32

Centre-State Financial Relations in the Post-Liberalization Period

Jose Sebastian

32.1 Introduction

The imbalance between revenue-raising powers and expenditure responsibilities is a common problem in most federations. Recognizing this, the constitutions of these countries have provided for mechanisms for federal fiscal transfers. These transfers are intended to: (i) remove or minimize the vertical imbalance originating from the division of functions, and sources of revenue, between the centre and subcentral units; and (ii) offset the horizontal fiscal imbalance arising from inadequate fiscal capacity to ensure the provision of certain minimum levels of essential public services in subcentral units. In India, Article 280(3)(a) and (b) of the Constitution empowers the President to appoint the Finance Commission every 5 years. The mandate of the Finance Commission is to assess the fiscal resources and needs of the centre and individual states, and to recommend the distribution between states, of shareable taxes under Article 270 (income tax other than corporation tax) and Article 272 (union excise duty), and to recommend grants-in-aid under Article 275 to states which may be in need of assistance. Article 280(3)(b) enables ‘other matters to be referred to the Finance Commission in the interests of sound finance’. Accordingly, 12 Finance Commissions have submitted recommendations since Independence. The purpose of this chapter is to provide a brief overview of the centre— state financial relations in the post-liberalization era, with special reference to the reports of the Tenth, Eleventh and Twelfth Finance Commissions and their implications for the finances of the centre and the states.

32.2 The Context

The context of the appointment of the Tenth, Eleventh and Twelfth Finance Commissions has been unique in several ways. First and foremost, India embarked on an ambitious programme of liberalization and structural adjustment. The government initiated the stabilization and structural adjustment programme in 1991 to tide over the situation of fiscal disequilibrium, which showed signs of a fiscal crisis.

Some of the major policy initiatives introduced as part of the reform agenda are deregulating the industry, dismantling the protective trade regimes, removing the restrictions on foreign investment, rationalization and restructuring of the tax system, and financial sector reforms. Of the reform measures, the ones relating to tax reform and reduction in fiscal deficit are immediately relevant to government finances. The focus of the tax reforms was on the reduction in rates of major taxes like income tax and corporation tax, and simplification of procedures and formalities. It was expected that the reduction of revenue, if any, consequent to these policy changes, would be offset by the growth in revenue resulting from the overall growth of the economy. But, contrary to expectations, both at the centre and in the states, the fiscal deficit registered a sharp increase, necessitating the reduction in the capital expenditure. The situation was particularly worse in the case of the states. After meeting the growing revenue expenditure, most of the states were left with meager resources for capital expenditure. This resulted in the poor upkeep of capital assets created in successive plans.

The liberalization and structural adjustment programme initiated by the centre has a direct bearing on the finances of the states. In the past, the vertical imbalance was invariably taken care of by the progressive fund transfers by the Finance Commissions. In the face of increasing fiscal strain at the centre, the states are forced to fend for themselves. In the changed circumstances, it is doubtful whether the Finance Commissions would be able to address in full measure the vertical imbalances that the differences in the level of economic development between the states may bring about. The resource endowments, both human and natural, differ between states and therefore the capacity of the states to exploit the opportunities that the liberalized environment has thrown up also differs. The opening up of the economy implies that the states should maintain a high degree of competitiveness, by investing in physical infrastructure and human resources, to attract investment. This necessitates drastic changes in the expenditure priorities of the states. The terms of reference and recommendations of the Finance Commissions in the post-liberalization era cannot be immune to these objective conditions.

The 73rd and the 74 th amendments to the Constitution added another dimension to the centre-state relations. With the ushering in of the three-tier Panchayat Raj system, the states have to effect devolution of resources to the local bodies, in accordance with the recommendations of the State Finance Commissions. Therefore, in future, Finance Commissions would have to consider ways to strengthen the local bodies by ensuring adequate fund transfers from the states.

It is against the above background that the President appointed the Tenth Finance Commission under the chairmanship of K. C. Pant.

32.3 Terms of Reference of the Commission

The following are the terms of reference of the Commission:

1. The distribution between the union and states of the net proceeds of taxes which are to be, or may be, divided between them under Chapter 1 of Part XII of the Constitution and the allocation between the states of the respective shares of such proceeds.
2. The principles which should govern the grants-in-aid of the revenues of the states out of the consolidated fund of India and the sums to be paid to the states, which are in need of assistance, by way of grants-in-aid of their revenues under Article 275 of the Constitution for purposes other than those specified in the provisos to clause (1) of that Article.
3. In addition to the above two constitutionally mandated terms of reference, the Commission, while making its recommendations, was required to have regard to:
   1. The objective of not only balancing the receipts and expenditure on revenue account of both the states and the central government, but also generating a surplus for capital investment and reducing the fiscal deficit.
   2. The resources of the central government and the demands thereon, in particular on account of expenditure on civil administration, defence and border security and other committed expenditures or liabilities.
   3. The maintenance and upkeep of capital assets, the maintenance expenditure on plan schemes, to be completed by 31 March 1995, and the norms on the basis of which the specified amounts are recommended for the maintenance of capital assets and the manner of monitoring such expenditure.
   4. The requirements of states for the modernization of the administration, that is, computerization of land records and providing faster channels of communication up to and above the district level, and for upgrading the standards in non-developmental sectors and services, and the manner in which such expenditures can be monitored.
   5. The revenue resources of the states for the five years commencing April 1995, on the basis of the levels of taxation likely to be reached in 1993–94, targets set for additional resource mobilization for the plan and the potential for raising additional taxes.
   6. The requirements of the states for meeting the non-plan revenue expenditure, also keeping in view the potential for raising additional taxes.
   7. The tax efforts made by the states.
   8. The need for ensuring reasonable returns on investment by the states in irrigation projects, power projects, state transport undertakings, departmental commercial undertakings and public sector enterprises.
   9. The scope for better fiscal management, consistent with efficiency and economy in expenditure.
4. The Commission may suggest changes, if any, to be made in the principles governing the distribution of:
   1. The net proceeds in a financial year of the additional excise duties leviable under the Additional Duties of Excise (Goods of Special Importance) Act, 1957 in replacement of the sales tax levied formerly by the state governments.
   2. The grants to be made available to the states in lieu of the tax under the repealed Railway Passenger Fares Act, 1957.
5. In making its recommendations on the various matters aforesaid, the Commission shall adopt the population figures of 1971 in all cases where population is regarded as a factor for determination of devolution of taxes and duties and grants-in-aid.
6. The Commission may review the present scheme of the Calamity Relief Fund and may make appropriate recommendations thereon.
7. The Commission may make an assessment of the debt position of the states as on 31 March 1994 and suggest such corrective measures as are deemed necessary, also keeping in view the financial requirements of the centre.
8. The Commission shall make its report available by 30 November 1993, on each of the matters aforesaid, covering a period of 5 years commencing on 1 April 1995. The Commission shall indicate the basis on which it has arrived at its findings and make available the state-wise estimates of receipts and expenditure.

The latter part of the terms of reference, which is in the nature of ‘other matters to be referred to the Finance Commission in the interests of sound finance’, under Article 280(3)(c), broadly reflects the growing fiscal strain at the level of both the centre and the states. But, in a federation, the issues relating to fiscal consolidation are a concern of both the centre and the states. On this count, the terms of reference of the Tenth Finance Commission have been criticized as being asymmetrical in the ‘norms to be applied to the centre, on the one hand, and the states, on the other’ (see Chelliah et. al., 1992). According to critics, while the need to consider the potential for raising additional resources by the states has been highlighted by the terms of reference, it is silent on such requirements for the centre. Similarly, the terms of reference excludes central public enterprises while speaking of the need to ensure a reasonable return on investment in the case of state enterprises.

32.3.1 Approach of the Commission

The goals set out by the terms of reference of the Tenth Finance Commission involved the difficult task of balancing the revenue account and generating a surplus for capital investment while making efforts at reducing the fiscal deficit. A reduction in fiscal deficit has to come about through an improvement in the revenue account balance emanating from the non-plan revenue account. The Commission adopted a holistic view of government finances and reassessed the revenue and expenditure of both the centre and the states, using its own methodology. A major departure was the principle adopted in vertical resource sharing, that is, between the centre and the states. The Commission was of the view that in the interests of better centre-state relations, all the central taxes should be pooled and a proportion of them devolved to the states. This will make the vertical sharing simple and transparent besides giving more freedom to the centre in choosing tax policy measures in an integrated manner. With regards to horizontal sharing, the Commission adopted criteria that blend equity and efficiency. Tax effort, or the efficiency in exploiting the tax potential, has been rewarded. The Commission recognized the importance of providing public services and the enhanced role of infrastructure, and therefore incorporated ‘area’ and ‘infrastructure’ as the two new elements in the criteria for horizontal distribution. To address the special problems of the states, grants have been recommended for individual states. The Commission went in depth into the problem of public debt and recommended an incentive-based system of debt relief. The following are the specific recommendations of the Commission.

32.3.2 Recommendations of the Commission

The Commission made recommendations with reference to each item of the terms of reference. In this section, we present some of the major recommendations.

 

32.3.2.1 Income Tax

1. Out of the net distributable proceeds of income tax, a sum equal to 0.927 per cent shall be deemed to represent the proceeds attributable to union territories.
2. The share of net proceeds of income tax assigned to the states shall be 77.5 per cent.

32.3.2.2 Union Excise Duties

1. From the net proceeds of the union excise duties, 40 per cent should be distributed during each financial year in the period 1995–96 to 1999–2000 to the states as per the shares recommended by the Commission.
2. From the remaining net proceeds of the union excise duties, 7.5 per cent should be distributed among the states in accordance with the shares specified by the Commission for each financial year during the period 1995–96 to 1999–2000.

32.3.2.3 Alternative Criteria of Devolution The share of the states in the gross receipts of central taxes shall be 26 per cent. The tax rental arrangements should be terminated and additional excise duties be merged with basic excise. The states will be eligible for a further share of 3 per cent in the gross tax receipts of the centre in lieu of additional excise duties. The Commission recommended that these shares of 26 per cent and 3 per cent should be suitably provided for in the Constitution and reviewed once in 15 years.

32.3.2.4 Grants-in-lieu of Tax on Railway Passenger Fares The quantum of the grant-in-lieu of the tax on railway passenger fares from 1995 to 2000 should be Rs 380 crores annually and the shares of the states will be as specified by the Commission.

32.3.2.5 Upgradation Grants For the period 1995–2000, the Commission recommended a sum of Rs 2,608.50 crores as grants for upgradation and special problems.

32.3.2.6 Financing of Relief Expenditure The total amount worked out for the financing of relief expenditure for the period 1995–2000 shall be Rs 6,303.27 crores, of which the contribution of the centre and the states shall be Rs 4,728.19 crores (75 per cent) and Rs 1,576.08 crores (25 per cent).

In addition to the Calamity Relief Funds for states, a National Fund for Calamity Relief (NFCR) should be created to which the centre and the states will contribute. A National Calamity Relief Committee, on which both the centre and the states would be represented, will manage it. The size of the NFCR would be Rs 700 crores to be built up over the period 1995–2000, with an initial corpus of Rs 200 crores to which the centre would contribute Rs 150 crores in the proportion of 75:25 per cent. In addition, the contribution of the centre and the states would be Rs 75 crores and Rs 25 crores, respectively.

32.3.2.7 Grants for Local Bodies A total grant of Rs 5,380.93 crores should be made available to the states in four equal installments commencing from 1996–97.

32.3.2.8 GrantS-in-Aid The Commission recommended grants-in-aid equal to the amount of the deficit as estimated for each of the years from 1995–96 to 1999–2000.

32.3.2.9 Debt Relief The Commission recommended a scheme of general debt relief for all the states linked to the fiscal performance and specific relief for states with high fiscal stress, special category states and states with debt problems warranting special attention.

32.3.3 Tenth Finance Commission: An Assessment

Experts have welcomed the recommendations of the Tenth Finance Commission. Though the states are not fully satisfied with the shares and debt relief, there is a general feeling that the Commission could not do more in the given fiscal context. It has been pointed out that the adoption of an identical formula predominantly based on the population and distance criterion is ‘sound and progressive in its economic logic’ (see Guhan, 1995). The Commission adopted uniform criteria for sharing income tax and excise. The grants to local bodies and the establishment of the NFCR are some of the noteworthy recommendations of the Commission.

The alternative scheme of devolution proposed by the Commission is a major departure from the recommendations of previous Finance Commissions. For quite some time, the states have been clamoring for a share in a larger pool of central tax revenues. The demand of the states for including the corporation tax in the divisible pool has been supported by some of the past Finance Commissions. The Sarkaria Commission on centre-state relations and the Tax Reforms Committee (1991) favoured a pooling of central taxes and fixing a share for the states. It has been pointed out that in the changed environment, central taxes are likely to exhibit higher buoyancy and therefore the proposed scheme will be beneficial to the states (Guhan, 1995). The proposed scheme also removes the apprehensions of the states that the centre is granting exemptions and deductions in taxes, the bulk proceeds of which go to the states.

32.4 The Eleventh Finance Commission

The Eleventh Finance Commission was appointed on 3 July 1998, under the chairmanship of Professor A. M. Khusro. The country had passed through the process of liberalization and structural adjustment programme for almost 5 years. Though the reform programme led to a number of corrective initiatives on the fiscal front, and produced some promising results in the first 2 years, budgetary imbalances widened by the close of the decade with acute fiscal stress in 1998–99. The success of the reform programme depended upon the corrective action on the fiscal front. Thus, the terms of reference of the Commission were reflective of the overall fiscal scenario of the country.

32.4.1 Terms of Reference

1. The Commission was required to make recommendations on the following matters:
   1. The distribution between the union and the states of the net proceeds of taxes which are to be, or may be, divided between them under Chapter 1 of Part XII of the Constitution and the allocation between the states of the respective shares of such proceeds.
   2. The principles which should govern the grants-in-aid of the revenues of the states out of the consolidated fund of India and the sums to be paid to the states which are in need of assistance by way of grants-in-aid of their revenues under Article 275 of the Constitution for purposes other than those specified in the provision to clause (1) of that Article.
   3. The measures needed to augment the consolidated fund of a state to supplement the resources of the panchayats in the state on the basis of the recommendations made by the Finance Commission of the state.
   4. The measures needed to augment the consolidated fund of a state to supplement the resources of the municipalities in the state on the basis of the recommendations made by the Finance Commission of the state.
2. The Commission was required to review the state of the finances of the union and the states, and suggest ways and means by which the governments, collectively and severally, may bring about a restructuring of the public finances to restore budgetary balance and maintain macroeconomic stability.
3. In making its recommendations, the Commission shall have regard, among other considerations, to:
   1. The resources of the central government and the demands thereon, in particular, on account of expenditure on civil administration, defence and border security, debt servicing and other committed expenditure or liabilities.
   2. Revenue resources of the states for the 5 years commencing 1 April 2000, on the basis of the levels of taxation possible to be reached in 1998–99, targets set for additional resource mobilization for the plan and the potential for raising additional taxes.
   3. The requirement of the states for meeting the plan and non-plan revenue expenditure, keeping in view the need for generating a surplus for capital investment and reducing the fiscal deficit.
   4. The maintenance and upkeep of capital assets and the maintenance expenditure of plan schemes to be completed by 31 March 2000, and the norms on the basis of which specified amounts are recommended for the maintenance of the capital assets and the manner of monitoring such expenditure.
   5. The requirements of the states for upgradation of standards in the non-developmental and social sectors and services, particularly of the states which are backward in general administration, to modernize and rationalize the administrative set-up in the interests of speed, efficiency and sound fiscal management.
   6. The need for ensuring reasonable returns on investment by the states in irrigation projects, power projects, state transport undertakings, departmental commercial undertakings and public sector enterprises.
   7. Such provision for emoluments and terminal benefits to the government employees, including teachers and other employees of aided institutions, as obtaining on a specified date as the Commission deems it proper and with reference to appropriate objective criteria rather than in terms of actual increases that may have given effect to.
   8. The scope for better fiscal management consistent with the efficiency and economy in expenditure, including the incentives that need to be provided for better realization of tax and non-tax revenue.
4. In the case of the local bodies, the terms of reference required the Commission:
   1. To take into account the recommendations of the State Finance Commissions.
   2. Where the State Finance Commissions have not been constituted as yet or have not submitted the report giving recommendations, the Commission will make its own assessment about the manner and extent of augmentation of the consolidated fund of the state to supplement the resources of the panchayats and the municipalities in the state. While making the assessments, the Commission:
      1. Shall take into account the provisions required to be made for the emoluments and terminal benefits of the employees of the local bodies, including those of teachers.
      2. Shall take into account the existing powers of the panchayats and the municipalities.
      3. The powers, authority and responsibility transferred to the panchayats and the municipalities under Article 243 G and 243 W of the Constitution read with Schedules 11 and 12.
5. In making its recommendations on the various matters aforesaid, the Commission shall adopt the population figures of1971 in all cases where the population is regarded as a factor for the determination of devolution of taxes and duties and grants-in-aid.
6. The Commission may make an assessment of the debt position of the states as on 31 March 1999, and suggest such corrective measures as are deemed necessary, keeping in view the long-term sustainability for both the centre and the states.
7. The Commission may review the present scheme of the Calamity Relief Fund and may make appropriate recommendations thereon.
8. The Commission shall indicate the basis on which it has arrived at its findings and shall make available the state-wise estimates of receipts and expenditure.

An additional term of reference was added on 28 April 2000. According to this, the Commission was required to draw a monitorable fiscal reform programme aimed at the reduction of the revenue deficit of the states and recommend the manner in which the grants to states, to cover the assessed deficit in their non-plan revenue account, may be linked to the progress in implementing the programme.

Though the overall terms of reference of the Eleventh Finance Commission reflects the grim fiscal situation of the country, doubts have been expressed whether it has paid adequate attention to the issues thrown up by the economic reforms initiated in the country in the early 1990s (see Godbole, 1998). A major departure in terms of reference is the additional terms of reference that required the Commission to draw a monitorable fiscal reform programme. Like the Tenth Finance Commission, the terms of reference of the Eleventh Finance Commission are also eloquent about financial discipline, and the need for ensuring reasonable returns on investment by the states in infrastructure and social overheads, while being silent on the issues pertaining to central investments and central public sector undertakings. The terms of reference relating to local bodies is a clear recognition of the need to strengthen the local bodies in light of the 73rd and the 74th amendments to the Constitution.

32.4.2 Approach of the Commission

The terms of reference of the Eleventh Finance Commission marks a striking departure from that of earlier commissions. The Commission was specifically asked to ‘review the state of finances of the union and the states and suggest ways and means whereby the governments collectively and severally may bring about a restructuring of the public finances so as to restore budgetary balance and maintain macroeconomic stability’ (p. 6). It reflects the grave fiscal situation both at the centre and the states. The large deficits at both levels of the government were increasingly becoming unsustainable. A disproportionately large share of the revenue was being spent on interest payments and unproductive expenditure, leaving too little for productive investment and social sectors. The terms of reference underscored the need for generating a surplus for capital investment and upgradation of standards in public services in the social and other sectors. The Commission was also required to pay attention to the scope for better fiscal management consistent with the efficiency and economy in expenditure.

The Commission attempted to find the root causes of the fiscal malaise. It was observed that in the 1990s, there was a considerable slack in the revenue realization and as a consequence, the revenue—GDP ratio registered a significant drop. The Commission tried to identify some of the principal impediments to improve the revenue productivity of the tax system and put forward suggestions for wide-ranging reforms, including constitutional amendments. In assessing the revenue-raising capacity and expenditure requirements of the states, the Commission adopted a normative approach. Another remarkable step was the attempt to strengthen the incentives for fiscal discipline. The Commission adopted a holistic approach to work out a transfer package consisting of all components of revenue transfer from the centre to the states.

32.4.3 Recommendations of the Commission

The Commission made 91 recommendations, some of which are reproduced below.

1. In the overall scheme of the transfer, 37.5 per cent of the gross revenue receipt of the centre is suggested to be transferred to the states.
2. User charges should be index-linked to input costs and the process of periodic revision should become automatic. Autonomous tariff commissions should be appointed to advise the government on the revision of power tariff, railway tariffs, bus fares and other administrative processes so that their links to cost is maintained while protecting the interests of the consumers.
3. The composition of government expenditure should be restructured in favour of priority areas like elementary education, primary healthcare, water supply, sanitation and infrastructure like roads and bridges. Expenditure on salaries, pensions, interest payments and subsidies requires a tight rein.
4. There is no need to appoint pay commissions as a routine at the intervals of 10 years. As the recommendations of the Central Pay Commission have a bearing on the states, its terms of reference, if and when appointed, should be determined in consultation with the states. The level of salaries and allowances should bear a relationship with the revenue expenditure of the states to be laid down by an expert committee.
5. For maintenance of capital assets, the states should make budgetary provisions each year at least to the recommended levels. The recommendation of the Tenth Finance Commission in this regard, for monitoring by a high power committee, should be actively operationalized. Further, the budgetary provisions for the maintenance of capital assets and for committed liabilities on plan schemes may be assessed by the Planning Commission, at the time of assessment of the state’s resources and estimation of the balance from current revenues. The Planning Commission may consider devising a suitable mechanism for this purpose.
6. Consideration needs to be given to evolving a system under which pensions do not become an unsustainable burden on the exchequer of the states. A large share of the pension goes to the defence sector. A suitable scheme to absorb the retirees from the armed forces in other government departments may be devised.
7. The share of the states is fixed at 28 per cent of the net proceeds of all shareable union taxes and duties for each of the 5 years, starting from 2000–01 and ending in 2004–05.
8. The share of the states in the net proceeds of union taxes and duties will be 29.5 per cent.
9. The criteria and relative weights for determining inter-se the share of the states are population (10 per cent), distance (62.5 per cent), area (7.5 per cent), index of infrastructure (7.5 per cent), tax effort (5 per cent) and fiscal discipline (7.5 per cent).
10. An amount of Rs 4,972.63 crores is recommended for the states towards the upgradation of standards in non-developmental and social sectors and special problem grants for the period 2000–05.
11. Article 243(1) should be amended to enable the states to set up the State Finance Commissions (SFCs) at the expiration of every fifth year or earlier, akin to the provision that already exists under Article 280 for constituting the Finance Commission.
12. State governments should take their decision on the recommendations of the SFCs, especially in regard to matters relating to resource transfer, and place the Action Taken Reports (ATRs) on the floor of the state legislature within 6 months. Amendments to the laws, if necessary, should be made to ensure this at the earliest.
13. A grant of Rs 1,600 crores for the panchayats and Rs 400 crores for the municipalities is recommended to be given to the states for each of the 5 years starting from the financial year 2000–01.
14. Inter-se shares ofthe states in the grants provided for the panchayats and the municipalities are based on the rural and urban population of the state (40 per cent), index of decentralization (20 per cent) distance from the highest per capita income (20 per cent), revenue effort of the local bodies (10 per cent) and geographical area (10 per cent).
15. The existing scheme of providing for contribution of 25 per cent by the states, and 75 per cent by the centre, to the Calamity Relief Fund (CRF) may be continued.
16. The amount of CRF for 2000–05 has been worked out at Rs 11,007.59 crores. This includes the centre’s share of Rs 8,255.69 crores and the share of the states of Rs 2,751.90 crores.
17. Only the natural calamities of cyclone, drought, earthquake, fire, flood and hailstorm should be eligible for relief expenditure from the CRF. The CRF should not be used for providing relief to people affected by manmade and other disasters and the concerned units from which a man-made disaster emanated should be made to pay for it.
18. The CRF should be kept separately outside the public account of a state and invested in a manner approved by the central government.
19. The NFCR may be discontinued in its present form.
20. A National Centre for Calamity Management (NCCM) should be established under the Ministry of Agriculture. This centre should be empowered to make recommendations regarding the eligibility of a state for assistance from the central government.
21. Assistance provided by the centre to the states for calamity relief should be financed by the levy of a special surcharge on central taxes for a limited period. Collections from such a surcharge should be kept in a separate fund to be known as the National Calamity Contingency Fund (NCCF), created in the public account of the Government of India. The union government should contribute an initial core amount of Rs 500 crores to this fund to be replenished by the levy of the special surcharge as and when any withdrawals are made from it. To ensure that there is no delay in the flow of funds to the states for administration of relief, a legislation enabling the central government to levy such a surcharge may be enacted.
22. After the devolution of central tax revenues, some states will still have deficit on the non-plan revenue account. Grants-in-aid amounting to Rs 35,359 crores have been provided to such states under Article 275(1) of the Constitution, equal to the amount of deficits assessed during the period 2000–05.
23. The scheme of general debt relief linked to fiscal performance, introduced by the Tenth Finance Commission, may be continued with modifications.
24. Limits on the guarantees given by the centre and the states may be fixed by suitable legislation, and should form a part of the overall limits to borrowing under Articles 292 and 293, respectively. This limit should also include borrowing from the Public Account and other sources.

32.4.4 Eleventh Finance Commission: An Assessment

The recommendations of the Eleventh Finance Commission have received both praise and criticism. The Commission has partially taken into account the implications of the 73rd and the 74th amendments to the Constitution by granting Rs 1,600 crores to the panchayats for the maintenance of core services at the local level. However, some scholars have felt this amount to be a meager sum considering the responsibilities assigned to the local bodies (see e.g. Mahipal, 2000). The recommendation of the Commission on the additional terms of reference generated controversy. One of the members of the Commission submitted a note of dissent on the Commission’s recommendation of linking 15 per cent of the revenue deficit grant with the progress in the implementation of the monitorable fiscal reform programme, stating that the Commission did not have the mandate to make grants given under Article 275 of the Constitution conditional on the implementation of the programme. While welcoming such an initiative, it has been pointed out that the Commission has excluded the centre from such reform programmes, though the centre’s deficits have reached alarming proportions (Godbole, 2001).

32.5 Twelfth Finance Commission

The President appointed the Twelfth Finance Commission on 1 November 2002, under the chairmanship of Dr C. Rangarajan. The country had passed a decade of liberalization and structural adjustment. Though the country witnessed significant growth rate during this period, it is accompanied by increasing regional disparities. Both the centre and the states were undergoing persistent fiscal strain. The Commission had to make its recommendations against this background.

32.5.1 Terms of Reference

The President, vide the notification dated 1 November 2002, mandated the Commission to recommend on the following:

1. The distribution between the union and the states of the net proceeds of taxes which are to be, or may be, divided between them under Chapter I Part XII of the Constitution and the allocation between the states of the respective shares of such proceeds.
2. The principles which should govern the grants-in-aid of the revenues of the states out of the Consolidated Fund of India, and the sums to be paid to the states which are in need ofassistance by way ofgrants-in-aid oftheir revenues under Article 275 ofthe Constitution for purposes other than those specified in the provisions to clause (1) of that Article.
3. The measures needed to augment the Consolidated Fund of a state to supplement the resources of the panchayats and the municipalities in a state on the basis of the recommendations made by the Finance Commission of the state.
4. The Commission shall review the state of the finances of the union and the states and suggest a plan by which the governments, collectively and severally, may bring about a restructuring of the public finances for restoring budgetary balance, achieving macroeconomic stability and debt reduction, along with equitable growth.
5. In making its recommendations, the Commission shall have regard, among other considerations, to:
   1. The resources of the central government for 5 years, commencing on 1 April 2005 on the basis of the levels of taxation and non-tax revenues likely to be reached at the end of 2003–04.
   2. The demands on the resources of the central government, in particular, on account of the expenditure on civil administration, defence, internal and border security, debt servicing and other committed expenditure and liabilities.
   3. The resources of the state governments, for the 5 years commencing on 1 April 2005 on the basis of the levels of taxation and non-tax revenues likely to be reached at the end of 2003–04.
   4. The objective of not only balancing the receipts and expenditure on revenue account of all the states and the centre, but also generating surpluses for capital investment and reducing the fiscal deficit.
   5. Taxation efforts of the central government and each state government as against targets, if any, and the potential for additional resource mobilization to improve the tax-GDP and the tax-Gross State Domestic Product (GSDP) ratios, as the case may be.
   6. The expenditure on the non-salary component of the maintenance and upkeep of capital assets and the non-wage-related maintenance expenditure on plan schemes to be completed by 31 March 2005, and the norms on the basis of which specific amounts are recommended for the maintenance of the capital assets and the manner of monitoring such expenditure.
   7. The need for ensuring the commercial viability of irrigation projects, power projects, departmental undertakings, public sector enterprises, etc., in the states through various means including the adjustment of user charges and the relinquishing of non-priority enterprises through privatization or disinvestments.
6. In making its recommendations on various matters, the Commission will take the base of population figures as of1971, in all such cases where the population is a factor for the determination of devolution of the taxes, duties and grants-in-aid.
7. The Commission shall review the fiscal reform facility introduced by the central government on the basis of the recommendations of the Eleventh Finance Commission and suggest measures for effective achievement of its objectives.
8. The Commission may, after making an assessment of the debt position of the states as on 31 March 2004, suggest such corrective measures as are deemed necessary, consistent with macroeconomic stability and debt sustainability. Such measures recommended will give weightage to the performance of the states in the fields of human development and investment climate.
9. The Commission may review the present arrangements as regards the financing of disaster management with reference to the NCCF and the CRF and make appropriate recommendations thereon.
10. The Commission shall indicate the basis on which it has arrived at its findings and make available the state-wise estimates of receipts and expenditure.
11. In addition to the above, through a subsequent notification dated 31 October 2003, the Commission was asked to make recommendations on the following matters:
    1. whether non-tax income of profit from petroleum to the union, arising out of contractual provisions, should be shared with the states from where the mineral oils are produced; and
    2. if so, to what extent.

32.5.2 Approach of the Commission

The terms of reference of the Twelfth Finance Commission reflect the fiscal situation of both the centre and the states, and the need to take further steps in the fiscal reform measures initiated on the basis of the recommendations of the Eleventh Finance Commission. The thrust of the terms of reference is on achieving fiscal discipline and better management of finances both at the centre and the states. They also reflect the need to make further advances in liberalization through privatization or disinvestment of public enterprises, and ensuring the commercial viability of public utilities through the levy of better user charges. The overall approach of the Commission has been to recommend a scheme of fiscal transfer that serves the objectives of equity and efficiency, while correcting both vertical and horizontal imbalances.

32.5.3 Recommendations of the Commission

The Twelfth Finance Commission made 71 recommendations, of which the major ones are reproduced in the following sections.

32.5.3.1 Sharing of Union Tax Revenues The share of the states in the net proceeds of shareable central taxes shall be 30.5 per cent. For this, additional excise duties in lieu of sales tax are treated as a part of the general pool of central taxes. If the tax rental arrangement is terminated and the states are allowed to levy sales tax (or VAT) on these commodities without a prescribed limit, the share of the states in the net proceeds of shareable central taxes shall be reduced to 29.5 per cent.

The indicative amount of overall transfers to the states may be fixed at 38 per cent of the central gross revenue receipt.

32.5.3.2 Local Bodies A grant of Rs 20,000 crores for the panchayati raj institutions and Rs 5,000 crores for the urban local bodies may be given to the states for the period 2005–10.

32.5.3.3 Calamity Relief The scheme of the Calamity Relief Fund may be continued in its present form with contributions from the centre and the states in the ratio of 75:25.

32.5.3.4 Grants-in-Aid to the States The system of imposing a 70:30 ratio between the loans and the grants for extending plan assistance to non-special category states (10:90 in the case of special category states) should be done away with. Instead, the centre should confine itself to extending plan grants to the states and leave it to the states to decide how much they wish to borrow and from whom.

A non-plan revenue deficit grant of Rs 56,855.87 crores is recommended during the award period for 15 states.

32.5.3.5 Debt Relief and Corrective Measures Each state must enact a fiscal responsibility legislation prescribing the specific annual targets to eliminate the revenue deficit by 2008–09 and reduce fiscal deficit based on a path for reduction of borrowings and guarantees. Enacting the fiscal responsibility legislation will be a necessary precondition for availing debt relief.

The central loans to states contracted till 31 March 2004 and outstanding on 31 March 2005 (amounting to Rs 128,795 crores) may be consolidated and rescheduled for a fresh term of 20 years (resulting in repayment in 20 equal installments), and an interest rate of 7.5 per cent be charged on them. This will be subject to the state enacting the fiscal responsibility legislation and will take effect prospectively from the year in which such legislation is enacted.

A debt write-off scheme linked to the reduction of the revenue deficit of the states may be introduced. Under the scheme, the repayments due from 2005–06 to 2009–10 on central loans contracted up to 31 March 2004, and recommended to be consolidated, will be eligible for write-off. The quantum of write-off of repayment will be linked to the absolute amount by which the revenue deficit is reduced in each successive year during the award period. The reduction in the revenue deficit must be cumulatively higher than the cumulative reduction attributable to the interest relief recommended by the Commission. Also, the fiscal deficit of the state must be contained at least to the level of 2004–05. In effect, if the revenue deficit is brought down to zero, the entire repayments during the period will be written off. The enactment of the fiscal responsibility legislation would be a necessary pre-condition for availing the debt relief under this scheme as well, with the benefit accruing prospectively.

32.5.3.6 Monitoring Mechanism Every state should set up a high-level monitoring committee headed by the Chief Secretary, with the Finance Secretary and the Secretaries and Heads of Departments as members for monitoring the proper utilization of finance commission grants.

32.5.4 Twelfth Finance Commission: An Assessment

The recommendations of the Twelfth Finance Commission have been generally welcomed, though there were a few dissenting voices. The new borrowing regime, which seeks to inculcate market-based discipline along with a scheme designed to alleviate existing debt burden, has been hailed as an improvement over the incentive scheme introduced by the centre following the recommendation of the Eleventh Finance Commission (Rao and Jena, 2005). Scholars, however, are divided over the impact of the proposed debt write-off scheme. It has been argued that its potential fiscal impact will differ across states, depending on the share of debt of a state to the centre in its debt stock and their maturity pattern (Rajaram and Majumdar, 2005). Some scholars have expressed apprehension that the proposed plan for restructuring the debt of the state governments contains stringent conditions that probably violate the basic tenets of fiscal federalism (Ghosh, 2005).

32.6 Impact of the Tenth, Eleventh and Twelfth Finance Commissions on Centre-State Relations

The structural adjustment programme initiated by the union government in the early 1990s had a profound impact on centre-state relations. Though the constitutional provisions have not undergone a drastic change, except that relating to the additional duties of excise, the centre has sent the message to the states to be competitive on their own to attract domestic and foreign investment. This, however, is possible if only the states find adequate resources for productive investment. It is also likely that the benefits of liberalization bypass the states that lag, thereby contributing to interregional disparity and the attendant problems. The terms of reference of the Tenth, Eleventh and Twelfth Finance Commissions relating to reduction in fiscal deficit and public debt reflect the concerns of the central government on the alarming debt position, the interest burden of the states and their inability to maintain existing assets and invest in infrastructure.

In the face of increasing fiscal strain at the central level, the states can no longer expect the centre to meet their fiscal needs through transfers. The scheme of rewarding fiscal discipline and tax effort, introduced by the Tenth Finance Commission and continued by the Eleventh and Twelfth Finance Commissions, is aimed at checking fiscal profligacy. Following this recommendation, the union government has devised incentive schemes for the states to encourage them to introduce monitorable fiscal reforms. The Eleventh Finance Commission had recommended the establishment of an incentive fund, the release from which was to be based on the fiscal performance of the states. This recommendation led to the setting up of a Medium Term Fiscal Facility Fund. The Twelfth Finance Commission scrapped the incentive fund and, in its place, recommended the new borrowing regime and a scheme for debt consolidation aimed at inculcating fiscal discipline. However, to avail of the benefits of these recommendations, the states should enact a Fiscal Responsibility Law with basic features.

Another area where innovative measures have been introduced relates to contingent liabilities. Till recently, the contingent liabilities of the states were not taken into account while considering the issues relating to the debt position of states. A major form of contingent liability is state government guarantees. Following the recommendation of the Eleventh Finance Commission, steps have been taken to rein in on guarantees, and several states have taken the initiative to fix a ceiling on guarantees.

32.7 Concluding Observations

The recommendations of the Tenth, Eleventh and Twelfth Finance Commissions reflect the economic philosophy underlying the structural adjustment programme and the spirit of the 73rd and the 74th constitutional amendments. Following the recommendations of these three Commissions, the states are under increasing pressure to manage their finances in a more efficient and responsible manner. The new fiscal initiatives are meant to penalize fiscal profligacy and reward efficient fiscal management. The recommendations targeted to local self-government institutions visualize a strong and more decentralized polity. These changes have redefined the role of the centre and the states as partners in development, thereby ushering in a new era in India’s fiscal federalism.

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