NATIONAL LAW UNIVERSITY ODISHA

PROJECT REPORT

ON

AN ANALYSIS OF THE RECOMMENDATIONS OF RECENT FINANCE COMMISSIONS OF

INDIA

COURSE: FISCAL FEDERALISM

SUBMITTED IN PARTIAL REQUIREMENT IN FULFILLMENT OF LL.M. IN CONSTITUTIONAL AND ADMINISTRATIVE LAW

FOR THE ACADEMIC YEAR 2023-24

SUBMITTED TO SUBMITTED FROM

MR. MAYANK MISHRA AYUSH SINGH
Asst. Professor of Law, NLUO Roll No. 06

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 An analysis of the recommendations of recent Finance Commissions in India

Background

“The Finance Commission of India was founded in 1951 pursuant to Article 280 of the
Constitution of India.”1 The Indian Finance Commission Act was enacted to establish a
systematic framework for the Finance Commission of India, in accordance with global
standards. In order to establish clear financial relationships between the central government
and the states, the colonial authority saw the necessity for this. The Constitution of India
clearly delineated the functions and responsibilities of the Finance Commission. The main
responsibilities of the Finance Commission are: advising the President of India on how to
distribute the net proceeds of taxes between the Union Government and the states; assessing
the growth of a state's consolidated fund to allocate resources to Panchayats in that state; and
assessing the growth of a state's consolidated fund to allocate resources to Municipal
Committees in the state. The head of the organisation is chosen among those who are
currently or have previously served as Judges of a High Court, or possess a comprehensive
understanding of economics.
Several Finance Commissions were established under this arrangement, each providing
different recommendations and criteria for distributing tax resources among the states of
India. The primary focus of the Finance Commission awards pertains to the recommendations
that determine the distribution of the states' collective share in central tax revenues. The
fundamental elements of horizontal sharing may be summarised in two main components:
(a) the criteria employed, and
(b) the corresponding weights allocated to these criteria.
Finance Commissions have employed diverse criteria in their allocations, including
population, income disparity, infrastructure disparity, contribution/assessment, income-
adjusted total population, area, poverty, tax effort, fiscal self-reliance, post-devolution
deficits, revenue equalisation, and indices of economic and social backwardness. The weights
ascribed to different criteria have varied significantly, ranging from 5 to 90 percent.
This project aims to provide a detailed examination of the suggestions made by various
Finance Commissions. The goal is to analyse potential improvements that might be
implemented to address the declining fiscal health of heavily indebted states such as Punjab.
Initially, we will examine several papers pertaining to the topic being considered.

1
Article 280 Constitution of India 1950

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Criteria adopted by recent Finance Commissions
So far, a total of fifteen Finance Commissions have been successfully concluded, with the
ongoing 16th Finance Commission, scheduled for the period of 2025-2030, now underway.
There have been significant modifications in the criteria used to determine the inter se shares
of states from the 1st to the 15th Finance Commission. The distribution formulae employed
until the Seventh Finance Commission pertained to the Union Excise Duties and were
delineated within distinct Articles of the Constitution. Article 270 stipulated the obligatory
distribution of Income Tax, whereas Article 272 stipulated the allocation of Union Excise
Duties based on the central government's judgement. This particular time frame may be
perceived as comprising Phase I. Subsequently, a phenomenon of convergence occurred
between the two sets of formulas. The proposals of the Eleventh Finance Commission,
following the 80th Amendment2 to the Constitution of India, resulted in a comprehensive
convergence. The time span between the 8th and 10th Finance Commission, prior to the
implementation of the alternative system of devolution, can be considered as Phase-II.
Lastly, the time span between the 11th and 15th Finance Commission may be considered as
Phase-III. Table 1 below provides a concise summary of the changes in the proportionate
weights attributed to different elements for the horizontal distribution of Income Tax, as
suggested by several Finance Commissions during Phase-I.

Table 1. Inter se sharing of Income tax during phase I

Finance Weight Assigned (%)
Commission
Populatio Collection
FC-I; FC-III; FC-IV n
80 20
FC-II 90 10
Populatio Assessment
FC-V; FCVI; FC-VII n
90 10
Source: Reports of Various Finance Commissions, Government of India

It is apparent that the significance attributed to population has been diminished over time by
successive Finance Commissions, whilst the emphasis on variables related to limited resource
bases has been enhanced. However, it is important to note that population remained the

2
The Constitution (Eightieth Amendment) Act 2000

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primary determinant until the 6th Finance Commission, albeit with a reduced weight of 75
percent.
Regarding the 8th and 9th Finance Commissions, it can be observed that they exhibited a
degree of alignment with the 7th Finance Commission in terms of the criteria and their
weighting scheme.
Following the implementation of the 7th Finance Commission 3, two significant modifications
were made to the devolution of central taxes to the states. The first adjustment was the
consolidation of formulas for the inter se allocation of both Income tax and Union Excise
Duties. Furthermore, a portion of the Union Excise Duties was set aside for allocation based
on evaluated deficiencies. Moreover, prior to the 9th Finance Commission, the principle of
derivation was accorded a certain level of significance, and the collection and assessment of
income tax were given a certain degree of priority, as stipulated in Article 270. Nevertheless,
the aforementioned principle was not implemented with regards to the distribution of Union
Excise Duties, specifically in relation to the issue of voluntary sharing as outlined in Article
272.

The 10th Finance Commission (FC-X)

The Tenth Finance Commission was established with the purpose of proposing
recommendations for the time frame spanning from 1995 to 2000. The Seventh Finance
Commission utilised population and collection/assessment as the only basis for establishing
the inter se shares of the states. Regarding Union excise charges, the criteria placed greater
importance on issues associated with the economic underdevelopment and budgetary fragility
of a certain state. The weight was subsequently decreased to 25 percent, representing a
decline of 50 percentage points compared to the previous commission, as stated in the Report
of the 10th Finance Commission.4

The 11th Finance Commission (FC-XI)

The establishment of the Eleventh Finance Commission was intended to provide
recommendations for the time frame spanning from 2000 to 2005. According to the
methodology employed by the 11th Finance Commission, the allocation of tax devolution to
each state was decided based on specific criteria and their corresponding relative weights. It
3
NJ Jhaveri, 'Seventh Finance Commission's Recommendations: An Evaluation' (JSTOR, 23 December
1978) <https://www.jstor.org/stable/4367207?seq=9> accessed 13 March 2024
4
S Guhan, 'THE REPORT OF THE TENTH FINANCE COMMISSION ' (Madras Institute of Development Studies, 1 April
1995) <https://www.mids.ac.in/assets/doc/WP_129.pdf> accessed 14 March 2024

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is apparent that the significance attributed to population has significantly decreased, dropping
from 20 percent during FC-X to a mere 10 percent during FC-XI. In addition, the 11th
Finance Commission5 substituted the income criteria with the per capita income gap. The
measurement of distance has been conducted by the Finance Commission using the average
of the top three states with the greatest per capita incomes, as stated in the Report of the
Eleventh Finance Commission.

The 12th Finance Commission (FC-XII)

The establishment of the Twelfth Finance Commission was intended to provide
recommendations for the fiscal year 2005-2010. The Commission proposed that the
allocation of net central tax revenue to states should be set at 30.5 percent. The earnings from
extra excise charges in place of sales tax on textiles, tobacco, and sugar were considered as
part of the divisible pool of central taxes for the purpose of tax devolution. FC-XII further
proposed a reduction in the states' portion of the net revenues generated by sharing central
taxes to 29.5 percent in the case of the termination of the Tax Rental Agreement. 6
Furthermore, it suggested that states should be granted the authority to impose sales tax (or
VAT) on certain goods without any specified restriction. The parameters used to ascertain the
proportional allocation of tax devolution among states, as well as the corresponding weights
allocated to them in FC-XII.

The 13th Finance Commission (FC-XIII)

In November 2007, the Thirteenth Finance Commission was established with the objective of
providing recommendations for the period spanning from 2010 to 2015. This action was
taken in response to the implementation of Fiscal Responsibility and Budget Management
(FBRM)7 laws by both the central government and the state governments. The Commission
was requested to consider the aim of achieving a balance between the revenue account of all
states and union territories, as well as creating surpluses for capital investment, prior to
formulating its recommendations. In addition, the Commission was obligated to carefully
analyse the taxing initiatives of both the central government and state governments, as well as
5
Sanket Suman, 'Recommendations of the Eleventh Finance Commission' (Economics discussion, 14 December
1999) <https://www.economicsdiscussion.net/india/recommendations-of-the-eleventh-finance-commission/
12921> accessed 13 March 2024
6
https://doe.gov.in/main-recommendation-twelfth-finance-commission
7
Pinaki Chakraborty, 'Recommendations of Thirteenth Finance Comission' (Theigcorg, 1 March
2011) <https://www.theigc.org/sites/default/files/2015/02/Chakraborty-2011-Working-Paper.pdf> accessed 18
March 2024

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the possibility of raising extra resources to enhance the tax-GDP and tax-GSDP ratios.
Therefore, FC-XIII had a significant responsibility in addressing the difficulties presented by
the worldwide economic downturn and in introducing a new era of fiscal federalism with the
intended implementation of the Goods and Services Tax (GST) starting in April 2010, which
was later rescheduled to April 2012.

The 14th Finance Commission (FC-XIV)

The Fourteenth Finance Commission (FC-XIV) was established in January 2013 with the
objective of providing recommendations for the period spanning from 2015 to 2020. The
Commission has proposed a significant suggestion to raise the proportion of tax devolution
from the current 32 percent to 42 percent. 8 According to the Report of the 14th Finance
Commission, the proposed increase in the divisible pool is anticipated to have two primary
objectives. Firstly, it would enhance the influx of unconditional transfers to the states.
Secondly, it will provide the Union with sufficient fiscal capacity to execute specific-purpose
transfers to the states. According to the recommendations put out by the Commission, the five
separate criteria would be given significance laid by them.

The 15th Finance Commission

The President of India established the 15th Finance Commission in November 2017, with NK
Singh serving as its chairperson. The proposals will encompass a five-year timeframe,
specifically from 2021-22 to 2025-26.
Vertical devolution, also known as the devolution of tax burdens from the central government
to individual states, has been suggested to be maintained at a rate of 41%, consistent with the
recommendation made in the interim report for the fiscal year 2020-21. 9
According to the recommendations of the 14th Finance Commission, the current level of the
divisible pool is at 42%.
The adjustment of about 1% has been made in response to the altered status of the former
State of Jammu and Kashmir, which has been transformed into the newly established Union
Territories of Ladakh and Jammu and Kashmir.

8
KT Jaggannathan, 'Recommendations of the 14th Finance Commission' (TheHindu, 4 December
2021) <https://www.thehindu.com/business/Recommendations-of-the-14th-Finance-Commission/
article60331671.ece> accessed 18 March 2024
9
https://pib.gov.in/PressReleasePage.aspx?PRID=1980688

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In the context of horizontal devolution, it has been proposed that a weightage of 12.5% be
assigned to demographic performance, 45% to income, 15% each to population and area,
10% to forest and ecological, and 2.5% to tax and fiscal efforts.10

Financial capacity for the central government:

The combined transfers from the 15th Finance Commission, including devolution and grants,
account for about 34% of the anticipated Gross Revenue Receipts to the Union. This provides
sufficient fiscal capacity to satisfy the Union's resource needs and expenditure commitments
related to national development goals.

Conclusion
The lack of consensus on the criteria and their respective relevance across various Finance
Commissions is apparent. The previous Finance Commissions have primarily focused on
population, size, states' contribution to central taxes, and poverty as key indicators. However,
more recent Commissions have expanded their considerations to include geographical
factors, fiscal performance, environmental concerns, and gender-related issues. More
precisely, the initial seven Finance Commissions used population and contribution as the
primary factors to determine the states' participation in income tax. 11 However, the Eighth and
Ninth Finance Commissions incorporated poverty level as a significant criterion. Regarding
the allocation of excise charges, population remained a significant factor until the 10th
Finance Commission. However, starting with the Sixth Finance Commission, per capita
income of the states was also considered an important criterion. Additionally, the 10th
Finance Commission incorporated the infrastructure index into its roster, a feature that was
subsequently maintained by the 11th Finance Commission. However, the Finance
Commissions that followed, namely FC-XII, FC-III, and FC-XIV, subsequently retracted it.
The 10th Finance Commission allocated a significant weightage of 10 percent to fiscal
discipline, without any specific reference. However, the 11th Finance Commission reduced
this weightage to 7.5 percent and added a new criterion, namely tax effort, which was given a
weightage of 5 percent. Consequently, FC-XI increased the overall weightage allocated to the
fiscal performance to 12.5 percent. FC-XII raised the percentage to 15.0 percent, while FC-
XIII upped it to 17.5%. In addition, the 13th Finance Commission introduced a novel metric

10
Report 15th Finance Commission https://dea.gov.in/fifteenth-finance-commission-0 11 March 2024
11
Report Tax Devolution <https://cag.gov.in/uploads/journal/january-2015/tax-devolution.html> 11 March
2024

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known as fiscal capacity distance, which has significant value at 47.5 percent. In addition, the
Finance Commission (FC-XIV) has made a significant modification to the criteria used.
Surprisingly, the criterion of fiscal performance has been disregarded, while the Commission
has introduced two new criteria: demographic change (with a weightage of 10.0 percent) and
forest cover (with a weightage of 7.5 percent).
The array of criteria used and the level of priority attributed to these criteria in calculating the
proportional shares of various states in the aggregated revenues have been subjects of intense
debate within the Federal Fiscal Transfer. Periodically, many Finance Commissions have
formulated their own formulas and endeavoured to aid economically disadvantaged states by
allocating disproportionate resources from the divisible pool to these states. Within this
framework, other perspectives exist, and several specialists in the field believe that the set of
criteria, as well as their significance, require a thorough reassessment. Furthermore, it is
imperative to enhance the transparency of the allocation of net revenues among the several
states. The needs and structure of the states have seen significant modifications in a
temporary manner. Hence, under the current context, there exist novel patterns in the
proposals put out by Finance Commissions, which have been briefly examined in this
chapter. Temporal changes have been seen in the requirements and functional obligations of
the states. Under the federal system, Indian states are obligated to allocate a significant
portion of their budget towards providing services such as social welfare (including
education, health, water supply & sanitation), public administration, economic services
(including the development of rural and urban infrastructure), and environmental protection.
These services are essential for the overall welfare of their citizens. It is evident that states
require sufficient funds in order to satisfy their needs, and as a result, several Finance
Commissions have played a significant role in facilitating this process.
During the 13th Finance Commission, the states submitted a joint memorandum, for the first
time, to the Commission, wherein a request was made to increase their share in the net
proceeds of central taxes from 30.5 to at least 50.0 percent (may be in a phased manner), with
a multiplicity of pleas, such as: (a) States’ share in combined developmental expenditure is
much higher than that of the centre; (b) Revision of pay-scales/ pensions of government
employees would grossly push up revenue expenditure of the states; (c) In order to honour
the ‘Right to Education (RTE) Act, 2009’12, the states would be compulsorily required to
provide free education to all the children in the age group of 06-14 years, which undoubtedly

12
Report Education Portal <https://www.education.gov.in/sites/upload_files/mhrd/files/upload_document/
rte.pdf> 10 March 2024

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will increase their expenditure perceptibly; (d) Under the ‘National Food Security Act’ 13, all
the BPL families would be entitled by law to get a certain quantity of food grains every
month at highly subsidised rates, thereby putting huge burdens on the states; and (e)
Although environment is a residual central subject, yet as per the existing rules/ regulations,
the responsibility for its maintenance lies primarily with the state governments. In order to
ensure adherence to various environmental legal requirements, state governments would
incur supplementary expenses. In addition, the states argued that the tax pool should
encompass all cesses and surcharges. Several states have proposed the implementation of
minimum guaranteed tax devolution as a means to protect them from potential income
shortfalls in the central government, which may differ from the projections presented by
Finance Commissions. It is noteworthy to add that the 14th Finance Commission has partially
complied with the request of state governments by increasing the proportion of net revenues
from the divisible pool from the current 32 to 42 percent. While The 15th Finance
Commission noted that the proposed fiscal deficit plan for the central government will lead to
a decrease in the entire liabilities of the central government from 62.9% of GDP in 2020-21
to 56.6% in 2025-26, and the combined liabilities of the states from 33.1% of GDP in 2020-
21 to 32.5% by 2025-26.

13
https://nfsa.gov.in/portal/nfsa-act