Economic Survey – Volume 2

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.

Grants-in-aid

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.

HORIZONTAL DEVOLUTION FORMULA IN THE 13^TH AND 14^TH FINANCE COMMISSIONS

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 was 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.