7 PM | A suggestion to reform India’s architecture of fiscal federalism | 20th September, 2019

Context: Amendments in Term of Reference of the Fifteenth Finance Commission and its implications.

More in news: On 29 July 2019, the government amended and added to the terms of reference (TOR) of the 15th Finance Commission (15th FC), asking it to “… examine whether a separate mechanism for funding of defence and internal security ought to be set up…”

Finance Commission:

Under Article 280 of the Constitution, Finance Commission is appointed at the expiration of every five years or earlier. Finance Commission focuses on the vertical (division of revenues between centre and states) and the horizontal distribution (between states to ensure regional equity).  Under the Constitution, the main responsibilities of a Finance Commission are the following.

1. The distribution between the Union and the States of the net proceeds of taxes which are to be divided between them and the allocation between the States of the respective shares of such proceeds.
2. Determination of principles and quantum of grants-in-aid to States which are in need of such assistance.
3. 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.

Fifteenth Finance Commission:

• The Government of India, with the approval Hon’ble President of India, has constituted Fifteenth Finance Commission in 2017.
• The Commission will make recommendations for the five years commencing on April 1, 2020.
• This Commission will be headed by Shri. N.K.Singh

Reason for adding the new Term of Reference:

• Economically:Central revenue is projected to grow by 25.6% in the 2019-20 budget, compared to the 8.9% actual rise in 2018-19. The expenditure projections are equally unrealistic. The central government is well aware that another major expenditure shortfall in 2019-20 will further reduce growth, which had decelerated to 5% by the first quarter of 2019-20. It is therefore seen as an attempt to pre-empt some resources of the states for funding defence and internal security.
• Politically:The conversion of the Jammu and Kashmir state into two Union territories by the stroke of a pen, along with the abrogation of Article 370. Opposition therefore claim that amendment of the 15th FC TOR is part of a larger campaign to undermine the federal character of the Constitution.

Standard Practice of distribution of ‘Sharable pool of Tax’:

• Two-thirds of the shareable pool of tax revenue is usually transferred to the states.
• In the 14th Finance Commission award period, this was set at 63%, with the balance 37% being the Centre’s share.
• The Centre also receives cesses and surcharges as well as dividends and profits of central public enterprises as well as public sector financial institutions such as banks and the Reserve Bank of India.
• In setting the Centre’s share at 37% of the shareable pool, the 14th FC had factored in the Centre’s access to these non-shareable revenues, as well as its expenditure needs, including the provision for defence and internal security.

Fiscal Space versus Fiscal Autonomy:

• If the 15th FC recommends that a certain portion of the shareable pool should be separately carved out for defence and internal security, it may not necessarily erode fiscal space of the states.
• However, defence is a central subject and internal security is the joint responsibility of the Centre and the states. This would imply that the provision for internal security would be carved out in advance from the resources of states, but without their approval.
• So, this would not erode fiscal space of the states but their fiscal autonomy.

Reforms in the architecture of fiscal federalism:

• Allow transfers through untied tax devolution: However, such step is unrealistic in the sense that issues of national importance such as basic education cannot be left alone on shoulders of states. Given the long legacy of Centrally Sponsored Scheme (CSS), it is difficult to imagine that any central government would completely walk away from CSS.
• Make the Finance Commission a permanent body and expand its mandate to undertake the resource allocation role. The scope of the Finance Commission should therefore be enlarged to reduce the interference of the Centre in the financial management of the States. In the context of raising revenues the recommendation of the Tenth Finance Commission to increase the role of industry, needs to be seriously considered.
• Revive the Inter-State Council as an effective federal decision-making body. It already exists as a constitutional body, but has been left dormant. It can be restructured as a federal institution outside the home ministry, a council with state chief ministers as members and chaired by the Prime Minister. The council should be supported by a secretariat of experts to design programmes and lay out the principles for their allocation among the states.

Conclusion: Financial relations are the most important aspect of Centre-State relations. No system of federation can be successful unless both the Union and the States have at their disposal adequate financial resources to enable them to discharge their respective responsibilities under the Constitution. The Union and States ‘are mutually dependent’ and this coordinate nature has given stability to the working of the Indian federation.

Our Constitution had adopted the desirability of the Finance Commission which by all accounts can provide the most logical and fair institution method as successive Finance Commissions have made valuable contributions to our federal system. Every State wants more resources, and a larger share of the divisible pool.

The Finance Commission is to do justice between the Centre and the States, and between a State and a State. Its purpose is to assure the States that they will have a fair deal.

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