The Finance Commission in India stands as a cornerstone of the nation’s fiscal federalism, a unique constitutional body established under Article 280 of the Constitution. Its primary mandate is to define the financial relations between the Union government and the state governments, ensuring a fair and equitable distribution of tax revenues and grants-in-aid. Each commission, constituted every five years or earlier, undertakes the intricate task of assessing the financial health of the Union and the states, recommending principles for the vertical devolution of funds from the Centre to the states and the horizontal distribution among states. This process is critical for maintaining cooperative federalism, enabling states to meet their developmental objectives while ensuring the overall macroeconomic stability of the nation.

The recent, or 15th, Finance Commission, chaired by Shri N.K. Singh, was constituted on November 27, 2017, against a backdrop of significant economic reforms and evolving fiscal challenges. The implementation of the Goods and Services Tax (GST) in 2017 fundamentally altered the indirect tax landscape, necessitating a fresh look at revenue sharing mechanisms. Furthermore, concerns regarding fiscal prudence, rising public debt, and the need for incentivizing performance-based governance at the state level gained prominence. The Terms of Reference (ToR) provided to the 15th Finance Commission were notably detailed and, in some instances, unprecedented, reflecting the Union government’s policy priorities and setting a complex agenda for the Commission to navigate over its tenure, which culminated in two reports: an interim report for 2020-21 and a final report for the period 2021-26.

General Mandate of a Finance Commission

Before delving into the specific Terms of Reference of the 15th Finance Commission, it is essential to understand the general mandate typically assigned to any Finance Commission. At its core, the Commission is tasked with making recommendations on: 1. **The distribution between the Union and the States of the net proceeds of taxes** which are to be, or may be, divided between them and the allocation between the States of the respective shares of such proceeds (vertical and horizontal devolution). 2. **The principles which should govern the grants-in-aid** of the revenues of the States out of the Consolidated Fund of India. 3. **The measures needed to augment the Consolidated Fund of a State** to supplement the resources of the [Panchayats](/posts/highlights-salient-features-evolution/) and Municipalities in the State on the basis of the recommendations made by the State Finance Commissions. 4. **Any other matter referred to the Commission by the President** in the interests of sound finance.

The 15th Finance Commission’s ToR largely aligned with these fundamental responsibilities but introduced several specific directives and new considerations that significantly shaped its approach and recommendations.

Specific Terms of Reference of the 15th Finance Commission

The notification constituting the 15th Finance Commission outlined a comprehensive set of directives, some of which proved to be particularly contentious and required careful deliberation by the Commission. These ToR can be broadly categorized as follows:

1. Vertical Devolution and Horizontal Distribution

The Commission was mandated to make recommendations on the percentage of the divisible pool of central taxes to be shared with the states (vertical devolution) and the criteria for distributing this share among the states themselves (horizontal distribution). * **Population Data:** Crucially, the ToR stipulated that the Commission "use the population data of 2011" for its recommendations. This was a significant departure from previous Finance Commissions, which primarily used the 1971 population census data. The rationale behind using 1971 data in earlier commissions was to not penalize states that had effectively implemented population control measures. The shift to 2011 data generated considerable apprehension, particularly among southern states, which feared that their success in population control would lead to a reduced share of central transfers, while states with higher population growth (mostly in the north) would benefit. The Commission addressed this by balancing the 2011 population criterion with a "demographic performance" criterion. * **Demographic Performance:** To mitigate the potential adverse impact of the 2011 population data on states that had successfully controlled their population growth, the ToR explicitly asked the Commission to consider "efforts and progress made by States in population control." This innovative criterion aimed to reward states for their demographic achievements, providing a much-needed counterweight to the raw population figures. * **Income Distance:** A standard criterion, the ToR required the Commission to continue using income distance (the difference between a state's per capita income and the per capita income of the state with the highest per capita income) to ensure equitable resource allocation, favoring less developed states. * **Area** and Forest & Ecology: These traditional criteria were retained, recognizing the spatial and environmental dimensions of state needs. [Area](/posts/analyse-causes-and-consequences-of-air/) accounts for the cost of delivering services in geographically larger states, while 'Forest and Ecology' recognizes the ecological services provided by states with dense forest cover and the attendant constraints on developmental activities. * **Tax and Fiscal Effort:** The ToR emphasized the need to incentivize states for their fiscal discipline and efforts in mobilizing their own tax revenues. This criterion encourages states to improve their tax collection and manage their finances efficiently.

2. Fiscal Management and Consolidation

The ToR placed a strong emphasis on fiscal prudence and sustainability, reflecting the Union government's concerns about rising [public debt](/posts/how-does-public-debt-help-economy/) and fiscal deficits. * **Review of FRBM Act:** The Commission was asked to review the current status of the Union and State governments' finances, deficit, debt levels, and cash balances, and "recommend a fiscal consolidation roadmap for both the Union and the States." This included a specific directive to "examine the need for and suggest measures for enforcement of the Fiscal Responsibility and Budget Management (FRBM) Act, and rules thereunder." This was critical as many states had deviated from their FRBM targets. * **Revenue Deficit Grants:** The Commission was tasked with examining whether revenue deficit grants should be provided to states and, if so, the principles governing their distribution. The implicit aim was to encourage states to become revenue surplus over time. * **Incentivizing Performance:** A significant aspect of the ToR was the directive to recommend "performance-based incentives" for states. These incentives were tied to various reforms and achievements: * **Implementation of Union Government's flagship schemes:** Encouraging states to effectively utilize funds provided for national priority programs. * **Ease of Doing Business:** Incentivizing states to improve their investment climate. * **Control of Smuggling, Illegal Trade, and Human Trafficking:** Promoting law and order and security initiatives. * **Performance in Delivery of Justice:** Encouraging reforms in the judicial system. * **Promotion of Tourism:** Recognizing its potential for economic growth and employment. * **Containing Expenditure on Subsidies:** Encouraging rationalization of subsidies to improve fiscal health. * **Adoption of Direct Benefit Transfer (DBT):** Promoting efficiency and transparency in welfare delivery. * **Waste Management:** Emphasizing environmental sustainability. * **Scaling up of Capital Expenditure:** Encouraging states to invest in productive assets.

3. Grants and Local Bodies

The traditional role of recommending grants-in-aid was elaborated upon with specific directives. * **Disaster Risk Management:** The ToR required recommendations for funding disaster management initiatives, including a framework for disaster risk management. * **Local Bodies:** The Commission was asked to make recommendations for grants to [Panchayats](/posts/highlights-salient-features-evolution/) and [Municipalities](/posts/explain-briefly-about-role-of-local/), including specific performance criteria for accessing these grants. This aimed to strengthen grassroots democracy and local governance.

4. Impact of GST and Other Tax Reforms

Given the recent implementation of GST, the ToR specifically asked the Commission to assess its impact. * **Impact on Divisible Pool:** The Commission was required to examine how the [GST](/posts/discuss-recent-changes-in-centre-state/) regime had affected the divisible pool of central taxes and state revenues, and to adjust its recommendations accordingly. This involved understanding the complexities of input tax credit, compensation to states, and the overall revenue buoyancy under GST.

5. Defence and Internal Security Fund

Perhaps the most controversial and novel ToR was the directive 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 operationalised." This particular ToR raised concerns among states that a dedicated non-lapsable fund for defence and internal security, financed from the divisible pool, could potentially reduce their share of central transfers and erode fiscal federalism. States argued that defence is a Union subject and its financing should be entirely the responsibility of the Union government without impinging on state resources. The Commission had to carefully consider the implications of such a fund on the overall fiscal architecture.

Implications and Controversies Arising from the ToR

The specific ToR for the 15th Finance Commission sparked considerable debate and highlighted the evolving dynamics of [Centre-State financial relations](/posts/discuss-recent-changes-in-centre-state/) in India.
  • 2011 Population Data: The shift from 1971 to 2011 population data was the most contentious point. Southern states, which had achieved significant success in population control, argued that using 2011 data would penalize them for their prudent policies and reward states that had not effectively managed population growth. This raised fundamental questions about equity, efficiency, and the spirit of cooperative federalism. The Commission attempted to address this by introducing the ‘demographic performance’ criterion, which allocated weight to states’ efforts in population control.
  • Defence and Internal Security Fund: The proposal to create a non-lapsable fund for defence and internal security was viewed with suspicion by many states. They feared that it would effectively reduce the size of the divisible pool available for distribution among states, thereby curtailing their financial autonomy. There were also concerns about the precedent it might set for earmarking funds from the divisible pool for Union-specific responsibilities, potentially undermining the unconditional nature of shared taxes. The Commission, while acknowledging the need for enhanced defence spending, ultimately recommended a non-lapsable fund for defence and internal security, but its financing mechanism was carefully designed to minimize direct impact on the states’ share from the divisible pool.
  • Performance-Based Incentives: While seemingly benign, the extensive list of performance-based incentives raised questions about the extent of central intrusion into state policy-making. Critics argued that such incentives could lead to ‘conditionality’ in transfers, potentially undermining state autonomy and diverting state resources towards centrally dictated priorities rather than state-specific needs. The challenge for the Commission was to design incentives that encouraged desirable outcomes without unduly coercing states or creating a system of subjective evaluation.
  • Fiscal Consolidation Roadmap: The emphasis on a stringent fiscal consolidation roadmap, particularly for states, was a point of concern for some states that were still grappling with developmental deficits and infrastructure needs. While fiscal prudence is essential, states argued for flexibility to undertake necessary capital expenditure for growth and welfare.

How the 15th Finance Commission Addressed the ToR

The 15th Finance Commission navigated these complex ToR by adopting a balanced approach, seeking to reconcile the diverse objectives of fiscal equity, efficiency, and sustainability.

In terms of horizontal distribution, the Commission carefully crafted its criteria to mitigate the negative impact of the 2011 population data. While it used the 2011 population (15% weight), it simultaneously introduced a ‘Demographic Performance’ criterion (12.5% weight) to reward states for their efforts in controlling population growth. Other weights included Income Distance (45%), Area (15%), Forest and Ecology (10%), and Tax and Fiscal Effort (2.5%). This blend aimed to address both the needs and the performance of states.

Regarding fiscal consolidation, the Commission provided a detailed debt trajectory for both the Union and the States, recommending a gradual reduction in fiscal deficit targets. It linked borrowing limits for states to their net outstanding debt and revenue deficits, incentivizing fiscal prudence.

On the controversial Defence and Internal Security Fund, the Commission acknowledged the necessity for robust defence spending. While it did not recommend creation of a separate non-lapsable fund from the divisible pool, it identified specific sources of funding within the Union government’s revenues and suggested setting aside a portion of the Union’s share of divisible pool towards this purpose, thereby not directly impinging on the states’ share. This was a nuanced approach to address the spirit of the ToR without violating the principles of fiscal federalism.

The Commission also provided significant grants to local bodies, nearly doubling the allocation compared to the 14th FC, with performance-based criteria attached to encourage reforms in sanitation, availability of audited accounts, and own-source revenue generation. It also recommended significant sector-specific grants and disaster management grants, tailored to meet specific needs of states and promote key policy objectives.

The ToR of the 15th Finance Commission played a pivotal role in shaping its recommendations and, consequently, the trajectory of India’s fiscal federalism for the period 2021-26. These directives were a reflection of the Union government’s policy priorities, notably its emphasis on fiscal consolidation, performance-based governance, and specific national concerns such as defence funding and population control. The inclusion of new criteria and specific mandates compelled the Commission to adopt innovative approaches, balancing the long-standing principles of equity and efficiency with emerging challenges and concerns.

The detailed and sometimes contentious nature of these ToR underscores the intricate balance that the Finance Commission must strike between addressing the diverse needs of states and adhering to the broader macroeconomic and strategic objectives of the Union. The Commission’s comprehensive engagement with each term, leading to nuanced recommendations on vertical and horizontal devolution, fiscal consolidation paths, performance incentives, and the delicate issue of defence funding, highlights its critical role in navigating the complexities of centre-state financial relations. The outcome of these ToR, as embodied in the 15th Finance Commission’s report, represents a significant chapter in the ongoing evolution of India’s unique federal fiscal architecture, aiming to foster both cooperative federalism and sound financial management across all tiers of government.