Unilateralism and the Finance Commissions

R. Srinivasan

In accordance with the federal spirit, a Finance Commission should function as an arbitrator between the Union and State governments.

The Finance Commissions can objectively redress fiscal inequalities in India only if the Union and State governments decide jointly on its constitution and its terms of reference.

The terms of reference to the 13th Finance Commission emphasise that it should include fiscal reform measures as conceived by the Union government, as the major conditions to distribute financial resources among States. The Constitution itself provides the terms of reference to the Finance Commission, which reflect the federal spirit and hence remain neutral. Article 280 requires the Finance Commission to recommend the share of State governments in the net tax revenue of the Union government, the formula for distribution of the States’ share among the States, the principle for distribution of grants-in-aid under Article 275, and measures to augment the Consolidated Fund of States to supplement the resources of the local governments. (This was included after the 73rd and 74th Constitutional amendment).

The Constitution states that the Union government can refer any other matter to the Finance Commission in the interest of sound finance. Using this provision in the Constitution, the Union government has been including in the terms of reference to successive Finance Commissions, provisions that reflect the Union government’s view of the States’ fiscal situation. There is no scope for the States to put forth their views on this matter.

The terms of reference to the first Finance Commission contained only those items mentioned in the Constitution. Those to the Second and Third Finance Commissions asked them to consider the financial requirements for implementing Five-Year Plans, and possible additional resource mobilisation by the States, while deciding the distribution of the grants-in-aid among States.

Those to the Fourth Finance Commission mentioned even the base year for the projection of State revenue and expenditure. The Fourth and Fifth Commissions were asked to consider mainly the non-Plan expenditure arising out of the Plan scheme and debt servicing while deciding the distribution of grants-in-aid, and to explore the scope to improve efficiency in administrative expenditure.

The terms of reference to the Sixth Finance Commission, in addition to all the conditions mentioned above, stipulated that it consider (i) Central assistance for State Plans, (ii) improving administration in backward States, (iii) terms for extending Union loans to States in the light of non-Plan capital gap, and (iv) the feasibility of establishing a national fund for relief expenditure in States affected by natural calamities.

For the first time, the terms of reference to the Seventh Finance Commission mentioned the need to consider the requirements of the Union government to finance civil administration, defence and border security, debt servicing, and so on. It added items like the need to ensure reasonable returns on investments in irrigation and power projects, transport undertakings, industrial and commercial enterprises, and the like, in the States.

Since the term of the Seventh Finance Commission the Union government has been asking successive Commissions to take into account only the 1971 Census figures wherever population is used as a criterion for revenue distribution.

The terms of reference to the ninth Finance Commission prescribed a normative approach to decide the States’ financial requirements and hence the base year for financial projections was not mentioned. The terms of reference to the 10th Finance Commission did not mention the normative approach, but wanted the Finance Commission to review both the Union and State governments’ finances to restore budgetary balance and maintain macro-economic stability.

The Union government asked the 11th Finance Commission to give a monitorable fiscal reform programme with a view to reducing the revenue deficit of the States and as a condition for the distribution of grants-in-aid. The Union government wanted the 12th Finance Commission to review the fiscal reform programme recommended by the 11th Finance Commission. Obviously, the 12th Finance Commission imposed the passage of fiscal responsibility legislation as a condition to access the debt restructuring facility from the Union government.

New items

The Union government has been adding new items in the terms of reference to successive Finance Commissions, evidently compelling them to take a particular view of State finances. For instance, the constitutional provisions in regard to the terms of reference to Finance Commissions do not require the Commission to recommend financial transfers only to the non-Plan revenue account. But the terms of reference set by the Union government require the Finance Commission to do so. This has facilitated the emergence of the Planning Commission, a non-constitutional body, as a dispenser of financial resources for State Plans as well as discretionary grants. This has certainly left the Finance Commission constrained in taking a holistic view of State finances, and has promoted a unilateralist tendency in deciding the Union’s financial transfers to the States.

It is generally accepted that the size of the public sector in a State is dependent on the size of its population. Understandably, the use of 1971 Census figures in all distribution formulas is meant to protect the interests of those States that have considerably reduced the population growth rate. But the fact remains that the 1971 population figure does not reflect the current level of the public sector that is needed.

Alternatively, had the Finance Commission been left to decide on this matter, it could have designed a suitable formula, which while taking into account the current population would also have rewarded those States that have controlled their population growth. Moreover, whenever per capita Gross State Domestic Product (GSDP) is taken as a criterion in the distribution formula, the current population enters the consideration. Invariably, the weightage given to per capita GSDP is more than that given to the population in the distribution formulas by all Finance Commissions. Hence the current population becomes more important in the system of financial transfers.

A review of the terms of reference to various Finance Commissions reveals that the Union government has unilaterally decided the contours of both Union and State finances, within which the Commission has to function. The Union government’s conception of fiscal reform for States includes commercial viability of all public sector initiatives and budgetary balance. This conception is based on the notion that the ‘state,’ like a corporate body, should at least break even — which is a neo-classical economic conception of state. This is contrary to the public mandate and the political conception at the regional level, and undermines the limited functional autonomy of State governments.

Consequent to the implementation of the States’ Debt Consolidation and Relief Facility as recommended by the 12th Finance Commission, the proportion of Union loan in the total debt liabilities of the State governments has come down significantly. Every State passed the Fiscal Responsibility Act and more or less reduced the revenue deficit to zero and the fiscal deficit to 3 per cent of GSDP in order to avail of the facility for debt restructuring. Evidently, budgetary balance is achieved at the cost of a lower level of public services in the developing and unequal economy, with the associated adverse distributional impact.

The 13th Finance Commission is asked to review the functioning of this facility and to recommend measures to maintain a stable and sustainable fiscal environment consistent with equitable growth. As mentioned earlier, in a diverse federal society there will be diverse opinions on the role of state and public finances; imposing a particular set of fiscal reform programme is a misadventure, as ‘one size does not fit all’ and ‘one school of thought does not get every one’s approval’ in a federal society.

The terms of reference to the earlier Finance Commissions mentioned that the Union government’s expenditures have the first claim on the Union government’s tax revenue. In addition to this, the terms of reference to the 13th Finance Commission mention the Gross Budgetary Support (GBS) to the Central and State Plans. Considering only the GBS for the Union government would result in enhancing the centralising tendency of the Union government. Rather, this is an opportunity for the Finance Commission to recommend transfers even for the State Plans, which is long pending demand of the States.

The terms of reference insist that only the non-salary component of maintenance and upkeep of capital assets and the non-wage related maintenance expenditure on the Plan schemes be considered. The Planning Commission itself considered certain rules in the Fiscal Responsibility and Budget Management (FRBM) as a major constraint on the government in expanding revenue expenditure during the 11th Plan and suggested in the approach paper to the 11th Plan a relaxation of FRBM rules. And the Plan-revenue expenditure is expected to leave a longer trail of non-Plan revenue expenditure than the Plan-capital expenditure. So it is unfair to consider only the non-wage component of maintenance expenditure. The need to improve the quality of public expenditure and to maintain the environment, as mentioned in the terms of reference, should not be used as criteria for the distribution of financial resources unless generally acceptable standards and metrics are arrived at.

The review of the terms of reference to the 13 Finance Commissions so far, reveal certain facts. One, the items in the terms of reference have deviated substantially from the letter and spirit of the constitutional provisions in this regard. Two, the terms of reference have been unilaterally decided by the Union government. Three, consequently the terms of reference are used to coerce the Finance Commission to take a particular view of the State finances and to indirectly compel the States to implement reform programmes as designed by the Union government.

In accordance with the federal spirit, a Finance Commission should function as an arbitrator between the Union and State governments, who compete to claim a larger share in the Union’s tax revenue. The root cause for the lopsided Union-State financial relations is the non-involvement of State governments in deciding the terms of reference. The Finance Commission could have gained strength in upholding the federal spirit of the Constitution, had the constitution of the Finance Commission and the terms of reference to it been decided jointly by the Union and state governments.

(R. Srinivasan is a former member of the Tamil Nadu State Planning Commission.)

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