Current Affairs: Finance Commission Recommendations
Hello and welcome to BYJU’s classes! This is a prelims special lecture. In this lecture we’ll be talking about Finance Commission with special emphasis on the 14th Finance Commission recommendations. Now why are we discussing Finance Commission? It is because of the fact that in a landmark decision the Finance Commission recommended 42% transfer, 42% devolution of funds from the divisible pool of taxes to the states. And this is a remarkable achievement, remarkable development. And because Finance Commission is in the news you might expect a question on Finance Commission or the report of the Finance Commission in this year’s prelims examination. So let’s get started and first have a look at what all you can expect from this lecture. We talk about Finance Commission, composition, role, functions, recommendations of the 14th Finance Commission and then we will follow it up with some of the mock questions as well.
So let’s get started and talk about Finance Commission of India. Finance Commission is a Constitutional body. Under Article 280 of the Indian Constitution, Finance Commission is constituted by the President of India. When is it constituted? Every fifth year or at such earlier time as he considers necessary. So Finance Commission is a Constitutional body provided by Article 280 of the Indian Constitution and it is constituted by the President of India. This is what we know about Finance Commission.
What is the composition of the Finance Commission? Finance Commission consists of a chairperson and 4 other members. That means the strength of Finance Commission is 5. But what is the qualification of these members? What is the criteria on the basis of which President appoints the chairperson and the members? The Constitution is silent on this aspect. However, the Constitution has authorized the Parliament to regulate this matter. And accordingly, the Parliament of India enacted Finance Commission Act 1951. This talks about the qualifications required for persons to be appointed as the Chairperson of the Finance Commission and the members of the Finance Commission. Now what are these qualifications? Let’s have a look at them very briefly. The Chairperson should be a person having experience in public affairs. This is the only qualification required for a person to be chosen to be appointed as the Chairperson of the Finance Commission. He should have experience in public affairs. What about other members of the Finance Commission? a) A judge of the High Court or a person qualified to be appointed as such. 1. 2, a person who has specialized knowledge of finance and accounts of the Government. What is the 3rd? A person who has wide experience in financial matters and administration. 4th qualification, a person who has special knowledge of economics. These qualifications are taken in account by the President when he appoints persons as Chairperson or members of the Finance Commission. So what we know as of now, we know that Finance Commission is a Constitutional body provided by Article 280 of the Indian Constitution. Composition, the strength of Finance Commission is 5, Chairperson and 4 members.
But what are the functions of Finance Commission? What is the use of Finance Commission in Indian polity and governance? Let’s have a look at them very briefly. The functions of Finance Commission. Now to tell you Finance Commission prepares a report. This report is given to the President and the President then lays this report on the floor of the house, under Article 281 of the Indian Constitution. What do we know? Finance Commission prepares a report, this report is sent to the President and the President causes this report to be laid on the floor of the Parliament. But on what matters? What are the functions of the Finance Commission? Let’s try and have a look at the functions of the Finance Commission. The first function. If you have gone through our previous lecture wherein we talked about goods and services tax, we talked about that there are number of indirect taxes. There are number of direct taxes as well. There are number of central taxes and duties. Now the proceeds from various central taxes and duties that the Central Government gets, the proceeds from these taxes and duties are to be shared between the Centre and the states. But he is going to determine how these central taxes and duties are going to be shared between the Centre and the states. This principle is laid down by the Finance Commission. This is one of the most important functions of the Finance Commission. Second important function, the Government provides grants and aid to the states under Article 275 of the Indian Constitution. What are the principles that govern these grants and aid to the states? These principles are enumerated by the Finance Commission of India. Third important function, we know that 73rd and 74th Constitutional Amendment Act provided Constitutional status to Panchayati Raj institutions and municipalities. Now because of this Constitutional status the Governor of every state is required to constitute state Finance Commission every 5 years. This state Finance Commission will look into the finances of Panchayati Raj institutions and municipalities. Alternatively, the central Finance Commission will also look into the ways how the consolidated fund of every state can be augmented, can be increased so that more funds are made available to these Panchayati Raj Institutions, to these municipalities so that they are enabled to function as the agents of local self-government. This is another important task of the Finance Commission of India. 4th task, any other matter referred to it by the President. That means President can refer any matter to the Finance Commission eliciting views from the Finance Commission on these matters, apart from the 3 functions that we have discussed as of now. So what we know, Finance Commission, composition, functions.
Now let’s try and have a look at one very important, very basic mock question that you must be able to solve. Let’s have a look at it. Which of the following statements regarding Finance Commission of India are correct? (1) The President is obligatory to constitute the Finance Commission at the expiry of every five years only. Now we have seen, Finance Commission is to be constituted by the President every 5 years or at an earlier time as he may deem necessary. So it’s not required that President constitutes a Finance Commission only at the expiry of the 5 years. So this statement is wrong. Finance Commission is a quasi-judicial body. Now this statement is correct. Let’s have a look at what do we mean by Finance Commission being a quasi-judicial body. The quasi-judicial body means it adjudicates certain disputes but it does not pass an order in the same manner and on the like grounds as the Supreme Court, the High Courts, the District Courts. But it still adjudicates certain matters. Now let’s cite an example. 80th Constitutional Amendment Act was enacted in the year 2000. Now this was enacted to give effect to the 10th Finance Commission recommendations, which was headed by K.C. Panth. Now what was the recommendation all about? There was a tussle between the Centre and the states. The states were complaining that since the central taxes and duties are imposed by the central Government in these states, the revenue central Government generates from the states, it is very important for the central Government to devolve more taxes to these states. The matter was looked at by the Finance Commission and it adjudicated on this matter and provided for that 29% of the divisible pool of taxes should go to the states. This is what came to be known as Alternative Scheme of Devolution. It was also given a retrospective effect from 1st of April, 1996. So what do we mean by saying that Finance Commission is a quasi-judicial body? That means, it has a very important Constitutional position by means of which it solves various financial related problems between the Centre and the states. Likewise it did in the year 2000 when 80th Constitutional Amendment Act was enacted in the year 2000. So the 2nd statement is correct. 3rd statement, the members hold the office for five years. This statement is wrong. Why? The tenure of the members are provided in the order that is issued by the President. That means whenever President issues an order appointing members to the Finance Commission the tenure is also mentioned in that order. So it is not required that every member is supposed to be present with the Finance Commission for 5 years. He can be for lesser number of years as well. So this statement is incorrect. 4th statement, the members are not eligible for reappointment. Sometimes UPSC might give you some statements to confuse you because you might not have read about these things. So it’s very important to have a clear picture at what is the composition of the Finance Commission and other related issues as well. So this statement is also wrong. The members are eligible for reappointment. So considering the fact, we come to know that option b) is correct. That means Finance Commission is a quasi-judicial body, only this statement among these 4 statements are correct.
14th Finance Commission was constituted by the President. This 14th Finance Commission is headed by former RBI Governor, Mr. Y.V. Reddy. Now let’s go back a bit. I told you that there are 3 important functions of the Finance Commission. Devolution of funds from Central Government to the states, or devolution of taxes as we call it. 2nd, principles surround the grants and aid to the states. 3rd, providing measures by which consolidated fund of every state is augmented so that we enable the Panchayati Raj Institutions and municipalities to function as the agents of local self-government. Now the 4th important function was that the President can give any matter to the Finance Commission. In this case, what are those other matters that were provided for by the President to the 14th Finance Commission? Let’s have a look at this. Now the UPSC might ask you in prelims 2015 which are the matters which are enumerated under other matters in 14th Finance Commission report. What are those? Pricing of public utilities. How can we price public utilities like water, electricity in an independent manner? 14th Finance Commission tell us about disinvestment, tell us about GST compensation, give us your insights on subsidies, the sale of non-priority public sector undertakings, review of finances, deficit and debt levels of the Central Government and the state governments, suggest measures for maintaining a stable and sustainable fiscal environment with equitable growth. All these matters you have to remember by heart. So these are very important considering the prelims point of view.
Now let us try and explain the recommendations of the 14th Finance Commission. First we will talk about tax devolution. In tax devolution we have 2 important concepts. Vertical devolution and horizontal devolution. What do we mean by vertical devolution? What do we mean by horizontal devolution? Let’s first talk about vertical devolution. 14th Finance Commission recommended that the Central Government should give to the states 42% of the divisible pool of funds. What does it mean? This means vertical devolution of taxes. That means from the Central Government to various states 42% of the divisible pool of taxes will be given to the states. But which are these divisible pool of taxes? The UPSC might ask you which of the following taxes are taken into account by the Finance Commission. Now let’s try and have a look at those taxes. 1, we have seen various central taxes and these are all central taxes like Corporate Tax, Income Tax, Excise Duty, Service Tax, STT on the sale and purchase of shares in the stock market. Now whatever the Central Government earns from these taxes and duties, the proceeds from these taxes are to be shared between the Centre and the states. This sharing formulas is provided by the Finance Commission. That means from the Central Government the taxes will be deferred to the states, this is known as vertical devolution of funds. But let us also have a look at which are those taxes which do not come into picture. That means, on which Finance Commission has no say, no role. Now before discussing this let me tell you that the Constitution has made a distinction. Distinction between the power to levy a tax and collect that tax and appropriate the tax. Let us try and have a look at some of these important issues.
Article 268. The taxes are levied by the Centre but these are collected and appropriated by the states. That means these are the taxes under Article 268 of the Indian Constitution, these taxes are levied by the Centre, but collected and appropriated by the states. For example, you have taxes like stamp duties, stamp duties on bills of exchange, checks, promissory notes. You’ve also excise duties on medical and toilet preparations, containing alcohol and narcotics. The proceeds from these taxes do not form part of consolidated fund of India. That means they are given to the states. But these taxes are levied by the Centre but collected and appropriated by the states themselves. So Finance Commission does not come into play. Article 238-A of the Indian Constitution, service tax. Service tax is levied by the Centre but collected and appropriated by both the Centre as well as the states. This is what we know about service tax. It is levied by the Centre, but it is collected and appropriated by the Centre as well as the states. But the proceeds are to be distributed between the Centre and the states. So who will determine the formula? Not the Finance Commission but the Parliament of India. So the Parliament of India will determine what percentage of the service tax will be devolved, will be distributed between the Centre and the states. This is what we know about Article 268-A of the Indian Constitution service tax. Let’s try and have a look at Article 269 of the Indian Constitution. These are the taxes that are levied by the Centre, that are collected by the Centre, but are assigned to the states. What is this tax? Central sales tax. We discuss the significance of central sales tax in our GST lecture. If you have not viewed that lecture, the link is still available, you can view it. We talked about why replacing central sales taxes is very important. But let’s not go into that. The central sales tax is the tax that is levied by the Centre, collected by the Centre, but given to the states. What is this central sales tax? Tax in the course of the movement of goods from one state to another. For example, there is a cement manufacturer in Gujarat, and the cement is exported from Gujarat to Tamil Nadu. Now on the movement of these goods from Gujarat to Tamil Nadu, central sales tax will be imposed the Centre, will be levied by the Centre, collected by the Centre but it will be given to Gujarat. That means the exporter state. The proceeds from these taxes are assigned to the states that means the Finance Commission does not come into play. Similar is the case regarding Cess. For example, in the union budget 2015-2016, the Finance Minister, Mr. Arun Jaitely told the Parliament that we will impose Swachch Bharat Cess. What is this Swachch Bharat Cess.? That means additional burden will be put on services. The services will attract Swachch Bharat Cess. The proceeds from this Cess. will be used exclusively for funding Swachch Bharat Abhiyan. That means Cess are imposed for specific purposes and the proceeds from these Cess. can be utilized for only that particular purpose. But even the Cess. does not come under the picture of Finance Commission. And also surcharges. So these are the matters under which Finance Commission has no role to play.
Let us now talk about horizontal devolution. What do we mean by horizontal devolution? We talked about that from the Centre to the states, 42% of the divisible pool of taxes will be given. But will every state in India get equal share? Can we compare a large and populous state like Uttar Pradesh with a developed and small state like Goa? That means the criteria has to be different. That is what we call horizontal devolution. 42% of divisible pool of taxes will be given to the states, but how much percentage each state will get in Indian union. This is what we know as horizontal devolution. But there has to be some criteria. This criteria is specified by the Finance Commission and on the basis of this criteria the proceeds from these taxes are devolved to the states. Let us look at the criteria. First, population. But 14th Finance Commission ensured that we look at the population figures of 1971 as well as the population figures of 2011. Why? Uttar Pradesh has a large population, so obviously it will get more funds. But what about Kerala, Tamil Nadu and Karnataka – whose population has stabilized more or less. Which performed very important and aggressive family planning procedures since 1971. Do these states want to lose out on revenue from the Finance Commission report? So the Finance Commission recommended that we take into account the population figures of 2011 as well as the demographic change from 1971 to 2011. More the population, more funds will be given to the states. This is one criteria. Second, income distance. Now income distance is a criteria that is not unique to the 14th Finance Commission. The 12th Finance Commission started this practice on income distance. That means making income distance as the criteria. What do we mean by the income distance? For example, Goa is the state which has the highest per capita income. Now, every state’s per capita income will be compared with Goa’s per capita income, or the state gross domestic product. Greater the distance, greater the devolution of funds will take place. That means if the income distance between Uttar Pradesh and Goa is very large, more funds to Uttar Pradesh. If the income distance between Bihar and Goa is lesser than the distance between UP and Goa, lesser amount of funds to Bihar, so on and so forth. So this is second criteria, income distance. 3rd, area. Greater the area, greater the devolution of funds. 4th, forest cover. But why is it important to have forest cover as a criteria for horizontal devolution of funds? You see there are states which have significant proportion of their lands under forest cover. They can’t clean up the forests to setup industries and factories. So that means they are losing out on revenue generating capacity because of these forests. So this criteria is used as some sort of subsidy provided to these states which have significant proportion of their lands under forest cover. So this criteria has also been used by 14th Finance Commission. Let us look at the weightage given by the 14th Finance Commission to these criteria. Income distance – 50%, demographic change – 10%, population – 17.5%, forest cover – 7.5%, area – 15%. So this is the weightage given to these criteria by 14th Finance Commission.
But now let us compare this criteria to the criteria specified by the 13th Finance Commission which was headed by Mr. Vijay Kalekar. The UPSC might ask you which are the new criteria set by 14th Finance Commission. Fine. So let us have a look. Population of 1971 was decreed into account by 13th Finance Commission as well as 14th Finance Commission, but more weightage was given by the 13th Finance Commission. 2011 population figures were not taken into account by the 13th Finance Commission. Income distance, area, forest cover is the area which 13th Finance Commission did not talk about. So this is a unique concept started by 14th Finance Commission. Using forest cover as a criteria for how horizontal devolution of funds. Then fiscal discipline. Fiscal discipline has been completely voted out by 14th Finance Commission. The Central Government used to set certain conditions to the states that if you follow these parameters, if you curtail your GDP deficit to these numbers, we will devolve more funds to you. The 14th Finance Commission has done away with this. So 2 important takeaways from this is that forest cover has been used as a criteria by the 14th Finance Commission and 14th Finance Commission departed from 13th Finance Commission in that it did not use fiscal discipline as a criteria for horizontal devolution of funds.
What are the other highlights of 14th Finance Commission? The 14th Finance Commission has ignored the Plan and Non-Plan distinction. This is one of the most important statements coming out from 14th Finance Commission. This statement can surely be asked in your prelims and you have to be absolutely sure that, yes, 14th Finance Commission has ignored this distinction between Plan and Non-Plan expenditure. It has taken into account all the revenue expenditure needs of the states without taking into account Plan needs and Non-Plan needs. So that means, devolution of funds through devolution of taxes is most important significant step taken into account by 14th Finance Commission. One. Second, what is the take of 14th Finance Commission on disasters? Now we know that every state has a state disaster response fund. This fund is utilized by the states in case of natural calamities or disasters. What type of disasters? Only those disaster which are listed, notified by Ministry of Home Affairs. Now the Ministry of Home Affairs comes up with a list of disasters. Now if these disasters happen in various states, the states can utilize the funds under State Disaster Response Funds. For such natural calamities, for such disasters. But there are some disasters which are unique to a particular state. Unique to a particular region in a state. And if these disasters are not mentioned, are not notified in the list of disasters published by Ministry of Home Affairs what is there for the state Government to do? The 14th Finance Commission recommended that 10% of the funds under State Disaster Response Funds can be utilized by the state Governments for disasters which are unique to their states. Even if these disasters are not notified in the list of disasters prepared by Ministry of Home Affairs. This is another very important takeaway from the 14th Finance Commission’s report.
Let’s try and have a look at another mock question here. Which of the following statesments would get assistance under ‘Post-Devolution Revenue Deficit Grants’. This is a very important thing from 14th Finance Commission almost ignored by the media, the newspapers and television channels. So this makes this a potential question in civil services preliminary examinations. The 14th Finance Commission took into account the revenue expenditure needs of a state. One. Second the tax devolved to them and third, revenue mobilization capacity of a state. The 14th Finance Commission after taking into account these 3 important criteria came to the conclusion that there are 11 states in this country which do not have revenue mobilization capacity even after devolving huge funds to these states. Now these 11 states would get Post-Devolution Revenue Deficit Grants. These revenue deficit grants would be given for a period of 5 years. Which are these states? Here comes our question. Kerala, Andhra Pradesh, West Bengal, Himachal Pradesh, Jammu & Kashmir and except Sikkim, Assam, Meghalaya, Mizoram, Nagaland, Tripura, Manipur. So this 6 out of the 7 states plus these 4 and Jammu & Kashmir, these 11 states would get Post-Devolution Revenue Deficit Grants for a period of 5 years.
What about Central-Sponsored Schemes? The 14th Finance Commission had recommended that since more devolution is taking place that means the 14th Finance Commission has taken into account the needs for funds regarding centrally sponsored schemes as well. So that means the 14th Finance Commission recommended that more burden should be put now on states. But Central Government said that we have certain obligations which we cannot wish away. There are some legal obligations like Mahatma Gandhi National Rural Employment Guarantee Act which we have to fulfil. So only 8 out of 30 centrally sponsored schemes would delinked from the central support. But in other 22 central sponsored schemes the scale, the contribution of the Central Government would come down. Earlier what used to happen for any central sponsored scheme, 70% funds would be given by the Centre, 30% would be given by the states. But in case of special category states, 90% of the funds were given by the Centre and 10% funds were given by the state governments. This brings us closer to another very, very important recommendation of the 14th Finance Commission, which is that it has discontinued the distinction between a special category state and another state. So this is very important takeaway from 14th Finance Commission report.
Now let’s try and have a look at another mock question, mock question number 3. The Chairperson of the Finance Commission is also a member of National Development Council. This option is wrong. According to Finance Commission Act 1951 former RBI Governor should be given preference while appointing Chairperson of the Finance Commission. You might think that since I.V. Reddy was the former RBI Governor, this statement might be true, but this is absolutely wrong. Third, the recommendations of the Finance Commission are binding on the Government. This statement is also wrong. The recommendations are advisory in nature. It is for the Central Government to accept or reject the recommendations, but since Finance Commission is a Constitutional body, more or less more sanctity is given to the report of the 14th Finance Commission. But what is the question asking you? Which of the above statements are incorrect. All these statements are incorrect.
What about Fiscal Deficit? Fiscal deficit target has been set at 3.6% of the GDP for the fiscal year 2016. And then from 2017 to 2018, 2019 fiscal deficit target is 3%. You might be asked sometimes these numbers so you have to be absolutely clear. What about GST? Because we looked at in other matters’ category the President of India asked the 14th Finance Commission to give its report on GST as well. The 14th Finance Commission recommended that you create a compensation fund. That means whenever we make a transition from the current regime to GST regime if the states lose out revenue you have to supplement funds to these states, compensate these states for their loss of revenue. This is very important. That means for first 3 years compensate the states fully, 100% compensation. For the 4th year, 75% compensation and for the 5th 50% compensation should be provided to the states if the states think, believe and tell that they have lost out on revenue because of transition to goods and services tax.
We’ve talked about Finance Commission devolving 42% taxes to the states. The 13th Finance Commission had recommended 32% devolution of funds. So this time we had 10% increase in the devolution. But what does that mean? That means you are giving more space to the states, making states fiscally autonomous to carry out whatever activities they want. In September 2013 a paper was published by Mr. Rajeev Jain and Prabhat Kumar of RBI. They make a very important observation among various other things that they talked about in that paper. They made an observation that every 1% that is spent by the Central Government, it results in 0.04% increase in gross domestic product. Fine. But every 1% spent by the state governments it leads to 0.11% increase in the GDP. So the multiplier in case of states is high as compared to the Central Government. This is very important to know from the point of view that the 14th Finance Commission used this rational to come to a conclusion that we need to give more fiscal space to the states.
But there has been criticism as well. We will not talk about all the criticisms regarding 14th Finance Commission. But there are some criticisms that are important from the prelims point of view. Like, this report has been criticized for scrapping Backward Regions Grant Funds. So might be given a statement: the 14th Finance Commission recommended the scrapping of Backward Regions Grant Fund. Fine. So this is very important statement. And there is another member of Finance Commission, Professor Abhijeet Sen, who dissented with this 14th Finance Commission report. He said not 42% but devolve 38% to the states, because then the Central Government will be left with very less revenue, very less money and social sector initiatives will be curtailed down by the Central Government. Whether valid, invalid or a farce charge, we will talk about all the criticisms of the Finance Commission report. We’ll talk about the implications of 14th Finance Commission on Mr. Narendra Modi’s pet word – Cooperative Federalism.
All this when you come back after writing your prelims examination. Till then this was a special lecture on Finance Commission and the report of the 14th Finance Commission from prelims point of view. We discuss some of the very important concepts in this lecture. Thank you for watching.