Finance Commission Report – Understanding the Formula for Devolution to States

The report of 15th Finance Commission (FC), constituted every five years, was tabled in the parliament on the day of the budget. The Finance Commission is an important constitutional body which determines the flow of revenue from centre to states and more importantly, fix a formula for the distribution of total pie among different states. Role of the commission is critical as most of the taxes are levied at the national level and states’ own tax revenue is less than half of their expenditure. The devolution forms the bedrock of India’s federal structure, giving states financial independence. Here is a look at how the commission arrives at the division and other details.

The term of the current commission was unique as it was required to submit one annual report for the year 2020-21 and another five-year report for financial year 2021-22 to 2025-26. In a departure from the past, FFC was also asked to review and consider performance-based incentives to motivate the efforts of State and/or local governments. The formula for devolution saw a marked change during 14th FC (2015-20) which raised the resource allocation to states from 32% to 42%. This was done to compensate for discontinuation of ‘grants’ that was made by planning commission. Abolishment of planning commission gave states access to more direct funds without any strings attached, freedom to spend as per their choices and provided greater transparency. The commission, this time, has reduced the share marginally to 41% to take care of the needs of J&K which would now be separately funded from the central kitty.

While the commission relied on past formula for ‘vertical split’, the bigger challenge was to devise the formula for horizontal split. The objective is to provide states sufficient resources to meet the basic needs of its population, yet, to reward overall performance of the state. Thus, six criteria have been chosen for inter-state sharing by the commission. These are population of the state, area of the state, per capital income relative to the state with highest per capita income (termed ‘income distance’), forest cover, demographic performance and tax collection efforts. Weightage of these criteria are 15%, 15%, 45, 10, 12.5 and 2.5%. It may be noted while the first three criteria meet the first objective of providing resources, the other three reward performance. “Income distance” assigns highest weightage to states with lowest per capital income so that it catches up with rest of the nation. This criterion had a high weightage of 62.5% in 11th FC but has been getting reduced gradually to create space to reward progressive states.

The criteria which involve maximum deliberation is ‘population’ with 1971 census taken as the basis till the 13th commission. On the face of it, this does not take into consideration the increase in population thus putting more populous state with lesser resources. However, the other argument is that taking 2011 population as benchmark would put states which have controlled their population at a disadvantage. Thus, instead of getting rewarded, they get penalized. To strike a balance, 14th FC took both 1971 and 2011 population with weight of 17.5% and 10%. The 15th FC had been specifically asked to base its recommendation on 2011 census only. While the commission sticks to the mandate giving 15% weight to population as per 2011 census, it has given 10% weightage to demographic performance (measured as inverse of fertility rate). The criterion is novel as it finds a way to reward states which have controlled their population growth.

The increasing stress on ecology and environmental de-gradation led to inclusion of forest cover as a criterion in 14th FC. Continuing the same, current FC has increased the weight further to 10%. The criteria not only encourage states to preserve ecological balance but also compensates them for opportunity loss in preserving it. On final analysis, share of some of the states works out as – UP – 17.9%, Bihar – 10.1%, MP – 7.9%, WB – 7.5%.

Other than tax devolution, FC also recommends several grants. Biggest of these is revenue deficit grants, provided to states who do not have enough funds even after the devolution due to low own taxes. FC has recommended total of Rs 2.94 lakh crore of grants under this during 2021-26. It also mentions that some of these states have high expenditure on expenses such as salaries, pension and interest payments and continuation of such grants would act as ‘moral hazard’. The commission has also recommended grants of over Rs 1 lakh crore for creating health infrastructure, 70% of which would go directly to local bodies. Another important recommendation of the commission is creation of a non-lapsable fund for defence needs.

Other than the centre-state and inter-state devolution, FCs are also required to allocate funds to municipal corporations including urban and rural local bodies. Delivery of social services through empowerment of local bodies has caught the attention of FCs in recent years as their involvement makes it more participatory and more effective. The commission cites experiment of Kerala in empowering primary healthcare bodies. The allocation to local bodies has gone up significantly, from Rs 97,000 crore during FC-XIII (2010-15) to Rs 2.9 lakh crore in FC-XIV and further to Rs 4.3 lakh crore by the current FC. The horizontal split, here too, involves rigorous exercise taking into account city infrastructure, air quality, water etc in case of urban bodies. The primary requirement for qualification is that the local body (both rural and urban) must submit and gets its account audited for previous years. The commission has laid stress on use of software and getting local accounts integrated with the state’s accounts. Of the total funds, two-thirds, or Rs 2.9 lakh crore during the five year would go to rural area. With nearly 6 lakhs village in the country, average share of each village works out to nearly Rs 10 lakh, to be spent largely on crating assets for drinking water and sanitation.

While the recommendations are the best possible with conflicting objective of rewarding performance and providing for basic needs, it still calls for out-of-the-box thinking. For instance, assume each state as separate country with their own level of prosperity and financial strength. In such a scenario, what would a poor state do? More importantly, would a rich state let go of its resources to the poor state? An option that needs to be explored is if it possible to transfer best practices from forward states to poorer ones by linking financial devolution to it.

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