How is the Finance Commission of India constituted? What do you about the terms of reference of the recently constituted Finance Commission? Discuss.

Introduction

The Finance Commission of India is a constitutional body established under Article 280 of the Indian Constitution to recommend the distribution of financial resources between the Union and the States. The 15th Finance Commission, chaired by N.K. Singh, was constituted in 2017 and submitted its final report for the period 2021–26. Its terms of reference (ToR) have sparked significant debate due to their implications for fiscal federalism.

Value Addition Block — Key Constitutional Provisions

How is the Finance Commission of India Constituted?

• Constitutional Mandate: The Finance Commission is constituted by the President of India every five years or earlier as deemed necessary under Article 280.

• Composition:

  • Chairperson: A person with experience in public affairs.
  • Four Members: Appointed based on expertise in finance, economics, administration, or law.
  • Members are appointed by the President and serve as per the terms specified in the notification.

• Advisory Role: The recommendations of the Finance Commission are advisory in nature and not binding on the government.

• Process:

  • The President specifies the Terms of Reference (ToR) for the Commission.
  • The Commission consults stakeholders, including the Union, States, and experts, before submitting its report.

Terms of Reference of the 15th Finance Commission

The ToR of the 15th Finance Commission included both traditional mandates and new challenges, which have been a subject of debate.

Traditional Mandates

• Vertical Devolution: Recommend the share of taxes to be distributed between the Union and the States.
• Horizontal Devolution: Determine the criteria for allocation among states based on factors like population, income, and area.
• Grants-in-Aid: Recommend grants to states for specific purposes under Article 275.
• Augmenting Local Bodies: Suggest measures to strengthen the finances of panchayats and urban local bodies.

New Challenges in the ToR

1. Use of 2011 Census Data:

   • The ToR mandated the use of 2011 Census instead of the 1971 Census, raising concerns among southern states about reduced allocations due to their success in population control.
   • ★ Example: States like Tamil Nadu and Kerala argued that this penalizes them for better demographic management.

2. Performance-Based Incentives:

   • Introduced criteria like tax effort, ease of doing business, and control of expenditure on populist measures.
   • Aimed to reward states for fiscal discipline and governance reforms.

3. Defence and National Security:

   • For the first time, the ToR included a mandate to examine the creation of a non-lapsable defence fund, raising concerns about encroachment on the divisible pool.

4. Revenue Deficit Grants:

   • Assess the need for revenue deficit grants to states post-GST implementation.

5. Disaster Risk Management:

   • Recommend measures for disaster risk mitigation and funding, especially in light of climate change.

Criticism of the Terms of Reference

• Erosion of Fiscal Federalism:

  • The inclusion of defence funding in the ToR was seen as reducing the divisible pool available to states.
  • ★ Example: States argued that this undermines the principle of cooperative federalism.

• Population-Based Allocation:

  • Southern states criticized the use of the 2011 Census, arguing it penalizes states with better population control measures.

• Performance-Based Criteria:

  • Some states viewed these criteria as subjective and potentially biased against poorer states.

• GST Compensation:

  • Concerns were raised about the adequacy of revenue deficit grants, especially after the end of the GST compensation period.

Way Forward

• Balanced Approach: Future Finance Commissions should balance equity (supporting poorer states) and efficiency (rewarding better governance).
• Strengthening Fiscal Federalism: Ensure that ToR are framed in consultation with states to uphold the spirit of cooperative federalism.
• Dynamic Criteria: Introduce dynamic and inclusive criteria that account for regional disparities, climate change, and emerging challenges like health crises.
• Transparency: Enhance transparency in the allocation process to build trust among stakeholders.

Conclusion

The Finance Commission plays a pivotal role in ensuring fiscal equity and cooperative federalism in India. While the 15th Finance Commission's ToR introduced innovative elements, they also highlighted the need for greater inclusivity and consultation in framing such mandates. Moving forward, a balanced and transparent approach will be essential to address the evolving challenges of India's fiscal landscape.