Role of the Finance Commission

General Studies Paper-3

Context: The sixteenth Finance Commission headed by Arvind Panagariya has begun its work by inviting suggestions from the public on the mandate set for it by the Centre.

What is the Finance Commission?

• The Finance Commission is a constitutional body constituted by the President of India under Article 280, that recommends how tax revenues collected by the Central government should be distributed among the Centre and various States in the country.
• The Commission is reconstituted every five years and usually takes a couple of years to make its recommendations to the Centre.
• The Centre is not legally bound to implement the suggestions made by the Finance Commission.

Tax Devolution

• The Finance Commission decides what proportion of the Centre’s net tax revenue goes to the States overall (vertical devolution) and how this share for the States is distributed among various States (horizontal devolution).
• The horizontal devolution of funds between States is usually decided based on a formula created by the Commission that takes into account a State’s population, fertility level, income level, geography, etc.
• The vertical devolution of funds, however, is not based on any such objective formula.
• The Centre also aids States through additional grants for certain schemes that are jointly funded by the Centre and the States.

Friction between the Centre and States

• The Centre and the States have been at loggerheads over the issue of sharing tax revenues.
• The Centre collects major taxes such as the income tax, the corporate tax, and the Goods and Services tax (GST) while the States primarily rely on taxes collected from the sale of goods such as liquor and fuels that are beyond the ambit of GST.
• This has led to complaints that the Centre has reduced the power of the States to collect taxes and that it does not give enough funds to the States to match with the scale of their responsibilities.

What are the disagreements?

• Demand for more funds: States argue they should receive more funds than recommended by the Finance Commission. States have greater responsibilities, including education, healthcare, and policing services.
• Disparities Among States: Developed States like Karnataka and Tamil Nadu feel they receive less money from the Centre than they contribute in taxes.
  • Tamil Nadu receives only 29 paise for every rupee contributed, while Bihar receives more than ₹7 for each rupee contributed.
  • In other words, it is argued that more developed States with better governance are being penalized by the Centre to help States with poor governance.
• Divisible Pool Concerns: Cesses and surcharges, which are not shared with the States, can constitute up to 28% of the Centre’s tax revenues, leading to revenue losses for States.
• Shortfall in Devolution: The Fifteenth Finance Commission recommended 41% of the divisible pool to the States. However, the Centre has devolved an average of only 38% of funds from the divisible pool to the States.
• Criticism of the Finance Commission: Critics believe the Finance Commission may not be fully independent due to the Centre’s role in appointing its members, leading to potential political influence.

Way Ahead

• In response to evolving economic and social dynamics, the Finance Commission needs to remain proactive and responsive. This entails addressing challenges stemming from GST implementation, the Covid-19 Pandemic, Climate Change, and Digital Transformation.
• Also, the concerns should be accommodated so that they do not feel penalized for development and better governance of their state.