FFC Implications for fiscal federalism in India

The Finance Commission is a Constitutional body formulated under Article 280 of the Indian Constitution. It is constituted every five years by the President of India to review the state of finances of the Union and the States and suggest measures for maintaining a stable and sustainable fiscal environment.

The Fourteenth Finance Commission(FFC) was appointed on 2ndJanuary, 2013under the chairmanship of Dr. Y. V. Reddy. In addition to the primary objectives mentioned above, the terms of reference for the commission sought suggestionsregarding the principles which would govern the quantum and distribution of grants-in-aid (no plan grants to states), the measures, if needed, to augment State government finances to supplement the resources of local government and to review the state of the finances, deficit and debt conditions at different levels of government.

The FFC has submitted its recommendations for the period 2015-16 to 2020-21. They are likely to have major implications for centre-state relations, for budgeting by, and the fiscal situation of, the centre and the states.

The FFC has radically enhanced the share of the states in the central divisible pool from the current 32 percent to 42 per cent which is the biggest ever increase in vertical tax devolution.

The last two Finance Commissions viz. Twelfth (period 2005-10) and Thirteenth (period 2010-15) had recommended a state share of 30.5 percent (increase of 1 percent) and 32 per cent (increase of 1.5 percent), respectively in the central divisible pool.

The FFC has also proposed a new horizontal formula for the distribution of the states’ share in divisible pool among the states. There are changes both in the variables included/excluded as well as the weights assigned to them. Relative to the Thirteenth Finance Commission, the FFC has incorporated two new variables: 2011 population and forest cover; and excluded the fiscal discipline variable.

Finance Commission - Concepts and definitions

Tax devolution
One of the core tasks of a Finance Commission as stipulated in Article 280 (3) (a) of the Constitution is to make recommendations regarding the distribution between the Union and the states of the net proceeds of taxes.

This is the most important task of any Finance Commission, as the share of states in the net proceeds of Union taxes is the predominant channel of resource transfer from the Centre to states.

Divisible Pool The divisible pool is that portion of gross tax revenue which is distributed between the Centre and the States.

Divisible pool
The divisible pool is that portion of gross tax revenue which is distributed between the Centre and the States. The divisible pool consists of all taxes, except surcharges and cess levied for specific purpose, net of collection charges.

Prior to the enactment of the Constitution (Eightieth Amendment) Act, 2000, the sharing of the Union tax revenues with the states was in accordance with the provisions of articles 270 and 272, as they stood then.

The eightieth amendment of the Constitution altered the pattern of sharing of Union taxes in a fundamental way. Under thisamendment, article 272 was dropped and article 270 was substantially changed.

The new article 270 provides for sharing of all the taxes and duties referred to in the Union list, except the taxes and duties referred to in articles 268 and 269, respectively, and surcharges on taxes and duties referred to in article 271 and any cess levied for specific purposes.

Grants-in-aid
Horizontal imbalances are addressed by the Finance Commission through the system of tax devolution and grantsin- aid, the former instrument used more predominantly.

Under Article 275 of the Constitution, Finance Commissions are mandated to recommend the principles as well as the quantum of grants to those States which are in need of assistance and that different sums may be fixed for different States. Thus one of the pre-requisites for grants is the assessment of the needs of the States.

The First Commission had laid down five broad principles for determining the eligibility of a State for grants. The first was that the Budget of a State was the starting point for examination of a need. The second was the efforts made by States to realize the potential and the third was that the grants should help in equalizing the standards of basic services across States.

Fourthly, any special burden or obligations of national concern, though within the State's sphere, should also be taken into account. Fifthly, grants might be given to further any beneficent service of national interest to less advanced States.

Grants recommended by the Finance Commissions are predominantly in the nature of general purpose grants meeting the difference between the assessed expenditure on the non-plan revenue account of each State and the projected revenue including the share of a State in Central taxes. These are often referred to as 'gap filling grants'.

Over the years, the scope of grants to States was extended further to cover special problems. Following the seventy-third and seventy-fourth amendments to the Constitution, Finance Commissions were charged with the additional responsibility of recommending measures to augment the Consolidated Fund of a State to supplementthe resources of local bodies.

This has resulted in further expansion in the scope of Finance Commission grants. The Tenth Commission was the first Commission to have recommended grants for rural and urban local bodies. Thus, over the years, there has been considerable extension in the scope of grants-in-aid.

Fiscal capacity/Income distance
The income distance criterion was first used by Twelfth FC, measured by per capita GSDP as a proxy for the distance between states in tax capacity.

When so proxied, the procedure implicitly applies a single average tax-to- GSDP ratio to determine fiscal capacity distance between states. The Thirteenth FC changed the formula slightly and recommended the use of separate averages for measuring tax capacity, one for general category states (GCS) and another for special category states (SCS).

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Horizontal Devolution Formula in the 13th and 14th Finance Commissions

Variable		Weights accorded
	13th FC	14th FC
Population (1971)	25	17.5
Population (2011)	0	10
Fiscal capacity/Income distance	47.5	50
Area	10	15
Forest Cover	0	7.5
Fiscal discipline	17.5	0
Total	100	100

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Fiscal discipline
Fiscal discipline as a criterion for tax devolution was used by Eleventh and Twelfth FC to provide an incentive to states managing their finances prudently. The criterion was continued in the Thirteenth FC as well without any change. The index of fiscal discipline is arrived at by comparing improvements in the ratio of own revenue receipts of a state to its total revenue expenditure relative to the corresponding average across all states.

Special Category States (SCS) and General Category States (GCS)
The concept of a special category state was first introduced in 1969 when the Fifth Finance Commission sought to provide certain disadvantaged states with preferential treatment in the form of central assistance and tax breaks.

Initially three states Assam, Nagaland and Jammu & Kashmir were granted special status but since then eight more have been included (Arunachal Pradesh, Himachal Pradesh, Manipur, Meghalaya, Mizoram, Sikkim, Tripura and Uttarakhand).

All other states barring these are treated as General Category States.The rationale for special status is that these states, because of inherent features, have a low resource base and cannot mobilize resourcesfor development.

Some of the features required for special status are:
(i) hilly and difficult terrain;
(ii) low population density or sizeable share of tribal population;
(iii) strategic location along borders with neighbouring countries;
(iv) economic and infrastructural backwardness; and
(v) non-viable nature of state finances

The FFC recommendations are expected to add substantial spending capacity to states’ budgets.