The 15th Finance Commission: A Deep Dive into Fiscal Federalism in India

Subhasis Das

January 28, 2025   

The Indian Constitution establishes a framework for fiscal federalism, where financial resources are allocated between the central government and the states. This allocation is not a static process; it's dynamic and needs periodic recalibration to reflect the changing needs of the nation. One of the key mechanisms for this is the Finance Commission, a constitutionally mandated body formed every five years (or earlier if required) by the President of India. The 15th Finance Commission, chaired by Mr. N. K. Singh, has concluded its work and presented its recommendations for the period 2021-2026.

The Finance Commission's central role, as stipulated in Article 280 of the Indian Constitution, is to recommend the principles governing the distribution of tax revenues between the Union (central government) and the states. It also makes recommendations on grants-in-aid to the states, ensuring financial stability, especially for those states facing deficits. These recommendations are crucial for maintaining a balance in the fiscal relationship between the centre and states, thereby promoting inclusive economic growth. The 15th Finance Commission submitted two reports, the first for fiscal year 2020-21, and the second for the five-year period 2021-26. This article primarily focuses on the latter report and its recommendations, while briefly touching upon the previous report to provide context.

A significant aspect of the Finance Commission’s work is determining the share of the central taxes to be devolved to the states. For the period 2021-26, the Commission recommended that 41% of the central divisible pool of taxes be transferred to the states. This figure is identical to what was recommended for the 2020-21 financial year. However, it’s a notable reduction from the 42% share recommended by the 14th Finance Commission for the 2015-2020 period. The rationale behind this 1% reduction is to accommodate the newly formed Union Territories of Jammu and Kashmir and Ladakh, with their share of central revenues now being drawn from the central resources.

To understand this, it is vital to appreciate the concept of “divisible pool of taxes.” It refers to the tax revenues of the Central Government that are constitutionally allowed to be shared with the states. Not all central taxes are part of this pool. Certain surcharges and cess collected by the Centre, are not shared. These are earmarked for specific purposes or kept exclusively for Union projects. The Finance Commission's recommendations revolve around this divisible pool, aimed at ensuring equitable distribution of the shared revenue among the states.

The critical question is how the 41% shared amongst the states? This distribution is not based on population alone. Instead, the commission uses a set of criteria (discussed below), assigning weights to each criterion, and these weights determine the share of each state. This approach tries to ensure a balance between needs and performance, and avoids pure population-based distribution, which often disadvantages poorer states with higher populations. The criteria and their weighting are central to the commission's work and the subsequent distribution of funds.

The Commission employs specific criteria to determine the share each state will receive from the central tax pool. The table below outlines the various criteria, and the weights assigned to each by the 14th and 15th Finance Commissions:

Criteria	14th FC (2015-20)	15th FC (2020-21)	15th FC (2021-26)
Income Distance	50.0	45.0	45.0
Area	15.0	15.0	15.0
Population (1971)	17.5	-	-
Population (2011)	10.0	15.0	15.0
Demographic Performance	-	12.5	12.5
Forest Cover	7.5	-	-
Forest and Ecology	-	10.0	10.0
Tax and Fiscal Efforts	-	2.5	2.5
Total	100	100	100

• Income Distance: With a weight of 45%, this is the single most significant criterion. The term 'income distance' refers to the economic disparity between a state and the state with the highest Gross State Domestic Product (GSDP) per capita. The GSDP is the total market value of all final goods and services produced within a state's boundaries during a specific period, usually a year. The income distance essentially measures a state's economic backwardness, where states with lower per capita GSDP receive a larger share. For the 2021-26 period, the GSDP data used for calculation is the average of the three years between 2016-17 and 2018-19. This criterion aims at promoting equity and ensuring that states with a weaker economic base receive additional fiscal support.


• Area: This criterion is straightforward and assigns a 15% weight to the geographical size of a state. Larger states tend to have greater administrative costs, and this criterion tries to partly acknowledge that fact.


• Population (2011): The population of a state is a key determinant of the resources it requires. The 15th Finance Commission, following the Terms of Reference given to it by the Union government, has used the 2011 census for all its recommendations. This criterion has a weight of 15%. Using the 2011 data, as opposed to the 1971 census data used previously, was contentious, especially from the southern states, where population growth has slowed down.


• Demographic Performance: This criterion, with a weight of 12.5%, rewards states that have been more successful in controlling their population growth. It measures demographic performance based on the Total Fertility Rate (TFR), or the number of children a woman has in her reproductive years. States with lower TFR receive a higher weight, incentivizing population control measures. It reflects the growing realization that India's population growth is putting tremendous pressure on the available natural resources.


• Forest and Ecology: This is a new criterion, introduced by the 15th Finance Commission, with a weight of 10%. This is a good attempt to incentivize forest conservation and environmental protection. The criterion calculates the share of the dense forest area in each state compared to the total dense forest area in the country. This is particularly important as India is seeing increasing pressure to balance development and forest conservation.


• Tax and Fiscal Efforts: The Tax and Fiscal efforts criterion is assigned a weight of 2.5%. It aims to reward states that are more efficient in collecting their own taxes. It is measured by the ratio of a state's average per capita tax revenue to the average per capita GSDP during the three-year period between 2016-17 and 2018-19. This criterion, though with a smaller weight, tries to promote tax compliance and fiscal discipline at the state level.

It is noteworthy that the reference periods for computing income distance and tax efforts have changed between the 2020-21 report and the 2021-26 report. Although the criteria and weights have been kept the same, these differing reference periods mean that the individual shares of states have shifted as each state's relative economic performance changes.

In addition to tax devolution, the Finance Commission also recommends various grants-in-aid to states, as stipulated in Article 275 of the Constitution. These grants are intended to address specific needs and deficiencies in certain areas of state finances. The grants for the 2021-26 period can be broadly categorized into several types:

1. Revenue Deficit Grants: These grants are allocated to states with a revenue deficit, which occurs when a state's revenue receipts are less than its revenue expenditure. These grants are vital for ensuring the states’ financial viability, especially for those states with weak financial positions. The 15th FC has identified 17 states that require such grants, which will amount to ₹2.9 lakh crore. The goal of these grants is to help these states eliminate their revenue deficit, over the next five years.


2. Sector-Specific Grants: These are targeted grants to be used in specific sectors and are aimed at improving the developmental outcomes in key areas. A total amount of ₹1.3 lakh crore has been allocated for sector-specific grants. The areas include:

·         Health: A critical area of concern, especially after the Covid-19 pandemic.

·         School Education: Essential for human resource development and skill formation.

·         Higher Education: Vital for innovation and creating a knowledge-based economy.

·         Implementation of Agricultural Reforms: Aimed at improving efficiency, productivity, and income security in the agricultural
sector.

·         Maintenance of PMGSY Roads: Acknowledges the importance of connectivity for economic development and ensures the upkeep of rural roads under the Pradhan Mantri Gram Sadak Yojana (PMGSY).

·         Judiciary: Recognizes the importance of access to justice.

·         Statistics: Acknowledges the importance of data for policy making.

·         Aspirational Districts and Blocks: Targets socio-economically backward districts with focussed interventions.

A key feature of these grants is that a portion of them is performance-linked, that is, states must achieve certain milestones in these sectors to receive the full amount. This encourages better implementation and targeted improvements and ensures a focus on outcome instead of expenditure.

3. State-Specific Grants: These grants, totalling ₹49,599 crore, are tailored to meet the specific needs and challenges of individual states. The specific areas includeSocial Needs, Administrative Governance and Infrastructure, Water and Sanitation, Preservation of Culture and Historical Monuments, High-Cost Physical Infrastructure, and Tourism.

The Commissionrecommended the establishment of high-level committees at the state-level to oversee the utilisation of these specific grants and sector-specific grants, to ensure their proper utilization and avoid wastage of resources.

4. Grants to Local Bodies: These are the grants allocated to local bodies, both rural and urban, with the aim of strengthening grassroots governance. This category amounts to ₹4.36 lakh crore. Within this,

·         ₹2.4 lakh crore is for rural local bodies (Panchayati Raj institutions),

·         ₹1.2 lakh crore for urban local bodies, and

·         ₹70,051 crore specifically for health.

These funds are to be transferred to all three tiers of the Panchayati Raj system: village, block, and district. The health grants, within these local body grants, will support the following:

·         Conversion of rural sub-centres and Primary Health Centers (PHCs) into Health and Wellness Centres (HWCs),

·         Diagnostic infrastructure at PHCs, and

·         Support for urban HWCs, sub-centres, PHCs and public health units at the block level.

The grants to local bodies (excluding health grants) are distributed based on population (90% weight) and area (10% weight) across the states. The Commission has also laid down certain conditions for states to avail these grants, primarily to promote fiscal discipline and accountability at the local level. These include the publishing of provisional and audited accounts, and the fixation of minimum property tax rates. Furthermore, states that fail to set up a State Finance Commission and act on its recommendations, will not be allocated these grants.

5. Disaster Risk Management: The Commission recommended maintaining the current cost-sharing pattern between the Centre and the states for disaster management funds. The cost-sharing ratio is 90:10 for the North-Eastern and Himalayan states and 75:25 for all other states. The total allocation for State Disaster Management Funds is to be ₹1.6 lakh crore, with the centre's share at ₹1.2 lakh crore. This recognizes the importance of a robust disaster management system in India, given the country's vulnerability to various natural calamities.

Fiscal Roadmap: Charting the Way Forward

The Commission has also laid out a roadmap for fiscal management for both the Centre and states. This includes specific recommendations regarding fiscal deficit and debt levels:

• Fiscal Deficit:

·         For the Centre, the Commission recommended bringing the fiscal deficit down to 4% of GDP by 2025-26.

·        For states, the Commission prescribed a fiscal deficit limit of 4% of GSDP in 2021-22, 3.5% in 2022-23, and 3% during 2023-26. Fiscal deficit is the difference between a government's total expenditure and its total revenue, indicating the amount a government needs to borrow to finance its activities. The Commission’s recommendations try to ensure that both the Centre and the States maintain fiscal discipline.

• Debt Levels: The Commission noted that these recommended fiscal deficit paths will lead to a reduction in the total liabilities for both the Centre and the states. The total liabilities of the Centre are expected to come down from 62.9% of GDP in 2020-21 to 56.6% by 2025-26, and that of states (in aggregate) from 33.1% of GDP in 2020-21 to 32.5% by 2025-26.


• Additional Borrowing for Power Reforms: The Commission has also recommended a provision that allows states to undertake additional borrowing equivalent to 0.5% of GSDP in the first four years (2021-25) in case they undertake power sector reforms. The reforms are aimed at improving the operational efficiency of state power utilities. This includes reduction in operational losses, reduction in the revenue gap, reduction in cash subsidy payments, and a reduction in tariff subsidy as a percentage of revenue. This highlights the importance of the power sector for the overall economy and encourages reforms at the state level.


• FRBM Review: The commission recommended setting up a high-powered inter-governmental group to review the Fiscal Responsibility and Budget Management (FRBM) Act and recommend a new FRBM framework for the Centre and States and oversee its implementation. The FRBM Act is the primary law guiding fiscal responsibility in the country. The commission recommends a review of the law and making it relevant for the changing needs of the economy.

Revenue Mobilisation: Plugging the Leaks

The Commission has emphasised the importance of enhanced revenue mobilization by the Centre and states. Here are some of its recommendations:

• Income and Asset-based Taxation: The Commission has advocated for strengthening income and asset-based taxation. It has called for broadening the base of TDS/TCS (Tax Deduction at Source/Tax Collection at Source) to reduce excessive reliance on income tax on salaried individuals. These are mechanisms where income tax is collected at the source, where the income is generated, making it more efficient for the government.


• Property Taxes: There is significant untapped potential in stamp duty and registration fees at the state level. The Commission recommends integrating computerised property records with registration of transactions and capturing the market value of properties. This promotes transparency and brings property tax revenue in line with actual market values.


• Goods and Services Tax (GST): The Commission has also suggested resolving the issues with the inverted duty structure in the GST regime. An inverted duty structure occurs when the tax rate on inputs is higher than the tax rate on final products. It has also called for restoration of revenue neutrality in the GST, and rationalisation of the tax rates by merging the rates of 12% and 18%. Further, states are required to step up field efforts to expand the GST tax base and ensure compliance.


• Financial Management Practices: The Commission has strongly advocated for strengthening public financial management and creating a comprehensive framework. This includes the establishment of an independent Fiscal Council with advisory powers. This body will help ensure accountability and transparency in fiscal matters. It has also called for adoption of standard-based accounting and financial reporting for both Centre and states. Furthermore, it has called for reporting on all contingent liabilities, and for Centre and states to not resort to off-budget financing or other non-transparent means of financing.

Other Key Recommendations

Besides fiscal matters, the Commission has touched upon other vital areas, recommending some key structural reforms:

• Health: The Commission recommended that states should increase their spending on health to over 8% of their budgets by 2022. Primary healthcare expenditure should be two-thirds of the total health expenditure by 2022. It called for making centrally sponsored schemes (CSS) in health more flexible, so that states can innovate and adapt. The Commission also recommended shifting the focus of health CSS from inputs to outcomes. Finally, it recommended setting up an All-India Medical and Health Service.


• Funding of Defence and Internal Security: The Commission recommended a dedicated non-lapsable fund, called the Modernization Fund for Defence and Internal Security (MFDIS), to bridge the gap between budgetary needs and allocations for capital outlay. This is aimed at strengthening the country’s defence capabilities. The total fund is to be of ₹2.4 lakh crore over the five-year period. ₹1.5 lakh crore will come from the Consolidated Fund of India, and the rest from measures such as disinvestment of defence public sector enterprises, and monetization of defence lands.


• Centrally Sponsored Schemes (CSS): A threshold should be fixed for annual allocation to CSS below which, the funding should be stopped, to phase out CSS which have either outlived their utility or have an insignificant outlay. It also called for third party evaluation of all CSS to be completed within a specified timeframe. Further, it called for fixing the funding patterns of CSS upfront and keeping it stable.

In conclusion, the 15th Finance Commission's report is more than a retrospective assessment; it’s a critical blueprint for states as they prepare their representations before the 16th Commission which is now undertaking visits to different states. A strategic, well-informed approach, based on a deep understanding of the previous commission's findings, will be essential for states to secure the financial resources they need to meet their developmental aspirations, and create an environment for inclusive growth for their people. The 16th Finance Commission presents an opportunity for course-correction, improvement, and a renewed commitment to the principles of fiscal federalism in India.

   (Tripurainfo)