, as complete equalization in fiscal capacities is
never achieved in any federation. This calls for varying the matching rates itself in favour of

the poorer states (Rao and Singh (1998)). ]

3a. The argument for equalisation on horizontal equity grounds is advanced initially by
Buchanan (1950) and later developed by Boadway and Flatters (1982).
Taking comprehensive income as the index of well-being, it is argued that the federal income
tax as is presently structured cannot ensure horizontal equity for, its base does not consider
the redistributive effect of States' fiscal operations.
States' fiscal operations cannot be distributionally neutral except in the unlikely case of
benefit taxes (People pay tax according to the benefit they receive from the government).
When the States’ quasi-public services (these gods and services have the property of both
private and public goods. Examples are roads, tunnels and bridges) are financed by
resource rents or source-based taxes as against residence-based taxes, the net fiscal benefits
will systematically vary.
[Source based and residence-based taxation: indianeconomy.net
Residence based taxation: Country (Regions) can tax people if they are residents or domiciled
in the country regardless of the source of income. It is not citizenship but residential stay that
determines the tax jurisdiction of an individual. In case of companies, it is the place of
incorporation or registration.
Source based taxation: Importance is to the source (region/country) where the income is
generated. This is relevant for people whose “residence” is in one place and their business is
in another.
India follows residence based taxation. ]
The residents in the resource rich (high income) regions will have higher NFBs and their
higher public consumption will not be included in determining the tax base of the Central
government.

[Principles of intergovernmental transfers: Have the finance commissions followed them?

ISEC WP 1999. M Govinda Rao
3b. Boadway and Flatters (1982) define horizontal equity in two alternative ways.
According to the broad view, the fiscal system should be equitable nation-wide vis-à-vis the
actions of all governments. Two persons equally well off before Central and State actions
must also be so afterwards. To fulfil this concept of horizontal equity, it is necessary to give
transfers so that each province is enabled to provide the same level of public services at a
given tax rate (like in a unitary State).
In contrast, the narrow view of horizontal equity takes the level of real incomes attained by
the individuals after a State's budgetary operation as the starting point and the Central fiscal
action will be directed to ensure horizontal equity after the State's fiscal system has been
established.
The Central budget need not offset the inequalities introduced by the operation of the State
budgets per se, but takes the income distribution effects of the States' fiscal operations as a
given datum.
4. The rationale for specific purpose transfer is routed in offsetting spillovers. In the absence
of perfect `mapping', the public services by sub-Central governments may spill over the
jurisdictions and such externalities result in the non-optimal provision of public services. A
Pigovian subsidy is required to ‘set the prices right’. To be cost-effective, specific purpose
transfers made to the States to ensure optimal provision of public services require matching
contributions from them.

2. The Design of Intergovernmental Transfers:

1. General-purpose transfers, as mentioned earlier, are given to offset fiscal disabilities.
So, they fulfil the objectives of both gap filling a well as equalization.
Gap filling:
These transfers offset the fiscal disadvantages arising from lower revenue capacity and higher
unit cost of providing public services. This is achieved by unconditional grants equivalent to
the ‘need-revenue’ gap (Bradbury, et al., 1984). The `need-revenue' gap measures the
difference between what a State ought to spend to provide specified levels of public services
and the revenue it can raise at a given standard level of tax effort.
Equalization:
Also, both the approaches of ensuring horizontal equity build a case for unconditional or
general purpose transfers from the centre to the states on a progressive scale so as to offset
the fiscal disabilities arising from low revenue capacity and high expenditure needs (Rao and
Singh (1998)).
2. Specific purpose transfers on the other hand, are intended to compensate the spillovers or
are given for merit good reasons or for reasons of “categorical equity” (This is another
approach to equity. It is defined not in terms of income but in terms of specific consumption
items. The floor may be defined as a minimum supply of food, clothing and shelter. It may be
taken to link merit good approach to that of distributive justice (Musgrave and Musgrave)).
The transfer system, therefore, should be specific purpose and open ended with matching
ratios varying with the size of spillovers. As the responsiveness of the States to a given
matching rate could vary with their level of its incomes, equalizing matching ratios are also
recommended (Feldstein, 1975).
3. Thus, in an ideal system, there should be an optimal combination of general and specific
purpose transfers. General-purpose transfers would enable all the States to provide a given
normative standard of public services at a given tax effort. The specific purpose transfers
would ensure a given standard of outlay on the aided services.

3. Intergovernmental Transfers in India:

Introduction
(i) A notable feature of transfer system in India is the existence of multiple channels.

(ii) The Constitution provides for the appointment of the Finance Commission by the
President of India every five years to make an assessment of the fiscal resources and
needs of the Center and individual States.

 Based on these, the Commission is required to recommend the shares of

personal income tax and union excise duty and grants-in-aid to the States.

(iii) However, with development planning gaining emphasis, the scope of the Finance
Commissions was restricted to cover the States' non-plan requirements in the current
account.

 The Planning Commission became a major dispenser of funds to the States by

way of both grants and loans.

(iv) In addition to these two channels, various Central ministries give specific purpose
transfers with or without matching requirements. These are the assistance to central
sector and centrally sponsored schemes
(This is discretionary transfer, based neither on recommendations of Finance
Commission or determined by any formula (UK Essays))

(v) The trends in the relative shares of the three channels of Central transfers to States
since the fourth five-year plan, as shown in Table 5 , bring out some interesting
features.
(There is a considerable amount of confusion in the term ‘transfers’. In Indian fiscal
literature, Central loans to States are also characterized as transfers. Such transactions involve
transfers only to the extent of any interest subsidy or write off of loans. Here we have only
taken tax devolution and grants as transfers)

Table 5

 First, the share of statutory transfers (Finance Commission Transfers) in the total
declined from 65 per cent during the fourth plan (1969-74) to a little over 60 per cent
during the seventh plan.
 Although it increased to 65 per cent in 1997-98, declined subsequently to less than 62
per cent in 2000-01.

 Second, the proportion of formula-based transfers (Gadgil Formula for Planning

Commission and Finance Commission Formula) given by the Finance Commission
and the Planning Commission has declined and that of discretionary transfers (Central
Ministries) has increased in recent years.

 Third, within the Finance Commission, the proportion of tax devolution is

overwhelming though in recent years, this has tended to decline.

Finance Commission Transfers (Tax Sharing and Grants):

1) Under Article 280 of the Constitution, President of India appoints the Finance
Commission every five years or earlier as deemed necessary.

2) The Commission is required to make recommendations on the following:

a) The distribution between the Union and the States of the net proceeds of shareable
taxes and allocation between the States of the States’ share of divisible taxes;

b) The principles that should govern grants in aid of revenues of the states out of the
consolidated fund of India and the amount to be paid to the States in need of
assistance;

c) The measures needed to augment the Consolidated Fund of a State to supplement the
resources of Panchayats (rural local governments) in the State on the basis of
recommendations made by the State Finance Commissions;

d) The measures needed to augment the Consolidated Fund of a State to supplement the
resources of municipalities on the basis of a recommendations by the State Finance
commissions;

e) Any other matter referred to the Commission in the interest of sound finance.

3) Approach of Finance Commission to transfers:

 (Scope of the Finance Commission has been restricted to meeting the non-plan current
expenditure requirements of the States due to the emergence of Planning Commission as
a major dispenser of financial assistance to States for plan purposes).

 Assessing the overall budgetary requirements of the Center and States to determine the
volume of resources that can be transferred during the period of their recommendation;

 Forecasting States’ own current revenues and non-plan current expenditures;

 Determining the States’ share in Central tax revenues and distributing between the States
of these shareable proceeds;

 Filling the post-devolution projected gaps between non-plan current expenditures and
revenues with grants- in -aid.

 This whole approach is known as the "gap-filling" approach.

(In the gap filling approach, the FC uses a fixed formula based on economic indicators to
decide tax devolution for each state. In the past, these indicators included population,
area, distance, infrastructure, fiscal discipline and tax effort. Distance formula was used
as a tool for fiscal capacity equalization and population criterion for vertical transfers.
Grants, on the other hand, are determined on the basis of projected gaps between the non-
plan current expenditures and post tax devolution revenues (UK Essay))
The latest Finance Commission (Eleventh) has made the recommendations for the five years
beginning April 2000.
4) 80th Constitutional Amendment - Devolution of selective central taxes replaced by general
tax sharing - and Finance Commission.

 Prior to the 80th Constitutional amendment, Finance Commissions were required to

recommend the transfer of additional excise duties in respect of sales taxes on sugar,
textiles and tobacco.

 In respect of these three groups of articles, the States had voluntarily surrendered their
right to levy sales taxes.

 The Center has been levying additional excise duties, which was passed on to them on
the basis of origin as recommended by the Commission.

 With the substitution of general tax sharing to sharing of individual taxes, separate
assignment of additional excise duties has been discontinued.

 Thus, the Eleventh Finance Commission has recommended the distribution of 29.5
per cent of net proceeds of net proceeds of central taxes consisting of 28 per cent for
general tax sharing and 1.5 per cent in lieu of additional excise duties.
  The entire 29.5 per cent is to be distributed according to a uniform formula given in
Table 6 below.

Table 6

5) An important feature of tax devolution recommended by the Finance Commission:

 While the criteria adopted for distribution are different from the principles of grants-
in-aid, nowhere is it made clear that the economic objectives of the two instruments
are different (Rao and Sen, 1996, Ch.6).

 The tax devolution is recommended mainly on the basis of general economic

indicators (Table 6).

 Grants are given to offset the residuary fiscal disadvantages of the States as quantified
by the Commissions.

 Further, assigning weights to contradictory factors like `backwardness' and

‘contribution’ in the same formula has rendered the achievement of the overall
objective of offsetting revenue and cost disabilities difficult.

6) Degree of equalization in transfer scheme:

 Over the years, attempts have been made to improve degree of equalization in the transfer
scheme.

 This is being achieved by assigning higher weight to per capita SDP either in the
“inverse” or “distance” form by the successive Commissions.
 Yet, population has continued to receive the largest implicit and explicit weight, though
the last Commission has significantly reduced explicit weight to this factor.

 Equally important is the unreliability of tax effort and index of fiscal discipline.

 In a tax system, which is predominantly origin based, there can be significant inter-state
tax exportation and the tax effort indicator ignores this phenomenon.

 Besides, there are a number of other factors in addition to per capita SDP that determines
taxable capacity of a State.

 The changes in the ratios of own revenues to revenue expenditures relative to all-State
average and their changes over time can occur due to factors 18 totally extraneous to
States own efforts at fiscal discipline.

 Equalization has been further blunted by the terms of reference, which require the
Commissions to use the 1971 population figures wherever it is used in the transfer
formula.

 The purpose of this is to penalize the States with higher population growth rates.

 The important questions are first, whether, the federal transfer mechanism should be
employed as an instrument of population policy and second, even if it is, why should
those States with high population growth due to migration be penalized.

7) Problems in ‘gap-filling’ approach:

(i) First, none of the Finance Commissions assessed the overall resource position and
requirements of the Center on any objective basis.

(ii) Second, the transfers made by the Finance Commissions were not designed specifically to
offset fiscal disadvantages of the States arising from lower revenue raising capacity and
the higher unit cost of public services.

 While the tax devolution is determined on the basis of general economic indicators, grants
are given on the basis of projected post-devolution budgetary gaps.

(iii) Third, the design of the grants has serious disincentive effects on fiscal management
of the States.

 Nor are the fiscally disadvantaged enabled to provide a given level of public service at a
given tax-price.

8) Solution to the problems of “gap-filling” approach (its possible disincentives on fiscal

management in States).
 (i) Modifying the terms of reference of the Ninth Finance Commission to follow a
“normative approach”.

(ii) The Commission did develop methodology for the purpose. However, the subsequent
Commissions simply abandoned the approach.

(iii) The 11th Finance Commission in the additional terms of reference asked to
prepare a new scheme –

A monitorable fiscal reforms program aimed at reduction of revenue deficit of the

state and recommended the manner in which the grants to the States to cover the
assessed deficit in their non-plan revenue account may be linked to progress in
implementing the program.

(iv)Scheme details:

 Pooling 15 per cent of revenue deficit grants and adding an equal amount to it to create an
incentive fund.

 This fund to be allocated among the states based on fulfilment targets of growth of tax
and non-tax revenues and expenditures on salaries, interest payments and subsidies set in
the fiscal restructuring plan detailed by the Commission.

 Equal weight to monitorable measures on the revenue and expenditure sides and specified
weights to each of the monitorable measures.

 The incentive fund has been allocated to the States according to their population shares.

 A State will get the full amount if it fulfils the targets and the amount will vary depending
on the degree of achievement of monitorable targets.

 If a State does not get the full amount during the first four years it will continue to be
available in subsequent years, but if by the fifth year the targets are not achieved, the
funds will lapse.

 To implement the scheme a monitoring agency should be set up by the Government of

India consisting of representatives of the Planning Commission, Finance Ministry of
Government of India and representatives of State governments.

(v) Problems with the proposed scheme: The problems include both with the monitorable
measures and implementation mechanism.
 The measures can vary not only due to factors within the States’ control but also beyond.
 Again, while determining the grants these measures have been considered, but a portion
of the grants thus determined is withheld for distribution according to the achievement of
these measures.
 There are also problems of fiscal autonomy of the States when its actions are supervised
by a monitoring agency.
 Finally, while the scheme tries to monitor the fiscal performance of the States, there is no
mechanism to monitor the performance of the Center.

Plan transfers
(i) The assistance given by the Planning Commission comprises of both grants and loans.

(ii) In earlier years, both the volume and the loan - grant component was project based, but
since 1969 the assistance has been allocated on the basis of a formula (Gadgil formula).

[The formula and its modifications from time to time are evolved on the basis of consensus the National
Development Council (NDC). The NDC is constituted by the cabinet ministers at the Center, chief ministers of
the States and the members of the Planning Commission and is chaired by the Prime Minister.]

(iii) At present, 30 per cent of the funds is kept apart for the special category States and
distributed among them on the basis of plan projects formulated by them, 90 per cent of
the assistance given by way of grants and the remainder as loans.

(iv)The 70 per cent of the funds available to the major States is distributed with 60 per cent
weight assigned to population, 25 per cent to per capita SDP, 7.5 per cent to fiscal
management and the remaining 7.5 per cent to special problems of these States (Table 7).

(v) 30 per cent of the resources is given by way of grants and the remainder as loans.

(vi)Thus, plan transfers and their grant-loan components, are determined independently of the
required plan investments, their sectoral composition, the resources available to the States
or their fiscal performances.

Table 7
Assistance to the Central Sector and Centrally Sponsored Schemes:
(i) This is the third component of transfer.

(ii) It is given for specified purposes with or without matching provisions.

(iii) Grants for the Central sector schemes are given to the States to execute Central
projects and are entirely funded by it.

(iv)Centrally sponsored schemes, on the other hand, are shared cost programs falling within
the States' ambit with uniform matching ratios across the States, but, varying with the
projects.

(v) There were 262 such schemes in 1985, and some more have been added in subsequent
years.

(vi)These transfers have attracted the sharpest criticism due to their discretionary nature and
conditionality attached to them.

(vii) They accounted for about 40 per cent of the total plan assistance and about 14 per cent
of total current transfers were given to these schemes in 2000-01 (Table 5).

Financing infrastructure at the State level: The loans

(i) Borrowing is an important source of financing infrastructure at the state level.

(ii) Until 1987-88, the government savings at the State level did contribute to financing
capital expenditures.
(iii) Since then, however, with increasing dissavings at the state level, the borrowing is
used not only to finance capital expenditures, but also a significant part of current
expenditures of the States.

 In 1998-99 for example, almost one-half of the States’ borrowing is used to finance
capital expenditure.

(iv)The States’ liabilities consist of Central government loans, market borrowings, share of
small savings collections, and provident funds, deposit accounts etc.

 The Central loans constitute 60 per cent of the States’ indebtedness.

 These loans are given mainly for financing the plans under the Gadgil formula.

 As already mentioned, the States receive 70 per cent of plan assistance in the form of
loans. Other Central loans consist of ways and means advances and the share of small
savings collections (These are post office savings in the form of national savings
certificates).

(v) The States can also borrow from the market.

a) However, if a State is indebted to the Center, it has to take central permission before
borrowing.

b) As all the States are indebted to the Center, the Ministry of Finance, Planning
Commission and the Reserve Bank of India determine market borrowing of the States.

c) In determining the volume of market borrowings, volume of repayments, the plan

investments decided upon and the volume of indebtedness of each of the states is
taken account of.

 In 1998-99, the market borrowings constituted 22 per cent of States’ indebtedness.

d) Subscription to State government loans constitutes a part of the Statutory Liquidity

Ratio (SLR), the commercial banks are required to maintain 35 per cent of their
lendable resources in stipulated assets, which includes state government borrowings.

e) Thus, the investible resources of the banking system is pre-empted for government
consumption and investment.
f) The interest rates on government bonds were significantly below the market rates.

g) However, financial sector reforms initiated since 1991 has gradually aligned the
interest rates on government bonds with market rates.
Shortcomings of Intergovernmental Transfers Summarized:
The design and implementation of intergovernmental transfer schemes in India suffer from a
number of shortcomings.
1) First, multiple agencies with overlapping jurisdictions have blurred the overall objectives
of transfers.

2) Second, accommodating different interests has unduly complicated the transfer formula.

3) Third, the design of the transfer system is not well targeted to achieve equalization and to
ensure minimum service levels in the States.

4) Fourth, they have disincentive effects on the fiscal management in the States.

5) While there is certainly a role for specific purpose transfers in Indian federation, the
design and implementation of the centrally sponsored schemes has not served the
purpose.

 It has tended to multiply State level bureaucracy and distort States’ own allocations in
unintended ways.

Equalizing Effect of Intergovernmental Transfers:

Figure 2 and Table 8

1) Analysis of intergovernmental transfers shows a fair degree of inter-State redistribution.

2) The transfers vary inversely with the level of per capita State domestic product (Figure
2) .

3) The cross-section income elasticity of aggregate transfers in 1998-99 was - 0.194 (Table
8, Last Column, Third Row).

4) The progressively in the transfer system was entirely due to the redistribution achieved in
Finance Commission transfers.
5) The elasticity of Finance Commission transfers with respect to GSDP in 1997-98 was
-0.26 (Table 8, Column 2, Row 3).

6) In contrast, grants for State Plan schemes and centrally sponsored schemes were not
significant. These transfers did not achieve significant equalization.

7) Thus by and large, the transfer system may be considered equitable.

8) Nevertheless, it should be noted that the absolute value of elasticity is low.

9) On an average, per capita transfers were higher by 0.19 percent when the per capita SDP
were lower by one per cent.

10) This shows that although the transfer system on the whole has an equalizing impact, it is
not designed to offset shortfall in fiscal capacity and cost disabilities fully.

Fiscal Transfers from the State to local governments:

1) As mentioned earlier, each State is required to appoint a State Finance Commission (SFC)
every five years to make recommendations on the transfers to be made to urban and rural
local bodies.

2) They are required to make recommendations on the assignment of tax revenues to local
bodies, sharing of tax revenues between the States and the local governments and their
distribution among individual local bodies and grants to be made to them.

3) The experience of implementation of this by various States does not bring much cheer,
however.

4) Some States are yet to constitute a SFC even after a decade of giving constitutional
recognition to local bodies.

5) In some States, SFCs are yet to submit reports and in many where it has been submitted,
the State governments have not accepted the recommendations.

6) As regards revenue raising powers, very little has been done in terms of giving revenue
raising powers.
7) The volume of transfers made is inadequate mainly because the States themselves have
been facing severe financial crunch and there is a general reluctance to pass on functions
as well as funds.

8) The distribution is not done in any scientific manner.

9) Often, particularly to village panchayats, the distribution is done on a lump sum basis
irrespective of their capacity or need.

10) In fact, after deducting the cost of electricity at source by the State government, very little
is available for actual spending by the local bodies.

11) The rural local bodies hardly collect any revenues.

12) The only major tax with the rural local bodies is the property tax, but its administration
and enforcement is so poor that very little revenue is actually collected.

13) Of course, these generalizations are simplistic and there are States where local bodies
play more active roles than that has been portrayed here, but that is an exception rather
than a rule.

VI. Federal Fiscal Arrangements in India: Major Issues

Introduction:
1. The preceding analysis brings out the important features of federal fiscal arrangements in
India.

2. The analysis highlights a number of shortcomings, which are due not merely to
Constitutional arrangements, but also to conventions, methods and working of
institutions.

3. The paper attempts to identify the reform areas, both in policies and institutions.

Issues:
1. Like in most other federations, the system of assignments has resulted in a significant
degree of vertical fiscal imbalance.
2. The wide differences in per capita incomes among the states have also caused severe
horizontal fiscal imbalances.
3. The transfer system should offset the fiscal imbalances.
4. However, the transfer system despite achieving as measure of equalization and attempts
to impart objectivity to the system, has left a lot of room for improvement in terms of
both equity and incentives.

5. It is therefore necessary to redesign the transfer system to improve accountability,

incentives and equity.

6. In particular, there are serious disincentives involved in the ‘gap-filling’ approach the
Commissions have adopted.

Reforms in transfer system:

1. Reforms in the transfer system will have to begin with redefining the scope of Planning
and Finance Commissions to avoid, overlap in their roles.

2. Preferably, the entire transfers should be the responsibility of the Finance Commission
and the Planning Commission should focus on physical infrastructure.

3. Until the debt market for the States is fully developed, the Planning Commission could
also administer loans to finance physical infrastructure.

4. For poorer States and those located in border areas, Planning Commission could even
provide loans at concessional rate of interest.

5. The Finance Commission should be made a permanent body with well qualified technical
personnel providing information and research base.

6. It could also be given the responsibility of administering and monitoring the specific
purpose transfers.

7. On the general purpose transfers, the Finance Commissions should move away the gap
filling role and adopt more scientific approach to the design of transfers.

8. Transfers should be designed to offset fiscal disabilities. It should be formula based,

simple and should not have disincentives.

9. As regards specific purpose transfers are concerned, there is an urgent need to consolidate
the prevailing schemes numbering more than 220 into just about 10-15, provide greater
 flexibility in their design and administration and if necessary have lower matching ratio
requirement for poorer States.

10. The States may even be allowed to choose from among a number of priority schemes
instead of fixing conditionality for each scheme.

11. Consolidation of the large number of centrally sponsored schemes could improve the
flexibility to the States and reduce resource distortions.

Conclusion:
1. Notwithstanding the weaknesses, it must be noted that the system of intergovernmental
fiscal arrangements in India has served well for over 50 years.
2. It has achieved a significant equalization over the years, instituted a workable system of
resolving the outstanding issues between the Center and the States and among the States
inter se, and adjusted to the changing requirements and thus has contributed to achieving
a degree of cohesiveness in a large and diverse country.
3. No doubt, the analysis brings out several areas of reform; what is however important, it is
eminently possible to reform the system
Fourteenth Finance Commission: Continuity, Change and Way Forward
Y. V. Reddy (2015).

NOTE TEXTS IN RED AND BLUE COLOUR ARE NOT A

PART OF THE SYLLABUS. SOME PART OF IT IS FOR
EXPLANATION OF SOME CONCEPT AND OTHER
PART IS FOR EXTRA NOTES.
STUDENTS CAN USE THE EXTRA TEXT FROM THE
FINANCE COMMISSION REPORT TO ADD TO THEIR
ANSWERS.

I. Guiding Factors and Work Processes

1. The FFC, like its predecessors, was guided by the “Terms of Reference (ToRs)”.
2. The approach of the previous Finance Commissions.
3. The experience gained in this regard [the prevailing macro-economic situation, in
particular, fiscal environment of the country; and the evolving circumstances relevant to
the ToRs].
4. In addition, the FFC reviewed in great detail the relevant deliberations in the meetings of
the National Development Council, the views of the Administrative Reforms Commission
(1966), National Commission on Review of the working of the Constitution
(Venkatachalaiah Commission 2002), Commission on Centre-State Relations (Sarkaria
Commission 1988), Commission on Centre-State Relations (Punchhi Commission 2010),
etc. to analyse the Union-State fiscal relations in a fundamental manner. In the process,
reference to debates in Constituent Assemblies also became necessary and useful.

5. The FFC followed the work processes and procedures consistent with previous practices.
These included internal procedures, consultations with States, Ministries in Union
Government, experts, political parties, local bodies and others. As in the past, a number of
studies were commissioned.

6. In addition, in order to obtain an overview of state finances from local experts, the FFC
commissioned studies for every State generally through universities and institutions
located in those States.
7. This was in addition to the previous practice of engaging the National Institute of Public
Finance and Policy (NIPFP), as well as other institutions, to study select subjects.
8. One of the studies commissioned gave an account of practices in select major emerging
economies; while the experience of major advanced economies was already available
with FFC.

II. Mandate
The core mandate of the FFC, as laid down in Article 280 of the Constitution and
incorporated in the ToR relates to:
a) Proceeds of taxes to be divided between Union and the States, usually referred to as the
Vertical Balance;
b) the allocation of distribution of taxes among the States, usually referred to as the
Horizontal Balance;
c) The principles which should govern the grant-in-aid to States by the Finance Commission,
which are over and above the devolution of taxes as per formula; and
d) Measures to augment the consolidated fund of a State to supplement the transfer of
resources to Panchayats and Municipalities, based on the recommendations of the respective
State Finance Commissions, usually referred to as Finance Commission Grants to Local
Bodies.
e) In addition, the ToR also incorporated what are generally referred to as other Terms of
Reference by virtue of the powers of the President to refer “any other matter in the
interest of sound finance”.

[ Chapter 1, 14th FCR, ToR DETAILS

The Terms of Reference (ToR) of the Commission mandated the following:

“4. The Commission shall make recommendations as to the following matters:

(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 under Chapter I, Part XII of
the Constitution and the allocation between the States of the respective shares
of such proceeds;

(ii) the principles which should govern the grants-in-aid of the revenues of the
States out of the Consolidated Fund of India and the sums to be paid to the
States which are in need of assistance by way of grants-in-aid of their revenues
under article 275 of the Constitution for purposes other than those specified in
the provisos to clause (1) of that article; and

(iii) the measures needed to augment the Consolidated Fund of a State to supplement
the resources of the Panchayat and Municipalities in the State on the basis of
 the recommendations made by the Finance Commission of the State.

5. The Commission shall review the state of the finances, deficit and debt levels of the
Union and the States, keeping in view, in particular, the fiscal consolidation roadmap
recommended by the Thirteenth Finance Commission, and suggest measures for
maintaining a stable and sustainable fiscal environment consistent with equitable growth
including suggestions to amend the Fiscal Responsibility and Budget Management Acts
currently in force and while doing so, the Commission may consider the effect of the
receipts and expenditure in the form of grants for creation of capital assets on the deficits;
and the Commission shall also consider and recommend incentives and disincentives for
States for observing the obligations laid down in the Fiscal Responsibility and Budget
Management Acts.

6. In making its recommendations, the Commission shall have regard, among other
considerations, to:

(i) the resources of the Central Government, for five years commencing on 1 April
2015, on the basis of levels of taxation and non-tax revenues likely to be reached
during 2014-15;

(ii) the demands on the resources of the Central Government, in particular, on

account of the expenditure on civil administration, defence, internal and border
security, debt-servicing and other committed expenditure and liabilities;

(iii) the resources of the State Governments and the demands on such resources
under different heads, including the impact of debt levels on resource availability
in debt stressed states, for the five years commencing on 1 April 2015, on the
basis of levels of taxation and non-tax revenues likely to be reached during
2014-15;

(iv) the objective of not only balancing the receipts and expenditure on revenue
account of all the States and the Union, but also generating surpluses for capital
investment;

(v) the taxation efforts of the Central Government and each State Government and
the potential for additional resource mobilisation to improve the tax-Gross
Domestic Product ratio in the case of the Union and tax-Gross State Domestic
Product ratio in the case of the States;

(vi) the level of subsidies that are required, having regard to the need for sustainable
and inclusive growth, and equitable sharing of subsidies between the Central
Government and State Governments;
(vii) the expenditure on the non-salary component of maintenance and upkeep of
capital assets and the non-wage related maintenance expenditure on plan
schemes to be completed by 31 March, 2015 and the norms on the basis of
which specific amounts are recommended for the maintenance of the capital
assets and the manner of monitoring such expenditure;

(viii) the need for insulating the pricing of public utility services like drinking water,
irrigation, power and public transport from policy fluctuations through statutory
provisions;

(ix) the need for making the public sector enterprises competitive and market
oriented; listing and disinvestment; and the relinquishing of non-priority
enterprises;

(x) the need to balance management of ecology, environment and climate change
consistent with sustainable economic development; and

(xi) the impact of the proposed Goods and Services Tax on the finances of Centre
and States and the mechanism for compensation in case of any revenue loss.

7. In making its recommendations on various matters, the Commission shall generally

take the base of population figures as of 1971 in all cases where population is a factor for
determination of devolution of taxes and duties and grants-in-aid; however, the
Commission may also take into account the demographic changes that have taken place
subsequent to 1971.

8. The Commission may review the present Public Expenditure Management systems in
place including the budgeting and accounting standards and practices; the existing system
of classification of receipts and expenditure; linking outlays to outputs and outcomes;
best practices within the country and internationally, and make appropriate
recommendations thereon.

9. The Commission may review the present arrangements as regards financing of Disaster
Management with reference to the funds constituted under the Disaster Management Act,
2005 (53 of 2005), and make appropriate recommendations thereon.

10. The Commission shall indicate the basis on which it has arrived at its findings and
make available the State-wise estimates of receipts and expenditure.”

1.3 The following additional item was added to the ToR of the Commission vide President’s
Order published under S.O. No. 1424(E) dated 2 June 2014 (Annex 1.2):
“Para 5 A. The Commission shall also take into account the resources available to the
successor or reorganised States on reorganisation of the State of Andhra Pradesh in
accordance with the Andhra Pradesh Reorganisation Act, 2014 (6 of 2014) and the Ministry
of Home Affairs notification number S.O. 655 (E) dated 4 March, 2014 and make
recommendations, for successor or reorganised States, on the matters under reference in
this notification”.

1.4 The Commission was originally asked to make its report, covering a period of five years
commencing on 1 April 2015, available by 31 October 2014. The Commission had completed
all its State visits and consultations with all stakeholders, including most of
Departments/Ministries of the Government of India by June 2014 and the process of
finalisation of its recommendations had reached an advanced stage. The bifurcation of
Andhra Pradesh and the additional ToR required the Commission to examine again various
comparable estimates for financial projections.

Subsequently, in view of the additional ToR notified, the President through his order,
published under S.O. No. 2806(E) dated 31 October 2014, extended the tenure of the
Commission to 31 December 2014 (Annex 1.3).]

Comments:
1. The core mandate of the Commission remains broadly no different from the previous
Commissions.
2. However, a reading of the ToR as a whole shows two striking aspects that have a bearing
on this core task.
First.
1) In some, though not all previous Finance Commissions, there is no specific
mention of the treatment of gross budgetary support to plan as a committed
liability of the Union Government (it was mentioned in the thirteenth finance
commission).
(The Government’s Support to the Central Plan is Gross Budgetary Support. It
includes tax receipts as well as other sources of revenue raised by the
Government. It was slightly more than 50 % of total plan and had risen
continuously since 2008-09 (Arthapedia). Central or Annual Plans are
essentially 5 YPs broken down into annual instalments)
2) The ToR also does not bind the FFC to look at only non-plan revenue
expenditure of the States (Looks at plan and Non-Plan revenue both).

3) The absence of reference created an opening to the FFC, if it so desired, to

dispense with the distinction between Plan and non-Plan.
 4) Unlike many of its predecessors, the FFC was emboldened to pursue this idea
since it was formally recommended by Dr. C. Rangarajan in his capacity as
Chairman of the High-Level Committee on Efficient Management of
Government Expenditures, but not acted upon by the Union Government.

5) The FFC seized the initiative and worked on operationalising the

recommendation. Actually, the recommendation of the FFC in this regard is to
make such a distinction redundant and irrelevant, but the Union and any State
could choose to retain the distinction if they find any use for it.

Second.

1) In the past, the ToR required the Commissions to take the base of population
figures of 1971 in all cases where population was a factor.
2) Our ToR indicated that, in addition, we may also consider the demographic
changes that have taken place since 1971.
3) The FFC took advantage of this opening to consider of both 1971 population
and 2011 population, while reluctantly giving higher weight to the 1971
population.

III. The Context

1) Every Finance Commission has to start with an initial position of the fiscal conditions in a
given macro context.
2) In a way, therefore, the macro context, as well as the fiscal position addressed by each
Finance Commission, is unique in its own way.
3) FFC recognised that the then prevailing macro-economic and fiscal position was not
encouraging while the global uncertainties were striking.
4) However, during the course of the work of the FFC, especially towards the later part of its
work, the sentiments improved for Indian economy.
5) Following past practice, the assessment of finances of Union and States, as well as the
projections, took account of the prevailing environment relevant to the FFC‟s work.

6) In addition, the FFC made special efforts to take cognizance of fundamental changes that
have taken place over the years which were critical to work of Planning Commission (as
it existed then) and the Finance Commission.
7) The fact that the balances between the public and private sectors, the government and the
public enterprises, the domestic and global economy, and the fiscal and non-fiscal
elements of the government, have dramatically changed over the years, was considered in
depth by the FFC, since this cannot but have a significant impact on the Union-State
fiscal relations during the award period (2015-16 to 2019-20).
 [ Fiscal elements: Taxes, Government Spending (Its components. Exs.: Wages paid to
civil servants and purchases of Goods and Services for current use), interest debt on
public debt, government debt and so on.
Non-Fiscal Elements: Expected Exchange Rate, LIBOR, Reserves, Money Supply and so
on
Reference: Pol Eco of Brazil Recent Eco Performance ]
8) The FFC, thus, took cognizance of the changing balances and the new realities of the
macro-economic management and tried to place the prevailing fiscal situation and the
evolving relationship between the Union and the States in the broader context also.
9) In a way, a balance had to be struck by FFC between the need for fundamental changes in
the balances and addressing the immediate challenges posed by the prevailing macro and
fiscal situations.

10) In addition to an appreciation of the broader context along with immediate challenges, the
FFC laid emphasis on listening and learning from all stakeholders, in particular all the
three tiers of the Government and political parties.
11) This approach resulted in special emphasis by the FFC on some of the issues that are
relevant to work of all Finance Commissions.
1) First, a demonstrably symmetric view of the Union finances, State finances and
their fiscal relations has been attempted.
2) Second, an integrated view of revenue expenditure with no distinction between
Plan and non-Plan, and a comprehensive view of revenue and capital
expenditures, including public debt were attempted.
[Expenditure that comes under planning commission is planned expenditure while
that which falls out of its purview are called non-plan expenditure. This includes
both developmental and non-developmental expenditure. Part of the expenditure is
obligatory like interest payments, pensionary charges and devolution /statutory
transfers to states as recommended by the Finance Commission. In the Union
Budget 2016-17, it was stated that plan and non-plan distinction would be
removed from 2017-18 fiscal. This is proposed to give greater focus to Revenue
and Capital Classification of Government Expenditure.
Reference: Arthapedia]
3) Third, the special responsibilities of the Union in macro-economic management
and its relationship with global economy had to be explicitly recognised.

4) Fourth, a comprehensive view of the transfer from the Union to the States, both
within and outside the recommendations of the Finance Commission, was
necessary to address the fundamental issues relating to constitutional assignment,
plans and Centrally Sponsored Schemes.
Implicitly, the issue of conditionalities in the transfers and the role of tied and
untied grants had to be reckoned.
5) Fifth, the predominant role of the States, in particular, the State Finance
Commissions, in empowering the local bodies, had to be recognised.
6) Finally, the FFC examined the issue of separate treatment of the special category
States.
 i. While each special category state argued that it is special within the special
category, some others in general category States demanded their inclusion
in the special category.
ii. It was felt that, as per the Constitution, all States have to be treated equally
by the FFC, and any categorization of States has to be based on application
of mind and reasoning by the FFC.
iii. On a detailed examination, it was found that such a two-fold categorisation
of States over-simplifies the reality.
iv. It was concluded that a combination of a well-designed formula to restore
Horizontal Balance by considering revenue and cost disabilities of the
states in the projection of revenues and expenditures, as necessary, will
address problems of all States, in a fair manner.
v. Given that the forest cover is an important factor in revenue and cost
disabilities, this approach provided an opportunity for the Commission to
mainstreaming sustainability in ecology and environment in the devolution
formula itself.

IV. Review of Fiscal Positions

[The Commission shall review the state of the finances, deficit and debt levels of the Union
and the States, keeping in view, in particular, the fiscal consolidation roadmap recommended
by the Thirteenth Finance Commission, and suggest measures for maintaining a stable and
sustainable fiscal environment consistent with equitable growth including suggestions to
amend the Fiscal Responsibility and Budget Management Acts currently in force and while
doing so, the Commission may consider the effect of the receipts and expenditure in the form
of grants for creation of capital assets on the deficits; and the Commission shall also consider
and recommend incentives and disincentives for States for observing the obligations laid
down in the Fiscal Responsibility and Budget Management Acts (Para 5 of 14 th FC Report
(FCR)). Union finances reviewed in Chapter 3 and State finances reviewed in Chapter 4 of
14th FCR]
Overview of Union Finances and Recommendations:
1. All fiscal indicators, both quantitatively and qualitatively, warranted a significant reversal
in the trend of dilution in the quality of fiscal management (fiscal, revenue and primary
deficits and so on) that had set in during the review period (the review of the major trends
in Union finances was for the period 2004-05 and 2014-15, Chapter 3, 14FCR) of the
Finance Commission.
i. However, FFC had to recognise that such a reversal may have to be anticipated and
projected in the award period in a realistic manner.
ii. In assessing what appears to be realistic, FFC had to make a judgement on whether it
should err on the side of more rapid improvement than that submitted by the Ministry
of Finance, Government of India.
iii. The judgement depended upon what was desirable, what appeared feasible, and above
all, the possible implications, both for the Union and the States, in case the projections
turn out to be overly optimistic or pessimistic.
 iv. In this regard, the track record of a Union Government in fiscal management could
not be totally ignored.

v. On balance, a view was taken that the Union Government’s projections in regard to
both macro and fiscal position should be−the anchor along which the FFC would
proceed.
2. At the same time, the FFC articulated that there is significant scope for improving the
fiscal position of the Union through increased disinvestment of shares in public
enterprises, a rational dividend policy, sale proceeds from spectrum, a discriminatory
capital infusion into the financial enterprises and the introduction of GST.

(i) Keeping this cushion in view, the possible initial fiscal burden due to GST has not
been reckoned.
3. In brief, the FFC was aware that there is ample scope if there were will and skill for
accelerating the fiscal consolidation projected and rapidly improving the quality of
fiscal management.

[EXTRA
Overview of Union Finances and suggestions, Chapter 3, 14th FCR)

3.50 The outstanding Union debt has remained within the limits set by the FC-XIII.
However, this is primarily due to a high nominal growth in GDP. With a strong policy
commitment to contain inflation in future, there will be need for caution in projecting the
position regarding debt-sustainability during the award period.

3.51 The gross tax revenues levied and collected by the Union Government, after
reaching a peak of 11.9 per cent of GDP in 2007-08, declined by over 1.7 percentage
points in 2012-13. This, to some extent, reflects the deceleration in the growth of the
economy and is also the effect of the reduction in the rates of Union excise duties and
service tax in response to the global economic crisis. Even after the tax rates were
partially restored in 2013-14, the tax-GDP ratio remained at the same level. There is,
therefore, considerable scope for increasing the tax-GDP ratio during our period, which
would provide greater fiscal space for increase in productive expenditures.

3.52 The decline in the tax-GDP ratio has been accompanied by a decline in non-tax
revenues and fluctuation in non-debt capital receipts as a percentage of GDP, over the
same period. The reduction in non-tax revenues is primarily due to declining interest
receipts on loans outstanding from State Governments. This source is likely to dry up
further in future, since no fresh loans are being extended to the States. However, the
dividends from CPSEs are abysmally low, indicating considerable scope in the future for
obtaining higher levels of dividends through appropriate policy initiatives.

3.53 Disinvestment receipts have generally fallen short of the estimates, mainly due to the
highly uncertain conditions prevailing in the financial markets. Though these
uncertainties may continue, it is safe to assume that this could be a potential source for
generation of additional revenues in the award period. The investment portfolio of the
 Union Government, in CPSEs, could be reviewed in the near future, to take account of the
new realities in the context of the role of public enterprises in economic development.

3.54 Large revenues foregone or tax expenditures, and expanding cesses and surcharges
during the review period, represent significant exclusions of States from the divisible
pool. No doubt, these are entirely in the jurisdiction of the Union Government. However,
in reality, they are eroding transferable resources to States. Under the circumstances, it
will be necessary to keep in view these developments while determining the share of the
states in the divisible pool during the award period.

3.55 As regards the quality of fiscal management, the period is characterised by a less
than desirable growth in revenues and a steep reduction in capital expenditures,
accompanied by a high level of subsidies. Overall, therefore, there is a case for reversing
the trend of dilution in the quality of fiscal management that has set in during the review
period. However, such reversal may have to be projected in the award period in a
realistic manner.]

Overview of state finances and recommendations

1. The fiscal position of all States taken together has shown significant improvement during
the review period (feature of state finances between 2004-05 and 2014-15, Chapter 4, 14 th
FCR) both in terms of quantity and quality.
[Example: There was also improvement in the fiscal position of States due to various factors
including: (i) increase in revenue collections as a result of the adoption of value-added tax
(VAT) by all the States (ii) retirement of high-cost debt, under the debt-swap scheme floated
by the Union Government, (iii) buoyant economic growth, (iv) increased tax devolution on
account of the high revenue buoyancy of central taxes and (v) a low interest rate regime.
Many States introduced measures such as the New Pension Scheme to rationalise their
expenditures and reduce future fiscal risks. Chapter 4, 14th Finance Commission Report]
i. In fact, many States had not fully utilized the fiscal space available to them to incur
capital expenditure within the fiscal targets prescribed by the 13th Finance
Commission.
ii. The States in general, with a few notable exceptions, are spared of undue stress on
fiscal
management due to outstanding debt in the years ahead.
iii. Perhaps, the record of fiscal management by States as a whole reinforced the
soundness of recommendations of 12th and 13th Finance Commissions relating to
fiscal responsibility.

2. The FFC recognized that the process of fiscal consolidation in the Union should ideally
be accompanied by prudent fiscal expansion at the level of States.
[ EXTRA
Overview of State Finances
4.42 Improvement in the fiscal position of all States taken together, during the period 2004-
05 to 2012-13, was reflected in a reduction of the aggregate gross fiscal deficit and revenue
deficit, relative to GDP, by 1.4 percentage points each, as well as a reduction in the primary
deficit, relative to GDP, by 0.2 percentage point. There is a need to ensure that the
momentum gained in improvement in the fiscal position of all States is maintained in the
award period also.
4.43 Fiscal improvement primarily resulted from an increase in the aggregate revenue
receipts by 1.2 percentage point relative to GDP. At the same time, capital expenditures fell
marginally relative to GDP. This may be indicative of the need to address state-specific
issues of resource constraints, policy inertia or lack of absorptive capacity. In States where
revenue expenditures were unduly compressed, it is inevitable that some corrections will take
place in the years ahead.
4.44 The increase in the aggregate revenue receipts was contributed by a rise in own tax
receipts relative to GDP (0.9 percentage point), as well as higher tax devolution (0.5
percentage point) and grants-in-aid (0.2 percentage point). However, own non-tax revenues
decreased (0.2 percentage point). The reasons for reduction in non-tax revenues are varied, as
are future prospects.
4.45 There was a reduction in interest payments (1.2 percentage point) and resultant
reduction in the revenue expenditure on general services (1.2 percentage point). At the same
time, there was an increase in the revenue expenditure on pensions (0.2 percentage point),
social services (0.9 percentage point) and economic services (0.1 percentage point).
4.46 Although there was a reduction in the expenditure on interest payments, the increase in
expenditure on social services and economic services resulted in only a marginal change in
overall expenditures relative to GDP. Thus, fiscal consolidation at the State level, up to 2012-
13, was mainly on account of increasing revenues, particularly the own tax revenues and
transfers from the Union Government.
4.47 It is noteworthy that many States had not fully utilised the fiscal space available to them
within the fiscal targets prescribed by the FC-XIII to incur capital expenditure. This indicates
the scope for paying increased attention to this issue in the years ahead. However, it is seen
that some of the States which did not utilise the available fiscal space and had low capital
expenditures as a ratio of GSDP, are low-income States. From the perspective of accelerating
growth and promoting equitable growth, increasing capital expenditures by enhancing the
absorptive capacity of these States could be of importance.
4.48 While it is necessary for States to keep adequate cash balances to cover risks, excessive
balances entail costs, both in terms of interest payments and lower capital expenditures.
There is merit in analysing the reasons that led to holding of such costly large cash balances
during the period and addressing the relevant issues.
4.49 The aggregate outstanding debt and liabilities, as a percentage of GDP, also
progressively reduced from 2004-05 to 2012-13. The States in general, with a few notable
exceptions, are spared of undue stress on fiscal management due to outstanding debt in the
years ahead, provided fiscal rules are adhered to.]

V. Inter-governmental transfers and consolidated Public Finance: A Review

Review of trends
1. The FFC paid considerable attention to an analysis of the consolidated public finance, and
in particular, inter-governmental transfers.
2. The review has shown that, within the overall fiscal trend in the country, there has been a
greater expansion in the fiscal activity of the Union than of States.
i. In particular, the transfers from the Union to the States have increased substantially.
Moreover, overall transfers, viz., FC transfers and other transfers put together, far
exceeded the indicative ceiling prescribed by the previous Finance Commissions.
ii. Within the transfers, discretionary components had increased in the review period,
undermining the role of the Finance Commissions.
Aspects of Union and State Finances assessed by the FC
3. These developments in other governmental transfers required the FFC to take a
comprehensive view on several aspects of Union and State Finances, viz.,
a. Union Finances as a whole, of which the divisible pool of taxes is one component;
b. the total transfers from the Union Government, of which transfers on account of
Finance Commission is one component;
c. the revenue expenditure of the Union and the States, as a whole; and
d. the consolidated public debt of the Union the States and their respective shares.
Functional assignments under fiscal federalism
4. The literature on fiscal federalism delineating the functions of different levels of
government assigns predominant responsibility for macroeconomic stabilization to the
central governments.

5. In Indian context, in taking a comprehensive but symmetric view of Union and State
finances, the criticality of the fiscal management of Union, relative to the States, had to be
recognised in terms of
(a) creating space to undertake countercyclical policies,
(b) managing the impact of shocks, such as global uncertainties and uncertain monsoon
conditions, and
(c) the sensitivity of financial markets to the fiscal policies of the Union Government.
6. In brief, it was concluded that the burden of fiscal consolidation rests heavily on the Union
Government, in view of the initial conditions and its importance.
Recommendations
7. In such a situation, the FFC concluded that it was not possible to increase the level of
aggregate transfers from the Union to the States.
8. The focus, therefore, was to concentrate on the composition and the quality of the
aggregate
transfers from the Union to the States.

[EXTRA: Chapter 5, 14th FCR

Overview of Consolidated Finance
5.20 The review of public finances shows that the fiscal situation continues to be a challenge.
The consolidated fiscal deficit of the Union and State Governments in 2014-15 (BE) is
estimated at 6.2 per cent of GDP and the revenue deficit at 2.7 per cent of GDP, implying that
a large proportion of borrowing is used to finance revenue expenditures. Capital expenditure
is estimated at 4.5 per cent of GDP in 2014-15 (BE), as compared to 5 per cent in 2007-08,
and the overwhelming proportion of this (2.8 percentage points) is at the level of the States.
The estimated aggregate government liability as a ratio of GDP in 2014-15 (BE) works out to
66.4 per cent (after adjustments for National Small Savings Fund and excluding liabilities
under the Market Stabilisation Scheme). This implies that, besides pre-empting a significant
proportion of household financial savings for government consumption, interest payments
will continue to remain a significant proportion of revenues. It is, therefore, important to
effectively contain deficits and debt by increasing revenues and rationalising expenditures.
5.21 The fiscal position of the Union Government improved during the period 2002-03 to
2007-08, coinciding with the high growth in GDP. However, it deteriorated in 2008-09 and
2009-10, partly due to the impact of the global crisis, and partly due to domestic expenditure
policy decisions unrelated to the crisis. Despite the crisis, growth performance was
impressive during 2009-10 and 2010-11, even though there was considerable structural
deterioration in the state of public finances. In other words, growth was maintained by the
Union Government with borrowed money and borrowed time. Since 2012-13, there has been
a deceleration in growth, along with some efforts towards fiscal correction. However, the
structural weaknesses continue to pose significant challenges, necessitating a credible
medium-term framework for appropriate fiscal consolidation during our award period.
5.22 The review indicates that, within the overall fiscal activity in the country, there has been
greater expansion in the fiscal activity of the Union than of the States. The issue that the
Commission has to address is whether the observed balance in the fiscal activity of the Union
and the States is in consonance with Constitutional intent in setting out expenditure
commitments and revenue sources and current economic realities, including the expectations
of the people.
5.23 It is also relevant to note that the transfers from the Union to the States have increased
substantially. Overall transfers- the Finance Commission transfers and other transfers put
togetherhave been well beyond the indicative ceilings prescribed by previous Finance
Commissions. A view has to be taken on the usefulness of such ceilings in the scheme of
Union-State relations, particularly taking recent trends and ground realities into account.
5.24 Within the transfers from the Union to the States, discretionary components have
increased in the review period, undermining the role of the Finance Commission. It is
essential to take a view on maintaining or reducing the share of discretionary transfers,
independent of the overall balance in fiscal activity between the Union and the States. In
other words, the relative shares of transfers from Finance Commission and others, during the
award period, need to be examined.
5.25 Above all, an important lesson from the review is that the management of fiscal policies
needs to take into account likely risks arising from external shocks, such as a global crisis or
fluctuating oil prices. Moreover, it is necessary to recognise that counter-cyclical policies
have been warranted in the review period. The need for headroom for meeting shocks and
undertaking counter-cyclical polices makes it necessary to ensure that structural weaknesses
in the fiscal position are rectified during the award period.
5.26 In conclusion, the review leads us to take a comprehensive view on several aspects of
Union and State finances.
First, it is necessary to consider Union finances as a whole, of which the divisible pool of
taxes is one component.
Second, the total transfers from the Union Government to the States should be considered, of
which transfers on account of the Finance Commission are one component.
Third, the revenue expenditure of the Union and the States should be considered as a whole,
of which revenue expenditure under non-Plan is one component, albeit a major one.
Fourth, the consolidated public debt of the Union and the States should be considered in
dealing with the fiscal environment. Consequently, the aggregate debt of the States and fiscal
rules should be seen as one component, and the debt and responsible fiscal management of
the Union Government as the other component.
Fifth, both the Union and the States have to take appropriate fiscal consolidation measures in
order to create the space to undertake counter-cyclical policies when needed as well as to
manage the impact of shocks such as global uncertainties and uncertain monsoon conditions.
Union finances are crucial in this context.
Sixth, while a conducive fiscal environment in both the Union and the States is important for
the national economy, the Union Government's fiscal policies have a more critical role to
play for all the reasons mentioned above. In fact, in view of the current state of fiscal stress in
the Union finances, there is need for responsible and credible fiscal policies during the award
period in order to ensure inclusive growth.
Finally, during the review period, concerns on the credibility front caused considerable
uncertainties in the conduct of fiscal policies. This indicates the need for institutional
mechanisms that will promote, in an assured manner, greater reliability in fiscal policy, which
is most critical for the credibility of public policy in general].

VI. Union Finances: Assessment

[Chapter 6 Union Finances: Assessment of Revenue and Expenditure

6.1 The terms of reference (ToR) require this Finance Commission, while making its
recommendations, to take into consideration the resources of the Union Government for
five years commencing on 1 April 2015, on the basis of the level of taxation and non-tax
revenues likely to be reached during 2014-15 as well as the demands on the resources of
the Union Government, especially on account of the expenditures on civil administration,
defence, internal and border security, debt servicing and other committed expenditure
liabilities. The ToR also emphasises the objective of not only balancing revenue receipts
and revenue expenditures of all the States and the Union, but also generating surpluses for
capital investment
6.2 Our ToR is broadly similar to those for earlier Finance Commissions. However, in
the case of the FC-XIII, there was an explicit reference that gross budgetary support
(GBS) to the Plan be treated as a committed liability of the Union Government. Like
earlier Finance Commissions, our assessment of Union finances has taken into
consideration the forecast of receipts and expenditure submitted by the Ministry of
Finance in its memorandum. Other Ministries and Departments of the Union
Government and the Planning Commission have also presented their views to us.

These have helped us in formulating our approach and assessment for the period from
2015-16 to 2019-20. In this regard, we have taken note of the amended Fiscal
Responsibility and Budget Management (FRBM) Act, 2003 and the MediumTerm Fiscal
Policy (MTFP) Framework presented with the Union Budget of 2014-15 in July 2014 in
compliance with the amended FRBM Act.We have also kept in view the various
observations that States have made on Union Government finances.]

1. Since FFC decided to dispense with the distinction between Plan and Non-Plan, and since
the Government of India had dispensed with its role of borrowing from the markets in
order to lend to the States − the FFC had to take responsibility of balancing Union and
States’ revenue powers with expenditure responsibilities listed in the Seventh Schedule of
the Constitution.

(i) Hence, in its assessment, the priority was to provide appropriate fiscal space to the
Union Government for expenditures, as defined in the Union list.
(ii) At the same time, the assessment recognized and articulated the scope for revenue
mobilization, though its full scope could not be quantified and incorporated in the
assessment.
(iii) In addition, the FFC has explicitly provided a fiscal head-room for the Union
Government to carry out the transfers to the States by way of expenditures with
externality considerations and equalization in select sectors.

(iv) In the treatment of committed expenditure, the FFC considered the resources required
for the Union to meet its commitment for providing the public services detailed in the
Union list.
[https://data.gov.in
Committed expenditure is defined by the Comptroller and Auditor General as the expenditure
on interest payments, salaries, wages, pensions and subsidies]
(v) In addition, it has considered the expenditure commitment of the Union Government
listed in the Concurrent or State lists, to the extent that it was warranted.

[14TH FCR Chapter 6

Treatment of Committed Expenditure
6.14 An assessment of the expenditures of the Union Government should take into account
the resources required to meet its commitments for providing the public services detailed in
the Union List. In addition, it should also take into account the expenditure commitment of
the Union Government on some services that are listed in the Concurrent and State Lists but
are provided by it due to its comparative advantage in terms of economies of scale or the
need to ensure country-wide uniformity in the minimum standards of services, to the extent
feasible. 6.15 Entries in the State List specify the functional domains of the States, which are
responsible for providing public services for carrying out these functions. In addition, there
are certain functions in the Concurrent List which have been traditionally undertaken by
States. However, even in the State and Concurrent Lists, there are functions which are of
national interest because of nationwide externalities or redistribution (provision of minimum
standards of service, for example) which have to be carried out by both the Union and State
Governments in the spirit of co-operative federalism. Equity requires that people receive
some services of minimum standards, irrespective of where they reside, and it is the joint
responsibility of both the Union and State Governments to ensure that such services are
provided. While State Governments would have to meet the bulk of financing requirements
taking into account local conditions, information and knowledge and institutional realities,
the Union Government would have to supplement the efforts of some or all the States as
appropriate. In the spirit of cooperative federalism, the sectors and the schemes should be
well defined, clearly focused and broadly acceptable to the Union and State Governments in
terms of their scope, coverage, inter-state distribution and design].

2. In brief, the FFC has followed the practice of assessment of Union finances that was done
by earlier Finance Commissions, but, in addition, the FFC considered the magnitudes,
legitimacy and appropriateness of Union transfers to States outside the mechanism of the
Finance Commissions, keeping in view the Constitutional provisions.
(i) A major challenge in this regard was the enacted legal commitment and
expenditures on ongoing schemes that fell under the Concurrent List and were
being funded by both, the Union and the States.
(ii) Several internal exercises on these matters were undertaken to obtain insights
relevant to the assessment of respective needs of Union and States.
(iii) Other united transfers from Union to States are not relatable to individual sectors
or activities in the Seventh Schedule, and hence did not pose a problem.

VII State Finances

[Extra: Chapter 7. State Finances: Assessment of Revenue and Expenditure
According to the terms of reference (ToR) 6(iii), the Commission needs to assess "the
resources of the State Governments and demands on such resources under different heads,
including the impact of debt levels on resource availability in debt stressed States for the five
years commencing from 1 April 2015, on the basis of the levels of taxation and non-tax
revenues likely to be reached during 2014-15". ToR 6(iv) requires the Commission to
consider "the objective of not only balancing receipts and expenditure on revenue account of
all the States but also generating surpluses for capital investment". ToR 6(v) mandates the
Commission to examine "the taxation efforts of . . . each State Government and the potential
for additional resource mobilisation to improve the . . . tax-gross state domestic product
ratio". Thus, in making our recommendations on tax devolution and grants-in-aid to the
States, in line with our primary mandate, we are required to assess revenues and expenditures
of each of the States for the period 2015-16 to 2019-20. Our assessment of revenue receipts
and revenue expenditure has been guided by these terms of reference.
The previous Finance Commissions had generally followed a two-step approach in
formulating their projections: (i) re-assessment of the base year data on revenues and
expenditures for individual States to ensure comparability and (ii) application of norms for
receipts and expenditures for the award period. The basic approach to assessment remained
similar, to a large extent, across Commissions, but there were differences in projecting
individual items of receipts and expenditure].

Overall Approach
1. To a large extent, the basic approach to assessment of State Finances remained
similar
across Commissions, though there were some differences in projecting individual
items of receipts and expenditures.

2. However, as mentioned, FFC differed from the earlier Commissions in taking

account of both Plan and non-Plan expenditures in the revenue account.

Revenues (Tax and Non-Tax)

3. In regard to assessment of the own tax revenues of States, FFC considered aggregate
own tax revenue as a single category, following the methodology adopted by the
preceding three Finance Commissions.
i. In making the projections, a two-step methodology was followed. The first step
involved reassessment of the base year 2014- 2015.
ii. The second step involved application of normative growth rates for the
projections.
iii. For States with an above average tax-GSDP ratio, the assumed own tax buoyancy
was 1.05 implying a moderate increase, and for others, a higher buoyancy of 1.5
till it reaches the target tax-GSDP ratio.
[The own tax revenue of States consists of VAT, State excise duties, stamp duty and
registration fee, motor vehicle tax, goods and passenger tax and other minor taxes.]
[Tax buoyancy is an indicator to measure efficiency and responsiveness of revenue
mobilization in response to growth in the Gross domestic product or National income. It is
measured as a ratio of growth in Tax Revenue to the growth in GDP. If the buoyancy value is
greater than one then the growth in tax collection would be higher than the growth in GDP
growth.]
4. This resulted in an improvement in the assumed aggregate tax-GSDP ratio from 8.26
of GSDP to 9.0% in the terminal year.

5. The assessment of own non-tax revenues was made in terms of major items of non-
tax revenue separately for each State, consistent with past practice.

[Chapter 7, 14th FCR

The components of non-tax revenue projected are: (a) interest receipt and dividends; (b)
royalty; (c) receipts from forestry and wild life; (d) other miscellaneous general services
including lotteries; and (e) earning from irrigation projects. The minor components of non-tax
revenue were clubbed together as a residual category and a uniform norm was applied for
projection.]

Expenditures - Approach
6. The FFC followed past practices in the assessment of revenue expenditures of States,
but made some notable departures.

7. It included revenue expenditure under plan also in the assessment. In the process,
only the States’ contribution towards share of Centrally Sponsored Schemes was
included.

[7.28 As mentioned in our approach, we have taken a holistic view of revenue

expenditure
on various services without making a distinction between Plan and non-Plan. We have
projected individual items of expenditure separately, based on normative principles and
added them to arrive at the aggregate expenditure requirement. This approach does not
require us to estimate committed liabilities of Twelfth Five-Year Plan schemes separately.
For the purpose of our assessment of Plan revenue expenditure we exclude Centrally
sponsored scheme (CSS) grants but includes States' contribution towards share of CSS.
Chapter 7, 14th FCR]

Liabilities of interest payments

 8. In computing the liabilities of the interest payment, the FFC took a view that it is a
legacy of the past and an inevitable commitment and hence it should be treated as
committed expenditure.
Debt Restructuring
9. It was assumed that each State will take full advantage of the fiscal deficit target of
3% of GSDP each year.
[4.3, Chapter 4.
Example of benefit of meeting the above fiscal deficit target.
The FC-XII had also recommended the creation of a Debt Consolidation and Relief Facility
(DCRF), which involved the rescheduling and consolidation of certain loans from the Union
Government to the States. The debt waiver under this scheme was linked to States
undertaking fiscal correction through their respective FRBM legislations.]

10. No request for debt restructuring was entertained, since the full burden of interest
payment for the debt had already been provided in the assessment of needs.

11. There was a view that such a full provision for interest payments would amount to
rewarding States that were fiscally not responsible.

12. The counterview was that the obligation arose out of less than responsible
enforcement of fiscal rules, and so the solution does not lie in the under-provision for
totally committed liabilities or restructuring debt to avoid full provision.

13. Further, restructuring would be a non-transparent manner of transfers to select States.

14. The FFC also did not consider any proposal for debt-restructuring on the ground that
it will be a good practice for governments to honour their debt obligations.

15. It was noted that open market borrowings by States through banks cannot be
restructured at the instance of FFC.
16. Hence, the relief may not be substantial in view of significantly reduced share of the
State’s debts to Government of India in the total debt outstanding.

Pension expenditure
17. The FFC also accepted the pension expenditure for the base year provided by the
States and assessed this expenditure in a manner that reflects true pension liabilities
for the assessment period.
Other expenditure
 18. The FFC also adopted norms for certain expenditure like police and general
administration in a way that reflects the need of State to make adequate spending on
these services.

Equalization Concerns

[Equalisation
Section 7.46
In formulating our assessment, we have not only taken a comprehensive view of the
expenditures of the States, but also attempted to address the goal of equalisation.
Our approach to equalising expenditures across States is not sector specific, but an
aggregate assessment of the per capita expenditure needs of States to enable all States to
spend a certain minimum expenditure, to the extent feasible within the overall resource
envelope.

The methodology used by us for equalisation first involved a baseline assessment of the
revenue expenditure (net of interest and pension payments and CSS transfers) of all
States based on the norms assumed for individual items of expenditure discussed earlier
in this chapter. Subsequently, we estimated the per capita revenue expenditures of
States for the period from 2015-16 to 2019-20, using our State-wise projections of
population. States were ranked on the basis of per capita expenditure, thus obtained, in
the terminal year. In the
equalisation exercise we made additional expenditure provision to ensure that in the
final
year of our projections, every State reached at least 80 per cent of the all-State average
projected per capita revenue expenditure (excluding interest payment and pension and
CSS transfers).

The FFC also attempted to address the goal of equalization of expenditures across the States
in terms of per capita expenditures.
19. It made additional expenditure provision in assessment of needs of States which
required such a provision to ensure that, in the final year of the FFC projections,
every State reached at least 80% of all State average per capita revenue expenditure
(excluding interest payment and pension and CSS transfers).

Summary of Assessment
 20. It is interesting to note that the own Revenue Receipt-GDP ratio will be 8.58%
during the award period, as against 7.36% projected by the States.
21. The assessment of expenditure needs would be 11.12% of GDP against 13.57%
projected by the States.
22. The pre-devolution deficit as estimated by FFC is 2.70%, which has been fully
covered by tax devolution and revenue deficit grants.
23. It needs to be highlighted here that for many States, post devolution surplus is huge
and the actual equalisation would be more than what has been estimated in the FFC
report.

[Summary of Assessment
Section 7.47
The summary of assessment shows the result of this detailed exercise of revenue expenditure
and pre-devolution revenue deficit of each State for each year. State-specific assessment of
assessed deficit and assessed post-devolution deficit is given in Annex 7.5 of the Report. A
summary view of the result for all States combined is presented in Table 7.2 below. The
assessment shows that the own revenue receipt-GDP ratio will be 8.58 per cent between
2015-16 and 2019-20 as against 7.36 per cent projected by the States. The assessment of
expenditure needs, as per our assessment, would be 11.12 per cent of GDP against 13.57 per
cent projected by the States. The pre-devolution deficit, as estimated by us, is 2.70 per cent of
GDP. This gap has been covered by tax devolution and revenue deficit grants.

[The issues of vertical and horizontal devolution are dealt in chapter 8 of the 14th FCR.
Chapter 8

Sharing of Union Tax Revenues

pARA 8.1
Article 280 (3) (a) of the Constitution and para 4 (i) of the terms of reference (ToR) mandated
us to make recommendations regarding "the distribution between the Union and the States of
the net proceeds of taxes, which are to be, or may be, divided between them" as well as the
allocation between the States of the respective shares of such proceeds.
We have considered six factors in determining the approach to sharing of Union taxes: (i) the
Constitutional provisions and intent; (ii) the approaches of the previous Finance
Commissions; (iii) the need for continuity, to the extent possible; (iv) the requirement for
rebalancing in the sharing of resources needed in the context of overall fiscal relations; (v)
the anticipated macroeconomic environment during the award period; and (vi) the views of
the Union and State Governments in the macroeconomic context of our award period. The
challenge we faced was to weigh the arguments by the Union and States advanced
before us and attempt appropriate rebalancing to meet the evolving circumstances. ]

VIII. Vertical Balance

[Vertical Devolution
8.2 The main task of the FC-XIV was to make a realistic estimate of the vertical imbalance
of resources between the Union and the States. This assessment required careful estimation of
the expenditure needs of each level of Government and the revenue resources available with
them. We have made assessments of the Union and State finances which are presented in
Chapters 6 and 7 respectively. While making assessments of vertical imbalance, we have, like
the past Finance Commissions, considered the views of the Union and State Governments
and also taken into consideration the emerging macroeconomic and fiscal scenarios having
implications for Union State fiscal relations during our award period.

Our Approach and Recommendations on Vertical Devolution

8.9 Conceptually, two issues become important in assessing the vertical imbalance. One, a
realistic estimation of revenue accruing solely to the Union as well as its expenditure needs
and the resources required to meet its obligations under the Constitution. Two, a realistic
assessment of the revenue capacities of the States and the expenditures required to meet
obligations mandated under the Constitution. As mentioned in Chapter 7, the States have
argued that functional overlap has led to an increase in the Union Government's expenditure
and a concomitant reduction in the revenues available for vertical devolution. We would have
to be conscious of States' submissions that increasing Union Government spending on
various State subjects has increased the expenditure at the Union level for functions, which
are primarily in States' domain. In this context, we have
examined three factors: (a) the spirit of Constitutional provisions; (b) the concerns
about
fiscal space expressed by States and Union; and (c) the need for clarity on the respective
functional and expenditure responsibilities of Union and States in the interest of sound
federal fiscal relations.
8.10 A related issue in the assessment of vertical imbalance is the issue of the non-
divisible
pool of resources, namely cess and surcharges. The share of cess and surcharges in gross
tax revenue of the Union Government has increased from 7.53 per cent in 2000-01 to 13.14
per cent in 2013-14. The States have argued that this denies the States their rightful share in
the devolution. However, Constitutionally, it is not possible to include cess and surcharges in
the divisible pool, as under Article 270, taxes referred to in Article 268 and 269 - surcharges
on taxes and duties and cesses levied for specific purposes - should not form part of the
divisible pool. Earlier Finance Commissions had recommended that the Union Government
review the current position with respect to the non-divisible pool arising out of cess and
surcharges and take measures to reduce their share in the gross tax revenue. However, this
has not happened. There are two ways of addressing this legitimate concern of the States - by
amending the Constitution to include these items in the divisible pool, or increasing the share
of the divisible pool to compensate States on this account. We ruled out the first option given
the record of experience so far.
8.11 We believe that we have to take a comprehensive view on the aggregate transfers
from the Union to the States. Total transfers are comprised of tax devolution, non-Plan
grants, Plan grants and grants for various CSS including those which were transferred directly
to the implementing agencies bypassing the State budget1 until 2013-14. To illustrate, the
aggregate transfer as percentage of gross revenues of the Union Government constituted
around 52 per cent for the period from 2009-10 to 2014-15 (BE). While the relative share of
tax devolution in total transfer remained at 46.8 per cent during this period, the share of Plan
grants, including CSS, and non-Plan grants have remained at 54 per cent of the total transfers.
The share of non-Plan grants, including the grants provided by Finance Commissions, in total
transfer declined from 11.3 per cent in 2009-10 to 8.7 per cent in 2014-15 (BE). The States
demanded higher resources for vertical devolution and also emphasised the need for more
unconditional transfers through the Finance Commission route. We are of the view that tax
devolution should be the primary route of transfer of resources to States since it is
formula based and thus conducive to sound fiscal federalism. However, to the extent
that formula-based transfers do not meet the needs of specific States, they need to be
supplemented by grants-in-aid on an assured basis and in a fair manner.
8.12 The aggregate resource flow for the year 2012-13 accounted for 50.4 per cent of gross
revenues, 57.1 per cent of the gross tax revenues and is equivalent to 63.9 per cent of the
divisible pool of resources of the Union Government. We recognise that amounts
equivalent to more than 60 per cent of the divisible pool goes to the States in various
forms of transfers and keeping in view the Union Government's expenditure
responsibilities, there is little scope to increase the share of aggregate transfers.
8.13 However, a compositional shift in transfers from grants to tax devolution is
desirable
for two reasons. First, it does not impose an additional fiscal burden on the Union
Government. Second, an increase in tax devolution would enhance the share of
unconditional transfers to the States. We have factored in four important
considerations: (i) States not being entitled to the growing share of cess and surcharges
in the revenues of the Union Government; (ii) the importance of increasing the share of
tax devolution in total transfers; (iii) an aggregate view of the revenue expenditure
needs of States without Plan and nonPlan distinction; and (iv) the space available with
the Union Government. Considering all factors, in our view, increasing the share of tax
devolution to 42 per cent of the divisible pool would serve the twin objectives of
increasing the flow of unconditional transfers to the States and yet leave appropriate
fiscal space for the Union to carry out specific-purpose transfers to the States.
8.14 Some States mentioned the issue of minimum guaranteed tax devolution for the purpose
of predictability of transfers in regard to vertical devolution. Trends in actual tax devolution
during the FC-XII and FC-XIII award periods were compared with the recommended tax
devolution. The experience in the past does not warrant concern in this regard. In any case, a
formula to determine such a minimum guarantee is difficult to derive. Hence, we have not
consented to the submission of States on minimum guaranteed devolution.]

Approach to vertical devolution

1. The approach to vertical devolution was governed by three factors, viz.
a) the spirit of Constitutional provisions;
b) the concerns about the fiscal space expressed by the States and the Union; and
c) the need for clarity on the respective functional and expenditure responsibilities of
the Union and States.

2. As already mentioned, FFC took the view that there was no scope to reduce the fiscal
space available for discharging its responsibilities in the Union List of the Constitution.

3. In this background, the FFC took a consolidated view of the aggregate transfers from the
Union and the States, while recognizing that the tax devolution should be the primary
route of transfer of resources to States since it is formula-based and, thus, conducive to
sound fiscal federalism.

4. It was also recognized that, to the extent the formula-based transfers do not meet the
needs of the specific States, they need to be supplemented by Grants-in-Aid on an assured
basis and in a fair manner.

Recommendations
1. Keeping this in view, the FFC recommended increasing the share of tax devolution to
42% of the divisible pool would serve the twin objectives of increasing the flow of
unconditional transfers to the States and yet leave appropriate fiscal space for the
Union to carry out its own functions and make specific-purpose transfers to the States.
 2. FFC has factored in four important considerations in arriving at the level of
devolution:
i. States are not entitled to the growing share of cess and surcharges in the revenues of
the Union Government, and the Constitution was not amended despite earlier
recommendations of the past Finance Commissions in this regard;

ii. The importance of increasing the share of tax devolution in total transfers;

iii. An aggregate view of the revenue expenditure needs of States without the Plan and
non-Plan distinction; and

iv. The space available for the Union Government.

3. In brief, tax devolution of 42% recommended by FFC with 32% recommended by the
previous FC needs to be seen in light of the changes mentioned.

a. However, there has been a composition shift in transfers from grants from the
Union to the States in favour of tax devolution, thus enhancing the share of
unconditional transfers to the latter.

b. The balance in fiscal space thus remains broadly the same in quantitative
terms, but tilts in favour of States in qualitative terms through compositional
shift in favour of devolution and hence fiscal autonomy.

IX. Horizontal Balance

[Our Approach and Recommendation on Horizontal Sharing

7.22 While determining the inter-se share of the States, the basic aim of Finance
Commissions has been to correct the differentials in revenue raising capacity and expenditure
needs, taking into account the cost disability factors to the extent possible. To achieve these
goals, the past Finance Commissions have generally followed the principles of equity and
efficiency. The criteria used by earlier Finance Commissions can be categorised as: (a)
factors reflecting needs, such as population and income; (b) cost disability indicators, such as
area and infrastructure distance; and (c) fiscal efficiency indicators such as tax effort and
fiscal discipline. Our Commission is of the view that the devolution formula should continue
to be defined in such a way that it attempts to mitigate the impact of the differences in fiscal
capacity and cost disability among States. While doing so, we have kept in view the
approaches suggested by individual States for horizontal distribution.
States' Views on Horizontal Sharing

Most indicators for horizontal or inter-se distribution proposed by various States can be
grouped into six broad categories -population, income and fiscal capacity distance, fiscal
performance, area, social and economic backwardness, and availability of
infrastructure.

Population and Demographic Change

8.23 Views of the States regarding the use of 1971 population figures were deeply divided.
This Commission is bound by its ToR which specifies that "in making its recommendations
on various matters, the Commission shall generally take the base of population figures as on
1971 in all cases where population is a factor for determination of devolution of taxes and
duties and grants-in-aid; however, the Commission may also take into account the
demographic changes that have taken place subsequent to 1971" (para 7). In other words, the
ToR recognised the changing demographic realities and provided a space for the
demographic changes across States in the last forty years to be taken into consideration while
deciding on the devolution. The Commission deliberated on the possible demographic
changes that have taken place since 1971, the obvious ones being the change in the
composition of population and also migration. While some States have achieved replacement
level fertility, some others still have a very high total fertility rate.
8.24 Migration is an important factor affecting the population of the State, apart from natural
factors like fertility and mortality. A large number of in-migrants in a State poses several
challenges resulting in additional administrative and other costs. Nonetheless, it is to be noted
that it is not only the pull factors of urban areas which are bringing in migrant but also
equally there are strong push factors which are forcing individuals to move out of their native
place in search of better opportunities. If net-migration in a State is taken as an indicator, it
will place a double burden on States from where out-migration is taking place. As it is, these
States do not have enough infrastructure to provide services to their citizens and that is why
much of the labour force is moving out. So denying resources on the basis of net migration
will mean penalising them for under-development-induced migration. Also, there is no
denying the fact that migrants contribute to the income of the destination States and help the
State of origin through remittances. However, the pressure of migration to bigger cities does
impose fiscal challenges on the destination States and a grant mechanism may be more useful
to deal with this specific problem.
8.25 We have taken the view that the weight assigned to population should be decided
first and an indicator for demographic changes be introduced separately. Though we
are
of the view that the use of dated population data is unfair, we are bound by our ToR
and have assigned a 17.5 per cent weight to the 1971 population. On the basis of the
exercises
conducted, we concluded that a weight to the 2011 population would capture the
demographic changes since 1971, both in terms of migration and age structure. We,
therefore, assigned a 10 per cent weight to the 2011 population (See Annex 8.2).

Area 8.26 We agree with the views of the some of the previous Finance Commissions that a
State with larger area will have to incur additional administrative and other costs in order to
deliver comparable services to its citizens. These costs increase with the increase in area, but
at a decreasing rate. It is necessary to put upper and lower caps on area due to the non-linear
relationship between area and cost. We have noted that a large majority of the States have
urged that area should continue as a criterion for devolution. We have, therefore, followed
the method adopted by the FC-XII and put the floor limit at 2 per cent for smaller
States and assigned 15 per cent weight (See Annex 8.3).

Forest Cover 8.27 Our ToR mandated us to give consideration to the need to balance
management of ecology, environment and climate change consistent with sustainable
economic development while framing our recommendations (para 6(x)). We recognise that
States have an additional responsibility towards management of environment and climate
change, while creating conditions for sustainable economic growth and development. Of
these complex and multidimensional issues, we have addressed a key aspect, namely, forest
cover, in the devolution formula. We believe that a large forest cover provides huge
ecological benefits, but there is also an opportunity cost in terms of area not available
for other economic activities and this also serves as an important
indicator of fiscal disability. We have assigned 7.5 per cent weight to the forest cover

Income Distance 8.28 Successive Finance Commissions have used the distance of actual per
capita income of a State from the State with the highest per capita income as a measure of
fiscal capacity. The FCXIII, however, introduced a new criterion based on distance between
estimated per capita taxable capacity for each State and the highest per capita taxable
capacity and used this for inter-se devolution. However, we observed that the relationship
between income and tax is non-linear, as the consumption basket differs between high,
middle and low income States. We have decided to revert to the method of representing
fiscal capacity in terms of income distance and assigned it 50 per cent weight (See
Annex 8.5).
8.29 We have calculated the income distance following the method adopted by the FC-XII. A
three-year average (2010-11 to 2012-13) per capita comparable GSDP has been taken for all
the twenty-nine States. Income distance has been computed by taking the distance from the
State having highest per capita GSDP. In this case, Goa has the highest per capita GSDP,
followed by Sikkim. Since these two are very small States, adjustments are needed to avoid
distortions and hence income distance has been computed from the State with the third
highest per capita GSDP - Haryana. We have provided Goa, Sikkim and Haryana the same
distance as obtained for the State with the smallest distance of income with Haryana

8.31 As service tax is not levied in the State of Jammu & Kashmir, proceeds cannot be
assigned to this State. We have worked out the share of each of the remaining twenty-
eight States in the net proceeds of service taxes and presented this in Table 8.3. If the
service tax starts to be levied in Jammu & Kashmir during the award period of this
Commission, the share of each State will be in accordance with Table 8.2. If in any year
during our award period, any tax of the Union is not levied in a State, the share of that State
in the tax should be considered as zero and the entire proceeds of that Union tax should be
distributed among the remaining States by proportionately adjusting their shares.]

Approach
In regard to horizontal balance, FFC was guided by the broad criteria of the earlier Finance
Commissions, viz.,
a) Population and income to reflect the needs;
b) area and infrastructure distance to indicate cost disabilities; and
c) fiscal indicators relating to tax and fiscal discipline to assess resources.

Discussion on the criteria used by 14TH FC

There are three notable features of the criteria used by FFC.
A. In recent years, the ToR of Finance Commission required use of population of
1971, whenever population was utilized as a factor for determination of
devolution of taxes and grants-in-aid. The ToR of FFC, however, added that
demographic changes that have taken place subsequent to 1971 could also be
considered.

i. FFC was of the view that use of dated population data was unfair, but having been
bound by the ToR, a weight of 17.5% has been given to the 1971 population.
ii. However, consistent with the unique ToR for FFC, the demographic changes were
incorporated by giving a 10% weight to 2011 population.

Analysis
1. No doubt, the age structure of the population and net immigration are more direct
indicators, but analysis showed that Population of 2011 best reflected the changes, while
being transparent and simple.
2. It may be useful to explain why the FFC expressed a view that using dated population
was not fair.
3. The requirement of the Constitution is that public services should be provided to the
entire population and, therefore, the needs should be assessed for the latest population
than that of forty years ago.
4. The objective of insistence on 1971 population was entirely in a different context,
namely, electoral constituencies, and expressed through a Parliamentary Resolution.
5. An incidental objective at that point of time was to provide incentives to States to adopt
family planning and not to penalize the States which have adopted family planning in the
allocation of funds.
6. There is also a question as to the effectiveness of tax devolution policy as an instrument
of population control.

7. It is difficult to establish that the weights in the recommendations of the FC operate as an

incentive or disincentive in regard to family planning activities.
8. Further, it is also doubtful whether the growth of population reflects the policy of the
State governments by itself in a significant manner.
9. It is also debatable whether it is appropriate to build any rewards, incentives or
disincentives as part of assessing the fiscal needs of a State.
10. To avoid distortions in assessment of needs, it may be appropriate to consider such
rewards and incentives on a standalone basis.
11. The FFC exploited the window of opportunity in its ToR to include the latest population
data (2011), while retaining dominant weight to population of 1971.

B. The second departure from the previous practice is assigning a weight of 7.5% to the
forest cover to assess cost disabilities.
1. The FFC was convinced that maintaining a good forest cover provides good ecological
benefits to the country as a whole, and even for the global community.
2. However, the concerned States will have to incur additional cost for provision of services
to the relevant population.
3. Because of the restrictions imposed on the exploitation of valuable resources due to
ecological resources, the concerned States are deprived of resources for development.
4. Hence, the FFC concluded that cost disabilities of maintaining large forest cover and
ecological balance are best reflected in assigning a weight to forest cover.
5. Use of forest cover as a factor addressed the issue of climate change that was mandated in
the ToR of FFC.
6. This step obviated the need for specific grants for incentivizing forest cover adopted by
the 13th FC.

7. The increase in the share of Area of a State as an indicator of need with 15 percent weight
was higher than the 10 per cent weight assigned by previous Finance Commission.
8. This helped the States in a way to take into consideration the disabilities arising due to
large area.
9. In order to ensure that States with small areas do not suffer due to this, a minimum cap of
2 % per cent area was assigned to States with area below 2 per cent.

C. Third, the FFC continued with the weights for revenue disability, but expressed it in
terms of income distance, which was the practice prior to the 13th FC.
1. The income distance method is an easy to understand, transparent and straightforward
method of assessing fiscal capacity.
 2. More sophisticated methods did not yield improvements in assessment of fiscal capacity
commensurate with a long-standing practice.

3. After considerable deliberations, the Commission did not take into account the fiscal
performance criterion in the tax devolution and three important reasons.

i. First, there are questions on the measurement of performance criterion. The improvement
or deterioration in the share of expenditures financed from own revenues may simply be
due to the variation in the transfers from other sources.

ii. Second, even if the measure is taken, it only reflects the past trend and does not reward or
punish the future behaviour.

iii. Third, there is no comparable approach to evaluate the performance of the Union
government.

iv. Fourth, it needs to be recognized that as States are operating in a rule based fiscal regime
due to Fiscal Responsibility Act, it is not necessary to introduce separate fiscal discipline
indicator in the devolution formula.

Share of states across different finance commissions

It is tempting to make a comparison of the shares of States between the successive Finance
Commissions.

1. In doing so, it will be useful to recognise that there are same elements of the inter-se
distribution recommended by the FFC which makes such comparisons difficult.

2. For instance, in the assessment of needs by FFC, revenue expenditures on account of Plan
are also included.

3. The practice of recommending State or sector-specific grants-in-aid was eschewed by the

FFC.

4. In any case, the share of States would have changed even if the criteria and weights
adopted, say by the 13 th FC, were retained by the FFC.

Recommendations on vertical and horizontal devolution

i. Considering all factors, in our view, increasing the share of tax devolution to 42 per
cent of the divisible pool would serve the twin objectives of increasing the flow of
 unconditional transfers to the States and yet leave appropriate fiscal space for the
Union to carry out specific purpose transfers to the States.

ii. We have not consented to the submission of States on minimum guaranteed

devolution.

iii. Though we are of the view that the use of dated population data is unfair, we are
bound by our ToR and have assigned a 17.5 per cent weight to the 1971 population.
On the basis of the exercises conducted, we concluded that a weight to the 2011
population would capture the demographic changes since 1971, both in terms of
migration and age structure. We, therefore, assigned a 10 per cent weight to the 2011
population.

iv. For area, we have followed the method adopted by the FC-XII and put the floor limit
at 2 per cent for smaller States and assigned 15 per cent weight.

v. We believe that a large forest cover provides huge ecological benefits, but there is
also an opportunity cost in terms of area not available for other economic activities
and this also serves as an important indicator of fiscal disability. We have assigned
7.5 per cent weight to the forest cover.

vi. We have decided to revert to the method of representing fiscal capacity in terms of
income distance and assigned it 50 per cent weight. We have calculated the income
distance following the method adopted by FC-XII.

Table 8.1 shows the criteria and weights assigned for inter-se determination of the shares of
taxes to the States. State-specific share of taxes is presented in Table 8.2.

As service tax is not levied in the State of Jammu & Kashmir, proceeds cannot be assigned
to this State. We have worked out the share of each of the remaining twenty-eight States in
the net proceeds of service taxes and presented this in Table 8.3.

Table 8.1
X. WAY FORWARD AND CONCLUSIONS
Way forward
1. The FFC has formulated its recommendations without reference to the distinction
between Plan and non-Plan.

As a follow-up, it is essential to delink the Plan from the classification in budget

documents and accounts so that the intended benefits accrue.

2. The inter-governmental fiscal relations in future will also, hopefully, reflect the principles
underlying the recommendations of FFC.

i. First, our Constitution, and for that matter, available literature on the subject, does not
confer overriding responsibilities to national governments on the economic and fiscal
management of state governments.

ii. Second, the global trend is towards greater centralization of taxes and decentralisation
of government expenditures, and such trends should be analysed in their relevance to
our systems.

iii. Third, it should be recognised that the Directive Principles of State Policy of the
Constitution or national priorities are of equal concern to Union and State
Governments. This requires a change in the “mindset”, and operationally a review of
composition of “other transfers”, in particular, centrally sponsored schemes.

3. The State Governments being closer to the people, have an increasingly important role to
play in view of greater fiscal freedom that has been accorded to them by FFC in the fiscal
transfers from the Union to the States.

4. In regard to Local Bodies, it is hoped that the State Governments will, depending
on the local circumstances, strengthen the local bodies, in particular, those in urban
areas.

Conclusions:

Positive:

Add from Deepashree “conclusions”

Downside Risks (From FICCI)

In the near term, huge tax devolution could put some strain on Centre’s finances, especially until
major CSS schemes get delinked and GST is implemented

With greater discretionary funds with States, there is a risk of wastage of funds by some states
towards populist and non-productive ends.
 15th Finance Commission:
A challenge and an
opportunity
The tax buoyancies have been affected by the transition to the goods and services tax (GST) and the GST
compensation to states will continue till 2022
IANS  Last Updated at January 4, 2018 17:46 IST
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
The 15th Finance Commission, which the government notified on November 27, 2017, will have
to first contend with the slowdown in the Indian economy.
There is an upward trend in the fiscal deficits of states. The inter-governmental transfer system
has become overly complex with different sharing arrangements for different taxes; the spending
autonomy of the states, combined with their ability to borrow, has obstructed efforts at
consolidating public finances; there is little incentive for states to improve revenue performances
and revenue-sharing arrangements have led to pro-cyclical policies at the state level.

The high levels of inter-governmental transfers necessitate that states ensure that provincial tax
enforcement and structural reforms are strengthened. The problem with persistent off-budget
spending has proved a drag on the fiscal deficits of the states.

The vertical balances to the states relative to the Centre's gross revenue receipts have shown trend
increases in every Finance Commission and it would not be possible to reduce the devolution
without a corresponding increase in fiscal and revenue deficits of the states. The higher
devolution under the 14th Finance Commission have seen marginal increases in social sector
allocations. There are pressures to increase allocations to the centrally sponsored schemes (CSS)
for higher expenditure on health and education.

The tax buoyancies have been affected by the transition to the goods and services tax (GST) and
the GST compensation to states will continue till 2022.

For the 15th Finance Commission, GST will usher in higher tax buoyancy by bringing in a large
number of new tax payers into the net. Higher tax collections under GST will provide the Union
government room for fiscal manoeuvre to finance the inter-governmental transfer system.

On the horizontal balances, the 15th Finance Commission has the responsibility of equalising the
widening gap between richer states and the low-income states. These inequalities have resulted in
widely differing social and capital expenditure between the states. A large part of the equalisation
effort by the 15th Finance Commission would have to be through grants-in-aid rather than
devolution.

The 14th Finance Commission's recommendations ushered in a new era of fiscal federalism in
India. Devolution to the states significantly went up from 32 per cent to 42 per cent. While most
countries have found it difficult to finance federal transfers of about 30 per cent to the provinces,
India has taken it to 42 per cent.

The government followed up the historic devolution with the constitution of the NITI Aayog to
promote cooperative federalism and enacted a constitutional amendment to establish the GST
Council.

These major progressive steps were backed by restructuring the CSS allocation ratio from 75:25
to 50:50 to provide greater flexibility and ownership to the states. In turn, the states were
mandated to pursue the objectives of zero revenue deficit, fiscal deficit not exceeding 3 per cent
of GSDP, interest payments-to-revenue receipt ratio not exceeding 10 per cent and debt-to-GSDP
ratio not exceeding 25 per cent.

Despite these historic steps, there remain challenges. The resource requirements of the power
sector remain very high. In some states, the fiscal deficit with power sector allocations have
climbed to around 9 per cent. The deteriorating public debt dynamics caused by the requirements
of the power sector's restructuring would be a major area of concern for the 15th Finance
Commission. An alternate fiscal scenario would need to be considered to limit the on-budget
fiscal deficits to 3 per cent by including the power sector.

Then, a debt-to-GSDP ratio of 25 per cent greatly limits the government's borrowing needs and
has the potential to curtail social sector expenditure. The NITI Aayog has pointed out that social
sector expenditure has increased only marginally since the 14th Finance Commission despite an
increase in total central transfers to the states by 21.9 per cent.

The 14th Finance Commission assessed state finances as (a) for states with above-average tax-
GSDP ratio the assumed tax buoyancy was 1.05, implying a moderate increase and (b) for other
states, a higher buoyancy of 1.5 was assumed. An increase in aggregate tax-GSDP ratio from
8.26 of GSDP to 9 per cent in the terminal year was assumed.

On the expenditure side, the 14th Finance Commission included the expenditure incurred on CSS
in revenue expenditure. The expenditure was projected as 11.12 per cent of GDP against 13.57
per cent projected by the states.

In sum, the 15th Finance Commission will review the current status of the finance, deficit, debt
levels, cash balances and fiscal discipline efforts of the Union and the states and recommend a
fiscal consolidation roadmap for sound fiscal management, taking into account the
responsibilities of the central and state governments. The Commission may also examine whether
revenue deficit grants be provided at all.

The best way forward would be to adhere to the letter and spirit of the constitution by balancing
the Union and state's revenue powers with expenditure responsibilities listed in the 7th schedule
of the constitution, appreciate the problems raised by stakeholders, and attempt to address the
contemporary issues relevant to the terms of reference.

(V.Srinivas, an IAS officer, is chairman Rajasthan Tax Board and holds additional charge of
Chairman Rajasthan's Board of Revenue. The views expressed are personal. He can be contacted
at vsrinivas@nic.in)

--IANS

srinivas/vm
First Published: Thu, January 04 2018. 17:45 IST
Livemint Article.
The tasks for the 15th Finance
Commission
Strengthen cooperative federalism, improve the quality of public spending
and help protect fiscal stability
Last Published: Wed, Dec 06 2017. 05 05 AM IST

The 15th Finance Commission led by N.K. Singh held its first meeting this
week. The tasks before it are unique in the sense that it has to make its
recommendations after the rules of fiscal federalism have been profoundly
reset by the introduction of the goods and services tax (GST). This is the
first finance commission that will do its work under the new tax system.

The impact of GST on federal public finances is still not clear. For example,
the fact that the new tax, which is a destination levy, will shift the incidence
of taxation from production to consumption means that the distribution of
indirect taxes between different states could change significantly. The
ambiguity about the revenue-neutral GST rate also puts a big question
mark on the health of public finances at all levels over the medium term.
These issues need to be framed against the larger challenge of increasing
the Indian tax to gross domestic product ratio.

Successive finance commissions have increased the proportion of tax

revenue that goes to the states—a necessary change given the growing
importance of direct taxes as well as the need for higher spending by state
governments in local public goods. The First Finance Commission headed
by K.C. Neogy had recommended that the states get a tenth of total taxes
collected centrally. That share has steadily increased. The 14th Finance
Commission headed by Y. V. Reddy recommended that the share of the
states should be 42%.

The Constitution empowers the finance commissions to go beyond the core

issues of how to divide taxes vertically between New Delhi and the states on
the one hand and horizontally between states on the other. Constitutional
provisions also allow finance commissions to make broader
recommendations in the interests of sound finance, a testimony to the
vision of our Constitution makers.

One of the key issues that the 15th Finance Commission will need to deal
with is how to incentivise the states to stick to fiscal discipline. The terms of
reference of the new commission have suggested linking transfers to a
range of parameters, such as efforts made to deepen GST, how quickly a
state moves towards the replacement level of fertility, eliminating power
sector losses, improving the ease of doing business, adoption of direct
benefit transfers and progress in sanitation. These performance parameters
are clearly a reflection of the policy preferences of the Narendra Modi
government.

One important change—and a tricky political issue—is the decision to use

population according to the 2011 census as the base for calculating the
expenditure needs of various states. Even the 14th Finance Commission
had been explicitly asked to use the 1971 population numbers while
deciding the devolution formula. The shift to the latest demographics is
necessary since public goods expenditure by the states has to be linked to
the number of citizens, but it could also be a sore point for southern states
that have been more successful in reducing their rate of population growth.

The Fifteenth Finance Commission is also expected to recommend new

fiscal targets for the Union and state governments. It can be assumed that
the targets will broadly be similar to what the recent fiscal review
committee suggested, especially since it was also headed by N.K. Singh.

A focus on state finances is needed, especially given the recent deterioration

in the fiscal parameters of the states. But the finance commission should
also not ignore the fiscal health of the Union government, given its
importance in the overall macro performance of the Indian economy.

Every finance commission has to do a political balancing act. It needs to

give more resources to the states given the growing importance of sub-
national governments in the Indian political economy. It also needs to
ensure that New Delhi is not fiscally constrained given its role in key
national public goods such as defence. Federalism can flourish only when it
is accompanied by a strong central agency that credibly enforces the rules
for a new political economy equilibrium (which is sometimes mistakenly
described as pooled sovereignty, even though Indian states are not
sovereign in any rigorous sense of the term).

The three central tasks of the 15th Finance Commission will thus be to
strengthen cooperative federalism, frame the incentives needed to shift
public spending in the desired direction, and do all this without
compromising fiscal stability.

tps://fincomindia.nic.in/writereaddata/html_en_files/fincom15/TermsofReference_XVF
C.pdf

FIFTEENTH FINANCE COMMISSION

TERMS OF REFERENCE

Terms of Reference and the matters that shall be taken into consideration by the
Fifteenth Finance Commission in making the recommendations are as under:

(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 under Chapter I, Part XII of the
Constitution and the allocation between the States of the respective shares of such
proceeds; (ii) The principles which should govern the grants-in-aid of the revenues of
the States out of the Consolidated Fund of India and the sums to be paid to the States by
way of grants-in-aid of their revenues under Article 275 of the Constitution for
purposes other than those specified in the provisos to clause (1) of that article; and

(iii) The measures needed to augment the Consolidated Fund of a State to supplement
the resources of the Panchayats and Municipalities in the State on the basis of the
recommendations made by the Finance Commission of the State.

2. The Commission shall review the current status of the finance, deficit, debt levels,
cash balances and fiscal discipline efforts of the Union and the States, and recommend a
fiscal consolidation roadmap for sound fiscal management, taking into account the
responsibility of the Central Government and State Governments to adhere to
appropriate levels of general and consolidated government debt and deficit levels, while
fostering higher inclusive growth in the country, guided by the principles of equity,
efficiency and transparency. The Commission may also examine whether revenue
deficit grants be provided at all.

3. While making its recommendations, the Commission shall have regard, among other
considerations, to:
(i) The resources of the Central Government and the State Governments for the five
years commencing on 1st April 2020 on the basis of the levels of tax and the non-tax
revenues likely to be reached by 2024-25. In the context of both tax and non-tax
revenues, the Commission will also take into consideration their potential and fiscal
capacity;

(ii) The demand on the resources of the Central Government particularly on account of
defence, internal security, infrastructure, railways, climate
change, commitments towards administration of UTs without legislature, and other
committed expenditure and liabilities;

(iii) The demand on the resources of the State Governments, particularly on account of
financing socioeconomic development and critical infrastructure, assets maintenance
expenditure, balanced regional development and impact of the debt and liabilities of
their public utilities;

(iv) The impact on the fiscal situation of the Union Government of substantially
enhanced tax devolution to States following recommendations of the 14th Finance
Commission, coupled with the continuing imperative of the national development
programme including New India – 2022;

(v) The impact of the GST, including payment of compensation for possible loss of
revenues for 5 years, and abolition of a number of cesses, earmarking thereof for
compensation and other structural reforms programme, on the finances of Centre and
States; and

(vi) The conditions that GoI may impose on the States while providing consent under
Article 293(3) of the Constitution.

4. The Commission may consider proposing measurable performance-based incentives

for States, at the appropriate level of government, in following areas:

(i) Efforts made by the States in expansion and deepening of tax net under GST;

(ii) Efforts and Progress made in moving towards replacement rate of population
growth;
(iii) Achievements in implementation of flagship schemes of Government of India,
disaster resilient infrastructure, sustainable development goals, and quality of
expenditure;

(iv) Progress made in increasing capital expenditure, eliminating losses of power sector,
and improving the quality of such expenditure in generating future income streams;

(v) Progress made in increasing tax/non-tax revenues, promoting savings by adoption

of Direct Benefit Transfers and Public Finance Management System, promoting digital
economy and removing layers between the government and the beneficiaries;

(vi) Progress made in promoting ease of doing business by effecting related policy and
regulatory changes and promoting labour intensive growth;

(vii) Provision of grants in aid to local bodies for basic services, including quality
human resources, and implementation of performance grant system in improving
delivery of services;

(viii) Control or lack of it in incurring expenditure on populist measures; and

(ix) Progress made in sanitation, solid waste management and bringing in behavioural
change to end open defecation.

5. The Commission shall use the population data of 2011 while making its
recommendations.

6. The Commission may review the present arrangements on financing Disaster

Management initiatives, with reference to the funds constituted under the Disaster
Management Act, 2005 (53 of 2005), and make appropriate recommendations thereon.

7. The Commission shall indicate the basis on which it has arrived at its findings and
make available the State wise estimates of receipts and expenditure.

8. The Commission shall make its report available by 30th October, 2019, covering a
period of five years commencing 1st April, 2020.
--------------------
EXTRA PORTIONS OF THE ARTICLE

Local Governments
Transfer and allocation of resources to local bodies by Finance Commissions is beset with
several complications. The recommendations are meant only to indicate measures to
supplement the resources available to the States to support the local bodies. They are to
be made on the basis of the recommendations made by the Finance Commissions of the
State. In reality, the Finance Commissions in many States do not exist, or, their
recommendations are not up-to-date. The amounts that each State sets apart for
transfer to local governments from the consolidated funds themselves are unclear. There
are certain areas which are explicitly excluded from the jurisdiction of the Finance
Commission. The FFC had to address these issues with basically similar limitations as
those of the previous Commissions. In addressing these issues, the FFC recognized that
the local bodies are the primary responsibility of States concerned, both in the spirit of
the Constitution and the wording of the ToRs. Similarly, State Finance Commissions are
required to play a key role in allocation of resources with a State. It noted that FFC
should not undermine or enhance the statutorily determined role and functions of local
bodies. It was essential to avoid advocacy of centralized mechanisms to facilitate
democratic decentralization through conditionality by FFC. In this background, the FFC
concluded that it was necessary to significantly enhance the resources to be transferred
to local bodies on an assured basis and mainly without imposition of conditions by Union
or States. The practice of using an index or indices of devolution or decentralization for
the purpose of transfer of resources to States on this account was given up.
13
The FFC devoted significant time and attention to quantitative and qualitative
improvements to the design of support to local bodies, without undermining the authority
of States. The working of the SFCs were examined in depth and detailed consultations
held with the Chairmen of the earlier Finance Commissions, to the extent possible. The
consultations were held with elected representatives of local bodies during visits to
States. As per the final recommendations, the local bodies are required to spend almost
all the grants only on the services within the functions assigned to them under the
relevant legislations. It has been clarified that no further conditions should be imposed
by either the Union or the States in this regard. Their performance grant has been
restricted to compilation of accounts and their audit, and generation of own resources.
The distribution of grants between the Panchayats and between the Municipalities has
been left to the State governments provided it is based on the recommendations of the
State Finance Commissions. In case the SFC formula was not available, a default option
was provided whereby the distribution was on the basis of 2011 population with a weight
of 90% for population and 10% for area. In regard to the measures to augment the
revenues from own resources, the focus has been on the roles of the States in removing
the bottlenecks under local bodies in this regard and empowering them. Among the
measures suggested is mobilization of funds for the local bodies through Municipal
Bonds, either directly or through an intermediary institution to be set-up by the State
Governments.
There are certain “scheduled” areas which are covered under the proviso to
Article 275(1) and excluded from the consideration of Finance Commission in the ToR. In
strict compliance with the legal provisions, and in a departure from the recent past, no
allocation has been recommended to these areas. However, the FFC urged the Union
Government to consider a large, sustained and more efficient intervention for the up
gradation of administration as well as development of these areas.
Disaster Management
The scope of the ToRs in regard to Disaster Management implied that its
recommendations be restricted to existing arrangements on the financing of constituted
funds. Funds have been constituted at national and state level, and to some extent at
the district level. The FFC adopted the practice of the previous Commissions and used
past expenditure on disaster relief for determining the corpus for Disaster Management
for each State. Similarly, the decision of constituting district level funds has been left to
the wisdom of State governments, and no separate grants have been recommended.
There are only three departures from the past. First, procedural changes for
14
reimbursement of expenditures incurred by the defence forces on disaster relief; State‟s
contribution to the SDRF to be uniform at 10% for all States, replacing the differentiation
between special category and other States; and (c) flexibility to States to make available
up to 10% of the SDRF funds to each State for “local disasters” beyond the list of
disasters notified at the national level.
Grants-in-Aid
Previous Finance Commissions have enunciated four main considerations governing
grants-in-aid to the States: (a) to meet their residuary budgetary needs after taking the
devolution of taxes into account; (b) to facilitate the up gradation of standards of
administrative and social services, and (c) to ensure minimum expenditures on such
services across the country. Grants-in-aid have been recommended in the past to meet
the special needs, burdens and obligations of the States and also to address the specific
sectors of national importance. (d) a separate grant was given to the states for
maintaining ecology and environment for promoting sustainable development. They
have generally been recommended for augmenting expenditures, rather than for
substituting what a State Government was already spending.
The FFC departed, to some extent, from previous practice, and adopted four
principles: First,the devolution of taxes from the divisible pool should, as in the past, be
based upon an appropriate formula which should, to a large extent, offset revenue and
cost disabilities. Second, the assessment of expenditures should build in additional
expenditures in the case of those States with per capita expenditure significantly below
the all-State average. The assessment of revenues should build in the scope for
additional revenue mobilization based on current tax-GSDP ratio relative to the all-State
average. This will enable fiscally-disadvantaged States to upgrade their services without
earmarking or specifying sectors. Third, if the assessed expenditure need of a State,
after taking into account the enabling resources for augmentation, exceeds the sum of
revenue capacity and devolved taxes, then the State concerned will be eligible to receive
a general purpose grant-in-aid to fill the gap. Fourth, Grants-in-aid for state-specific
projects or schemes will not be considered, as these are best identified, prioritised and
financed by the respective States. Fifth, promotion of sustainable development is
mainstreamed by taking the area under forest cover as a factor in tax devolution itself.
The FFC conceded that there is a case for transfers from the Union Government
to the States to augment expenditure in specific sectors with a high degree of
externalities in order to ensure desired minimum level of expenditures in every State.
15
However, past experience shows that achieving this through the mechanism of Finance
Commission grants may not be appropriate. Further, Finance Commission grants on this
account often operate in parallel with other transfers. FFC concluded that all such
transfers, in whichever sectors are considered necessary, should be addressed through a
different institutional arrangement proposed by FFC.
Other Transfers
In recent years, the aggregate transfers from the Union to the States, including “direct
transfers” to implementing agencies in the States as a percentage of the gross revenue
receipts of the Union, have ranged between 45-54%. The Finance Commission transfers
comprised only 59% of the aggregate transfers of the Union to the States, with the other
transfers accounting for 41%. The FFC decided to consider other transfers in detail. In
the past, there was a controversy as to whether transfers from the Union to the States
outside the recommendations of the Finance Commission were in consonance with the
constitutional provisions. There was a view that such transfers should be exceptional and
not excessive. Irrespective of the legal or constitutional position or appropriateness, it is
a fact that the other transfers are of a magnitude and complexity that it has a serious
bearing on the fiscal relations of the Union and the States, which could not be ignored by
the FFC.
The other transfers flow mainly as Plan grants, and marginally as Non-plan
grants. Plan grants can be divided into two broad categories, viz., (a) central assistance
(normal, additional, special and special plan); and (b) central schemes and centrally
sponsored schemes which are conditional upon the implementation of specified schemes
and programs. A detailed analysis of the existing arrangements, in particular, the
Centrally Sponsored Schemes, was attempted in terms of the State lists, Union list and
the concurrent list of the Constitution, as also through a differentiation between public
goods and private goods. The views of the State governments and the Union
Government, in terms of their operations, were considered carefully. A reference was
also made to the discussions in National Development Council and various Commissions
and Committees to review the Centre-state relations. The previous Finance Commissions
had also made several observations. A comprehensive review of other transfers led FFC
to the following conclusions:
There is some need for transfer of funds from the Union to the States which go
beyond tax devolution and grants from the Finance Commission. Such transfers should
be for supplementing the transfers recommended by the Finance Commission, and not
16
supplanting or undermining them. At the same time, duplication should be avoided.
There are differences in views about the scope or purpose of other transfers, and the
conditionalities associated with such transfers. There is agreement, however, about the
need for flexibility for the States in regard to design and mechanism for implementation
of such schemes. Significant discomfort has been expressed about the Union
Government unilaterally deciding the scope, the nature and design of the Centrally
Sponsored Schemes. The Union Government was keen to accord flexibility to States.
Finally, the previous Finance Commissions had also expressed their discomfort in regard
to the significant quantum of Central transfers being made, particularly through centrally
sponsored schemes. Their suggestions included transferring of all these schemes to the
States along with funds and restoring the pre-dominance of formula-based Plan transfers.
The approach of the FFC can be summarised as follows: First, the option of
entrusting the Finance Commission with responsibilities relating to all transfers from the
Union to the States is not advisable when the Finance Commission is a temporary body.
At the same time, the FC should take a comprehensive view of all fiscal transfers from
the Union to the States. However, it should limit its own recommendations only to tax
devolution, grants-in-aid as per principles indicated earlier and any other matter referred
to it in the interest of sound finance. Second, the Union Government should continue to
have fiscal space to provide grants to States for functions that are broadly in the nature
of „overlapping functions‟ and for area specific interventions especially of inter-State
significance. Third, the existing arrangements for transfers between the Union and the
States need to be reviewed with a view to minimising discretion, improving the design of
transfers, avoiding duplication and promoting cooperative federalism, insofar as such
transfers are required to be made outside the recommendations of the FC. Fourth,in the
light of this, the FC recommended for consideration the evolution of a new institutional
arrangement for: (i) identifying the sectors in the States that should be eligible for grants
from the Union, (ii) indicating criteria for inter-state distribution, (iii) helping design
schemes with appropriate flexibility being given to the States regarding implementation,
and (iv) identifying and providing area-specific grants. In this light, FFC suggested that
present role of the inter-state council be expanded to operationalise the institutional
arrangements for rationalizing other transfers in the interest of sound and healthy union
fiscal relations.
Goods and Services Tax (GST)
The ToR in regard to Goods and Services Tax is contextual and, thus, required the
Commission to consider the impact of the proposed tax on the finances of Centre and
17
States, and the mechanism for compensation. In the absence of clarity on the design of
GST and the final rate structure, the FFC was unable to estimate revenue implications
and quantify the amount of compensation. It, however, recognised that the Union
Government may have to initially bear an additional fiscal burden on this account, and
expressed that such fiscal burden should be treated as an investment which is certain to
yield substantial gains in future. It was also observed that the GST compensation can be
accommodated in the overall fiscal space available with the Union Government. This
statement was made keeping in view the fact that the Union Government has several
cushions (to which a reference has been made in the Report) beyond the formal
projections made by the Finance Commission.
The FFC did not indicate any fiscal incentives to the States to adopt such a tax,
nor did it indicate an appropriate design. However, to facilitate speedy resolution of the
outstanding issues, suggestions were made for consideration of the Union and States on
(a) period of GST compensation; (b) legal status of the compensation fund; and (c)
universal application of the GST regime.
Fiscal Environment
The ToR of FFC relating to the fiscal environment and fiscal consolidation roadmap is, in
many ways, more comprehensive than the previous Commissions. FFC has been tasked
with evolving an approach based on its review of Union and State finances to create a
fiscal environment that is sustainable, and also promotes equitable growth. The FFC had
the benefit of pioneering work in this regard done by the 12th and 13th FCs. It also had
the benefit of experience in implementing these fundamental changes. Inevitably, the
review by FFC encompassed legal and institutional aspects. A major problem faced by
the FFC in assessing fiscal environment in a comprehensive manner was the debt position
of States, and to some extent, the Union Government also. The concept of extended
debt could not be applied for want of requisite information. The FFC has recommended
computing of extended public debt of both Union and States and presenting it as a
supplement to the budget documents.
The FFC noted that both the Union and State Governments often take up capital
projects far in excess of capacity to implement them. This has complicated fiscal
management and also assessment of the committed liabilities in regard to capital works
for the future. In fact, a statutory ceiling on the sanction of new capital works to an
appropriate multiple of the annual budget provision has been proposed.
18
As regards fiscal rules, consistent with the approaches in the past, a ceiling on
fiscal deficit at 3% of GDP in respect of the Union was considered appropriate, though
realistically it may be implemented from the year 2016-17. There was a view in the FFC
that fiscal rules in regard to the Union should provide for counter-cyclical fiscal policies.
While there was an agreement that in theory this was desirable, there was a counterview
about its relevance to India at this juncture, especially in the light of experience so far.
The counterview also felt that the international experience both in law and in practice is
somewhat equivocal on this subject.
In regard to fiscal deficit targets for the States also, following the past practices,
a limit of 3% was suggested. Further, for the States, some flexibility has been suggested
in regard to fiscal targets and annual borrowing limits linked to: a) a shortfall in utilization
of borrowing limits in the preceding year; b) the interest payments being less than or
equal to 10% of the revenue receipts in the preceding year, provided there were no
revenue deficits in the year in which borrowing limits are to be fixed, and c) the debtGSDP
ratio being less than or equal to 25 per cent of the preceding year. The flexibilities
have been provided taking into account several factors including the huge cash balances
held by the States with the Reserve Bank of India. Ambiguities in regard to the
procedure for assessing of borrowing limits to each State by the Union were also
removed.
In view of the uncertainties in regard to the future of National Small Savings
Fund (NSSF) and the frictions in Union-State relations in this regard, including an element
of involuntary borrowings, the FFC recommended discontinuance of operations of NSSF.
Accordingly, in future, while the State Governments will have to repay the dues under
NSSF to the Union, the Union will not be lending receipts under NSSF to States.
As specifically required by the ToR, the operation of the Fiscal Responsibility
Budget Management (FRBM) Act was reviewed. In addition to the amendments required
consequent to various recommendations, the FFC suggested that the concept of effective
revenue deficit should be dispensed with in view of inconsistencies with the globally
accepted best practices.
It noted the experience in regard to independent fiscal councils globally, and has
suggested amendments to FRBM Act in the Union for this purpose.
19
The FFC suggested replacing the existing FRBM Act with a debt ceiling and fiscal
responsibility legislation, specifically invoking Article 292 in its Preamble. This
recommendation for formally invoking the Constitution is to accord greater sanctity and
legitimacy to fiscal management legislation. In this regard, a reference was made to the
debates in the Constituent Assembles wherein Dr. Ambedkar stated: “I therefore think
that from all points of view this article 268 as it stands is sufficient to cover all
contingencies and I have no doubt about it that, as my friend Mr. Ananthasayanam
Ayyangar said, we hope that Parliament will take this matter seriously and keep on
enacting laws so as to limit the borrowing authority to the Union. I go further and say
that I not only hope but I expect that Parliament will discharge its duties under this
article.‟ (Dr. Ambedkar in the Constituent Assembly– 10-8-1949).It may be noted that
Article 268 in his remarks corresponds to Article 292 of the Constitution.
The FFC computed the implicit capital outlay of the Union and each Sate, as per
the road map indicated in FFC‟s projections. The results show that capital outlay by
States put together is likely to exceed that of the Union, during the award period.
In our meetings, many of the States expressed the view that while they had
adhered to the fiscal targets given to them, the Union government was found wanting in
meeting its fiscal targets. There were questions relating to the realism of budget
forecasts, monitoring fiscal targets and making policy announcements and initiating
programmes without costing them at the Union level. These have implications on the
fiscal management in the States. We have, based on the international experience
recommended the institution of an independent fiscal institution reporting to the
Parliament on the above issues to provide adequate checks for improved budgeting
practices and monitoring the fiscal rules.
Pricing of Public Utilities:
For the first time, the FC was asked to consider statutory provisions relating to pricing of
public utilities. The ToRs of previous Commissions emphasised commercial viability of
public utilities mainly at the State level. The FFC‟s ToR does not distinguish between the
Union and State Governments. FFC took the view that pricing of public utilities raises
several policy issues, and that insulating pricing from policy fluctuations need not exclude
targeted subsidies. It recognised that it would be appropriate for pricing of public utilities
to be considered essentially as a matter to be determined by independent regulators.
20
The thrust of the FFC recommendations, therefore, was a) to establish
independent regulators where they do not exist; b) to empower the regulators with
sufficient independence; c) to ensure effective implementation of the legislative
provisions and the recommendations of the regulators; and d) to ensure that the
consumption of public utilities is measured even if they are subsidized, to enable
appropriate regulation. In view of the importance of water and energy for fiscal
management in our country, FFC recommended universal metering essential for
regulation and subsidization. These recommendations have essentially been made in the
context of fiscal implications, both in terms of the profitability of government owned
public utilities and the policies of subsidizing them.
Public Sector Enterprises
The ToR of the FFC in regard to Public Sector Enterprises differs from the ToR of earlier
Finance Commissions in several ways. Unlike in the past, it covers both the Union and
State Governments in a comprehensive manner, and makes a reference to relinquishing
of non-priority enterprises. Implicit in the ToR is the idea that the Government could
raise resources through making the enterprises competitive and also through listing and
disinvesting in them. Accordingly, the FFC took a comprehensive approach to the
prioritization of Central Public Enterprises, based on new realities, fiscal implications and
interest of employees.
The main recommendation is that the new realities should be considered in
evaluating the future of each public enterprises in the entire portfolio, rather than view
the policies incrementally and purely from the point of view of disinvestment. Secondly,
it is suggested that fiscal implications in terms of opportunity cost should be factored in,
while evaluating the desirable level of government ownership for each public enterprise.
The disinvestment would then be derived from this approach. Other recommendations
relate to the approach to the payment of dividends, transfer to reserves, creation of
subsidiaries, and immense scope for borrowings by the public enterprises instead of
depending on government support of retained earnings and establishment of new public
enterprises. In particular, FFC noted that the policies of the government in regard to
public enterprises as a whole have tended to ignore the fiscal implications, and made
recommendations accordingly.
One recommendation of particular interest to Union-State relations is a
suggestion to the Union Government to consider dispensing a small share of proceeds of
disinvestment to the States in recognition of the fact States have also contributed
21
significantly to the establishment and growth of central public enterprises in several
ways, including in some cases, provision of free land and other facilities.
Public Expenditure Management
In regard to Public Enterprise Management Systems also, FFC has been given a wider
mandate than the previous Commissions. However, on a detailed examination, it was
noticed that the issue has been examined by several Commissions and Committees in the
past. In addition, an Expenditure Management Commission was appointed by the Union
Government recently. Accordingly, the thrust of recommendations was that the
Government should examine all the recommendations made by various Committees so
far, and decide on the future course of action and implement the actions as soon as
possible. In addition, the FFC recommended the linking of pay with productivity, with a
simultaneous focus on technology, skills and incentives, and designating Pay
Commissions as „Pay and Productivity Commissions‟, with a clear mandate to recommend
measures to improve „productivity of an employee‟, in conjunction with pay revisions.
X. WAY FORWARD
The FFC benefitted immensely from the work done by the previous Commissions.
It benefitted spectacularly from the way the Terms of Reference was constructed for which
credit should go to the President of India, Mr. Mukherjee, the then Prime Minister, Dr.
Manmohan Singh and the then Finance Minister, Mr. P. Chidambaram.
The ToR gave an opening for examining several fundamental issues, such as population, Plan
and non-Plan distinction, fiscal management legislations, privatisation of public-enterprises,
etc.
The ToR required the consideration of several issues affecting both Union and States
symmetrically.
The listing of considerations in assessment of resources and needs was thoughtful, though
superfluous matters persist.
Regarding the way forward, it is hoped that the ToRs of future Finance Commissions will
continue to facilitate, but will be confined to, consideration of fundamental and contextual
issues directly relevant to sound finance and will also accommodate some of the suggestions
made in the report of FFC.

The FFC has formulated its recommendations without reference to the distinction between
Plan and non-Plan.
As a follow-up, it is essential to delink the Plan from the classification in budget documents
and accounts so that the intended benefits accrue.

Such a delinking will facilitate assessment, scrutiny and approval of all expenditures in a
sector or activity, or department in a comprehensive manner, and not only incrementally.

It will facilitate greater attention to maintenance expenditures, and hopefully reduce

incentives to boost capital works and show large sized plans.
The provision of some public goods, such as police and judicial services, may attract the
attention they deserve.

Above all, the planning process will also be liberated from its close association with the
budget, reflecting the new realities, namely, that the process of development requires
significantly more than investments by government in development activities, and actions
by the regulators, private sector and financial markets are at least equally important.
A planned approach in the current context involves actions in multiple areas, as well as by
several institutions and layers of government.
The Union Government may have to consult the Comptroller and Auditor General on this
matter, though the proposed change will not be inconsistent with globally accepted budgeting
and accounting practices.
In brief, the plan mindset should be replaced with a development mindset, of which
government budgets are one element.

The inter-governmental fiscal relations in future will also, hopefully, reflect the principles
underlying the recommendations of FFC.
First, our Constitution, and for that matter, available literature on the subject, does not confer
overriding responsibilities to national governments on the economic and fiscal management
of state governments.

Every tier of government should be regarded as equally accountable and responsible for
functions assigned to it.
At the same time, existence of overlapping responsibilities should be recognised and
mechanisms put in place for their discharge.
Clarity in regard to respective jurisdictions including overlapping responsibilities will add to
healthy Union State relations.
In this regard, every entry in the Concurrent List of the Constitution should be disaggregated
into distinct components in the interest of clarity, and assigned to Union, State and
overlapping or truly concurrent.
No doubt, the residuary powers will remain with Union, but residuary powers do not imply
overriding powers.
Second, the global trend is towards greater centralization of taxes and decentralisation of
government expenditures, and such trends should be analysed in their relevance to our
systems.

Similarly, globalisation of economic activity and need for provision of global goods cast
special responsibility on the Union.
These do have an impact on Union-State fiscal relations.
Third, it should be recognised that the Directive Principles of State Policy of the Constitution
or national priorities are of equal concern to Union and State Governments.
Similarly, a subject of national importance does not automatically confer total expenditure
responsibility on the Union Government without reference to the Constitution.
The new economic realities, including globalization, may warrant greater importance of the
Union Government in many ways, but they do not necessarily justify intrusion into the
legitimate fiscal space of the States accorded by the letter and spirit of the Constitution.
This requires a change in the “mindset”, and operationally a review of composition of “other
transfers”, in particular, centrally sponsored schemes.

The State Governments being closer to the people, have an increasingly important role to
play in view of greater fiscal freedom that has been accorded to them by FFC in the fiscal
transfers from the Union to the States.
In particular, each State has the opportunity to take a comprehensive view of its
developmental strategies and allocate financial resources appropriately without being unduly
constrained by approvals of annual plans by an agency like the Planning Commission in the
Union Government and multiplicity of central schemes with conditions attached.
Further, if the recommendations of the FFC in regard to other transfers are fully
implemented, the States may also have a say in regard to sectors to which the centrally
sponsored schemes will be justifiable, their distribution across the States and their design.
The States could take full advantage of interacting with the experience of various strategies
and programmes in other States, in view of greater autonomy in deciding some of their
strategies and schemes.
On the way forward, it may be appropriate to consider significant inter-state exchange of
information and even expertise in regard to public fiscal management and public
expenditures, in particular.
The implicit capital outlay of all States during the award period is projected to be about
double that of the Union which implies that States have a critical role to play in
maintaining growth momentum at a time when Union would be focusing on fiscal
consolidation.
In regard to Local Bodies, it is hoped that the State Governments will, depending
on the local circumstances, strengthen the local bodies, in particular, those in urban
areas.
The State Governments could consider three important initiatives, viz.,
to remove the bottle necks and hurdles in the exercise of the powers of local bodies within the
existing legislation;
empower the State Finance Commissions;
assist capacity building at local levels for implementing works and maintaining accounts; and
review the existing legislations to empower the local governments in terms of resources and
functions.

These efforts would enhance the contribution by the FFC in terms of a steep step-up in untied
grants recommended for local bodies.

The quality and credibility of fiscal management in both Union and States requires to be
critically examined.
In this regard, the relationships between government, public enterprises, and regulators are
still treated with a “joint family approach”, where contributions, burdens and financial
linkages are seldom clearly accounted for.
Hence, the fiscal accounts conceal more than what they reveal, both at Union and State
levels.

As explained in the report of the FFC, computation of extended public debt, and the fiscal
implications of the functioning of public enterprises become difficult under the current
dispensation. Improvements in this regard will facilitate the work of future Finance
Commissions.

Finally, what did the FFC learn from the process that could be of benefit for the
future Finance Commissions?
Value is added by adhering to the letter and spirit of the Constitution. It helps to listen and
learn from the stakeholders so that current problems are appreciated.
It is most productive to attempt to address, in a focused manner, the troubling contemporary
issues relevant to the ToRs.
Further, legitimacy for the Finance Commission in advocating policy-agendas and assigning
priorities, should be kept in view.

In addition, the expertise available with, or at the disposal of the Finance Commissions
and the time span available to them for making their recommendations limits their capacity to
address many issues, except in terms of general principles.
In brief, the inherent complexities in rebalancing the resources and needs of Union and
several States are so complex in India that the task of the Finance Commissions warrants
humility.
 EXTRA PLEASE IGNORE

http://www.ciesin.org/decentralization/English/Issues/Tra
nsfer.html (World Bank)
Intergovernmental Transfers/Grants Design
Intergovernmental transfers are the dominant source of revenues for subnational governments
in most developing countries. The design of these transfers is of critical importance for
efficiency and equity of local service provision and fiscal health of subnational goverments.

Taxonomy of grants

For the purpose of economic analysis, grants can be broadly classified into two categories:
non-matching and selective matching.

Nonmatching transfers:

Non-matching transfers may be either selective (conditional) or general (unconditional).

Selective non-matching transfers offer a given amount of funds without local matching,
provided they are spent for a particular purpose. Such conditionality will ensure that the
recipient government’s spending on the specified category will be at least equal to the amount
of grant monies. If the recipient is already spending an amount equal to grant funds, some or
all of the grant funds may be diverted to other uses. In theory, due to fungibility of funds,
increase in expenditures on the specified category would only at the limit equal to grant
funds; in practice it is possible that the lumpiness of investments in areas such as
infrastructure may result in increases in expenditures exceeding grants.

If the non-matching grant is unconditional or general, no constraints are put on how it is spent
and unlike conditional grants, no minimum expenditure in any area is expected. Since the
grant can be spent on any combination of public goods or services or to provide tax relief to
residents, general non-matching assistance does not modify relative prices and is the least
stimulative of local spending.

In some empirical studies, it has been observed that the portion of these grants retained for
greater local spending tends to exceed local government’s own revenue relative to residents’
income; that is grant money tends to stick where it first lands. This is referred to as the
"flypaper effect." The implication is that for political, technical and bureaucratic reasons,
grants to local governments tend to result in more local spending than if the same transfers
were made directly to local residents.

Selective (Conditional) Matching Transfers:

Selective matching grants or cost-sharing programs require that funds be spent for specific
purposes and that the recipient match the funds to some degree. Such a subsidy/transfer has
two effects: (a) income effect – the subsidy gives the community more resources, some of
which may go to acquire more of the assisted service; (b) price or substitution effect: since
the subsidy reduces the relative price of assisted service, the community acquires more for a
given budget. Hence both effects stimulate expenditures on the assisted category. Such
transfers can be open-ended (no limit on matching funds) or closed-ended. Matching transfers
may distort local priorities and be considered inequitable in that richer jurisdictions can raise
matching funds more easily. But the latter problem can be offset, if desired, by varying
matching rates with jurisdictional wealth and the former may be the desired outcome when
the transfer is intended to e.g. internalize spillovers or achieve overriding national policy
objectives. Table: The Conceptual Impact of Conditional Grants

Economic rationale for transfers and implications for grant design

We can identify five broad economic arguments for central-state transfers each of which is
based on either efficiency or equity, and each of which may apply to varying degrees in
actual federal economies.

Summary Table

i. The fiscal gap

An imbalance between the revenue-raising ability of subnational governments and their

expenditure responsibilities (the "vertical imbalance") might arise for two reasons. First, there
may be (often inappropriate) assignment of taxing and spending responsibilities such that
expenditure needs of subnational governments exceed their revenue means. Second, many
taxes are more efficiently collected at the central level responsibilities to avoid tax
competition and interstate tax distortions, so transfers are necessary to enable local levels to
carry out their expenditure responsibilities.
ii. Fiscal inequity

A country which values horizontal equity (i.e., the equal treatment of all citizens nationwide)
will need to correct the fiscal inequity which naturally arises in a decentralized country.
Subnational governments with their own expenditure and taxation responsibilities will be
able to provide their residents different levels of services for the same fiscal effort owing to
their differing fiscal capacities. If desired, these differences may be reduced or eliminated if
the transfers to each jurisdiction depend upon its tax capacity relative to others, and upon the
relative need for and cost of providing public services.

iii. Fiscal inefficiency

The argument for such transfers is reinforced by the fact that the same differentials which
give rise to fiscal inequity also cause fiscal inefficiency.

iv. Interstate spillovers

This is the traditional argument for matching conditional grants. Normally, subnational
governments will not have the proper incentive to provide the correct levels of services which
yield spillover across jurisdictions. In theory, a system of matching grants based on the
expenditures giving rise to the spillovers will provide the incentive to increase expenditures.
In practice, the extent of the spillover will be difficult to measure so the correct matching rate
to use will be somewhat arbitrary.

v. Fiscal harmonization

To the extent that the central government is interested in redistribution as a goal, there is a
national interest in redistribution that occurs via the provision of public services by the
subnational governments. Expenditure harmonization can be accomplished by the use of
(non-matching) conditional grants, provided the conditions reflect national efficiency and
equity concerns, and where there is a financial penalty associated with failure to comply with
any of the conditions. In choosing such policies there will always be a trade-off between
uniformity, which may encourage the free flow of goods and factors, and decentralization
which may encourage innovation, efficiency and accountability.

As Bahl and Linn (1992) show and as discussed earlier, the most appropriate form of a
transfer depends in large part upon its objective. (See Chart) Regardless of the particular
design, however, experience demonstrates that good intergovernmental transfer programs
have certain characteristics in common:

 Transfers are determined as objectively and openly as possible, ideally by some well-
established formula. They are not subject to hidden political negotiation. The transfer
system may be decided by the central government alone, by a quasi-independent
expert body (e.g., a grants commission), or by some formal system of central-local
committees.

 They are relatively stable from year to year to permit rational subnational budgeting
but at the same time sufficiently flexible to ensure that national stabilization
objectives are not thwarted by subnational finances. One system that appears to
 achieve this dual objective is to set the total level of transfers as a fixed proportion of
total central revenues, subject to renegotiation periodically (say, every 3-5 years).

 The formula (or formulae, if there is more than one grant) are transparent, based on
credible factors, and as simple as possible. Unduly complex formulae are most
unlikely to prove either feasible or credible in developing countries because there are
often serious disputes on fundamental issues such as regional population sizes.

 If several of the objectives discussed earlier are applicable - for example, some degree
of equalization is desired while at the same time there are clear national policy
objectives, e.g., with respect to the provision of minimal standards of education and
perhaps variable degrees of national support for certain local infrastructure activities -
it will generally assist both clarity and effectiveness if separate transfers are targeted
at each objective.

Revenue Sharing

Many countries attempt to achieve various of the objectives ascribed above to transfers
through systems variously described as "tax sharing" or "revenue sharing." While there are a
wide variety of such systems, most of them - perhaps most markedly in the transitional
countries - suffer from several common problems. First, if they are partial, that is, do not
apply to all national taxes but only to a subset of such taxes, they may bias national tax
policy. Second, if - as is often the case - they share the revenues from origin-based
(production) taxes to the jurisdictions from which the revenues are collected, they break the
desirable link between benefits and costs at the local level and hence reduce accountability
and the efficiency of decentralization. Third, since in such systems tax rates are invariably set
by the central government, and in addition since the sharing rate is often applied uniformly
throughout the country, once again the accountability link is broken and subnational
governments have no incentive to ensure that the amount and pattern of their spending is
efficient. In addition, if, as in some of the transitional countries, such taxes are collected by
local governments and then supposedly shared with national governments - and in this case
perhaps especially if the sharing rates are higher (more flows upwards) for richer areas -
either an undesirable disincentive for collection effort is created or, more usually, the
temptation to "cook the books" is likely to be overwhelming.

Practical guidance on the design of these transfers is summarized in the following:

Criteria for the design of intergovernmental fiscal arrangements

 Autonomy
Subnational governments should have complete independence and flexibility in
setting priorities, and should not be constrained by the categorical structure of
programs and uncertainty associated with decisionmaking at the center. Tax base
sharing—allowing subnational governments to introduce their own tax rates on
central bases, formula-based revenue sharing, or block grants—is consistent with this
objective.
 Revenue adequacy
Subnational governments should have adequate revenues to discharge designated
responsibilities.
  Equity
Allocated funds should vary directly with fiscal need factors and inversely with the
taxable capacity of each province.
 Predictability
The grant mechanism should ensure predictability of subnational governments’ shares
by publishing five-year projections of funding availability.
 Efficiency
The grant design should be neutral with respect to subnational government choices of
resource allocation to different sectors or different types of activity. The current
system of transfers in countries such as Indonesia and Sri Lanka to finance lower level
public sector wages contravenes this criterion.
 Simplicity
The subnational government’s allocation should be based on objective factors over
which individual units have little control. The formula should be easy to comprehend
so that "grantmanship" is not rewarded, as appears to occur with plan assistance in
India and Pakistan.
 Incentive
The proposed design should provide incentives for sound fiscal management and
discourage inefficient practices. There should be no specific transfers to finance the
deficits of subnational governments.
 Safeguard of grantor’s objectives
The grant design should ensure that certain well-defined objectives of the grantor are
properly adhered to by the grant recipients. This is accomplished by proper
monitoring, joint progress reviews, and providing technical assistance, or by
designing a selective matching transfer program.

The various criteria specified above could be in conflict with each other and therefore a
grantor may have to assign priorities to various factors in comparing policy alternatives.

https://www.ukessays.com/essays/economics/fisc
al-fedaralism-in-india-intergovernmental-
transfers-explored-economics-essay.php

Fiscal Federalism In India: Intergovernmental

Transfers Explored

As diverse as one could imagine, for the Indian state adoption of a federal structure
was a natural option. Based on a quasi federal system, fiscal arrangements in India
were designed in a way to meet the requirements of centralized planning in a mixed
economy framework. In this paper we attempt to analyse the Intergovernmental
transfers in the Indian context. We would go through the rationale, framework and
major issues and concerns regarding Intergovernmental transfers in India.

INTERGOVERNMENTAL TRANSFERS: RATIONALE

A distinctive and crucial policy instrument, intergovernmental transfers can serve a
number of functions. The economic rationale for these transfers rests on three
potential roles it can play. They are

Offsetting fiscal imbalances or closing fiscal gaps,

Establishing horizontal equity across the federation, and

Offsetting inter jurisdictional cost and benefit spillovers or for merit good reasons.

Most important reason for transfers arises out of fiscal mismatch between revenues
and expenditures of different governmental units. Fiscal imbalances can be of two
types, vertical or horizontal. ‘Vertical fiscal imbalance refers to the difference between
expenditures and revenues at different levels of government, while horizontal
federalism refers to the differences between revenue and expenditure levels within a
particular level of government.'(Rao, Singh, 2005)

Implicit in the division of power into multiple levels of government, it is vertical

imbalance that mandates sharing of revenues raised by the centre. This arises
because central government has a comparative advantage in raising revenues as
there are economies of scale in collecting taxes. But at the same time sub national
governments can better supply public goods whose quantity and quality vary
according to the requirements and preferences of residents. [1] Vertical fiscal
imbalances can arise also out of factors such as intergovernmental tax competition or
differential fiscal performances .In the Indian scenario the vertical imbalance is well
pronounced. In 2002-3, state governments on an average raised about 38 per cent of
total revenues but accounted for 58 per cent of expenditures, this in contrast to
1955-6 when the shares were around 41 per cent and 59 respectively. While it is
crystal clear that there is a considerable degree of vertical imbalance in Indian fiscal
system, this in itself cannot be a vindication for providing transfers. ‘In fact a vertical
fiscal imbalance rationale for such transfers is tautological, because growth of the
vertical fiscal imbalance itself could be due to

Increases in revenue capacity at the state level not keeping pace with growing
expenditure needs and

Slackening fiscal management at the state level resulting in lower tax effort and
increased fiscal profligacy.’ [2] 

Horizontal fiscal imbalances are the results of revenue and expenditure differences
between the states. Differences in revenue arise mainly due to difference in fiscal
capacity or effort. On a similar note expenditure differences could be due to
difference in quantity or quality of public goods offered or differences in unit cost.
While these disparities could arise out of state policies it could very well be a result
of factors beyond states’ control. The per capita net state domestic product (NSDP)
in the richest state (Haryana) in 2007-08 was over 5.4 times that of the poorest state
(Bihar) even when only the large states are considered. Of course, the state with the
highest per capita GSDP is the small state of Goa and if this is considered, the
difference between the lowest and highest per capita GSDP state is 9.5 times. [3] If
we are to divide state into special category states and non special category the
disparity is even wider.

Interjurisdictional spillover is a problem that results from decentralisation policy in

fiscal federalism. Local government might be in a better position to provide better
quality public goods, but the problem that remains is that the benefits of these
goods might not be limited to a particular geographical area. Local government who
provide these goods often lacks the incentive to consider how this would affect the
neighbouring states. Thus the amount supplied would be inefficient from a national
perspective. Central government can step in such cases to ensure an efficient
allocation.

INTERGOVERNMENTAL TRANSFERS IN INDIA

In India fiscal transfers are made from centre to state under article 270 of the
constitution as well as grants under article 275 and 282.Intergovernmental transfers
in India takes place mainly through three main channels. First there is a finance
commission appointed every five years by president of India to devolve tax shares
and give grants. Secondly, we have a planning commission which dispenses funds by
the way of grants and finally there are ministerial allocations which funds central
sector and centrally sponsored schemes taken up in states.

Formed under article 280 of Indian constitution, finance commission’s primary

responsibility is to determine states share in tax revenue sharing. ‘The approach of
finance commission to transfers consists of

Assessment of overall budgetary requirement of the center and states to determine

the volume of resources that can be transferred during the period of their
recommendation.

Foreseeing states own current revenues and non plan current expenditures.

Determining the states’ share in central tax revenues and distributing between the
states of these shareable proceeds

Filling the post-devolution projected gaps between non plan current expenditures
and revenues with the grants in aid.’ [4] 
Known as gap filling approach, finance commission uses a fixed formula based on
economic indicators to decide the tax devolution for each state. This formula is based
on population, area, distance, infrastructure, fiscal discipline and tax effort. The two
core criteria in the scheme of sharing of central taxes are: population and distance.
While distance formula is used as a tool for fiscal capacity equalization, the
population criterion is a tool for vertical transfers as it provides equal per capita
transfers to all states independent of their fiscal capacities. Grants recommended by
the finance commission, on the other hand are determined on the basis of projected
gaps between non plan current expenditures and post tax devolution revenues. The
Finance Commission grants is provided to meet the assessed revenue gap of the
states (on non-plan or total revenue account) and also some other purposes
including special needs and up gradation of standards. The share of grants in total
transfers has varied in the range from the lowest share of 7.7 percent (Seventh
Finance Commission) to the highest share of 26.9 percent for the Third Finance
Commission with reference to actual transfers. (Rao, Singh; 2005)

Planning commission, the second channel of transfers assists states through grants
and loans. Often considered as a centralizing force in fiscal federalism, role of
planning commission in Indian fiscal system has increased in the recent past. Prior to
1969, these transfers were mostly project based and hence highly discretionary. From
1969 the plan assistance is based on Gadgill formula. This was introduced with an
aim to eliminate preferential allocation and discretionary nature of plan assistance
provided. ‘According to this, at present 30 per cent of the funds available for
distribution are kept apart for the special category states. Assistance to them is given
on the basis of the plan projects formulate by them and 90 per cent of the transfer is
given by the way of grants and the remaining as loans. The 70 per cent of funds
available to major states is distributed with 6o per cent weight assigned to
population, 25 per cent to per capita SDP, 7.5 per cent to fiscal management, and the
remaining 7.5 per cent to special problems of the states. Of the 25 per cent weight
assigned to per capita SDP, 20 percentage points worth is allocated only to states
with less than average per capita SDP on the basis of ‘inverse’ formula and the
remaining is assigned to all states according to the distance formula.’ [5] 

Assistance to the central sector and centrally sponsored schemes is the third
channels of transfers in India. This is neither based on the recommendations of the
finance commission nor is determined by any formula. Grants for the central sector
schemes are given to the states to execute central projects and are entirely funded
by it. Centrally sponsored schemes, on the other hand, are shared cost programs
which stipulate matching requirements from the state government. The economic
rationale offered for these programs is that certain finance activities have a high
degree of interstate spillovers or are in nature of merit goods. Though many of them
are well designed, these transfers have attracted sharpest criticism due to the
conditionality’s and discretion implicit in them. ‘These programs have provided the
central government an instrument to interfere with the states allocation. [6] ‘ The
volume and quantum of these transfers have increased considerably especially post
1969 adoption of Gadgill formula for plan assistance. They accounted for about 4o
per cent of the total plan assistance and about 14 percent of total current transfers
were given to these schemes in 2000-01.

What we have seen till now are explicit modes of fiscal transfers. In addition to these
the state makes use of a number of implicit and invisible ways to further mainly its
political interests. This happens primarily in through following ways.

Interstate tax exportation.

Subsidized lending by banking and financial institutions to the private sector.

Subsidized borrowing by the states from the central government and the banking
system.

Implicit transfer arising out of control of prices and outputs

ISSUES AND CONCERNS

System of intergovernmental transfers in India faces multiple and varied challenges.
The challenges faced by Indian transfer system stems out of its very basic character,
Presence of multiple agencies whose functions overlap with each other. Though
revamped many times certain issues still persist in the Indian system of fiscal
federalism. Most importantly there has been a rise in discretionary element of
transfers. Often cited as a tool to override constitutional and formula based transfers
this is employed to achieve political goals. Bulk of the discretionary transfers is
constituted by ministerial allocations. ‘The share of these transfers increased steadily
from less than 12 percent in the fourth and fifth plan periods to about 20 per cent by
the end of 1990’s’ (Rao, Singh;2005).Most of them require a matching contribution
from the states. Thus it could be a potential tool for centre to make preferential
allocations. Central government has increasingly used discretionary loans, often with
interest subsidies or ex-post conversion of loans into grants as a component of
political influence.

Though this problem was prelevant for a long time, recently many central schemes
are bypassing states and makes direct transfers to the implementing agencies.
‘Although, the central intrusion into states’ domain by introducing a large number of
central sector and centrally sponsored schemes has been in vogue for a long time,
the recent political developments have resulted in the centre bypassing the states
and making direct transfers to the implementing agencies with adverse
consequences on both accountability and efficient.’. [7] This has happened at a time
when coalition politics and role of regional parties has attained unprecedented
dimensions. Thus at a time health of state finance was already taking a hit, central
governments activities especially discretionary transfers added oil to the fire further
worsening the fiscal health of Indian states.

There are serious concerns raised regarding finance commission also. The biggest
problem faced by finance commission is the attempts to restrict its scope. This has
taken matters to the level of conflict of domains between finance commission and
planning commission. As the role played by planning commission in charting out the
road map for countries development increased exponentially, finance commissions
role gets restricted. ‘the increased domination of planning commission in allocative
decisions and its empowerment to dispense assistance to states to finance their
developmental activities substantially curtailed the role of finance commission in
making intergovernmental transfers.’ Now finance commission makes only non plan
transfers required to meet the needs of the state. This had multiple impacts on
finance commission. First its ability to effect redistribution was constrained. Second, it
resulted in failure to undertake a comprehensive periodic review and precluded it
from taking a holistic view of state finances. More over it has been pointed out that
the division between plan and non-plan, created a craze for large sized plans leading
to proliferation of expenditure and inadequate provision for maintenance of existing
assets. (Rao, Singh; 2005)

Another major issue that has been pointed out is regarding the gap filling approach
followed by fiancé commission. The critics argue that the methodology followed by
finance commission could create a moral hazard problem and can cause fiscal laxity.
In the present context states with larger deficits gets rewarded while others suffer.
This would not have been the case had the budget gaps of the states been assessed
on the basis of objective norms independently of actual. ‘Projections are made by the
FC, on the basis of growth rates or norms of their own. But the starting point the
base year figures from which the projections start still rely heavily on history or past
actuals.'(Bagchi, 2001) Proliferation of grants from centre to state is another concern
as it could result in reduced tax effort from states end. Studies show that higher the
ratio of central grants in total expenditures of a state government, the lower is its tax
effort (Jha, et.al. 1999). According to the revised estimates of 2009-10, States’ tax
receipts declined over the budget estimates of that year, reflecting a perceptible fall
in States’ share in Central taxes and a marginal decline in States’ own tax revenue
(OTR). [8] The tendency is more persistent in special category states suggesting the
presence of a dependency syndrome.

The tax devolution formula used by finance commission in itself has attracted many
criticisms. First as mentioned elsewhere tax devolution is determined on basis of
general economic indicators and is not based on fiscal disadvantages per se.
‘Assigning weights to contradictory factors like ‘backwardness’ and contribution in
the same formula has rendered the achievement of the overall objective of offsetting
revenue and cost disabilities difficult.’ [9] Rao and Singh (2005) points out that in
spite of higher weights to backwardness in the formula, the methodology is
inherently biased against the poorer states. Projection made by commission is firmly
based on existing revenues and non plan expenditures. This has caused the
prevailing tax levels and standards of service to implicitly become the most
important determinant. Further the practice of using general economic indicators has
helped the states with greater means to have larger plan investments.

As noted earlier, plan transfers which comprise of grants and loans is enjoying
increased prominence these days. It should be noted that an undeniable reasons for
irregularities in the Indian fiscal system arises out of planning commission too. Major
issue is lack of co-ordination with finance commission which we have already looked
into. It has been noted that plan assistance often lacks proper relationship with the
investment requirement of the state. The transfers are not directly related to the
shortfall in states’ resources. ‘the plan assistance given to the states, as also its grant-
loan components are not related to the required plan investments, their sectoral
composition, resources available with the states or their fiscal performances.
‘ [10] The grant component of central assistance has remained constant over the
years. This inherently results in bias against states with strategies for development
through human capital formation, as against those with emphasis on physical capital
formation. Another area of concern is planning commission’s role in state
borrowings. It is suspected that while approving or mediating state borrowings or
grants debt sustainability of the state concerned is largely ignored.

Most controversial of all transfers problems of central sector and centrally sponsored
schemes have been partially explored earlier. These national programs initiated by
either by central government or at request of ministries at state level are largely
discretionary in nature. Most of them designed at the central level, fails to take into
account the idiosyncrasies of the areas in which they are applied. This results in huge
wastage of public finance at almost all levels of implementation. The objectivity and
transparency of these schemes are also at doubt as these have been widely used for
attainment of political gains. Huge increase in quantum and volume of these
schemes in recent times and multiple agencies giving transfers in an uncoordinated
manner also attracts sharp criticism. ‘Choosing the programs on political
considerations and spreading the resources thinly across multiple schemes without
proper monitoring mechanism may serve the political objective of dispensing
political patronage to groups and parties ,but does not help to fulfill the economic
objectives of such transfer.’ [11] In spite of various efforts to cut down the
duplication of programs, the result in this direction has been far from satisfactory.

In spite of many weakness and draw backs fiscal federalism and decentralisation has
come a long way in India. But certain issues persist. There are anomalies in
assignments both between Center and States and States and local bodies. There is
considerable need to rationalize the assignment system to enable the decentralized
governments to raise revenues and incur expenditures according to the preferences
of their citizens. Federalism in India as everywhere else has to face the challenges of
changing times. Maintaining an appropriate balance in the relationship between the
centre and the constituent units in a federation is the key to future. The federal
structure needs perpetually to be altered and mended to cope with changing
environment and emerging challenges. However, the one cardinal reality that should
never be lost sight of is that federalism is the only possible form of government for a
polyglot country like India.