The Finance Commission (FC) constituted with an interval of five years plays a critical role in transfer of resources from the Union to the States to alleviate the asymmetry in powers of raising resources by the constitutional units in federal structure.

The Commission, while transferring resources between the Union and the States (the vertical sharing) also determines the share that would accrue to each State (horizontal sharing) and in doing so looks at the revenue realised (realizable) and the expenditure that would need to be incurred through a normal assessment.

Besides the FC, the Union also transfers resources through Ministries and Departments for specific programmes and schemes. The broad institutional architecture of fiscal transfer could be well understood through the diagram given.

The overall flow of resources is quite significant both from the perspective of the Union and States. While for the Union, transfers constitute nearly half of its gross Revenue Receipts (GRR), for the States, these transfers account for nearly 47 per cent of their revenue receipts. The transfers witnessed an upsurge with the Fourteenth FC, which raised the divisible pool to 42 per cent of taxes (net of cess and surcharge and collection costs).

Notwithstanding the importance of transfers for the Union and the States, three issues are often raised on the constitutionally mandated transfers through FC. These issues indicate that the FC transfers are status quoist and not dynamic; these transfers hardly are able to influence policy paradigm at the level of the States; these transfers are non-transparent; they are just handed down.

These criticisms are not often out of place. Transfers have been status quoist because the criteria governing the transfers have hardly undergone significant changes. Almost equal weight has been allocated to the need and fiscal capacity, with poorer and smaller States getting a significantly larger share. This should change.

On per capita transfers, against an average transfer of little over ₹8,000 during 2014-22, the range has been varying; from under ₹6,000 to Haryana, Maharashtra and Gujarat to over ₹50,000 for Sikkim, Mizoram and Arunachal Pradesh. Even Goa, a better off State, gets over ₹20,000.

Similarly, transfers from the Union, as per cent to overall revenue receipt of the States, during 2014-2022, have varied from 23.4 per cent for Haryana to 72.9 per cent for Bihar and more than 80 per cent for most smaller North-Eastern States.

Little policy impact

The awards of the FC have hardly been able to influence policy patterns. The Commissions, since the Twelfth FC, have been emphasising fiscal responsibility and setting debt ceiling relative to GSDP.

Twelfth Finance Commission recommended a ceiling of 25 per cent as Debt/GSDP. Fifteenth FC reiterated this in its Fiscal Responsibility recommendations, but the actual debt to GSDP ratio of the States has remained elevated. In 2023-24 (BE), it was 13.9 per cent for Odisha (the lowest) to 47.6 per cent for Punjab. It exceeded 50 per cent for Arunachal Pradesh.

Due to debt waivers, interest subvention and other special programmes by the States, FCs were hardly able to enforce the required fiscal discipline. While the Union Government is equally responsible, as every proposal for borrowing must be agreed to by it, the fiscal situation in some States is nearly crumbling.

Discretionary transfers through Departments are preferable as they are pointed, specific and better targeted and monitored, as compared to such transfers through FCs. However, to relieve the serious debt distress of some States, a one-time grant under strict conditionalities is needed. Criteria must be evolved after due consultation with experts and the States. Again, cesses must be merged with the divisible pool.

Non transparency is a complaint made by most States. According to them, while FCs discuss their Memorandum, there is hardly any forum where they can collectively raise their issues and get answers as why their demands are unacceptable.

Similarly, each State usually suggests different criteria for inter-State distribution of divisible pool, but FCs, without getting into the merit of these cases, decide the criteria. Their approach is often seen to be guided by the Union, not from the perspective of the States.

It is not that these apprehensions are unfounded. It is, therefore, important that steps should be taken to remove any apprehensions in the interest of cooperative federalism. For transparency, it may be desirable for the FC to hold inter-State meetings at regional level or with comparable States to convince them of the approach the FC proposes to follow.

It has been observed that as a result of equity considerations dominating weights, the ratio of resource transfers to better off and poor States has remained largely unchanged.

The Twelfth FC did talk of equalisation of revenue expenditure for some merit goods like education and health, but that was not pursued by the later commissions. Given that discretionary transfers are better targeted and monitored, FC transfers could themselves be in two parts, fully equity based, and entitlement based.

It is important that inequality as is being observed in terms of per capita income or expenditure or asset holding are reduced, but mechanism for an appropriate intervention needs to be conceived by the FC. The current approach creates more heartburn than address the needs.

There has often been talk of constituting a mechanism like inter-State GST Council where these issues are discussed, but such a forum where decisions are taken on unanimous basis is not feasible in FCs.

Similarly, an arrangement like that of the Inter State Council is also not very useful. Better inter-State communication, a genuine mix of entitlement with discretion for better monitoring are the key issues and the FC must arrive at a consensus on these.

Gopalan is former Secretary, Economic Affairs, and Singhi is former Senior Economic Adviser, Ministry of Finance. Views are personal