The Constitution recognized that its assignment of tax powers and expenditure functions would create imbalances between expenditure ‘needs’ and abilities to raise revenue. The imbalances could be both vertical, among different levels of government, and horizontal, among different units within a sub-central level.
Therefore, the Constitution originally provided for the sharing of the proceeds of certain centrally levied taxes (e.g., non-corporate income tax, Article 270; and Union excise duty, Article 272) with the states, as well as grants to the states from the Consolidated Fund of India. Recent constitutional changes in this scheme have simplified this sharing arrangement, replacing it with an overall share of the Consolidated Fund.
The shares of the center and the states, and their allocation among different states are determined by the Finance Commission, which is also a constitutional creation, and is appointed by the President of India every five years (or earlier if needed). In addition to tax devolution, the Finance Commission is also required to recommend grants to the states in need of assistance under Article 275. Finance Commission transfers are, thus, all unconditional in nature.
The Finance Commissions’ approach to federal transfers has consisted of (i) assessment of overall budgetary requirements of the center and states to determine the volume of resources available for transfer with the center during the period of recommendation, (ii) projecting of states’ own revenues and non-plan current expenditures, (iii) determining and distributing the states’ share of the consolidated fund of the center, and (iv) filling gaps between projected expenditures and revenues after tax devolution with grants.
Over the last sixty years, 13 Finance Commissions have made recommendations to the central government and sixty barring a few exceptions, these have been accepted. In this process, the Commissions have developed an elaborate methodology for dealing with horizontal as well as vertical fiscal imbalances.
In particular, the formula for tax devolution is quite complicated, as a result of attempts to capture simultaneously disparate (and even contradictory) factors such as poverty, ‘backwardness’, tax effort, fiscal discipline, and population control efforts.
The result has been that the impact of Finance Commission transfers on horizontal equity (equalizing fiscal capacity across states) has been somewhat limited. Despite the ad hoc nature of the tax-sharing formula, its persistence reflects the nature of precedent that has grown around the Finance Commission, even though it is not a permanent body, and lacks continuity in its staffing and its analysis.
Grants recommended by the Finance Commissions have typically been determined on the basis of projected gaps between non-plan current expenditures and post-tax devolution revenues. As with tax sharing, these grants have generally been unconditional, although some of the Commissions (particularly after the Sixth) also attempted to enhance outlays on specified services in the states by making closed- ended specific purpose non-matching grants. In either case, however, the incentive problems with this “gap-filling” approach are obvious. Some of the Commissions did attempt to take account of normative growth rates of revenues and expenditures in projections, but these attempts were selective and relatively unimportant.
Despite the Finance Commissions’ success in establishing guidelines and stability for center-state tax sharing, their methodology and processes have been often criticized.
The main criticisms are (i) the scope of the Finance Commissions through the Presidential terms of reference has been too restricted; and (ii) the design of their transfer schemes has reduced state government incentives for fiscal discipline (through ‘gap-filling ‘transfers), while doing relatively little to reduce inter-State inequities.
Therefore one can argue that there is still an opportunity to improve this aspect of India’s IGFR system.