47

3. FISCAL FEDERALISM IN INDIA

Like in other countries, the fiscal dimensions of federalism are a reflection

of the political federal structure in India. The traditional subjects of concern of

fiscal federalism, such as the assignment of taxes and responsibilities as well as

the correction of vertical and horizontal imbalances, continue to remain important

in India. Devolution of taxes and duties still constitutes the most significant

dimension of fiscal federalism in India (Krishna, 2004).

Fiscal federalism in India unlike in many rich countries has to satisfy the

competing demands to deliver a number of essential and basic socio-economic

services. As a paramount objective, fiscal federalism is expected to enable the

national and sub-national governments to operate in such a way that leads to

efficiency in the use of resources - not only in terms of the quality of services

provided by the various levels of government but also in terms of creating the

environment in which all economic agents use resources efficiently (Rangarajan,

2004).

Political environment is important in determining contours of fiscal

federalism. After Independence, there was a single and same party rule at the

Centre and in almost all states for many decades. There are now telltale signs that

India is moving away from an era of cooperative federalism towards competitive

federalism, due to multi-party polity, and predominance of regional parties at the

state level, and coalition governments at the centre. The existence of competition

brings-in the importance of transaction cost of coordinating policies and their

implementation (a) vertically between different levels of government and (b)

horizontally between different units within each of the levels. Many challenges,

therefore, lie ahead for fiscal federalism in the country.

Bulk of literature on federalism in India had focused on economic aspects

of fiscal federalism. There is a little work done in the area of environmental

policy and its influence on intergovernmental financial relations in India. Within

the context of Indian Federalism, what remains important is to take into account

the social diversity in a general sense and the diverse ways in which each member

state is able to relate to the federal system as a whole and to other member states

(Thornton, 1995). The existing cultural, economic, social, environmental and

48

political factors combining to produce asymmetrical variations in the country, if

not handled properly, have the potential to affect harmony within the federal

structure of the country.

3.1 EVOLUTION OF FISCAL FEDERALISM

The history of fiscal federalism in modern India goes back to the

Government of India Acts of 1919 and 1935. While the Act of 1919 provided for

a separation of revenue heads between the Center and the provinces, the 1935 Act

allowed for the sharing of Center’s revenues and for the provision of grants-in-aid

to provinces. The salient features of Government of India Acts of 1919 and 1935

are provided as Box –3.1 and Box – 3.2 respectively.

Box 3.1

MAIN FEATURES OF THE GOVERNMENT OF INDIA ACT, 1919

(1) Relaxation of Central control over the Provinces: The Act of 1919 made a separation of the subjects of administration and sources of revenue into two categories-Central and Provincial. The Provinces could run the administration with the aid of revenues they themselves raised. Provincial budgets were separated from the budget of the Government of India.

(2) Diarchy in the Provinces: The Provincial subjects were divided into ‘transferred’

and ‘reserved’ subjects. Transferred subjects were to be administrated by the Governor with the aid of Ministers responsible to the Legislative Council in which the proportion of elected members was 70 percent. Reserved subjects were to be administrated by the Governor without any responsibility to the Legislature.

(3) The Indian Legislature: It was made more responsible and bicameral, but on a

communal and sectional basis. The diarchy was impracticable and devoid of any real substance. The Governor had all the powers and the introduction of ministerial government over a part of the Provincial sphere was only an empty shell and was, as such, a failure. Even though subjects were divided, the Central Legislature retained the power of legislation for the whole of India. No popular responsibility was introduced at the Centre and the Governor General-in-council continued to remain responsible only to the British Parliament through the Secretary of State for India.

Source: GoI Act, 1919

Box 3.2

THE MAIN FEATURES OF THE GOVERNMENT OF INDIA ACT, 1935 (1) Federal Scheme: Under all the earlier Acts, the Government of India was unitary,

while the Act of 1935 prescribed a federation, taking the Provinces and the Indian States as units. It was proposed to unite the Provinces and the India States into a federation under the Crown. This involved the breaking up of the unitary State into a number of autonomous Provinces which were to derive their authority directly

49

from the Crown, and then building them up into a federal structure, in which both the federal and Provincial governments would get definitely demarcated powers by delegation from the Crown. The federal structure envisaged by this Act never came into being, because it was optional for the Indian States to join, and they never gave their consent.

(2) Provincial Autonomy: Though the part relating to the federation never came into

effect, the relating to Provincial autonomy was given effect to from April 1937. To this extent, the Government of India assumed the role of a federal government vis-à-vis the provincial government, although the Indian states did not come into the fold to complete the federal scheme. The Act of 1935 retained the control of the central government over the provinces in certain spheres requiring the Governor to act without ministerial advice and through him, of the Secretary of State.

(3) Diarchy at the Centre: The executive authority of the Centre was vested in the

Governor General (on behalf of the Crown), whose functions were divided into:

(a) reserved subjects- defence, external affairs, etc., left to the Governor General in his discretion; and

(b) other than reserved subjects-in which the Governor General was to act on

the advice of a ‘Council of Ministers’.

In fact, no Council of Ministers came to be appointed; and the old Executive Council provided by the Act of 1919 continued to advice the Governor General until the Indian Independence Act, 1947.

The executive authority of the Act of 1935 was applied as between the Central government and the Provinces. This is of special interest in view of the fact that the States, proceeds largely on the same lines. A three-fold division was made in the Act of 1935: Federal List, Provincial List and Concurrent List. The allocation of residuary powers of legislation in the Act was unique in the sense that it was not vested in either the Central or Provincial Legislature, but empowered the Governor to authorize either the federal of the Provincial Legislature to enact a law with respect to any matter which was not enumerated in the Legislature Lists.

(4) Non-sovereign character of the Legislature: The legislature powers of both the

Central and Provincial Legislatures were subject to various limitations and neither could be said to have possessed the features of a sovereign legislature.

(5) Federal Court: Consistent with the federal scheme, the Act set up, for the first

time, a Federal Court for India. The Federal Court had an original jurisdiction to determine disputes between the units of the federation inter se and it was also the Appellate Court on constitutional questions, Appeal, however, lay from the decisions of the Federal Court to the Privy Council until such appeal was abolished by the enactment of the Abolition of the Privy Council Jurisdiction Act, 1949.

Source: GoI Act, 1935

After independence, the Indian Constitution that came into existence in

1950 is widely known as basically ‘federal’ in nature, but with striking ‘unitary’

features, owing to the circumstances of the times when ‘unity and integrity’ of the

country was of prime concern (Basu, 1980). Fiscal relations in India had evolved

50

over time through political, institutional and functional changes within the ambit

of the provisions of Indian Constitution. The Finance Commission had played an

important role in this evolving structure because resource sharing, based on

constitutional division of functions and finances between the Centre and states, is

a critical element in the Indian federal system (Rangarajan, 2004).

The Indian Constitution has not only provided a frame work for social and

political development but also established the national ideals and, laid down the

manner in which they were to be pursued. The members of the Constituent

Assembly “skillfully selected and modified the provisions they borrowed” and

“applied to their task two concepts – ‘accommodation’ and ‘consensus’.

Accommodation was applied to the principles to be embodied in the Constitution.

Consensus was the aim of the decision making process, the single most important

source of the constituent Assembly effectiveness” (Granville, 1966). While the

spirit of accommodation has been evident not only in the finalization of the

provisions of Constitution but also in the manner in which Indian union and the

constituent states have discharged their responsibilities of serving an ever

increasing population within the democratic framework of governance.

The profile of Federal India has undergone significant changes over the

last six decades, with the population increasing from 36.10 million 1951 to 1027

million in 2001, and with the number of states emerging in 1956 in a major way

and at subsequent points of time in a minor way. What has been significant is the

remarkable continuity even while political and institutional changes had taken

place in India.

3.1.1 Division of functions and resource asymmetry

The Indian Constitution has, under Article 246 and Seventh Schedule,

distributed powers and allotted subjects to the Union and the states with a

threefold classification of subjects:

(i) List I invests the Union with all functions of national importance such as

defence, external affairs, communications, constitution, organization of the

supreme court and the High courts, elections etc.

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(ii) List II invests the states with a number of important functions touching on the

life and welfare of the people such as public order, police, local government,

public health, agriculture, water land etc.

(iii) List III is the Concurrent list, which includes administration of justice

(excluding Supreme Court and High Courts), economic and social planning,

trade and commerce, etc. It is of interest to note that higher education; forests

and population control were all added to this list in 1977 during the

emergency when it was felt that the states were not doing justice to these

subjects of national importance.

Accordingly, the Parliament has exclusive powers to make laws regarding

matters enumerated in List I. On the other hand, the Legislature of any state has

exclusive power to make laws for that state regarding any of the matters

enumerated in List II, subject to other clauses of Article 246. With regard to List

III, both the Parliament and State Legislature can make laws but in case of any

conflict, the law made by Parliament will prevail (Article 254). The residuary

functions, that is, those not included in either lists I or II, vest with the Union.

The Union and State lists include the powers of taxation as well. The

enumeration of taxation powers placed in the Union List includes: tax on income

other than agricultural income, excise duties, customs and corporate tax. Recently

service tax had been included in view of diminishing importance of customs. The

State List contains land revenue, excise on alcoholic liquor, tax on agricultural

income, estate duty, tax on sale or purchase of goods, tax on vehicles, tax on

professions, luxuries, entertainment, stamp duties etc. However, due to political

reasons, none of the states had imposed tax on agriculture income. The Concurrent

List does not include any tax power. The distribution of revenues between the

Union and the States and approaches for determining grants as per various Articles

of the Indian Constitution is given at Box - 3.3.

Distribution of resources between the Centre and the states together with

the perceived mismatch between the functional responsibilities and revenue

raising powers assigned by the Constitution to the two layers of Governments i.e.,

Centre and states, has been the subject of considerable discussion and debate in

the relevant literature. Two points have been made in this regard: (i) that there is

mismatch between the functions allocated to the centre and to the states, their

52

powers of taxation and (ii) that the more buoyant tax areas have been assigned to

the centre. But, it has also been pointed out that “the Constitution recognizes that

the division of resources and functions between the Union and the states was such

that there would be imbalance between them” and that “the Finance Commission

periodically corrects the imbalance bringing about an alignment between them”

(Vithal and Sastry, 2001).

A moot point is whether relative responsibilities of the Centre and states

could be defined and worked out in financial terms. The Indian Constitution had

given a workable solution that has been able to sustain the federal spirit and

provide the framework for many years to come. Many scholars are of the view that

in the context of the changes in a growing economy, it is good that they did not

freeze the financial relations in a tight frame; they rather chose to provide an

institutional mechanism like the Finance Commission to be appointed every five

years with powers to make recommendations for statutory devolution and grants

(Srinivasan, 2002).

3.1.2 Vertical and horizontal imbalances

Adequacy and elasticity are the essential elements of federal finance.

Adequacy implies sufficient resources for discharging constitutional

responsibilities and elasticity implies an expansion of resources in response to the

growing needs of Government. The practical effect of the division of tax powers

has been to deny both these characteristics in the case of states in India (Vithal and

Sastry, 2001). A vertical imbalance between the Centre and states is built into the

Constitution by the provisions relating to powers of taxation. This arises, not out

of any consideration of making the centre stronger, but out of the desire to build a

common economic space in the country and out of an apprehension that with more

powers the states may put up ‘barriers’ within this space.

The vertical imbalance is further accentuated by the assignment of several

responsibilities involving the public expenditure to the states on the grounds that

tiers of government nearer to the people would be more sensitive to their needs

and thus be better able to discharge such responsibilities. Since states differ in

their resource endowments, levels of development and standards of delivery of

public services, there are sharp horizontal imbalances among the states in India.

53

3.1.3 Inter-governmental transfers

In order to correct built-in vertical and horizontal imbalances for an even

and equitable development of the entire country, the main instrument for

achieving this is fiscal transfers from the Centre to states through different

channels and the mechanisms as provided in the Constitution (Box 3.3). Fiscal

transfers to the third tier of government through subsequent Constitutional

Amendments (73rd and 74th) had also been envisaged in India. Accordingly, there

are both mandatory and enabling provisions facilitating a wide ranging transfer of

resources from Union to states, arranged in a systematic manner as given in

Box – 3.3.

Box 3.3

CONSTITUTIONAL PROVISIONS FOR DISTRIBUTION OF REVENUES BETWEEN THE UNION AND THE STATES IN INDIA Article 268: Duties levied by the Union but collected and appropriated by the States. Article 268 (A): Taxes on services shall be levied by the GoI and such tax can be collected and appropriated by GoI and the States. (88th Amendment) Article 269: Taxes levied and collected by the Union but assigned to the States. Article 270: Taxes levied and collected by the Union and distributed between the Union and the States. Article 271: Surcharge on certain duties and taxes for purposes of the Union. Article 272: Taxes which are levied and collected by the Union and may be distributed between the Union and the States. Article 275: Grants from the Union to certain States. Article 276: Taxes on professions, trades, callings and employments. APPROACHES FOR DETERMINING GRANTS Article 280 (3) (b): Finance Commission to make recommendations as to the “principles” which should govern such grants in aid. Article 275 (1): Specific “sums” to be paid to the states which are assessed to be in “need of assistance”.

Source: The Constitution of India

The Indian Constitution, having provided for a certain division of the

powers of taxation between the Union and states, also gives the states a share in

the resources available to the Centre as contained in Articles in part XII of the

Constitution. Any amendment to the List from which the Union and the states

54

derive their power of taxation is covered by the proviso to Article 368. This

requires ratification by the Legislatures of not less than one-half of the states. On

the other hand, if any of provisions of part XII are to be amended, this can be done

under Article 268(2) which requires the approval of only half of the members of

each house of Parliament. This means that the share of the Union resources that

the states are entitled to, can be altered by Parliament by its powers of amendment.

3.1.4 Mechanism of Transfers

Over the last six decades, an overarching institutional framework had

emerged to deal with Centre-state financial relations in India. The main pillars of

this frame work are:

(a) Finance Commission appointed periodically as per Article 280 of the

Constitution of India, intended to address the vertical imbalance in

financial resources between the centre and states and to address the

horizontal distribution of resources among the states.

(b) Planning Commission set up by a Resolution of the Government of India

dated 15th March 1950 to make an assessment of the material, capital and

human resources of the country, and to formulate a plan for effective and

balanced utilization of the country’s resources.

(c) National Development Council set up in August 1952 to strengthen and

mobilize the effort and resources of the nation in support of the Five year

plans.

The financial provisions of the Constitution are in accordance with what

experts would consider acceptable principles for a federal constitution and a

desirable attribute of inter-governmental tax power assignment (Bagchi, 2001).

However, it is the actual working of the scheme that has revealed deficiencies that

seriously detract from much of its supposed merits. Bagchi (2001) cites the under

utilization of Article 269 by the Union Government, the abridgement of the scope

of Article 275, and, consequently, the extensive use of Article 282 by the Union to

make extensive grants to the states as examples of the original constitutional

scheme being distorted in actual practice over the years.

55

It is the combination of all three agencies, namely, the Finance

Commission, Planning Commission and the various Ministries of Government of

India, that has taken, over several years, qualitatively significant and quantitatively

demanding decisions resulting in an increasing level of transfer of resources from

the Centre to states. Federal transfers to the states in India, are made in three

streams, as

(1) Devolution of states share in Central Taxes

(2) Grants from Central to the states (classified as statutory or non

statutory; and plan as well as non-plan) covering

(i) Non-Plan grants, comprising –

i. Statutory grants recommended by the Finance Commission to

cover gap in revenue;

ii. Assistance for relief measures after natural calamities

(ii) Non Statutory grants, comprising –

i. Plan grants-

(a) State plan schemes

(b) Central plan schemes

(c) Centrally sponsored schemes

(d) Special schemes for North Eastern council etc

(3) Loans from Centre

a. Plan loans

b. Non Plan loans including Ways and Means Advance

3.1.5 Distribution among the states

In the approach to horizontal devolution, each of the previous Finance

Commissions has come up with its own formula, with changes in criteria adopted

and with the assignment of weights to different criteria for determining the share

of individual states in the total share of Central resources. The choice of criteria

and the weights assigned by each Commission for the distribution of income tax

and union excise duties had regularly provoked not only reaction from the state

56

governments but also invoked critical comments from academics and public

finance experts. Table 3.1 and Table 3.2 capture the criteria and weights assigned

by various finance commissions for distributing income tax and union excise

duties respectively among states.

In so far as the allocations made by the Finance Commissions are

concerned, it has been claimed that these were made, often, on the considerations

of ensuring equity with pursuing redistributive principles. It does appear that the

transfer scheme, after taking into account pre-devolution and post-devolution

financial position of the states, has helped the relatively poorer states (Srinivasan,

2002). However, this approach has led to a criticism that the “gap filling

approach” of the successive Finance Commissions, had encouraged fiscal

imprudence of some of the states.

The relative importance to be attached to equity in distribution and

efficiency in utilization of resources in determining the respective shares of

various states in federal transfers has become a critical factor. Resolving the

tension between equity and efficiency remains a fundamental challenge in public

policy (Bagchi, 2001).

3.2 Approach of Finance Commissions

All the Finance Commissions have in their reports so far, initially set out

the general approach to the duty cast on them by the provisions of the Constitution

and the tasks mandated to them under their specific terms of reference. Most

Commissions had followed a broad and consistent frame work in whose context

their recommendations could be placed and their logic appreciated. The First

Finance Commission (I FC) felt that the transfer of resources from the Centre had

to be such that it could bear without undue strain, taking into account of its own

vital responsibilities. The persistence of this concern in the approach of all the

commissions can be seen from the fact that the Fifth Commission felt that “the

pre-emptive character of the financial needs of the Union constitutes a limiting

factor in formulating the scheme of transfers to states”. Similarly, the Eight

Commission stated that “the overriding consideration is the national interest taken

as a whole. Ultimately, the solutions we have chosen have been judged on this

touchstone”. The Tenth Commission also followed this approach when it stated

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that the problems facing the country could be ‘tackled only by taking a holistic

view of government finances and looking for an integrated solution’.

3.3 NORMS FOLLOWED BY FINANCE COMMISSIONS

3.3.1 First Finance Commission

The First Finance Commission (IFC) was not given any specific terms of

reference. Therefore, it had spelt out its own functions in terms of the provisions

of Article 280 of the Constitution. Being the first Commission, it reviewed the

history of the evolution of Centre-state relations leading to the relevant provisions

in the Constitution. The Commission stated that it had ‘no doubt about the

imperative need for a substantial augmentation of the revenues now available to

the states’. However, its report emphasized that ‘the prosperity of the states must

rest on the solid foundation of a reasonably strong and financially stable Centre’.

While states have large and expanding responsibilities for the welfare and

development of the people, the capacity of the Centre to make additional resources

available is conditioned both by the amount of revenue it can raise and by its own

essential needs, which are the needs of the country as a whole (I FC, Chapter I,

para 19).

The First Commission laid down two principles that had by and large,

been followed by succeeding Commissions that:

(1) at the time of distribution of revenues between the states, the

determination of grants-in-aid for them must be based on principles that

are uniformly applied to all states; and

(2) the scheme of distribution should attempt to lessen the inequalities

between the States.

3.3.2 Second Finance Commission

The Second Commission added an equally important third principle (3)

that it was necessary to maintain ‘a balance between devolution by transfer of

shares of taxes and devolution by fixed grant-in-aid’ (II FC, para-199). It

elaborated that ‘the gap between the ordinary revenue of a state and its normal

inescapable expenditure should, as far as possible, be met by sharing of taxes.

Grants-in-aid should be largely be a residuary type of assistance given in the form

58

of general and unconditional grants’ (II FC, Para 66). Such grants, it clarified,

could be given for broad purposes.

The Second Commission also set out another principle that the scheme of

devolution it recommended was ‘an integrated scheme’ and that any modification

of individual recommendations would ‘upset its balance’ (II FC, Para 199).

3.3.3 Third Finance Commission

The Third Commission (1961) took note of certain disturbing features that

arose in the management of the finances of the states, namely ‘an allergy (on the

part of the states) to tap resources in the rural sector’ and a ‘disinclination to make

up the lee-way’ in other sectors. According to the III FC, the states did not attach

‘importance to a proper and adequate control of expenditure in the matter of

services and supplies’. It could not evolve any scheme that would recognize the

effort made by the states in affecting economies in expenditure or in raising

resources; and was compelled ‘to cover the annual budgetary gaps of all the states’

including ‘mounting interest charges’ and condone even ‘a measure of

improvidence’. Another disturbing feature, as pointed out by III FC, was that ‘the

unsound financial policies of a state affected neighboring states as well’ (III FC,

paras 88, 90, 93). The Commission suggested a comprehensive examination ‘to

access the tax potential of each state’.

3.3.4 Fourth Finance Commission

The Fourth Commission observed that the Constitution did not make any

distinction between plan and non-plan expenditure, and that even capital

expenditure need not necessarily be outside the scope of the Finance Commission.

At the same time, it felt that there should be a division of responsibility between

the two Commissions - Finance and Planning; and, for this reason, ‘it would not

be appropriate for the Finance Commission to take upon itself the task of dealing

with the states’ new plan expenditure’ (IV FC, Para 16).

Like the previous Commission, the Fourth also took the view that a

Finance Commission could not ‘merely fill-up non-plan revenue deficits reported

by the states’ (IV FC, Para 17). It, therefore, did not take the budgetary deficits as

a criterion for distribution but reassessed the states’ estimates. It differed from the

view of the Third Commission that ‘the relative financial weaknesses of the states’

59

should be the criterion for determining the shares of states in the divisible pool. Its

approach was that the principles of tax sharing should be uniformly applied and if,

as a result, some states have larger deficits, these should be covered by explicit

grants under Article 275, rather than being disguised as shares of taxes. It

advocated ‘a trade-off between the sharing of taxes and grants such that the total

transfers were not affected’ (IV FC, Para 20).

3.3.5 Fifth Finance Commission

The Fifth Commission was of the view that in covering the revenue

deficits of states due regard should be given to financial prudence and the efforts

made by the states in raising resources. However, it could only ‘keep in view

broad considerations which can be applied to all the states’ as it is difficult for any

outside authority ‘to judge the propriety’ of the policies of the states in regard to

taxation, expenditure and investment within their own constitutional sphere (V

FC, Para 2.22). The Commission did try to asses the tax performance of state and

the quality of their expenditure. However, the problem it identified was that the

existing levels of taxations both at the Centre and the states were ‘not adequately

indicative of their potential resources’ and termed it as a real constraint on the

magnitude of transfers (V FC, Para 27).

3.3.6 Sixth Finance Commission

The Sixth Commission that came twenty-five years after the First, felt that

the provisions of the Constitution concerning Union-state financial relation had

been designed with great care and circumspection and ‘had demonstrated

remarkable resilience in coping satisfactorily with the new demands made on it

from time to time’. However, ‘the strains and stresses’ in the national economy as

also, perhaps, the spirit in which ‘the provisions of the constitution had sometimes

been worked, particularly by the Central Ministries, had given rise to some signs

of dissatisfaction’ (VI FC, II.2). It pointed out that there could be significant

improvement in the climate of Centre-State financial relations ‘if decisions that

affect the revenues of the states were taken after the widest possible measure of

consultations’ (VI FC, II.2.6).

60

Table 3.1 Criteria Adopted by Finance Commissions for Distribution of Income Tax (percentage)

Commission Population Contribution Per capita income Poverty ration

Infrastructure Index

Area Adjusted

Fiscal Discipline

Tax Effort Inverse Distance

First 80 20* - - - - - - -

Second 90 10* - - - - - - -

Third 80 20* - - - - - - -

Fourth 80 20* - - - - - - -

Fifth 90 10# - - - - - - -

Sixth 90 10# - - - - - - -

Seventh 90 10# - - - - - - -

Eighth 22.5 10# 22.5 45 - - - - -

Ninth (I) 22.5 10# 11.25 45 11.25 - - - -

(II) 22.5 10# 11.25 45 - 11.25** - - -

Tenth 20 - - 60 - 5+ 5 - 10

Eleventh 10 62.5 7.5 7.5 7.5 5

Twelfth 25 50 - 10 7.5 7.5 Thirteenth 25 47.5 10 17.5 * Collection # Assessment ** Index of Backwardness +Index of Infrastructure Note: Under Eighth and Ninth Commissions, the formula was used for *90 percent of income tax and 'total of Union excise duties'. Under the Tenth Commission, the same formula was used for both the taxes

(Source: Reports of various Finance Commissions as compiled by the Author)

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(Source: Reports of various Finance Commissions as compiled by the Author)

Table 3.2 Criteria for Distribution of Union Excise Duties

(percentage)

Commission Population Contribution Per capita income IATP Poverty ration

Revenue Equalization

Area Adjusted

Tax Effort Inverse Distance

First 100 - - - - - - - - Second 90 - - - - - - - -

Third Population major factor. Relative financial weakness of states, disparity in levels of development, population of SCs and STs, etc were also taken into account

Fourth 80 20* - - - - - - - Fifth 80 6.66# - 13.34** - - - - - Sixth 75 - - 25 - - - - - Seventh 25 - - - 25 25 25 - - Eighth 25 - - 25 50 - - - - Ninth (I) 25 - - 50 12.5 12.5 - - - (II) 25 12.5# - 33.5 12.5 - 16.5 for deficit states Tenth 20 5+ - 60 - - - 5 10 Eleventh Twelfth Thirteenth

*Relative economic backwardness ** To states whose per capita income is below the all-states average # Index of backwardness + Index of infrastructure

62

The VI Finance Commission also noted that with the advent of economic

planning the Planning Commission had acquired a voice ‘in the entire range of

developmental activities, cutting across the Constitutional delimitation of powers

between them under the Constitution’. The Commission’s scheme of devolution

was based on the view that the resources belonged to the entire nation and they

should be applied at points where they were most needed according to accepted

priorities. ‘While the emphasis is on social justice, there is no escape from a

realignment of the resources in favor of states, because services and programs

which are at the core of a more equitable social order come within the purview of

the states under the Constitution’ (VI FC, II.16).

The VI Finance Commission was also of the view that the question of

allocation of resources between the Centre and the states should not be viewed in

isolation from the allied issue of the relative share of each state in the pool of

national resources. Such imbalances existed not only among different states but

also between different areas within individual states themselves. As the people’s

needs could be effectively attended to only by agencies close to them and in the

functioning of which they are involved, it recommended that this idea could find

‘its full consummation only if the states also, in their turn, realize the imperative

need to transfer resources and powers to local bodies’ (VI FC, II.19).

3.3.7 Seventh Finance Commission

The Seventh Commission dealt with the issue that its terms of reference

were different from those of the previously applied to the determination of grants-

in-aid, were made applicable to the clause concerning the sharing of taxes also,

and certain states had questioned this limitation placed on it. However, the

Commission’s view was that the change in the terms of reference was, ‘a purely

formal one’. These ‘were not constraints on the Commission in any way (and) the

Commission’s freedom to take into account other factors is not inhibited’ (VII

FC, Para 4).

Like a few previous Commissions, the Seventh also considered that the

exclusion of plan expenditure, ‘in no way limited the freedom of a Finance

Commission’ and ‘whatever may have been the position in the past in the matter

of the size of discretionary Central transfers’, these did not affect the freedom or

discretion of a Finance Commission to do its duty under the Constitution. In

63

regard to the grants-in-aid, the Commission’s approach was based on three

principles namely to:

(1) fill fiscal gaps;

(2) narrow disparities in the availability of various administrative and social

services between the developed and less developed states; and

(3) take into account the special burdens cast on a state because of its

peculiar circumstances or matters of national concern.

VII FC also took the view that the grants-in-aid element in the transfers

should, as far as possible, be a residual item. The Commission noted that ‘the

general concern over the widening disparities in the levels of development among

the states is reflected in the criticism of the existing arrangements of the Centre-

state financial relations’. It, however, felt that this could not be blamed on the

Planning Commission or any particular arrangement. The transfers made by the

Finance and Planning Commissions had to be viewed together as part of an

overall process (VII FC, 9.17). Like the Sixth Commission, the Seventh also

expressed disappointment that there were no reviews or studies of the finances

and expenditures of local bodies and expressed the hope that the states would

‘pay increasing attention to the subject of local body finances’ (VII FC, 9.16).

3.3.8 Eighth Finance Commission

The approach of the Eighth Commission in the matter, such as the share

of taxes, grants-in-aid etc., was similar to that of the previous Commissions. One

issue that it considered was the states’ contention that for some commodities

produced by the central public sector, price increase were being effected instead

of increasing excise duties, which were divisible with the states. The

Commission’s view was that administered prices would be justified if the

increase was due to an increase in the cost of production, but if the intention was

to obtain revenue, then the appropriate course would be to increase excise duties.

3.3.9 Ninth Finance Commission

The Ninth Commission submitted two reports and stated in its second

report that the principles upon which financial transfers under the Constitution

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were affected ‘must be so as to ensure that the linking of revenue and expenditure

decision and fiscal responsibility are not unduly weakened’. It went full circle

back to the First Commission, stating that ‘the method of extending financial

assistance should be such as to avoid any suggestion that the Central Government

have taken upon themselves the responsibility for helping the States to balance

their budgets from year to year’ (IX FC, Para 2.11). The Commission had set out

three basic principles on which its approach was based.

(1) a fair apportionment of revenue resources between the Centre and the

states;

(2) preserving the fiscal autonomy of the states; and

(3) ensuring inter-state equity while not penalizing ‘fiscal prudence and the

effort and growth impulses’ (IX FC, 2.2)

IX FC observed that ‘the steadily deteriorating fiscal scenario in the

country was due to the slow rate of growth of revenue receipts in the case of both

the Centre and the states’ (IX FC, 2.3). This had resulted into ‘revenue deficits on

a large scale year after year (implying) an infraction of one of the fundamental

principles of sound public finance in any economy’ (IX FC, 2.4). As the public

debt and, as a result, the burden of interest payments was going up, the

Commission felt that its first task had to be ‘to restore balance in the budget by

phasing out the revenue deficits’ (IX FC, 2.6, 2.7).

The terms of references of the Ninth Commission had, for the first time

stated that it should adopt ‘a normative approach’. Many states protested against

this formulation since this could have led to the Commission dictating

expenditure norms, which were hitherto the prerogative of the state governments.

The Commission later, clarified that its methodology implied ‘no interference

with the right of the state government to raise resources and incur expenses at

such levels and in such a manner as desired by its people and its Legislature. The

norms are relevant only in arriving at the relative entitlement to Central transfers

and are so designed as to ensure inter-state enquiry in working out such

entitlement’ (IX FC, Para 2.17). It also cautioned that while the total transfers

from the Centre to the states ‘should not be less than what they are as a

percentage of estimated Central revenues, the fiscal situation at the Centre being

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what it is they cannot be substantially higher’ (IX FC, 2.26). This Commission

also took the plan expenditure of the states into account since its terms of

reference referred to ‘revenue expenditure’. It, therefore, took a total view of

transfers and grants-in-aid to the states, including assumed central assistance

under the Gadgil Formula. In the process, it sought to correct what it considered a

basic flaw in the existing system of federal fiscal transfers (IX FC, 7.9).

3.3.10 Tenth Finance Commission

The Tenth Finance Commission stated that its approach had been ‘guided

by the paramount need to restore fiscal equilibrium in the economy’ as the

economy had moved into ‘a state of continuous deficit on revenue account’. The

rate of growth of expenditure exceeding that of revenues had led to a build-up of

public debt and interest burden. It noted that ‘the structure of expenditure has

imparted downward rigidity and inflexibility to its level’ because of interest,

wages and salaries becoming major components (X FC, 2.9). Like other

Commissions it also confined its reassessment to the non-plan revenue account

because of ‘the practical difficulties of making acceptable projections of plan

outlay’ (X FC, Para 2.27), while asserting its constitutional competence to deal

with the entire revenue account. As almost all states have gone through

deterioration in the revenue account balance, it observed that “all the states have

had almost identical turning points seems to suggest that there are systemic

factors underlying the deterioration rather than state specific reasons.” (X FC,

P.5).

The Tenth Finance Commission’s basic approach was influenced by its

view that all Central taxes should be pooled, as had been suggested in its

alternative scheme of devolution; but its recommendations were based on the

existing provisions of the Constitution. As regards the horizontal distribution

among the states, its concern was to ‘blend equity with efficiency’ (X FC, 2.23).

Grants-in-aid recommended by the Commission under Article 275 were based not

only on the surplus or deficits at the end of the process of devolution but also

took into account the special problems of states. Although the Seventy-third and

Seventy-fourth amendments to the Constitution had not become operative

because the reports of State Finance Commissions were not available, the Tenth

Commission recommended grants for local bodies also, based on its own

assessment.

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3.3.11 Eleventh Finance Commission

The Eleventh Finance Commission suggested that the amount involved

by the way of tax devolution - plan and non-plan grants - should not exceed

37.5% of Gross Revenue receipts of the Centre. The Union Finance Minister

informed the Parliament in July 2000, that the Government of India has accepted

this ceiling on total revenue account transfers, with a rider that “the acceptance

does not imply the establishment of a principle of mandatory sharing of a fixed

percentage of Centre’s revenue, receipts with the states.” While the Tenth

Finance Commission recommended a minimum of 29% of tax receipts for

transfer to the states, the Eleventh Finance Commission approached the issue

from the other end suggesting a cap of 37.5% of gross revenue receipts on the

quantum of total transfer of resources, as a share of Centre’s revenue receipts.

The issue is still open, either in terms of prescribing the share of the states as the

floor or as a ceiling (Srinivasan, 2002).

3.3.12 Twelfth Finance Commission

The Twelfth Finance Commission suggested the measures on fiscal

consolidation by the Central and State governments. Following this

recommendation, the Government of India had set up a Debt Consolidation and

Relief Facility and enactment of Fiscal Responsibility and Budget Management

(FRBM) legislation. In so far environmental aspects were concerned, the state

governments inter alia pointed out before the Twelfth Finance Commission that

the maintenance of the forest area as per the working plans had become a

problem due to financial constraints. Many states pleaded for separate grants for

the maintenance of forests. The Finance Commission recognized the problem and

recommended a grant of Rupees 1000 crores spread over the award period 2005-

2010 for the maintenance and preservation of forests to be distributed among the

states according to their respective forest area. This initiative by XII FC could be

considered as the turning point in the Indian fiscal federalism for “recognizing

area based approach for management of natural resources”.

3.3.13 Thirteenth Finance Commission

The Thirteenth Finance Commission had been constituted as per TOR at

Box - 3.4 and had given their report to the Government of India. The Thirteenth

Finance Commission’s Terms of Reference provide for considerable continuity as

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well as some fresh ground to cover. For the first time in the history of Finance

Commissions, issues of environment, ecology and climate change etc had been

included as one of the terms of reference of this Commission.

Box 3. 4

TERMS OF REFERENCE OF THE THIRTEENTH FINANCE COMMISSION

The Commission shall make recommendations as to the following matters, namely:-

(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 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 state of the finances of the Union and the States, keeping in view, in particular, the operation of the States’ Debt Consolidation and Relief Facility 2005-2010 introduced by the Central Government on the basis of the recommendations of the Twelfth Finance Commission, and suggest measures for maintaining a stable and sustainable fiscal environment consistent with equitable growth.

3. 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 1st April 2010, on the basis of levels of taxation and non-tax revenues likely to be reached at the end of 2008-09;

(ii) the demands on the resources of the Central Government, in particular, on account of the projected Gross Budgetary Support to the Central and State Plan, expenditure on civil administration, defence, internal and border security, debt-servicing and other committed expenditure and liabilities;

(iii) the resources of the State Governments, for the five years commencing on 1st April 2010, on the basis of levels of taxation and non-tax revenues likely to be reached at the end of 2008-09;

(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;

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(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 impact of the proposed implementation of Goods and Services Tax with effect from 1st April, 2010, including its impact on the country’s foreign trade;

(vii) the need to improve the quality of public expenditure to obtain better outputs and outcomes;

(viii) the need to manage ecology, environment and climate change consistent with

sustainable development; (ix) 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 31st March, 2010 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;

(x) the need for ensuring the commercial viability of irrigation projects, power projects,

departmental undertakings and public sector enterprises through various means, including levy of user charges and adoption of measures to promote efficiency.

4. In making its recommendations on various matters, the Commission shall take the base of population figures as of 1971, in all such cases where population is a factor for determination of devolution of taxes and duties and grants-in-aid.

5. The Commission may review the present arrangements as regards financing of Disaster Management with reference to the National Calamity Contingency Fund and the Calamity Relief Fund and the funds envisaged in the Disaster Management Act, 2005(53 of 2005), and make appropriate recommendations thereon.

6. The Commission shall indicate the basis on which it has arrived at its findings and make available the estimates of receipts and expenditure of the Union and each of the States.

7. The Commission shall make its report available by the 31st day of October, 2009, covering the period of five years commencing on the 1st day of April, 2010.

Source: The Gazette of India: Extraordinary dated 13 November, 2007.

Ministry of Finance, Department of Economic Affairs:

XIII FC had recommended reduction in the number of Centrally

Sponsored Schemes (CSS) and to restore the predominance of formula based plan

transfers (Para 4.56 XIII FC). In so far fiscal consolidation is concerned, it hoped

that the revenue deficit of the Centre needs to be progressively reduced and

eliminated latest by 2014-15 (Paras 9.18 and 9.31 of XIII FC). While addressing

environmental concerns, XIII FC had proposed an amount of Rs. 5000 crores as

forest grant (Para 12.46), an incentive grant of Rs. 5000 crores for grid-connected

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renewable energy (Paras 12.52 and 12.53) and another Rs. 5000 crores as water

sector management grant subject to setting up of a Water Regulatory Authority

and achieving the normatively assessed state-specific recovery of water charges

(Para 12.58). In addition, another Rs. 6,721 crore state specific grants had been

made by the XIII FC for environmental purposes.

XIII FC had also come out with “a grand bargain between the Centre

and the states” to implement the Model Goods and Services Tax (GST). It had

recommended a 32 percent share to states in net proceeds of shareable central

taxes in each of the financial years covered under the recommendation of the

Commission (Paras 8.17 and 8.18).

3.4 FINANCE COMMISSIONS IN INDIA: A REVIEW

After more than six decades of functioning, Finance Commissions of the

past, have in their approach to transfer of Central resources to the states have

appraised the ‘quantitative’ and assessed the ‘qualitative’ aspects of public

expenditure. Salient principles enunciated by various Finance Commissions are

presented in Table 3.3. Having experienced thirteen Finance Commissions in

India, it could be concluded that the mechanisms envisaged in the Constitution

have proved adequate for dealing with the consequences of the asymmetry of

resources between the Centre and the states. The Commissions did not feel

constrained by the terms of reference given by the Centre, and derived authority

from the constitutional provisions to go beyond these terms whenever they felt

that an equal treatment between the Centre and the states required this. They

excluded the plan expenditure from their purview, not because they accepted this

as a constraint imposed by the Constitution or the terms of reference, but because

they recognized the complementary role of the Planning Commission in the plan

process (Srinivasan, 2002).

The broad approach of the Commissions has been to follow the principles

of justice in what is called the vertical division of resources between the Centre

and the states; while in the horizontal distribution of these resources among the

states equity has to be taken into consideration in view of the disparate levels of

development of different states. For this purpose, the two main instruments they

resorted were: (a) progressive formulae for the distribution of the divisible pool

and (b) grants-in-aid under Article 275. The Commissions and the states have

been in agreement that the more important instruments of transfer from the

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Centre to the states should be the devolution of taxes, with the grants-in-aid

playing a residuary role.

Table 3.4 presents total amount and relative share of various states as

allocated by VII to XIII Finance Commissions. An examination of the

recommendations of Finance Commissions over the period of time reveals that

the total transfers, as also the share of each state (Table 3.4), do not follow a

consistent pattern, owing to frequent change of criteria and weightage for inter-se

allocation among the states. It is further evident from the Table 3.4 that quantum

of total transfers to various states increased significantly during XI and XIII FCs.

It would also be proper to mention that each Commission left its own

stamp on its specific recommendations, based partly on the circumstances at that

time and partly on its own emphasis on priorities within their general approach.

Nevertheless, it could be observed that there were three consistent strands that run

through the recommendations of all the Commissions namely (1) satisfaction

with the provisions of the Constitution; (2) a desire to do justice to both the

Centre and the states; and (3) a concern to ensure equitable treatment among the

states taking into account the special circumstances of each state (Srinivasan,

2002).

An objective analysis also leaves one with the uncomfortable thought that

some of the previous Finance Commissions, in trying to transfer higher level of

resources to the states, to help them out of their financial distress, have

unwittingly or otherwise, led the Central Government to meet a relentless series

of revenue deficits and daunting gross fiscal deficits, from year to year. A study

of public expenditure management by state Governments, carried out by the

Indian Institute of Economics for the Planning Commission, concludes that “the

most important contribution to fiscal imbalances in the states have been on the

expenditure side”; it identifies other problem areas like the falling levels of

budgetary marksmanship, declining standards of public accountability, leakage

and wastage of funds in programme implementation, tardy devolution of funds to

local bodies and continuing intra-state disparities (Srinivasan , 2002).

Like other facets of Indian federalism, various aspects of the Indian

Constitution have been subjected to judicious scrutiny. However, there has not

been a systematic analysis of the issues involved in any other aspect of the

Constitution to the extent there has been on financial relation due to periodic

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constitution of Finance Commissions in India. In the next Sections, other

institutional mechanisms dealing with fiscal federalism in India are discussed.

3.5 PLANNING COMMISSION FUNDS

It is appropriate to mention that in addition to the Finance Commission,

the Planning Commission is also a major dispenser of funds in India. Planning

Commission funds are distributed according to the formula (Gadgil Formula from

the IV Five Year Plan of 1969-74) further evolved and modified by the National

Development Council (NDC) from time to time. The states are entitled to get the

following types of Central Assistance for their Plans as mentioned subsequently:

Table 3.3 Key Principles Enunciated by the various Finance Commissions Finance Commission Key Principle(s) First (i) The determination of grants in aid to states must be based on

principles that are uniformly applied to all states. (ii) The scheme of distribution should attempt to lessen the

inequalities between the states. Second (iii) It is necessary to maintain the balance between devolution

by transfer of share of taxes and devolution by fixed grant in aid.

(iv) The scheme of devolution is an integrated scheme and any modification of individual recommendations would upset the balance.

Third (v) The unsound financial policies of a state also affect neighboring state.

Fifth (vi) In the distribution of resources among the states, there is a need for equalization and large disparities have to be avoided.

Sixth (vii) The people’s need could be effectively attended to by the agencies close to them. To achieve this, states should transfer resources and powers to local bodies.

Seventh (vii) The transfers made by the Finance Commission and Planning Commission had to be viewed together as part of an overall process.

Ninth (viii) Mandated to follow ‘the normative approach’, clarified that there will be no interference with the right of the State Government to raise resources and incur expenses at such levels and in such a manner as desired by its people and its Legislature.

Twelfth (ix) Recognition of area based approach for management of natural resources

Thirteenth (x) The Grand Bargain Source: Author based on the reports of various Finance Commissions

(a) Normal Central Assistance, which is governed by the modified Gadgil

Formula;

(b) Additional Central Assistance, which is received for the implementation

of externally assisted projects;

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(c) Other Assistance for schemes through various Ministries like the

Jawaharlal Nehru National Urban Renewal Mission (JNNURM),

Accelerated Irrigation Benefit Program (AIBP), National Rural

Employment Guarantee Assistance (NREGA) and Accelerated Power

Development and Reform Programme (APDRP) etc.

The details of allocation of Central Plan Assistance to states based on the

yardsticks of population, tax efforts (performance), per capita income, ongoing

irrigation and power projects, special problems and fiscal management are as

given in Annexure 3.1. Besides the Finance Commission and Planning

Commission, various Central Ministries also make transfers to the states and,

often, to local bodies directly, for specific purposes, under various Central

Sponsored Schemes. Some of the specific-purpose transfer schemes are entirely

funded by the Center and other are shared cost programs.

In addition to these explicit transfers, there are implicit transfers as well.

The important sources of implicit transfers are subsidized loans to the state

governments by the Central government. Moreover, resource transfers (not

necessarily through governments) occur also due to subsidized lending to priority

sector by the financial and banking system and, more importantly, inter-state tax

exportation. Also, state governments and local bodies depend upon loans from

Central Government and other Public Financial Institutions. Depending on socio-

economic development and robustness of their policies and institutions, debt

raising capacity widely varies from state to state. Barring a few well performing

states and large local bodies, most of them find it difficult to raise resources from

financial institutions. Subsidies provided and levies charged by Central

government also indirectly affect the state governments.

3.6 THE QUANTUM OF FISCAL TRANSFERS

The Fiscal Transfers of Federal System, as they now stand to cover (a)

State share of Central Taxes and duties (b) Non Plan grants and loans (c) Central

assistance for State plans (d) Assistance for Central sector and Centrally

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Sponsored Schemes. The sum of the above transfers makes up to Gross Transfers.

The Central Government recovers its loans and advances including interest, due

from the states, which gives rise to Net Transfers. The details of the total transfer

of financial resources from centre to states as percent of gross revenue receipts of

the Centre in recent years are shown in the Table 3.5. It shows average transfers

from Centre to states as percentage of gross revenue receipts of the Centre

coinciding with various Finance Commissions. Total transfers through Finance

Commission varies from 22.77 (VIII FC) to 26.20 percent (XII FC), while total

transfers after taking into consideration other transfers varies from 35.27 (XI FC)

to 40.33 percent (IX FC). Finance Commission transfers include share in Central

Taxes as well as grants. Similarly, other transfers consist of grants through

Planning Commission and non-plan grants (Non-statutory). Planning

Commission grants vary from 10.57 (X FC) to 14.49 percent (IX FC). As can be

seen from Table 3.6, the transfers recommended by successive FCs have

increased enormously.

The level of transfers, whether viewed in gross or net terms show that

over the decades the transfers, from Central to the states have been increasing in

absolute terms, but the states have a different perception on this as they feel that it

is not only the sums in all but also the manner of transfer, whether statutory or

discretionary, and whether as a share of central revenues or of state expenditure.

One major area of criticism of fiscal federalism in India is the downfall in the

relative share of resources to states. Under the Eleventh Plan, a further reduction

in the share of resources to states has been envisaged, with the central assistance

coming down from 26 percent to 23 percent. With the untied funds being

constantly reduced, the dependence of states on the Centre has been increasing.

The increasing size of Centrally Sponsored Schemes amounts to almost

completely taking away the flexibility of the state governments (Address of Chief

Minister, Rajasthan in the 54th Meeting of National Development Council).

Growing disparities in fiscal capacities and levels of services among states upset

this stability as widening disparities require larger and more progressive transfers. 3.7 THE CRITERIA FOR DEVOLUTION OF TAXES AND GRANTS

As regards the determination of the inter se shares of the states, the basic

aim of the finance commission transfers in the past has been to (i) correct the

differentials in revenue capacity and cost disability factors inherent in the

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economies of states and (ii) foster fiscal efficiency among the states. The criteria

used in the past for these purposes can be grouped under:

(a) factors reflecting the needs, such as population and income, measured

either as distance from the highest income or as inverse;

(b) cost disability indicators such as area and infrastructure distance; and

(c) fiscal efficiency indicators such as tax effort and fiscal discipline.

In so far as devolution of central taxes and grants are concerned,

population is the basic indicator of need for public goods and services and it

ensures equal per capita transfers across states. However, the overall population

criterion does not take into consideration effective family welfare measures

adopted by various states. The result being the states those are tardy in controlling

their population gets unduly rewarded. Among the criteria used for correcting

differential fiscal capabilities for enabling poorer states to meet better the needs

for public goods services, per capita income distance is the preferred indicator.

The use of ‘geographical area’ of a state as a criterion for determining its

share emanates from the additional administrative and other costs that a state with

a larger area has to incur in order to deliver a comparable standard of service to

its citizens. Cost disabilities are defined as the circumstances, like excess /

deficient rainfall, hilly terrain, and large and remote areas with low density of

population, that lead to higher than average per capita costs for delivering the

same level of services at an average level of efficiency. The use of ‘area’ of a

state as a criterion for determining its share emanates from the additional

administrative and other costs that a state with a larger area has to incur in order

to deliver a comparable standard of service to its citizens. The Finance

Commissions recognize that the costs of providing services increase with the size

of a state, but only at a decreasing rate. Similarly, the State Finance Commissions

use ‘area’ and ‘remoteness’ as criteria for financial devolution from the state

governments to rural and urban local bodies.

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Table 3.4: Total Transfer of Resources to States by Finance Commissions' Recommendations (Rs. in Crores) States/Territories VII FC VIII FC IX FC X FC XI FC XII FC XIII FC 1 Andhra Pradesh 1522.5 7.31 2897 7.34 7239 6.8 18081 7.98 31011 7.13 50353.26 6.66 114148.3 6.69 2 Arunachal Pradesh 835 0.8 1768 0.78 2315 0.53 3525.56 0.47 9103.8 0.53 3 Assam SC 518.65 2.49 1607 4.07 3956 3.7 8328 3.67 13281 3.05 24329.4 3.22 57832.7 3.39 4 Bihar 2212.9 10.62 4220 10.7 11176 10.5 24655 10.88 56728 13.04 75646.83 10.01 172944.1 10.13 5 Chattisgarh 18273.7 2.42 42000.7 2.46 6 Goa SC 509 0.5 622 0.27 821 0.1 1724.53 0.23 4374.0 0.26 7 Gujarat 963.87 4.63 1489 3.77 3713 3.5 8876 3.92 12000 2.76 25608.75 3.39 53789.9 3.15 8 Haryana 308.57 1.48 439.2 1.11 1195 1.1 2793 1.23 4206 0.97 8042.44 1.06 19470.3 1.14 9 Himachal SC 325.07 1.56 774.4 1.96 1860 1.8 4762 2.1 4760 1.72 14450.36 1.91 21691.6 1.27

10 Jammu & Kashmir 376.89 1.81 1120 2.84 3359 3.2 7322 3.23 16428 3.78 20880.28 2.76 40438.7 2.37 11 Jharkhand 23656.84 3.13 47878.6 2.81 12 Karnataka 1005 4.82 1728 4.38 4063 3.8 10521 4.64 19692 4.53 31416.28 4.16 74376.3 4.36 13 Kerala 770.34 3.7 1288 3.27 3448 3.3 7722 3.41 12317 2.83 19607.72 2.59 40325.8 2.36 14 Madhya Pradesh 1597.5 7.67 2958 7.5 7843 7.4 16094 7.1 34998 8.05 46321.96 6.13 116593.4 6.83 15 Maharashtra 1714.1 8.22 2635 6.68 6201 5.8 13709 6.05 19387 4.46 36194.25 4.79 91709.8 5.37 16 Manipur SC 194.03 0.93 469.1 1.19 1085 1 2137 0.94 3216 0.74 6870.2 0.91 13567.5 0.79 17 Meghalaya SC 134.15 0.64 581.9 0.97 822 0.8 1889 0.83 2961 0.68 4367.77 0.58 9842.4 0.58 18 Mizoram SC 1021 1 1802 0.08 2535 0.58 4660.91 0.62 8805.3 0.52 19 Nagaland SC 240.59 1.15 527.4 1.34 1244 1.2 2793 1.23 4450 1.02 7453.41 0.99 13744.2 0.81 20 Orissa 984.45 4.72 1910 4.84 5223 5.2 9706 4.28 20754 4.77 36942.77 4.89 78974.9 4.63 21 Punjab 419.53 2.01 646.2 1.64 1674 1.6 3589 1.58 5429 1.25 12884.59 1.7 25686.6 1.51 22 Rajasthan 902.81 4.33 1676 4.25 6526 6.2 11401 5.03 23589 5.42 39062.47 5.17 97842.0 5.73 23 Sikkim SC 36.85 0.18 104.5 0.27 252 0.2 699 0.31 1634 0.38 1829.14 0.24 4525.7 0.27 24 Tamilnadu 1503.6 7.21 2465 6.25 6198 5.8 13361 5.89 21601 4.97 36688.13 4.85 83437.3 4.89 25 Tripura 199.84 0.96 561.2 1.42 1434 1.4 2873 1.27 4361 1 8417 1.11 13127.6 0.77 26 Uttar Pradesh 3314.7 15.9 6105 15.47 17449 16.5 36159 15.95 78509 18.05 133471.5 17.66 312140.0 18.29 27 Uttaranchal 12194.34 1.61 20308.1 1.19 28 West Bengal 1597.1 7.66 3450 8.74 7409 7 14980 6.61 35220 8.1 50877.28 6.73 117997.2 6.91 Delhi (NCT) 0.00 Total: All States 20843 100 39452 100 1060036 100 434905 100 434905 100 755751.6 100 1706676.8 100.00

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In the past (up to Eleventh Finance Commission) ‘index of infrastructure’

was used as a cost disability criterion as an indicator of the relative availability of

economic and social infrastructure in a state. This index was inversely related to the

share. The Twelfth Finance Commission was of the view that the infrastructure index

distance criterion is correlated with the income distance criterion and the fact that this

index is better used in an ordinal way. For these reasons, Twelfth FC had dropped the

index of infrastructure as a criterion.

In so far as tax effort is concerned, measurement of tax effort on a

comparable basis among the states is not a straightforward exercise, because tax

effort must be related to some notion of tax potential and the composition of tax base

among the states. Given the data constraints, the Tenth FC used per capita GSDP as a

proxy for the aggregate tax base. Tax effort was measured by the ratio of per capita

own tax revenue of a state to its per capita income. In order to provide for an

adjustment for states with poorer tax bases, tax effort ratio as defined above was

weighted by the inverse of per capita income – implying that if a poorer state exploits

its tax-base as much as a richer state, its gets an additional positive consideration in

the formula.

The index of fiscal discipline was proposed by the Eleventh FC with a view

to providing an incentive for better fiscal management and was defined as

improvement in the ratio of own revenue receipts of a state to its total revenue

expenditure in a reference period in comparison to a base period. This index had also

been accepted and followed by the subsequent Finance Commissions.

3.8 TRANSFER OF RESOURCES TO LOCAL BODIES

As per the constitutional scheme of things, local bodies constitute the third

administrative and political structure of the Indian federation. In so far fiscal transfer

of resources from state to local bodies is concerned, the State Finance Commissions

(SFCs) play an important role. Article 243 I of the Indian Constitution prescribes that

the Governor of a State shall, as soon as may be within one year from the

commencement of the Constitution (Seventy-third Amendment) Act, 1992, and

thereafter at the expiration of every fifth year, constitute a Finance Commission to

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review the financial position of the Panchayats and to make recommendations to the

Governor as to:

A. The principles which should govern

1. The distribution between the State and the Panchayats of the net

proceeds of the taxes, duties, tolls and fees leviable by the state,

which may be divided between them under this Part and the

allocation between the Panchayats at all levels of their respective

shares of such proceeds;

2. The determination of the taxes, duties, tolls and fees which may be

assigned as, or appropriated by, the Panchayats;

3. The grants-in-aid to the Panchayats from the Consolidated Fund of

the state;

B. The measures needed to improve the financial position of the Panchayats;

C. Any other matter referred to the Finance Commission by the Governor in the

interests of sound finance of the Panchayats.

Article 243 Y of the Constitution further provides that the Finance

Commission constituted under Article 243 I shall make similar recommendation vis-

à-vis municipalities. The Governor is required to cause every recommendation made

by the State Finance Commission together with an explanatory memorandum as to

the action taken thereon to be laid before the Legislature of the state.

When it comes to devolution of resources, Indian fiscal federalism has very

interesting insights to offer. While the states clamor for greater financial devolution

from centre, but when it comes to them in turn to devolve authority and resources to

local bodies, most of them develop cold feet. States have often been not prompt

enough to constitute the state finance commissions with the required regularity.

In so far as transfers from centre to local bodies are concerned, XII FC had

provided a total grant of Rs 20,000 crore to panchayats and Rs. 5,000 crore to

municipalities in its report. Index of decentralization, revenue effort and index of

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deprivation are other important considerations in addition to population, geographical

area and distance from highest per capita income for allocation of grants by the FC to

local bodies. Table 3.7 provides shares of states for panchayats and municipalities for

2005-10 by the XII FC.

XIII FC in its report had exclusively dealt with the issue of strengthening

local bodies (both urban and rural) and had proposed a grant of Rs. 87,519 crore to

urban and rural local bodies as per criterion given in Table 3.8 including general and

specific areas - basic and performance grants covering the award period 2010-2015.

3.9 EFFICIENCY VERSUS ECONOMY DEBATE

It is not that the working of fiscal federalism in India had not attracted

negative comments. There is criticism as well about the working of fiscal federalism

in the country as at the core is the rob-Peter-to-pay-Paul approach that punishes

productivity, diligence and thrift (Ramachandran, 2005). According to

Ramachandran, India have too few Peter states that are wealthy enough to be robbed.

The remaining states that are a little productive will choose to become poor instead of

being robbed. It is only when inter-state and intra-state disparities are reduced, that

the federal system would become stable. The question, therefore, is a tightrope

walking between equity versus efficiency concerns while providing economic, social

and ecological services.

While some amount of equity needs to be introduced into the process of

distributing the devolved taxes among states, efficiency had also to be given due

consideration in this process. The main instrument to help the poorer and the less

developed states could be grants-in-aid under Article 275. The Tenth Finance

Commission argued that equity and efficiency are not mutually exclusive and that is

had given weight in its Report to efficiency on the revenue side, by recognizing tax

effort. The Eleventh Finance Commission, considered both tax effort and fiscal

discipline as criteria for determining the share in devolution.

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Table 3.5: Transfers from Centre to states as Percentage of Gross Revenue Receipts of the Centre (Finance Commission Period Averages)

Finance Commission

Finance Commission Transfers Other Transfers

Total Transfers

Share in Central taxes

Grants

Total Transfers through Finance Commission

Grants through Planning Commission

Non-Plan Grants (Non-statutory)

Total Transfers

1 2 3 4 5 6 7 8 VII FC 22.39 1.96 24.35 12.11 1.66 13.77 38.12 VIII FC (1984-89) 20.25 2.52 22.77 13.56 1.54 15.10 37.86 IX FC (1989-95) 21.37 3.42 24.79 14.49 1.06 15.55 40.33 X FC (1995-2000) 22.22 2.34 23.56 10.57 0.67 11.24 35.79 XI FC(2000-2005) 20.59 3.88 24.47 10.10 0.70 10.80 35.27 XII FC (2005-10) 21.75 4.45 26.20 10.99 1.32 12.31 38.51

Source: Union Government Finance Accounts and Revenue Receipts are from Central Government Receipts Budget (Various issues)

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Table 3.6: Finance Commission Transfers (Rs. Crore)

Devolution Grants Total Increase over PFC

%

% of Total Transfer

Devolution Grant I FC (52-57) 362 50 412 - 88 12 II FC (57-62) 852 197 1049 120 81 19 III FC (62-66) 1068 244 1312 25 81 19 IV FC (66-69) 1323 422 1745 33 76 24 V FC (69-74) 4605 711 5316 205 87 13 VI FC (74-79) 7099 2510 9609 70 74 26 VII FC (79-84) 19233 1610 20843 117 92 8 VIII FC(84-89) 35683 3769 39452 89 90 10 IX FC (89-90) 11785 1877 13662 303 83 17 1990-95 87882 18154 106036 - - - X FC (95-00) 206343 20300 226643 89 91 9 XI FC (00-05) 376318 58587 434905 92 87 13 XII FC (05-10) 613112 142639 755751 74 81 19 XIII FC (10-15) 1448096 258581 1706676 126 84 16 Grand Total 2813761 509651 3323411 - 84.67 15.33

Source: Reports of XIII Finance Commission At this stage it is appropriate to recognize significant conceptual differences

between ‘efficiency’ and ‘economy’ in practice though they are used synonymously.

Efficiency refers to the process of gaining more outputs for a given quantity of

inputs. Economy refers to using fewer inputs to gain a specified level of outputs. The

scope for achieving either is largely dependent on two factors (a) a consideration

given to these aspects in the initial design of a programme and (b) at a later stage the

economy derived and efficiency secured through the exploitation of competitive

pressures in the procurement of materials and equipment and in the utilization of

management techniques to reduce inventories, overlapping services and

administrative overheads.

It has also been realized that the pursuit of fiscal consolidation, mainly

through expenditure reduction, has its snares, since government expenditure on

consumption and investment constitute an important part of aggregate demand in the

economy with its impact on the economic growth prospects. Over a period of time,

there has been increasing emphasis on proper attention to the expenditure side of

fiscal restructuring in India through ‘programmes for structural adjustment and fiscal

stabilization’. Concomitant attention to expenditure reduction and to improvement in

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quality of public spending is thus crucial to ensure economic growth with equitable

distribution of benefits among various social classes and different regions of the

country.

Although references have been made in the Terms of References’ of various

Finance Commissions, none of those Commissions did set out any specific criteria

for assessing efficiency or make its observance a condition for release for Central

funds. At this stage, it would be suffice to say that the federal transfer system needs

to be retuned and the states made to assume greater responsibility for managing their

fiscal situation and for achieving budgetary balance.

The design of federal transfers should be so as to facilitate the processes of

economic growth and public financial management intertwined with social and

political objectives of governance. The economic growth rate has to be assessed

along with quality of expenditure and distributional equity. Reiterating this, in his

address to the nation on June 25th 2004, the Prime Minister Dr. Manmohan Singh

observed that “Equity and efficiency are complementary, not contradictory, and we

must move forward on both these. While some regions of the country seem to be on

an accelerating growth path, there is a concern that other regions are not only lacking

but are also falling behind” and that “as a nation we cannot accept such disparities “.

It would also be appropriate to mention that “stepping up the rate of growth

and improving its quality calls for incentives to the performers forging ahead and

intelligent guidance to those lagging behind” (Srinivasan, 2002). In the interest of

improved federal fiscal framework, and of ensuring equal availability of quality

public services in all states, it is imperative that an attempt is made to utilize the

federal transfers, as an instrument to prod the states into more efficient ways of

utilizing their own revenue as well as the resources transferred by the Centre by

careful planning and budgeting of expenditure and improved systems of monitoring. 3.10 MACRO POLITICAL ENVIRONMENT

The Constitution of India had ushered a Union of States, giving the nation a

Federal character even while several features appeared to be those of a unitary state.

The democratic framework sustained through regular elections to the Union

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Parliament and State Assemblies has brought India credit in the comity of nations,

but the history of Federal Republic that came into existence in 1950 has not been

without challenges. The spirit of federalism has however been kept alive, overcoming

stress and strain inevitable in a nation marked by economic, social, political and

cultural diversity.

It would be prudent to say that the fiscal federalism in India has withstood

many changes in the political environment. However, the political history of the past

sixty plus years in the country is testimony to the fact that multi party coalitions are

here to stay both at the centre and state levels. There are also increasing trends that

the same party or coalition may not rule at the centre and the state. The differences in

political ideologies, is expected to lead to hard time for fiscal federalism in the

country as charges of favoritism and neglect will be hurled frequently and with

greater intensity. It is also important to put environmental issues sufficiently along

with social and economic issues on the radar screen of political process in India. The

past experience of fiscal federalism brings testimony to the facts that ‘equity

considerations’ had often preceded over ‘efficiency considerations’ in resource

allocations over a period of time.

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Table 3.7 : Shares of States in Allocation (2005-10)

Sl.No State Panchayats Municipalities

Percent (Rs Crore) Percent (Rs Crore) 1 Andhra Pradesh 7.935 1587 7.480 374 2 Arunachal Pradesh 0.340 68 0.060 3 3 Assam SC 2.630 526 1.100 55 4 Bihar 8.120 1624 2.840 142 5 Chattisgarh 3.075 615 1.760 88 6 Goa 0.090 18 0.240 12 7 Gujarat 4.655 931 8.280 414 8 Haryana 1.940 388 1.820 91 9 Himachal Pradesh 0.735 147 0.160 8 10 Jammu and Kashmir 1.405 281 0.760 38 11 Jharkhand 2.410 482 1.960 98 12 Karnataka 4.440 888 6.460 323 13 Kerala 4.925 985 2.980 149 14 Madhya Pradesh 8.315 1663 7.220 361 15 Maharashtra 9.915 1983 15.820 791 16 Manipur 0.230 46 0.180 9 17 Meghalaya 0.250 50 0.160 8 18 Mizoram 0.100 20 0.200 10 19 Nagaland 0.200 40 0.120 6 20 Orissa 4.015 803 2.080 104 21 Punjab 1.620 324 3.420 171 22 Rajasthan 6.150 1230 4.400 220 23 Sikkim 0.065 13 0.020 1 24 Tamilnadu 4.350 870 11.440 572 25 Tripura 0.285 57 0.160 8 26 Uttar Pradesh 14.640 2928 10.340 517 27 Uttaranchal 0.810 162 0.680 34 28 West Bengal 6.355 1271 7.860 393 100.00 20000 100.00 5000

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Table 3.8: Weights Allotted to Criteria for Grants to Local Bodies by XIII Finance Commission (2010-15)

Criterion Weights Allotted (%)

PRIs ULBs Population 50 50 Area 10 10 Distance from highest per capita sectoral income 10 20 Index of devolution 15 15 SC/ST proportion in the population 10 0 FC local body grants utilization index 5 5 Total 100 100

Source: Report of the XIII Finance Commission

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ANNEXURE- 3.1

ALLOCATION OF CENTRAL PLAN ASSISTANCE

The states are entitled to get three types of ‘plan assistance’ from the Planning

Commission namely (a) Normal Central Assistance (NCA) which is governed by the

modified Gadgil Formula; (b) Additional Central Assistance (ACA) which is received

for implementation of externally assisted projects; and (c) Special Central Assistance

(SCA) for special schemes. The Normal Central assistance is given as per the Gadgil

formula being adopted from the fourth F.Y.P. (1969-74). This formula has been

revised from time to time as shown below:—

Criteria Year

1969 1980 1990 Dec. 1991

(1) Population 60% 60% 55% 60%

(2) Tax efforts (performance) 10% 10% …

7.5% (Tax efforts, management of economy, implementation of national priorities)

(3)Per capita Income 10% 20% 25%

25% (5% distance criteria 20% deviation criteria)

(4)On going irrigation / Power Projects.

10% … … …

(5)Special Problems* 10% 10% 15% 7.5%

(6)Fiscal Management … … 5% …

*Special problems includes, problems relating to metropolitan areas, floods, chronically drought affected areas and tribal areas.

In the NDC meeting held in January 1997 it was pointed out that the modified

Gadgil/Mukharjee formula revised in December 1991 does not take into account the

strain on the resources of a State where the extent of immigration is high. The Plan

Panel suggested that the population criterion, which has a weightage of 60% in the

modified Gadgil/Mukharjee formula, should be split into two elements - a weightage

of 5% is given to net immigration into a State and 55% to the population of the state

as per 1971 Census. 5% of the Central assistance should be distributed to the state

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having net immigration, in proportion to the net cumulative immigration since 1971,

including natural growth of immigration in the earlier decades.

Similarly, per capita income of some states is overstated to the extent because

the remittances to other states by labour coming into in search of better opportunities

which result in an outflow of funds from such states and correspondingly, the per

capita income of the recipient states is understated. Therefore, the gap between high

per capita income states and low per capita income states is also much wider than if

the flow of funds because of remittances were to be taken into account. It had been

argued that ‘allowance’ should therefore be made for these factors in determining

Central assistance.

ADDITIONAL CENTRAL ASSISTANCE FOR EXTERNALLY AIDED PROJECTS:

The state Governments receive external aid for projects in various sectors

from agencies such as the World Bank, USAID (United States Agency for

International Development), EEC (European Economic Community), and JBIC

(Japanese Bank for International Cooperation) etc. When the state proposes to pose a

project for external assistance, its primary responsibility is to make the provision of

adequate funds to cover the cost of the project and to have competent technical staff

for implementing the project. The assistance is either in the form of grant or loan, or

both, to cover the entire cost of the project or some percentage of project cost as per

the agreement. Unless adequate outlay is provided in the Annual Plan/Five Year Plan,

as per the year-wise schedule of requirement of funds, the projects are not accepted

for external aid. The required outlay is, therefore, provided in the Annual Plan and

additional central assistance (ACA) is claimed on the basis of the expenditure as per

the agreement. Hence ACA is estimated while working out the resources for the

Annual/F.Y.P. and treated as a part of resource of the annual plan size. The ACA is

not paid directly to the State Government but routed through the Government of India

that releases it to the concerned state on the basis of the expenditure incurred on the

externally aided projects (EAP). The state Government has to pay back (now largely

on back to back basis, with full exchange rate risk and repayment liability borne by

the states) this additionality received by way of loan from the foreign donors in

installments to the Government of India that in turn, pays back the loan with interest

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in foreign exchange to the donor. Many of the loans received from the foreign donors

are in the nature of soft loans where the pay-back period is 20 years.

ASSISTANCE FOR CENTRAL SCHEMES

Various Central Ministries implement a number of schemes. There are two

types of Centrally Sponsored Schemes for which Central Assistance is received. They

are –

(i) Central Sector Schemes, and (ii) Centrally Sponsored Schemes. CENTRAL SECTOR SCHEMES

These schemes because of their national importance are called Central Sector

Schemes. They are initiated, proposed and formulated by the Central Ministries

concerned, approved by the Planning Commission and financed largely by the Centre.

The schemes are implemented by the States because they are in the sector of States’

competency.

CENTRALLY SPONSORED SCHEMES

Up to the 4th Five Year Plan Central assistance to State for implementation

of plan programmes within the State’s jurisdiction was given in the form of scheme

wise allocation of funds. However, later the Government of India felt that the system

of scheme wise assistance should be discontinued as it had earlier resulted in an

inequitable distribution of central assistance. These schemes were then classified as

Centrally Sponsored Schemes. Besides 100% Central Sector Schemes, for the other

Centrally Sponsored Schemes the percentage of Central assistance is different for the

different schemes i.e. 25, 33, 50, 75 or 80 percent etc. and balance amount is required

to be spent by the State. For special category States, there share in Centrally

Sponsored Schemes is often different than that for normal category States. The

Central Assistance is received in the following manner:—

(i) By the concerned state Department from Ministries of Central Government. (ii) From Corporation (e.g. rural electrification corporation) or other agencies of Central Government. (iii) Directly received by institutes and Corporations etc., from Central Government.