The 15th Finance Commission Report

Context: The government will appoint a Finance Commission in the next few months to determine how much of the Centre’s tax revenue should be given away to States (the vertical share) and how to distribute that among States (the horizontal sharing formula).

In the pre-reform period, the Finance Commission recommendations were not that critical because the Centre had other ways to compensate States, or indeed to play favourites, through plan financing and public sector undertaking (PSU) investments. Post-reforms, fresh PSU investments have thinned out and the Planning Commission was abolished in 2014 with the result that the Finance Commission remains virtually the sole architect of India’s fiscal federalism. Its responsibility and influence are, therefore, much larger.

Before going into details of the report which shall be extremely important from the perspective of Mains examination, Let us first understand the need for any such body at the first place? Specially given that states and centre both have been enabled to levy and collect taxes in their domains. 

Now finance commission is body to facilitate fiscal balance in the Indian federal structure and hence enabling Fiscal federalism. 

What is a Fiscal imbalance?

• Fiscal imbalance occurs when the revenues of a unit are not appropriate to carry out the responsibilities allocated to it. 

Now there are two kinds of imbalances that can occur in Indian Federalism: 

• vertical imbalance (between state and centre)
• horizontal imbalance (among the states)

FINANCE COMMISSIONS – A HISTORICAL PERSPECTIVE

Vertical and horizontal imbalances are common features of most federations and India is no exception to this.

So why does vertical imbalance (between state and centre) occur? 

• Because there is a mismatch of responsibilities and revenue sources between the Union and the States? 
• Now why is that?: mainly because of two reasons 
  1. Constitution assigned taxes with a nation-wide base to the Union (which earn higher revenues)
     • Why was this done? 
       • This was done to make the country one common economic space unhindered by internal barriers to the extent possible. 
  2. Constitution assigned functional responsibilities involving high expenditure disproportionate to their assigned sources of revenue 
     • Since the expenditures are incurred mainly in the executive branch, let us see the constitutional scheme for the same: 

	Legislative responsibility	Executive responsibility
LIST I	Union	Union
LIST II	State	State
LIST III	Both	State

• So you can see that states take care of both List 1 and List II
• Why was this done? 
  • States being closer to people and more sensitive to the local needs have been assigned 
• These two factors have resulted in vertical imbalances.

So why does horizontal imbalance (among the states) occur? 

• Unlike in most other federations, differences in the developmental levels in Indian States are very sharp. 
• Horizontal imbalances across States are on account of factors, which include historical backgrounds, differential endowment of resources, and capacity to raise resources. 

So you can say that the creation of Finance commission is the recognition of the imbalance which exists in the federalism and hence mechanisms under article 280 and 281 have been created to ensure that these imbalances are minimized. 

Hence let us have a look at the constitutional provisions related to the finance commission as far as constitution of India is concerned:

So as you read in article 280, the report of the Finance Commission has to be submitted for every five years and you also know that the report of the last FC (14th) was applicable for 2015-2020 period, then why did FC 15 not submit the final report for the period 2020-2025? 

• At the formation of the 15^th FC, It was required to submit the report by October 30, 2019 for five years for the period 2020-21 to 2024-25. 
• However, due to various political and fiscal developments, its term was extended. 

So what are the reasons behind the extensions? 

• Speak: the basic reason is that the reports of the FC are based on the projections of various parameters related to taxation, GDP and deficits. the current state of Indian economy makes it difficult for any panel to successfully do a projection. 

So why making medium-term projections in the current scenario would mean serious risks? 

• Changes in the federal units 
  • the abolition of Statehood to Jammu and Kashmir required the Commission to make an estimation excluding the Union Territory. 
• Historically low Nominal growth rate 
  • the deceleration in growth and low inflation has substantially slowed down the nominal GDP growth which is the main tax base proxy; making projections of tax revenues and expenditures based on this for the medium term could have posed serious risks. 
• Issues related to Tax revenues 
  • Poor revenue performance of tax collection more particularly Goods and Services Tax 
  • Also the compensation agreement to the loss of revenue to the States is applicable only till 2022(which means  it will cover only two years of the period covered by the Commission’s recommendations hence posing uncertainties)

So these are the factors which have compelled the extension of the term of 15^th FC as well as its submission of interim report. 

Let us now discuss the highlighting features of the report: 

	14th FC	15 FC	Remarks
Vertical distribution	42	41	the Fifteenth Finance Commission continued with the recommendation of the previous Commission relating to vertical division of taxes, and adjusted the States’ share to 41% to exclude the share of Jammu and Kashmir.
Horizontal Distribution
Population	1971 (17.5%) 2011(10.0%)	2011(15.0%)
Income Distance	50.0%	45.0%
Area	15.0%	15.0%
Forest cover	7.50%	10.0%
			it has used two additional factors — demographic performance and tax effort.
Demographic Performance	NA	12.5%	the inverse of fertility rate hence showing sensitivity to the concerns of these States.
Tax Efforts	NA	2.5%

So how have states fared after overall devolution? 

• Major observations 
  • In terms of relative shares in tax devolution, among the major States the biggest loser is Karnataka followed by Uttar Pradesh, Kerala, Telangana and Andhra Pradesh. 
• Kerala and Andhra Pradesh have post-devolution gaps and hence qualify for revenue gap grants. 
• Karnataka and Kerala have net loss after devolution. Why? 
  • The major reason for Karnataka and Kerala losing on devolution is that their per capita income growth has been faster than most other States. 
  • The difference from the highest per capita income in both Karnataka and Kerala is just about 10% now as compared to 34% and 23%, respectively, for the two States when the Fourteenth Finance Commission made the recommendation. 

What are recommendations of the 15^th FC regarding Local body grants

	Panchayats	Municipalities
Grants	₹60,750 crore	₹29,250 crore₹9,229 – million plus cities ₹20,021 – rest of the cities
Conditions	50% of the grant is tied to improving sanitation and supply of drinking water	50% of the grant is tied to improving sanitation and supply of drinking water

Did 15^th FC make any recommendations regarding Disaster management? 

• For disaster management, a total of ₹28,183 crore has been determined of which the Central contribution will be ₹22,184 crore

• The Commission has recommended the creation of Disaster Mitigation Fund at the Central and State levels.
• But how is this remaining amount distributed among the states?
  • Inter-State allocation is made based on past expenditures, area and population and disaster risk index.

Are there any sectoral grants? 

• Nutrition: 

The Commission has worked out a framework for giving some sectoral grants as well.  For 2020-21, it has recommended ₹7,735 crore for improving nutrition based on the numbers of children in the 0-6 age group and lactating mothers