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2nd April 2021 – Editorials/Opinions Analyses


  1. Still no recognition of the third tier



Unlike the previous Finance Commissions, the Fifteenth Finance Commission was in the background of the COVID-19 pandemic which reinforced the significance of local governments, gram sabha and other participatory institutions in containing the crisis and delivering social protection in India.


GS-II: Polity and Governance (Constitutional Provisions, Structure of Government, Fiscal federalism), GS-III: Indian Economy (Economic Development and Growth, Fiscal policy, Devolution and Appropriation of taxes)

Mains Questions:

In the Context of the 15th Finance Commissions recommendations, to what extent does it address the goal of fiscally empowering local governments to deliver territorial equity? (10 marks)

Dimensions of the Article:

  1. What is fiscal federalism?
  2. Recent development related to fiscal federalism?
  3. Challenges to fiscal federalism in India:
  4. About Finance Commission of India
  5. Fifteenth Finance Commission
  6. Positive Aspects of the XVFC’s recommendations w.r.t. LSGs
  7. Lacunae in the XVFC’s recommendations w.r.t. LSGs and the trends

What is fiscal federalism?

Fiscal federalism is financial relationship between centre and states, it deals with the division of governmental functions and financial relations among levels of government.

Structure of fiscal federalism in India:

The Seventh Schedule to the constitution of India defines and specifies allocation of powers and functions between Union & States. It contains three lists; i.e., 1) Union List, 2) State List and 3) Concurrent List.

  1. Union list: The Union Government or Parliament of India has exclusive power to legislate on matters relating to these items.
  2. State list: The respective state governments have exclusive power to legislate on matters relating to these items.
  3. Concurrent list: This includes items which are under joint domain of the Union as well as the respective States
  4. Article 268 to 293 in Part XII deal with the financial relations.

Recent development related to fiscal federalism?

Three landmark changes in union-state fiscal relations since 2015-16 have been:

  1. The abolition of the Planning Commission in January 2015 and the subsequent creation of the NITI Aayog.
  2. Fundamental changes in the system of revenue transfers from the centre to the states by providing higher tax devolution to the states from the fiscal year 2015-16 onwards based on the recommendations of the Fourteenth Finance Commission (14th FC).
  3. The Constitutional amendment to introduce the Goods and Services Tax (GST) and the establishment of the GST Council for the central and state governments to deliberate and jointly take decisions.

Finance commission of India: The Finance Commission is a Constitutionally mandated body that is at the centre of fiscal federalism. Set up under Article 280 of the Constitution, its core responsibility is to evaluate the state of finances of the Union and State Governments, recommend the sharing of taxes between them, lay down the principles determining the distribution of these taxes among States.

Challenges to fiscal federalism in India:

Horizontal imbalances

  • The horizontal imbalances arise because of differing levels of attainment by the states due to differential growth rates and their developmental status in terms of the state of social or infrastructure capital. However, Replacing the Planning Commission with NITI Aayog has reduced the policy outreach of government by relying only on single instrument of fiscal federalism i.e. Finance commission. This approach if not reviewed can lead to a serious problem of increasing regional and sub regional inequalities.

Vertical Imbalances

  • Vertical imbalance arises due to the fiscal asymmetry in powers of taxation vested with the different levels of government in relation to their expenditure responsibilities prescribed by the constitution.
  • Central Government collects around 60% of the total taxes, while its expenditure responsibility (for carrying out its constitutionally mandated responsibility such as defence, etc.) is only 40% of the total public expenditure.
  • Such vertical imbalances are even sharper in the case of the third tier consisting of elected local bodies and panchayats.
  • Vertical imbalances can adversely affect India’s urbanization, the quality of local public goods and thus further aggravating the negative externalities for the environment and climate change.

Restructuring the fiscal federalism

India’s Fiscal Federalism needs to be restructured around the four pillars namely Finance Commission, NITI Aayog, GST and decentralization in order to eliminate the inadequacies of vertical and horizontal imbalances.

  1. Finance commission: it should be relieved from the dual task of dealing with provision of basic public goods and services and capital deficits. It should be confined to focussing on removal of basic public goods imbalance
  2. NITI Aayog: it should deal with infrastructure and capital deficit.
  3. Decentralisation can serve as the third pillars of the new fiscal federalism by strengthening local finances and state finance commission.
  4. GST should be simplified in its structure and can serve as the fourth pillar of our fiscal federalism, by ensuring.

About Finance Commission of India

  • The Finance Commission (FC) is constituted by the President of India every fifth year under Article 280 of the Constitution.
  • Finance Commission is a constitutional body.
  • It was formed to define the financial relations between the central government of India and the individual state governments.
  • FC determines the method and formula for distributing the tax proceeds between the Centre and states, and among the states.
  • The Finance Commission also decides the share of taxes and grants to be given to the local bodies in states. This part of tax proceeds is called Finance Commission Grants, which is a part of the Union budget.
  • The Finance Commission (Miscellaneous Provisions) Act, 1951 additionally defines the terms of qualification, appointment and disqualification, the term, eligibility and powers of the Finance Commission.
  • The Finance Commission consists of a chairman and four other members, who are appointed by the President of India.
  • There have been fifteen commissions to date, the most recent was constituted in 2017.

Fifteenth Finance Commission

  • The Fifteenth Finance Commission (XV-FC or 15-FC) is an Indian Finance Commission constituted in November 2017 and is to give recommendations for devolution of taxes and other fiscal matters for five fiscal years, commencing 2020-04-01.
  • The main tasks of the commission were to “strengthen cooperative federalism, improve the quality of public spending and help protect fiscal stability”.

Positive Aspects of the XVFC’s recommendations w.r.t. LSGs

Higher vertical devolution

  • The vertical devolution recommended to local governments is raised remarkably high.
  • From a measly share of 0.78% of the divisible pool with an absolute sum of Rs. 10,000 crores by the Eleventh Commission, the Fifteenth Finance Commission raised it to 4.23% with a reasonably estimated amount of Rs. 4.3 lakh Crores.
  • Compared with the Fourteenth Finance Commission there is a 52% increase in the vertical share.
  • All the Commissions since the Eleventh Commission have tied specific items of expenditure to local grants and the Fifteenth Finance Commission has raised this share to 60% and linked them to drinking water, rainwater harvesting, sanitation and other national priorities in the spirit of cooperative federalism.

Entry-level criterion

  • An important recommendation of the Fifteenth Finance Commission is the entry-level criterion to avail the union local grant (except health grant) by local governments (strictly speaking, it is performance-linked).
  • For panchayats, the condition is online submission of annual accounts for the previous year and audited accounts for the year before. For urban local governments, two more conditions are specified.
  • Although Finance Commissions, from the Eleventh to the Fourteenth, have recommended measures to standardise the accounting system and update the auditing of accounts, the progress made has been halting. Therefore, the entry-level criteria of the Fifteenth Finance Commission are timely.

Lacunae in the XVFC’s recommendations w.r.t. LSGs and the trends

Vertical devolution

  • It reduced the performance-based grant to just ₹8,000 crore — and that too for building new cities, leaving out the Panchayati Raj Institutions (PRIs) altogether.
  • The performance-linked grants thoughtfully introduced by the Thirteenth Finance Commission earmarked 35% of local grants specifying six conditions for panchayats and nine for urban local governments and covered a wide range of reforms.
  • The Fourteenth Finance Commission, however, cut the performance grant share to 10% for gram panchayats and 20% to municipalities with the conditionality that all local governments will have to show improvements in own source revenue.
  • Municipalities are additionally required to publish service level benchmarks for basic services. The transformative potential in designing performance-linked conditionalities for improving the quality of decentralised governance in the context of indifferent states is missed.

Entry-level criterion

  • Although the XVFC recommended entry-level criterion to avail the union local grant (except health grant) for panchayats and urban local governments, it is not clear why gram panchayats (especially the affluent and semi-urban categories) are left out from this.

Lack of reliable data

  • The Twelfth Finance Commission did not publish any local fiscal data.
  • The Thirteenth Finance Commission published data online and some researchers did use them. Unlike the previous Commissions, the Fourteenth Finance Commission conducted a sample survey covering (15%) gram panchayats, (30%) block panchayats and all district panchayats besides (30%) municipalities, presumably to ensure quality in canvassing data.
  • The results too were not published. Interestingly, neither the Fifteenth Finance Commission nor the earlier counterparts took pains to examine how and where the financial reporting system has failed.

Equalization principle

  • The Fifteenth Finance Commission claims that it seeks to achieve the “desirable objective of evenly balancing the union and the states”. It is not clear why there is no recognition of the third tier in this balancing act.
  • Although the Fifteenth Finance Commission outlines nine guiding principles as the basis of its recommendation to local governments, there is no integrated approach (in contrast to the recommendations of the Thirteenth Finance Commission).
  • That the tasks of the Union Finance Commission were broadened as part of the decentralisation reforms (280(3) (bb) and (c)) is a firm recognition of the organic link of public finance with the development process at all tiers of government. Although the Fifteenth Finance Commission stresses the need to implement the equalisation principle, it is virtually silent when it comes to the local governments.

Criteria used

  • It is equally important to note that in the criteria used by the Fifteenth Finance Commission for determining the distribution of grant to States for local governments, it employed population (2011 Census) with 90% and area 10% weightage the same criteria followed by the Fourteenth Finance Commission.
  • While this ensures continuity, equity and efficiency criteria are sidelined. Equity is the foundational rationale of a federation.
  • Abandoning tax effort criterion incentivises dependency, inefficiency and non-accountability.

-Source: The Hindu

December 2023