Cooperative federalism is a convenient advocacy tool when one wants to centralize decision-making. Even as the Union government has been asserting its commitment to the values of cooperative federalism, it has not hesitated to encroach on state subjects through centrally sponsored schemes (CSS). Nor has it been at peace with the Fourteenth Finance Commission’s recommendations increasing the states’ share in the devolution of taxes.

It is not surprising that while extending the tenure of the Fifteenth Finance Commission (FFC) to 30 November 2019, through the presidential order, it amended the terms of reference (TOR) to examine whether “….a separate mechanism for funding of defence and internal security ought to be set up and if so, how such a mechanism could be operationalized". This is in addition to the usual direction issued in the original TOR, to take into consideration the demands on resources of the Centre, particularly on account of defence, internal security, infrastructure and railways and other such needs.

The inescapable conclusion is that this is an attempt to nudge the FFC to apportion larger proportion of the taxes from the divisible pool for the Centre. The Centre is well within its right to create such funds from its own consolidated fund and does not need endorsement by the FFC. However, for the FFC to recommend creation of such a non-lapsable fund before determining the shares of the Union and states raises questions of Constitutional propriety.

Watch video: Beware the nudge effect in Indian federalism | Long Story Capsule


Constitutional mandate

The Finance Commission derives its mandate from the Constitution. The basic TORs are detailed in Article 280 of the Constitution. These relate to the distribution of central taxes between the Union and states and the shares of individual states thereof; the principles of grants to states and the amounts of revenue deficit grants needed to augment the consolidated funds of the states to supplement the resources of their rural and urban local bodies based on the recommendations of State Finance Commissions; and “any other matter in the interest of sound finance".

Under “any other matter", directives are given to the commissions in the TOR issued in the Presidential Order appointing the commission. The original TOR issued in the Presidential Order had already courted considerable controversy. It had directed the commission to use 2011 population, about which some of the states were aggrieved. Then, there were three sets of considerations that were controversial.

First, asking the commission to examine whether the revenue deficit grants should be given at all. Secondly, suggesting to the commission to review the impact of substantially enhanced devolution recommended by the Fourteenth Finance Commission coupled with “….continued imperative of the national development programme under New India-2022" on the Centre’s finances. Finally, suggesting that the commission should propose performance-based incentives for the states on a number of matters including implementation of flagship schemes of the Government of India and control over expenditure on “populist measures".

The revenue deficit grants are integral to the methodology followed by the past commissions. Directing the FFC to do away with it is tantamount to asking it to change its approach and method. There have been instances in the past too when directives were given to the Finance Commissions. The Ninth Finance Commission, for example, was directed to follow the “normative approach" while making the assessment of revenues and expenditures of the states. This was vehemently opposed by then Kerala chief minister, in a letter to the chairman of the commission, on the grounds that the directive is asymmetric and does not extend to the assessment of the Centre.

The chairman of the Ninth Commission wrote a letter to all chief ministers assuring them that Article 280 (4) and the Finance Commission Act empower the commission to adopt any approach and methodology it considers appropriate, and in doing so, it would apply a “uniform, just and equitable" yardstick to both the Union and states. In fact, the basic methodology of the past commissions was to fill the normatively projected post-devolution gaps in the revenue accounts of the states with grants to balance their revenue accounts under Article 275. It is not clear how this basic task of balancing can be achieved if revenue deficit grants are not given. Furthermore, it is for the commission to determine the appropriate method to balance the books.

Tax devolution

On the second issue, the TOR wants to influence the commission’s recommendation by stating the previous commission substantially enhanced tax devolution, which is contrary to facts. As a matter of fact, there was only a marginal increase in tax devolution recommended by the Fourteenth Finance Commission over that of the previous commission. The Thirteenth Finance Commission recommended the devolution of 32%, but this was only to cover the non-plan requirements. Plan requirements amounting to over 5.5% was given as a separate grant by erstwhile Planning Commission under the Gadgil formula.

The Fourteenth Finance Commission had to take account of both plan and non-plan requirements in its devolution. Furthermore, the previous commissions gave separate grants for sectors like education, healthcare, environment, police and judiciary, and this amounted to about 1.5-2% of the divisible pool. If these are added, the total transfers received by the states excluding grants for central schemes during the Thirteenth Finance Commission works out to 39%. The devolution recommended by the Fourteenth Finance Commission is only marginally higher at 42%.

Ironically, the Union government, after accepting the Fourteenth Finance Commission’s recommendations, countered it by increasing the matching ratio on CSS in the name of consolidation and rationalization, and resorted to raising additional revenues from taxes through cesses and surcharges which are not shareable.

Finally, on the issue of preempting resources to formulate national development plan under “New India-2022", the Centre is well within its rights to put forth its demand to the Finance Commission in its memorandum. However, seeking larger allocation to the Union government in the Presidential Order raises questions of Constitutional propriety. It is as yet not known what “New India-2022" comprises of, and in any case, the commitment to national development should be by both the Union and state governments. If indeed, this means expansion of CSS on state subjects, then it will be further encroachment on their autonomy.

The convention has been that the Finance Commission is required to adopt uniform approach and method in making its assessments. However, while the TOR nudges the commission to adopt a more incentivised approach to making transfers to states, there is no such provision to influence the behaviour of the Union government. Improving tax effort is an issue relevant to both the Union and state governments. Moreover, now that the power to levy goods and services tax (GST) rests with the GST Council, states have limited manoeuvrability.

Populism is a bane arising from electoral politics and both the Union and state governments are equally guilty. The states are naturally aggrieved that the TOR is asymmetric in making the suggestion that the commission should discipline the states but not the Centre. In fact, late S. Guhan, an ardent federalist used to say that the Finance Commissions only “bark" at the Centre, but they “bite" the states.

Defence and internal security

The new amendment of the TOR asks the commission to examine the feasibility of creating and operationalizing a separate non-lapsable fund for defence and internal security. This raises further uneasiness for those who cherish the values of cooperative federalism.

In fact, the original TOR itself states, “While making the recommendations, the commission shall have regard among other considerations to…. the demand on the resources of the central government particularly on account of defence, internal security, infrastructure, railways, climate change, commitments towards administration of Union territories without legislature, and other committed expenditure and liabilities". The amendment is to further nudge the commission to preempt resources for the Centre.

As a matter of fact, there is nothing that prevents the Union government from creating a separate non-lapsable account from its consolidated fund. In fact, the commission, in its projections, does take into account the expenditure obligations of the Union and states on the subjects assigned to them in the Constitution. If the suggestion is to create such a fund from the divisible pool before determining the shares of the Union and states in tax devolution, there will again be questions of Constitutional legitimacy.

On the other hand, if the fund is recommended from the Centre’s consolidated fund after tax devolution, it is superfluous because, the Centre does not need a recommendation of the Finance Commission to allocate the funds to the subjects within its domain.

The Finance Commissions in the past have considered the requirements of the Centre for defence and internal security as required by the TOR. The Fourteenth Finance Commission, for example, projected higher defence revenue expenditure (including salaries) of 30% in 2016-17 which was also supposed to incorporate the pay commission impact, and allowed for an increase of 20% for the remaining years of its award. The capital expenditure requirements in any case are not covered in the Finance Commissions’ recommendations.

Despite this, the actual defence expenditure ratio to GDP declined from over 2% in 2014-15 to 1.48% in 2018-19, and is proposed even lower at 1.45% in 2019-20. As a ratio of total central government expenditure, it has declined from 14.3% in 2015-16 to 11% in 2019-20.

The Constitution divides the responsibilities of the Union and states in terms of Union, State and Concurrent lists. Curiously, while the expenditures as a ratio of GDP on subjects like defence which are entirely in the Union list have declined over the years, the Centre has been spending more on the subjects in the domain of the states and concurrent subjects.

The Fourteenth Finance Commission had noted that the ratio of the Centre’s spending on state subjects in the total increased from 14% in 2005 to 20% in 2012 and its share in spending on concurrent subjects increased from 13% to 17%. It would not be incorrect to infer that it is the Centre’s foray into state and concurrent subjects through CSS has been an important factor responsible for crowding out defence expenditures.

What has prompted this amendment in the TOR? The only explanation seems to be to nudge the Finance Commission to recommend lower share to the states in tax devolution. Even after securing additional fiscal space by increasing the states’ share in the CSS and raising additional resources mainly through non-sharable measures, the Centre wants larger share of taxes ostensibly in the name of “New India-2022", probably to enter further into state subjects through additional CSS.

In conclusion

The FFC is in the process of finalizing its recommendations. During their visits, most of the states, even those where the ruling party at the Centre is in power, have demanded higher devolution. They have expressed their concern about expanding CSS and their shrinking fiscal space to meet expenditures on constitutionally mandated services like basic education, healthcare, agriculture, water supply and sanitation, agriculture and urban development. It appears the proposal for the amendment in the TOR is to persuade the FFC not to increase the states’ share in the devolution and even to reduce it in its recommendation. The whole idea is not for making additional allocations to defence, but in its name, secure additional fiscal space for more CSS under the rubric of “New India-2022".

The FFC is a Constitutional body and while it should make fair assessments of the requirements of the Union and states. It should simply follow its Constitutional mandate and not take cognisance of this additional directive. If the Centre wants to increase allocation to defence and make it non-lapsable, it could do so from its consolidated fund.

M. Govinda Rao was a member of the Fourteenth Finance Commission and is former director of NIPFP.

Close