Economics for Everyone- Finance Commission (India) - Part 2- Centre State Relationships and Tax Devolution

The 14th Finance Commission headed by former RBI governor, YV Reddy, has recommended an increase in the share of states in the centre's tax revenue from the current 32% to 42%. This is indeed the single largest increase ever recommended by a Finance Commission.

August 25, 2015 10:39 IST | AICAR Business School
 “I feel more and more that we must function more from below than from the top… too much of centralization means decay at the roots and ultimately a withering of branches, leaves and flowers.”
-Pandit Jawaharlal Nehru
“Finance commission as a quasi-arbitral body whose function is to do justice between the Centre and the states”.
 “Indian federalism is a cooperative federalism. In a Democratic Constitution without the finance commission, the distribution of revenues would have degenerated into something like open warfare”.
-Granville Austin (American historian and a leading authority on the Indian Constitution)
“We want to promote co-operative federalism in the country. At the same time, we want a competitive element among the states. I call this new form of federalism Co-operative and Competitive Federalism”
- Prime Minister Narendra Modi

Section I Background
The 14th Finance Commission headed by former Reserve Bank of India governor, YV Reddy, has recommended an increase in the share of states in the centre's tax revenue from the current 32 per cent to 42 per cent. This is indeed the single largest increase ever recommended by a Finance Commission. This is a step further beyond the resource sharing recommendations all Finance Commissions do and outlined a new paradigm of Centre-state relations. The 14th Finance Commission (FFC) was constituted on 2nd January, 2013 and submitted its report on 15th December, 2014. The report was submitted by the Secretary of the Finance Commission to the Secretary to the President of India.
The Key Functions of the Finance Commission are
  1. Distribution of net proceeds of taxes between Centre and the States, to be divided as per their respective contributions to the taxes i.e. to recommend measures and methods on how revenues need to be distributed between the Centre and states.
  2. Suggesting the mechanism to share tax revenues, the Commission also lays down the principles for giving out grant-in-aid to states and other local bodies as follows
    1. Determine factors governing Grants-in Aid to the states and the magnitude of the same.
    2. To make recommendations to president as to the measures needed to augment the Consolidated Fund of a State to supplement the resources of the panchayats and municipalities in the state on the basis of the recommendations made by the Finance Commission of the state.
Article 280 of the Constitution lays down that the Central government shall set up a finance commission once every five years to recommend how the taxes collected by the Centre should be shared with and among the states and how grants from the Centre should be provided to the states. The framers of the Constitution had the Australian Commonwealth Grants Commission as a model.
In part 1, I have discussed the functions and recommendations of the Finance commission. Now, let us understand some details about the Financial Relation between Centre and State in India and the Tax devolution concept. Without understanding these topics, the study of finance commission is not complete.
To understand the Financial Relation between Centre and State in India, we need to know the following issues
  • Relation Between Centre And State In India
  • Three-fold distribution of legislative powers between the Union and the States
  • Distribution of Taxes between Union and the States
  • Issues related to the distribution of Taxes.
Source: Mint
Section II Indian Federalism and Center State Relations- CENTRE – STATE RELATIONS
The Constitution provides a federal system of government in the country even though it describes India as ‘a Union of States’. In effect, India is a federation consisting of one National or Union Government and a number of Governments of the federating units such as the states and the Union Territories. In such a composite polity, it is essential that the financial resources should be divided between the Union Government and the government of the federating units.
Relations between the Union and States can be studied under the following heads
(a) Legislative Relations-
(b) Administrative relations
(c) Financial Relations
In this article we will see the overview of the financial relation between the Centre and State relationship.
Financial Relationship: Intergovernmental Transfers
According to a World Bank study, transfer of funds from the central government to sub national units is essential because the centre has monopolised the most productive sources of tax revenue. Also according to the study in most cases, national governments impose income taxes because sub national governments (say states) lack the resources and the skill to administer such a complex tax system. Also, transfer to the sub national governments constitute a sizeable proportion of the government sharing of financial resources.
The Financial relationship between the Centre (Union) and the States is provided in the constitution. The constitution gives a detailed scheme of distribution of financial resources between Union and the States. The constitution makes a broad distinction between the power to levy a tax and the power to appropriate the proceeds of a tax. Thus the legislature which levies a tax is not necessarily the authority which retains the proceeds of a tax levied.
There are three main channels for transfer of resources from the Centre to the states. These are the Finance Commission, the Planning Commission and the Central ministries -- through what are called "Central-sector projects" and Centrally sponsored schemes. If the word "transfers" includes tax shares, loans and grants, then the Finance Commission transfers account for around 38 per cent of all Central inflow to states, with the Planning Commission accounting for 40 per cent and Central ministries for another 22 per cent. But if "transfers" are taken as just tax devolutions and grants, as indeed they should be since loans have to be repaid at some time or the other, then the Finance Commission's share increases to around 60 per cent. Central transfers, in turn, account for 40-45 per cent of the states' current expenditures.
Finance Commission –One of the instruments which the Constitution has evolved for the purpose of distributing financial resources between the Centre and the states is the Finance Commission. The Finance Commission according to Article 280 of the Constitution is constituted by the President once every five year and is a high- power body. The duty of the Commission is to make recommendations to the President as to: (a) the distribution between the union and the states of the net proceeds of the taxes which are to be divided between them and the allocation between the states themselves of the respective share of such proceeds; (b) the principles which should govern the grants-in-aid of the revenues amongst the states out of the Consolidated Fund of India.
Vertical and horizontal imbalances
Vertical and horizontal imbalances are common features of most federations and India is no exception to this. The Constitution assigned taxes with a nation-wide base to the Union to make the country one common economic space unhindered by internal barriers to the extent possible. States being closer to people and more sensitive to the local needs have been assigned functional responsibilities involving expenditure disproportionate to their assigned sources of revenue resulting in vertical imbalances. Horizontal imbalances across States are on account of factors, which include historical backgrounds, differential endowment of resources, and capacity to raise resources. Unlike in most other federations, differences in the developmental levels in Indian States are very sharp. In an explicit recognition of vertical and horizontal imbalances, the Indian Constitution embodies the mandatory provisions to address them through the transfer of resources from the Centre to the States. 
Economists use a term called "vertical imbalance" to denote the mismatch between revenue raising capacity and expenditure needs as far as different levels of governmental units are concerned. To some extent, vertical imbalance is built into any federation since the Central government has a comparative advantage in raising revenues while the states are better placed to spend money more effectively.

Section III - Three-fold distribution of legislative powers between the Union and the States
The Indian Constitution has adopted system of three-fold enumeration, namely, Union, State and Concurrent.
List I includes all those subjects which are in the exclusive jurisdiction of Parliament.
List II consist of all the subjects which are under exclusive jurisdiction of the State Legislature, and
List III which is called the Concurrent List, consists of subjects on which both Parliament and the State legislatures can pass laws.
(i) Union List:
List I, or the Union List, includes areas, including residuary powers, most of them related to matters which are exclusively within the jurisdiction of the Union. Subjects of national importance requiring uniform legislation for the country as a whole are inducted in the Union List.
The more important examples are defence, armed forces, arms and ammunition, atomic energy, foreign affairs, coinage, banking and insurance. There are also items dealing with inter-state matters like inter-state trade and commerce regulation and development of inter-state rivers and river valleys, and inter-state migration, which have been placed under the jurisdiction of the Union Parliament.
Certain items in the Union List are of such a nature that they enable Parliament to assume a role in certain spheres in regard to subjects which are normally intended to be within the jurisdiction of the States; one such example is that of industries. While assigned primarily to the State List; industries, the control of which by the Union is declared by a law of Parliament, to be expedient in the public interest’ are to be dealt with by parliamentary legislation alone. Parliament, by a mere declaration, can take over as many industries as it thinks fit.
It is under this provision that most of the big industries, like iron, steel and coal, have been taken over by Parliament under its jurisdiction. Similarly, while museums, public health, agriculture etc. come under State subject, certain institutions like the National Library and National Museum at New Delhi and the Victoria Memorial in Calcutta have been placed under the jurisdiction of Parliament on the basis of a plea that they are financed by the Government of India wholly or in part and declared by a law of Parliament to be institutions of national importance.
The university is a State subject but a number of universities have been declared as Central Universities and placed under the exclusive jurisdiction of Parliament. Elections and Audit, even at the State level, were considered matters of national importance. The Extensive nature of the Union List thus places enormous powers of legislation even over affairs exclusively under the control of the States in the hands of Parliament.
(ii) State List:
List II or the State List, comprises entries over which the State Legislature has exclusive power of legislation. The subject of local importance, where variations in law in response to local situations may be necessary, has been included in the State List.
Some subjects of vital importance in the list are State taxes and duties, police, administration of justice, local self-government, public health, agriculture, forests, fisheries, industries and minerals.
But, in spite of the exclusive legislative jurisdiction over these items having been given to the States, the Constitution, through certain reservations made in the Union List has given power to Parliament to take some of these items under its control. Subject to these restrictions, one might say, the States have full jurisdiction over items included in the State list.
(iii) Concurrent List:
The inclusion of List III or the Concurrent List, in the Constitution gives a particular significance to the distribution of legislative power in the Indian federal scheme. The Concurrent List consists of 52 items, such as criminal law and procedure, civil procedure, marriage, contracts, port trusts, welfare of labour, economic and social planning.
In case of over-lapping of a matter between the three Lists, predominance has been given to the Union Legislature, as under the Government of India Act, 1935. Thus, the power of the State Legislature to legislate with respect to matters enumerated in the State List has been made subject to the power of the Union Parliament to legislate in respect of matters enumerated in the Union and Concurrent Lists, and the entries in the State List have to be interpreted accordingly.
The above stated list along with the Federal Objective of distribution of finance between the Central and the State Government has influenced the distribution of Taxes.
Section IV Distribution of Taxes between Union and the States
Some Details of Distribution:                                                                          
 The distribution of the tax-revenue between the Union and the States stands as follows:
1. Taxes Belonging to the Union Exclusively:
(i) Customs, (ii) Corporation tax. (iii) Taxes on capital value of assets of individuals and Companies, (iv) Surcharge on income tax, etc. (v) Fees in respect of matters in the Union List (List I).
2. Taxes belonging to the States Exclusively:
(i) Land Revenue, (ii) Stamp duty except in documents included in the Union List, (iii) Succession duty, estate duty, and Income tax on agricultural land, (iv) Taxes on passengers and goods carried on inland waterways, (v) Taxes on lands and buildings, mineral rights, (vi) Taxes on animals and boats, on road vehicles, on advertisements, on consumption of electricity, on luxuries and amusements, etc. (vii) Taxes on entry of goods into local areas, (viii) Sales Tax. (ix) Tolls, (x) Fees in respect of matters in the State List, (xi) Taxes on professions, trades, etc., (List II).
3. Duties Levied by the Union but Collected and Appropriated by the States:
Stamp duties on bills of Exchange, etc., and Excise duties on medicinal and toilet preparations containing alcohol, though they are included in the Union List and levied by the Union, shall be collected by the States insofar as leviable within their respective territories, and shall form part of the States by whom they are collected (Article 268).
4. Taxes Levied as well as Collected by the Union, but Assigned to the States within which they are Leviable:
(i) Duties on succession to property other than agricultural land, (ii) Estate duty in respect of property other than agricultural land, (iii) Terminal taxes on goods or passengers carried by railway, air or sea. (iv) Taxes on railway fares and freights, (v) Taxes on stock exchange other than stamp duties, (vi) Taxes on sales of and advertisements in newspapers, (vii) Taxes on the sale or purchase of goods other than newspapers, where such sale or purchase takes place in the course of Inter-State trade or commerce, (viii) Taxes on Inter-State consignment of goods (Article 269).
5. Taxes Levied and Collected by the Union and Distributed between Union and the States:
Certain taxes shall be levied as well as collected by the Union, but their proceeds shall be divided between the Union and the States in a certain proportion, in order to effect an equitable division of the financial resources. These are:
(i) Taxes on income other than on agricultural income (Article 270).
(ii) Duties of excise as are included in the Union List, excepting medicinal and toilet preparations may also be distributed, if Parliament by law so provides (Article 272).
The Constitution has left it to the discretion of Parliament to decide by law whether any of the union duties of excise should be shared with the States, how these are to be shared, and how the shares are to be distributed to the States, Taxes which are to be levied and collected by the Centre, but to be distributed entirely (except for those proceeds which are attributable to the Union territories) to the States in accordance with such principles of distribution as may be laid down by Parliament by law.
These taxes consist of succession and estate duties; terminal taxes on passengers and goods carried by rail, sea or air taxes on railway fares and freights; taxes on the sale or purchase of newspapers; sale or purchase taxes on inter-State trade,
Distribution of Non-Tax Revenue:
The principal sources of non-tax revenues of the Union are the receipts from:
Railways; Posts and Telegraphs; Broadcasting; Opium; Currency and Mint; Industrial and Commercial Undertakings of the Central Government relating to the subjects over which the Union has jurisdiction.
Of the Industrial and Commercial Undertakings relating to Central subjects may be mentioned. The Industrial Finance Corporation; Air India; Indian Airlines.
Industries in which the Government of India have made investments; such as the Steel Authority of India; the Hindustan Shipyard Ltd; the Indian Telephone Industries Ltd.
The States, similarly, have their receipts from: Forests, Irrigation and Commercial Enterprises (like Electricity, Road Transport) and Industrial Undertakings (such as Soap, Sandalwood, Iron and Steel in Karnataka, Paper in Madhya Pradesh, Milk Supply in Mumbai, Deep-sea Fishing and Silk in West Bengal).
The residuary power of taxation belongs to the centre. It means that the subjects which have not been included either in the union or in the state list may be taxed only by the union government.
Grants and Loans:
Besides the devolution of revenues the Union meets the financial needs of the State in two other ways:
By making grants-in-aid of State revenues and other grants and
By giving loans. According to the Constitution, both the Union and the States are empowered to make grants.
But by virtue of the resources at its disposal, the Union’s power is greater. The Union can make grants for purposes outside its legislative jurisdiction, and it is under this provision that any of the large capital grants for national development schemes are made. Grant-in-aid may be made to a State to defray its budgetary deficits, or it may make grant-in-aid on the basis of budgetary need, and to aid States whose revenues, even after devolution fall short of their expenditures. Efforts are generally made to keep these grants-in-aid to a minimum by making devolution adequate. Other grants are generally unconditional, but in certain cases, as in Assam, grants have been made for the development of backward areas and tribes.
Besides grants-in-aid, States also sometimes depend heavily on the Union for loans. The Union government has unlimited power to borrow either within India or outside, and may exercise this power subject only to such limits as might be fixed by Parliament from time to time.
In the case of the States, however, their borrowing power is subject to a number of Constitutional limitations. The State executive has the power to borrow within the territory of India, subject to many conditions.
Borrowing Powers:
The Union has unlimited power of borrowing, upon the security of the revenues of India either within India or outside. The Union Executive can exercise the power; subject only to such limits as may be fixed by Parliament from time to time.
The borrowing power of a State is, however, subject to a number of Constitutional limitations:
(i) It cannot borrow outside India, (ii) The State Executive shall have the power to borrow, within the territory of India upon the security of the revenues of the State, subject to the following conditions: (a) limitation as may be imposed by the State Legislature; (b) if the Union has guaranteed an outstanding loan of the State, no fresh loan can be raised by the State without consent of the Union Government; (c) The Government of India may itself offer a loan to a State, under a law made by Parliament; so long as such a loan or any part thereof remains outstanding, no fresh loan can be raised by the State without the consent of-the Government.
Section V Issues related to the distribution of Taxes.
The relationship between the Centre and the States covers a wide range and covers a very large part of the functions and activities in the administrative, social and economic spheres. Since 1950, many events have occurred which have a direct or indirect bearing on the Centre-State relations.
For instance, the Planning Commission (now NITI Aayog) was set up by a resolution of the Government of India in March, 1950 with the object of accelerating the economic growth of the country and to meet the social urge for the extension of social services. According to some experts, the re organization of the States in 1956 and thereafter, especially with the emergence of non-Congress Governments in some States after the 1967 gave the issue of Centre-State relations a new dimension and importance.
Generally the States have the following grievances/issues against the centre
  • The States regard as inadequate the resources placed at their disposal and demand transfer of more financial resources.
  • The States have, to look to the Centre for funds in case of unforeseen calamities or to carry out various schemes. They do not see eye to eye with the Centre on the issue of overdraft facilities and debt and repayment liabilities of State governments.
  • The Centre has the prerogative to decide finally the location of various industries and projects. Undue delays in clearance of projects have adversely affected the interests of the States.
  • The States resent the Centre’s encroachment into their sphere, evidence in the transfer of subjects from the State List to the Concurrent List.
  • The States do not like the persistence of the Centre in the matter of getting sales tax abolished.
  • The States disapprove of the Centre’s practice of unilaterally increasing the wages and salaries of its staff, as this creates problems for the State governments vis-a-vis their own staff.
  • The administered prices are controlled by the Centre, and arbitrary and drastic increase in the prices upset State budgets.
The Centre, for its part, feels displeased at the attitude of the States over various issues. Its aim is to achieve equitable development of the country. It feels perturbed at the objections of the more advanced States over its special concessions and measures to develop the backward areas.
The Centre also alleges that State governments tend to divert funds allocated for a particular scheme to other purpose. The Centre also resents the States’ claiming credit for the successful implementation of Centrally-sponsored projects.
Section VI Reforming Centre-State Relations Committees and Model Formulation
Some of the major recommendations made by different committees and teams are as under:
1. The Setalvad Study Team:
The Setalvad Study Team had recommended the Constitution of an inter- State Council composed of the Prime Minister and other central ministers holding key portfolios, Chief Ministers and others, invited or co-opted. It suggested measures to rationalize the relationship between the Finance Commission and the Planning Commission.
Besides, it recommended that the office of Governor be filled by a person having ability, objectivity and independence and the incumbent must regard himself as a creation of the Constitution and not as an errand boy of the Central Government
2. The Administrative Reforms Commission:
The Administrative Reforms Commission noticed that the Central Government had even moved into the fields earmarked for the States under the Constitution and asked it to withdraw from such areas.
It recommended the setting up of an inter-State Council but made a novel suggestion about its composition. Instead of giving seats in this body to all the Chief Ministers, it wanted to have five representatives one each from the five zonal councils.
Much more importantly, the ARC highlighted the need for formulation of guidelines for governors in the exercise of their discretionary powers. This would ensure uniformity of action and eliminate all suspicions of partnership or arbitrariness.
The question whether a Chief Minister enjoys majority support or not should be tested on the floor of the Legislature and for this he should summon the Assembly whenever a doubt arises.
It also opined that when a ministry suffers a defeat in the Legislative Assembly on major policy issues and the outgoing chief minister advises the governor to dissolve the Assembly with a view to obtaining the verdict of the electorate, the governor should normally accept the advice.
3. Rajamannar Committee Report:
The DMK government of Tamil Nadu appointed a Commission with a direction to suggest changes in the existing level of Union-State relations. Their terms of reference were to examine the entire question regarding the relationship that should exist between the Centre and the States in a federal set-up and to suggest amendments to the Constitution so as to “secure utmost autonomy to the States.”
The Committee headed by P.V. Rajamannar, a retired Chief Justice of Madras High Court, presented its report on May 27, 1971. Some of the important recommendations of the Committee were:
(i) The Committee recommended the transfer of several subjects from the Union and Concurrent Lists to the State List. It recommended that the ‘residuary power of legislation and taxation’ should be vested in the State Legislatures.
(ii) An Inter-State Council comprising Chief Ministers of all the States or their nominees with the Prime Minister as its Chairman should be set up immediately.
(iii) The Committee recommended the abolition of the existing Planning Commission and that its place must be taken by a statutory body, consisting of scientific, technical, agricultural and economic experts, to advise the States which should have their own Planning Boards.
(iv) The Committee advocated deletion of those articles of the Constitution empowering the Centre to issue directives to the States and to take over the administration in a State. The Committee was also opposed to the emergency powers of the Central Government and recommended the deletion of Articles 356, 357 and 360.
(v) The Committee recommended that every State should have equal representation in the Rajya Sabha, irrespective of population.
(vi) The Governor should be appointed by the President in consultation with the State Cabinet or some other high power body that might be set up for the purpose and once a person had held this office, he should not be appointed to any other office under the Government.
(vii) On recruitment to the services, the Committee recommended that Article 312 should be so amended as to omit the provision of the creation of any new All-India cadre in future.
(viii) The High Courts of States should be the highest courts for all matters falling within the jurisdiction of States.
(ix) The Committee said that ‘territorial integrity’ of a State should not be interfered with in any manner except with the consent of the State concerned.
(x) It recommended that the States should also get a share of the tax revenues from corporation tax, customs and export duties and tax on the capital value of assets and also excise duties.
4. Sarkaria Commission Report:
In view of the various problems which impeded the growth of healthy relations between the Centre and the States, the Central Government set up a Commission in June 1983, under the Chairmanship of Justice R.S. Sarkaria mainly to suggest reforms for an equitable distribution of powers between the Union and the States. The Commission submitted its report in 1988.
Major Recommendations:
(i) Though the general recommendations tilt towards the Centre – advocating the unity and integrity of the nation, the Commission suggested that Article 258 (e.g. the Centre’s right to confer authority to the States in certain matters) should be used liberally.
(ii) Minimal use of Article 356 should be made and all the possibilities of formation of an alternative government must be explored before imposing President’s Rule in the State. The State Assembly should not be dissolved unless the proclamation is approved by the Parliament.
(iii) It favoured the formation of an Inter-Government Council consisting of the Prime Minister and the Chief Ministers of States to decide collectively on various issues that cause friction between the Centre and the States.
(iv) It rejected the demand for the abolition of the office of Governor as well as his selection from a panel of names given by the State Governments. However, it suggested that active politicians should not be appointed Governors.
When the State and the Centre are ruled by different political parties, the Governor should not belong to the ruling party at the Centre. Moreover, the retiring Governors should be debarred from accepting any office of profit.
(v) It did not favour disbanding of All India Services in the interest of the country’s integrity. Instead, it favoured addition of new All India Services.
(vi) The three-language formula should be implemented in its true spirit in all the States in the interest of unity and integrity of the country.
(vii) It made a strong plea for Inter-State Councils.
(viii) The Judges of the High Courts should not be transferred without their consent.
(ix) It did not favour any drastic changes in the basic scheme of division of taxes, but favoured the sharing of corporation tax and ‘every of consignment tax.
(x) It found the present division of functions between the Finance Commission and the Planning Commission as reasonable and favoured the continuance of the existing arrangement.
5. Gadgil formula
The Gadgil formula is named after Shri.Dhananjay Ramchandra Gadgil, a social scientist and the first critic of Indian planning. It was evolved in 1969 for determining the allocation of central assistance for state plans in India. Gadgil formula was adopted for distribution of plan assistance during Fourth and Fifth Five Year Plans.
The Gadgil formula was formulated with the formulation of the fourth five-year plan for the distribution of plan transfers amongst the states. It was named after the then deputy chairman of the Planning Commission Dr. D. R. Gadgil. The objective was to formulate a model which would help the Central Government to share its resources for equal and balanced growth in the states. The National Development Council (NDC) approved the following formula:
1. Special Category states like Assam, Jammu and Kashmir and Nagaland were given preference. Their needs should first be met out of the total pool of Central assistance.
2. The remaining balance of the Central assistance should be distributed among the remaining states on the basis of the following criteria:
60 per cent on the basis of population;
10 per cent on the basis of tax effort, determined on the basis of individual State's per capita tax receipts as percentage of the State's per capita income;
10 per cent on the basis of per capita state income, assistance going only to States whose per capita incomes are below the national average;
10 per cent on the basis of spill-over into the fourth plan of major continuing irrigation and power projects;
10 per cent for special problems of individual states.
Reasoning behind the given weights:
i. Population
In a country like India, population acts as an apt measure to represent the requirements of the people because a major portion of the population lives below the poverty line. This proposition was also supported by the empirical data which showed a negative correlation between population of states and their per capita income.
ii. Tax effort
This is an important factor to measure the potential of the state as far as its own resources are concerned. This relative measure incentivizes the states to undertake measures to increase their own potential through various tax measures.
iii. State per capita income
A problem regarding unequal development amongst the states was faced in the earlier plans because of larger states with their large plans were able to get a larger share of resources from the centre. This led to increased inequalities amongst the states. Therefore, to make the distribution fairer to the smaller states with a lesser than national per capita average income were given extra share in the resources.
iv. Special problems
This factor was introduced so as to provide enough resources to states to overcome problems like droughts, famines etc. In the absence of this share, such states would have suffered huge losses because of these problems and the implementation of their plans could have been hindered. This was a discretionary element in the formula which required proper scrutiny of the states situation by the Finance Commission.
v. Irrigation and power projects
These projects have been in the process of implementation before the fourth plan was formulated. They needed extra resources for the successful completion of these projects.
The Gadgil Formula, though well-intentioned, did not achieve much success in reducing inter State disparities. For instance, Andhra Pradesh and Tamil Nadu, which came under the low income category at the time, received below average Plan assistance and Bihar and Uttar Pradesh, just managed to get Plan assistance equal to all the States’ average. Therefore, there was an increasing clamour for modification of the formula, especially from the economically backward.
Modified Gadgil Formula
The formula was modified on the eve of the formulation of the Sixth Plan. The 10 percent indicator for ongoing power and irrigation projects was dropped and the share of per capita income was increased to 20 percent, to be distributed to those states whose per capita incomes were below the national average. The modified Gadgil formula continued for the Sixth and the Seventh Plans. Compared to the allocations in the Fourth and Fifth Plans, the allocations during the Sixth and the Seventh Plans show a definite shift in favour of the poorer states. All the low income states, except Tamil Nadu, received Plan assistance higher than the average income of the 14 states taken into consideration at the time. This can certainly be attributed to the higher weightage given to per capita income as per the modification. Per capita income serves as a suitable proxy for changes in the economy.
Section VII Economic Reforms and Coalition Politics – Devolution Models- Emerging Trends
The economic landscape has been transformed in the 1990s necessitating a whole new look at the Centre-states-local bodies triangle. Three far-reaching developments have already taken place for which successive governments all of them deserve credit . First, instead of sharing just income tax and excise duty, now the Centre will share all the taxes with a slightly increased share for the states.
Gadgil-Mukherjee Formula
The National Development Council (NDC) meeting held in 11, 1990; discussed and approved a New Revised formula. The new revised formula is popularly known as Gadgil-Mukherjee formula after the name of then deputy chairman of Planning commission and the current President of India Shri.Pranab Mukherjee. The new revised formula as approved by NDC is given in the following table. Criteria for inter-state allocation of Plan Assistance

Criteria  Weight (%)
Population 55
Per Capita Income 25
Fiscal Management 5
Special Problems 15
Total 100

Under the new revised formula, Population was given maximum weightage by considering it as most important factor for the allocation of central assistance, but in comparison with old Gadgil formula the weightage has been reduced by 5%.
At the advent of the 21st century the formula was reviewed and the component of ‘performance’ by the respective states was adopted. The allocation accruing to the states under this head was 7.5 percent. Within this, 2.5 percent of the allocation was based on tax efforts of the states, 2 percent for fiscal management at state level and 1 percent for undertaking population control measures. Special attention was also paid to the sluggish improvements in female literacy and 1 percent allocation was set aside taking female literacy into account. Timely completion of externally funded projects and land reforms undertaken accounted for the remainder of the 7.5 percent figure.
Single Divisible Pool:
During the start of millennium, in the year 2000 the Lok Sabha passed the 89th Amendment to the Constitution that creates a single divisible pool of Central taxes. This was a historic step. Till then, only income tax and Union excise duties have been shared with and devolved to the states under articles 270 and 272 of the Constitution.
The then Finance Minister Mr. Yashwant Sinha has said that the bonds of "cooperative federalism" would be strengthened with this change. Tax reforms in the country will also be facilitated.
The Tenth Finance Commission recommended the concept of a single divisible tax pool in November 1994. Mr.P. Chidambaram who was the Finance Minister during that time announced the acceptance of this recommendation in his July 1996 budget. Discussion papers were then prepared for deliberations in the Inter-State Council which gave its green signal in July 1997. Legislation was also finalised but then the United Front government fell in November 1997. Mr.Sinha accepted this idea in his very first vote-on-account in March 1998.
Also Article 280 was amended in 1992 to provide for state-level finance commissions as well to strengthen the finances of local bodies.
Green devolution formula for taxes
For the first time, in the 14th Finance Commission forest cover itself has been incorporated into the formula for the allocation of the single divisible pool of taxes among the states
For the first time, forest cover itself has been incorporated into the formula for the allocation of the single, divisible pool of taxes among the states. The formula has five elements: (i) population as of 1971 with a weight of 17.5%; (ii) demographic change reflecting population shifts between 1971 and 2011 with a weight of 10%; (iii) area with a weight of 15%; (iv) fiscal capacity measured by the income distance method (difference of a state’s per capita income from that of the state with the highest per capita income) with a weight of 50%; and (v) forest cover with a weight of 7.5%.
The formula used by its predecessor was: (i) population as of 1971 with a weight of 25%; (ii) area with a weight of 10%; (iii) fiscal capacity with a weight of 47.5%; and (iv) fiscal discipline with a weight of 17.5%. The Thirteenth Finance Commission had provided for a special grant of Rs.5,000 crores spread over five years and shared among the states depending on the quality of forest cover and conservation efforts. It was untied for the first two years and conditional thereafter.
Horizontal Devolution Formula in the 13th and 14th Finance Commissions


Coalition politics.
One of the major trends in India since last two decades has been the gradual movement towards coalition politics. This had its impact on the Centre State financial relations. Since last two decades the central government in India is more in the form of coalition government. This is true both for the UPA (lead by the Congress Party) and the NDA (lead by the BJP)
Due to this factor, the regional leaders and CM’s have emerged as the key players or even king makers at the centre. With multiple allies, in which some of them volatile, the central government has the challenge of managing the coalition government successfully, by sheer negotiation or bargaining. The government’s stability depended on its bargaining capacity coping with the diverse demands put up by the allies. The new emerging trend that is seen is that the regional parties forming the government in various provinces and they start the process of political bargaining with the coalition government at the centre. In this process, all the regional have tried to extract the maximum share of the financial resources to seek solutions of the problems in their respective states.
For example, more than a decade back Mr.Chandrababu Naidu has created a stir over the recommendations of the Eleventh Finance Commission (EFC). He claimed that "reforming" and "performing" states have been penalised. Mr.Naidu claimed that some states have "lost". He compares the share of taxes and duties during 2000-05 with those during 1995-2000.
According to experts, since the formula for determining the share of states worked out by the EFC is based on population (10 per cent), per capita income (62.5 per cent), area(7.5 per cent), infrastructure (7.5 per cent), tax effort (5 per cent) and fiscal discipline (7.5 per cent). Per capita income works thus: the average of Maharashtra, Punjab and Goa, the richest states, is first computed and then the distance of each state from this average is calculated. Obviously, the poorer states will gain.
According to experts, that is precisely the purpose of the finance commission since richer states are in a better position to attract private investment, borrow more and mobilise more external aid. Redistribution from the rich to the poor is at the very core of federal transfers. The very basis of our public finances--the Planning Commission concerned with "plan" or new investments and the finance commission dealing with "non-plan" revenue expenditure--needs a complete change.
Key Concepts:
Co-operative Federalism where a State (like India), shares the powers between the Union/Centre and the States, while inclining towards the strong Centre. The term was coined by Granville Austin, which means a system which produces strong central government yet it does not necessarily result in weak provincial governments that are largely administrative agencies for central policies.
Cooperative federalism (1930s-1970s) is a concept of federalism in which national, state, and local governments interact cooperatively and collectively to solve common problems, rather than making policies separately but more or less equally (such as the dual federalism of the 19th century United States) or clashing over a policy in a system dominated by the national government.
Federalism is a political concept in which a group of members are bound together by covenant with a governing representative head. The term "federalism" is also used to describe a system of government in which sovereignty is constitutionally divided between a central governing authority and constituent political units (such as states or provinces). Federalism is a system based upon democratic rules and institutions in which the power to govern is shared between national and provincial/state governments, creating what is often called a federation.
Asymmetric federalism
A distinguishing aspect of Indian federalism is that unlike many other forms of federalism, it is asymmetric. Article 370 makes special provisions for the state of Jammu and Kashmir as per its Instrument of Accession. Article 371 makes special provisions for the states of Andhra Pradesh, Arunachal Pradesh, Assam, Goa, Mizoram, Manipur, Nagaland and Sikkim as per their accession or state-hood deals. Also one more aspect of Indian federalism is system of President's Rule in which the central government (through its appointed Governor) takes control of state's administration for certain months when no party can form a government in the state or there is violent disturbance in the state.
Coalition politics
A multi-party system (India), with political allegiances frequently based on linguistic, regional and caste identities, necessitating coalition politics, especially at the Union level.
Finance Commission - Concepts and definitions
Tax Devolution: One of the core tasks of a Finance Commission as stipulated in Article 280 (3) (a) of the Constitution is to make recommendations regarding the distribution between the Union and the states of the net proceeds of taxes. This is the most important task of any Finance Commission, as the share of states in the net proceeds of Union taxes is the predominant channel of resource transfer from the Centre to states.
Divisible Pool: The divisible pool is that portion of gross tax revenue which is distributed between the Centre and the States. The divisible pool consists of all taxes, except surcharges and cess levied for specific purpose, net of collection charges. Prior to the enactment of the Constitution (Eightieth Amendment) Act, 2000, the sharing of the Union tax revenues with the states was in accordance with the provisions of articles 270 and 272, as they stood then. The eightieth amendment of the Constitution altered the pattern of sharing of Union taxes in a fundamental way. Under this amendment, article 272 was dropped and article 270 was substantially changed. The new article 270 provides for sharing of all the taxes and duties referred to in the Union list, except the taxes and duties referred to in articles 268 and 269, respectively, and surcharges on taxes and duties referred to in article 271 and any cess levied for specific purposes.
Horizontal imbalances are addressed by the Finance Commission through the system of tax devolution and grants in-aid, the former instrument used more predominantly. Under Article 275 of the Constitution, Finance Commissions are mandated to recommend the principles as well as the quantum of grants to those States which are in need of assistance and that different sums may be fixed for different States. Thus one of the pre-requisites for grants is the assessment of the needs of the States. The First Commission had laid down five broad principles for determining the eligibility of a State for grants. The first was that the Budget of a State was the starting point for examination of a need. The second was the efforts made by States to realize the potential and the third was that the grants should help in equalizing the standards of basic services across States. Fourthly, any special burden or obligations of national concern, though within the State's sphere, should also be taken into account. Fifthly, grants might be given to further any beneficent service of national interest to less advanced States. Grants recommended by the Finance Commissions are predominantly in the nature of general purpose grants meeting the difference between the assessed expenditure on the non-plan revenue account of each State and the projected revenue including the share of a State in Central taxes. These are often referred to as 'gap filling grants'. Over the years, the scope of grants to States was extended further to cover special problems. Following the seventy-third and seventy-fourth amendments to the Constitution, Finance Commissions were charged with the additional responsibility of recommending measures to augment the Consolidated Fund of a State to supplement the resources of local bodies. This has resulted in further expansion in the scope of Finance Commission grants. The Tenth Commission was the first Commission to have recommended grants for rural and urban local bodies. Thus, over the years, there has been considerable extension in the scope of grants-in-aid.
Fiscal capacity/Income Distance: The income distance criterion was first used by Twelfth FC, measured by per capita GSDP as a proxy for the distance between states in tax capacity. When so proxied, the procedure implicitly applies a single average tax-to GSDP ratio to determine fiscal capacity distance between states. The Thirteenth FC changed the formula slightly and recommended the use of separate averages for measuring tax capacity, one for general category states (GCS) and another for special category states (SCS).
Fiscal discipline: Fiscal discipline as a criterion for tax devolution was used by Eleventh and Twelfth FC to provide an incentive to states managing their finances prudently. The criterion was continued in the Thirteenth FC as well without any change. The index of fiscal discipline is arrived at by comparing improvements in the ratio of own revenue receipts of a state to its total revenue expenditure relative to the corresponding average across all states.
GSDP: Gross State Domestic Product is defined as a measure, in monetary terms, of the volume of all goods and services produced within the boundaries of the State during a given period of time, accounted without duplication.
Special Category States (SCS) and General Category States (GCS)
The concept of a special category state was first introduced in 1969 when the Fifth Finance Commission sought to provide certain disadvantaged states with preferential treatment in the form of central assistance and tax breaks. Initially three states Assam, Nagaland and Jammu & Kashmir were granted special status but since then eight more have been included (Arunachal Pradesh, Himachal Pradesh, Manipur, Meghalaya, Mizoram, Sikkim, Tripura and Uttarakhand). All other states barring these are treated as General Category States. The rationale for special status is that these states, because of inherent features, have a low resource base and cannot mobilize resources for development. Some of the features required for special status are: (i) hilly and difficult terrain; (ii) low population density or sizeable share of tribal population; (iii) strategic location along borders with neighbouring countries; (iv) economic and infrastructural backwardness; and (v) non-viable nature of state finances.
“While the constitution continues to be read, and its principles known, the states, must, by every rational man, be considered as essential component parts of the union; and therefore the idea of sacrificing the former to the latter is totally inadmissible.”
  • Alexander Hamilton (Alexander Hamilton was a founding father of the United States, Chief staff aide to General George Washington, one of the most influential interpreters and promoters of the U.S. Constitution, the founder of the nation's financial system, the founder of the Federalist Party, the world's first voter-based political party, and the Father of the United States Coast Guard. As the first Secretary of the Treasury, Hamilton was the primary author of the economic policies of the George Washington administration)
Finance Commission Of India
http://indiabudget.nic.in/,Ministry of Finance
Business Standard
Kautilya Today: Jairam Ramesh on a Globalizing India
The Economics of Development, World Bank
-  Prof. M. Guruprasad,
AICAR Business School

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