Finance Commission – Functions, Achievements & Challenges – Explained Pointwise

Introduction:

• Finance Commission is a constitutional body established under Art 280 of the Indian constitution.
• It is a non-permanent body and is constituted by the President for a term of 5 years or earlier.
• Its function is to maintain fiscal federalism by recommending the distribution of tax revenues between the central and state governments.

Functions of the Finance Commission:

• Tax Revenue Distribution: Recommends the sharing of net tax proceeds between the Union and States, and among the States themselves (income tax, GST, etc.):
  • Vertical Devolution: Recommending the percentage of central taxes and duties that should be shared with the states. This is the division of funds between the Union and the states.
  • Horizontal Devolution: Laying down the principles for the distribution of the shared funds among the individual states. The commission uses a formula based on various criteria, such as population, area, forest and ecology, and tax effort, to ensure a fair allocation.
• Grants-in-Aid: Suggests principles for grants-in-aid to support states that may not generate adequate revenue, ensuring essential services like health and education and promoting social welfare.
• Strengthening Local Governance: Advises measures to augment the Consolidated Fund of States to support Panchayats and Municipalities, strengthening local self-government.
• Fiscal Discipline & Stability: Reviews and recommends policies for fiscal consolidation, expenditure efficiency, and sustainable debt management at both Union and State levels.
• Contemporary Fiscal Challenges: Addresses emerging issues such as disaster management financing, impact of GST, and public sector reforms, as referred by the President.
• Promotes Cooperative Federalism: Encourages consultation and collaboration between Centre and States on financial matters for balanced development.

Composition of Finance Commission:

• It consists of 1 chairman and 4 members.
• Qualification of the members of the commission is decided by the Parliament.
• The chairman must have had experience in public affairs.
• Other 4 members:
  • Should be qualified to be a judge of a High Court.
  • Have special knowledge of finance and government accounts.
  • Have wide experience in financial matters and in administration.
  • Have special knowledge of economics.

Implementation & monitoring of finance commission’s recommendations:

• The recommendations of FCs are advisory in nature and not binding on the Union government. However, they are usually accepted with minor modifications or deviations.
• The Union government notifies the acceptance of the recommendations through a Presidential Order, which also specifies the period for which they are valid (usually five years).
• The Union government also tables an explanatory memorandum in Parliament, stating the action taken on the recommendations and the reasons for any deviation.
• The implementation and monitoring of the recommendations are done by various ministries and departments at the Union and state levels, depending on the subject matter and the conditions attached to the transfers.

Recommendations of 15th Finance Commission:

• 15th finance commission tenure is from 2020-26.
• The recommendations for FY 2020-21 & 2021-26 include vertical devolution of 41% to the states and 1% for the erstwhile state of J&K.
• The only change for 2020-21 and 2021-26 is: Income distance reference period for 2020-21 is 2015-2018 and for 2021-26 is 2016-19.
• Horizontal devolution is based on 6 indicators:
  1. 45% to income distance.
  2. 5% for demographic performance.
  3. 15% to population [2011 census]
  4. 10% to Area
  5. 10% to forest and ecology
  6. 5% to tax and fiscal efforts
• Principles for grant-in-aids/performance incentives to states are based on 4 areas:
  1. Social sector such as health, education
  2. Rural economy such as agriculture, roads
  3. Governance and administrative reforms
  4. Reforms in power sector
• Local body grants include total grants Rs 4.36 lakh crore with 2.4 lakh crore for rural and 1.2 lakh for urban.
• Disaster Risk Management Corpus Fund by Centre and the States in the ratio of 90:10 percent for NE and Himalayan states and 75:25 for other states.
• Modernisation Fund for Defence and Internal Security (MFDIS) with the total corpus of 2.4 lakh crore and 1.5 lakh crore from consolidated fund of India.

Achievements of the Finance Commission:

1. Introducing tax devolution as a major component of vertical transfers, increasing the share of states from 10% to 42% over time.
2. Introducing performance-based incentives for states to encourage fiscal discipline, population control, forest conservation, power sector reforms, etc.
3. Introducing disaster relief funds for states and local bodies for enhancing their preparedness and response capacity for natural calamities.
4. Introducing grants for local bodies strengthening their fiscal autonomy and accountability for delivering basic services.
5. Introducing grants for specific sectors such as health, education, justice delivery, statistical system, etc. addressing critical gaps and needs in these areas.

Challenges/Limitations of Finance Commission:

1. Data Gaps and Quality Issues: The finance commission relies on official data sources to assess the fiscal situation and performance of the Union and states, but these data are often incomplete, inconsistent or outdated.
2. Centre v/s State:
   1. The Commission must navigate conflicting interests between central and state governments, local bodies, civil society, etc.
   2. Rising centralization and demands for more state fiscal autonomy create tensions in resource sharing.
3. Limited Implementation & Monitoring Power:
   1. Finance Commission recommendations are advisory and not binding. Actual implementation depends on the Union and states, often leading to delays, non-compliance, or misuse of recommended grants.
   2. The Commission has no direct enforcement or oversight ability; accountability is limited.
4. Resource v/s Responsibility imbalances:
   1. Frequently faces situations where states have growing expenditure responsibilities but limited revenue mobilization capacity, making equitable sharing highly complex.
   2. Handling vertical and horizontal imbalances, especially with newer challenges like GST revenue sharing and compensation, adds complexity.
5. Overlap with GST Council: Intersecting jurisdictions with the GST Council, especially in tax pool size and distribution, pose coordination challenges for effective fiscal federalism.
6. Limited Role in 3rd-tier Governments: Recommendations regarding Panchayats and Municipalities are based only on State Finance Commission reports, restricting the Finance Commission’s direct impact on grassroots fiscal empowerment.
7. Changing Economic Contexts & Inequality: Balancing regional disparities, post-pandemic fiscal health, disaster response, and new urban infrastructure demand requires dynamic and sometimes contentious negotiations.

Way Forward:

1. Improve Data Quality:
   1. Establish robust, comprehensive data-sharing mechanisms between the Centre, States, and local bodies for accurate, timely fiscal and economic data.
   2. Leverage technology and auditing to ensure transparency and reliability of data underpinning recommendations.
2. Enhance Accountability & Compliance Mechanisms:
   1. Introduce mechanisms to promote adherence to the Finance Commission’s recommendations, such as monitoring frameworks, fiscal performance audits, and incentive-linked transfers.
   2. Strengthen Parliamentary oversight and involve independent fiscal institutions in evaluating compliance and impact.
3. Strengthen Fiscal Federalism through Balanced Approach:
   1. Balance revenue sharing and expenditure responsibilities transparently, considering states’ fiscal capacity, needs, and development levels.
   2. Foster cooperative federalism by regularly consulting states and stakeholders to reconcile conflicts and expectations.
4. Improve Coordination with GST Council & Local Bodies:
   1. Develop integrated fiscal management frameworks involving the GST Council to harmonize revenue sharing and policy coherence.
   2. Increase the Finance Commission’s role in empowering Panchayats and Urban Local Bodies through better mandates and funding models.
5. Focus on Outcome-oriented & Developmental Measures:
   1. Align transfers with performance and developmental outcomes to ensure effective use of resources.
   2. Encourage states to adopt long-term fiscal sustainability plans and reform agendas through incentivized grants.
6. Institutional Strengthening:
   1. Expand the Commission’s secretariat capacity with fiscal, economic, and legal experts for deeper analysis.
   2. Engage academic and policy research institutions for evidence-based recommendations and impact assessments.