Model Answer
0 min readIntroduction
Fiscal federalism refers to the financial relationship between different levels of government – Union, State, and local bodies – within a federal structure. It encompasses the division of financial powers, responsibilities, and resources. India, as a quasi-federal state, experiences both vertical and horizontal fiscal imbalances. Vertical imbalance arises from the Union government’s greater revenue-raising capacity compared to states, while horizontal imbalance stems from disparities in economic development and resource endowments among states. Since 2001, the Finance Commissions (FCs) have played a crucial role in mitigating these imbalances through their recommendations on tax devolution and principles governing grants-in-aid to states, aiming for a more equitable and efficient allocation of resources.
Understanding Fiscal Imbalances
Vertical Fiscal Imbalance: The Union government collects most of the taxes (e.g., income tax, corporation tax, GST) while states bear a disproportionate responsibility for expenditure on social sectors like education, health, and law & order. This creates a dependency of states on the Union for financial resources.
Horizontal Fiscal Imbalance: States differ significantly in their economic development, resource endowments, and demographic characteristics. More developed states have a higher tax base, while less developed states struggle to generate sufficient revenue, leading to inequalities in service delivery.
Role of Finance Commissions since 2001
11th Finance Commission (2001-2005)
The 11th FC, chaired by K.C. Pant, focused on consolidating fiscal discipline. It recommended a devolution of 30.5% of the divisible pool of central taxes to states. It also emphasized the need for states to undertake fiscal reforms and introduced a performance-based incentive system through grants.
12th Finance Commission (2005-2010)
Under Vijay Kelkar, the 12th FC increased the states’ share in the divisible pool to 32%. It introduced the concept of ‘distance criteria’ in determining devolution, giving weightage to population, income distance, area, and forest cover. This aimed to address horizontal imbalances by providing more resources to poorer and backward states. It also recommended grants for local bodies.
13th Finance Commission (2010-2015)
The 13th FC, headed by B.K. Chaturvedi, significantly increased the states’ share to 32% (same as the 12th FC but with a different base). It emphasized fiscal consolidation and recommended grants based on performance in areas like education, health, and infrastructure. It also introduced a new criterion – demographic performance – to incentivize states to control population growth.
14th Finance Commission (2015-2020)
This commission, chaired by Y.V. Reddy, marked a paradigm shift by recommending a substantial increase in the states’ share in the divisible pool to 42%. This was a significant jump, aiming to enhance states’ fiscal autonomy. It also rationalized the number of central schemes and emphasized the importance of cooperative federalism. The commission also recommended grants to local bodies based on the 2011 population census.
15th Finance Commission (2020-2026)
Led by N.K. Singh, the 15th FC recommended a 41% devolution to states (adjusted for the newly formed Union Territories of Jammu & Kashmir and Ladakh). It introduced a new criterion – demographic performance (rewarding states that have made progress in controlling population growth) – and emphasized the need for performance-based incentives. It also recommended sector-specific grants for health, education, and agriculture. The commission faced criticism for using the 2011 census data, which was considered outdated by some southern states.
16th Finance Commission (2026-2031)
Currently deliberating, the 16th FC, chaired by Arvind Panagariya, is expected to address emerging challenges like climate change, demographic shifts, and the impact of the Goods and Services Tax (GST) on state finances. It is also expected to review the existing criteria for devolution and grants, potentially incorporating new indicators of performance and equity. The terms of reference include recommending measures to enhance the fiscal capacity of local bodies.
Impact and Challenges
The successive Finance Commissions have demonstrably reduced fiscal imbalances. Increased devolution has provided states with greater financial autonomy and resources for development. Performance-based grants have incentivized states to improve their performance in key sectors. However, challenges remain. The GST implementation has affected states’ revenue autonomy, and the reliance on central transfers continues. Furthermore, the criteria used by FCs have been subject to debate, with some states arguing that they do not adequately reflect their needs and performance.
| Finance Commission | Devolution (%) | Key Features |
|---|---|---|
| 11th (2001-2005) | 30.5% | Fiscal consolidation, performance-based incentives |
| 12th (2005-2010) | 32% | Distance criteria, grants to local bodies |
| 13th (2010-2015) | 32% | Demographic performance criterion |
| 14th (2015-2020) | 42% | Significant increase in devolution, rationalization of schemes |
| 15th (2020-2026) | 41% | Demographic performance, sector-specific grants |
Conclusion
The Finance Commissions have been instrumental in shaping India’s fiscal federalism, progressively addressing vertical and horizontal imbalances. While significant progress has been made in enhancing states’ fiscal autonomy and promoting equitable resource allocation, ongoing challenges related to GST revenue, evolving demographic patterns, and the need for performance-based incentives require continued attention. The 16th Finance Commission has a crucial role to play in adapting to these new realities and ensuring a more sustainable and equitable fiscal framework for the future.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.