CHAPTER-VI

TRANSFER OF FINANCE FROM

CENTRE TO STATES THROUGH
GRANTS AND LOANS
 //109 //

CHAPTER-VI
TRANSFER OF FINANCE FROM CENTRE TO
STATES THROUGH GRANTS AND LOANS

The preceding chapter deals with the distribution of revenue between

the centre and the states through sharing of taxes as per the recommendations
of the several Finance Commissions under Articles 268 to 273 to bring
financial equity, and fiscal balance among the states as well as to make the
states financially viable. Even after the transfer to the states a share of divisible
taxes, the resources of some of the states may remain inadequate to meet
their needs. Therefore, the Constitution provides for Grants-in-Aid by the
Centre to the states as in needs of assistance.

The question of grants-in-aid arise because the economies of the

different regions of India differ from one another in ways which have an
important bearing on the relative capacity of several State Governments to
provide welfare services. This difference occur because of several factors,
e.g., area, climate, topography, natural resources, size of population, productive
capacity and levels of income and expenditure.1 The framers of the
Constitution knew that to leave the poor states to their resources would result
in creating imbalances in politics and economy of the nation. Hence, along
with the distribution of tax revenue, fiscal grants-in-aid constitutes an
important technique in India for making inter-governmental adjustments.

Grants-in-Aid may be a kind of general form of aid for overcoming

current revenue deficit as well as to correct inter-state disparities in the
resources. Article 280(3)(b) requires the Finance Commission to make
recommendations as to the principles which should govern the grants-in-aid
of the revenue of the states under Article 275(1).

1. Sharada Rath, Federalism Today, Approaches, Issues and Trends, Sterling Publishers
Private Limited, 1984, p. 131.

\
 //no//

The term “grants-in-aid of the revenue” has not been defined clearly in
the Constitution. Both the Government of India Act, 1935 and Constitution
of 1950 contain provisions under which assistance may be given to the States
by way of grants. Two types of grants are provided by the Centre to the States:
the first under Article 275 which rooted through the Finance Commission
and second under Article 282 which have traditionally been determined by
the Planning Commission. Article 275(1) of the Constitution in its substantive
part is worded similarly to Section 142 of the Government of India Act, 1935,
while Article 282 follows the wording of Section 150 of the Government of
India Act, 1935. The first one is considered ‘general purpose transfer’, while
the second one is in the nature of ‘specific purpose grant’. “Thus, the grants
given to the states under Article 275 were not designed to upset the fiscal
disadvantages of the States perse but to help them to overcome their projected
budgetary difficulties and raise the levels of certain specified services to ‘bench
mark’ level as it is related largely to the backwardness of States and population
and not specifically to the fiscal disadvantages of the States.”2

Indian Constitution provides for the following grants.

i. Compensatory grant [Art.273].
ii. Fiscal need grant [Art. 275(1)].
iii. Grant for development of tribal regions [Art. 275(1)].
iv. Discretionary grants to be sanctioned for public purposes
[Art.282].
The first three grants are provided to the states by the Centre on the
recommendation of the Finance Commission, while the last one is provided
to the States on the recommendation of the Planning Commission. Under
Article 273, the Central Government gave grants to compensate for the loss
of revenue on account of the federalization of Export Duty on jute and jute
products. Similarly, under Article 278, the Government of India gave grants
to t he erstwhile Part B States for the net loss of revenue on account of their
financial integration with the Union.
2. N.R. Rao, Inter-Governmental Financial Relations in India, Uppal Publishing House,
1996.
 //Ill//

Some grants may be general in the sense of the general contribution to

the revenue of the States and may be called ‘fiscal need grants’. They are
intended to help the States to overcome the over all inadequacy of revenue in
comparison with their expenditure needs. In India, the Union Government
give such grants under Article 275(1). In addition, the Union Government
may also give grants to the States for the development of Scheduled Tribes
and Scheduled Areas under proviso to Article 275. Also, there may be
discretionary grants which may be sanctioned for any purpose. Article 282 of
the Constitution empowers the Government of India (and the States) to give
such grants, notwithstanding the existing distribution of financial resources.
The Finance Commission is not authorized to deal with these grants. The
Government of India gives conditional grants to the States, usually under this
discretionary power for specific purposes like flood relief, plan schemes and
the like.
Article 280(3)(b) requires the Finance Commission to make
recommendation as to the principles which should govern the grants-in-aid
of the revenue of the States under Article 275(1). Accordingly, the First Finance
Commission recommended grants-in-aid taking the budgetary needs of the
States as the important criterion in determining the grants-in-aid required by
the States under Article 275(2) of the Constitution. This principle, added
with the consideration of the impact of Five-Year Plans, was accepted by the
Second, Third, Fourth and Fifth Finance Commissions. The Sixth Finance
Commission, however, had accepted fiscal needs of the States as the important
criterion for determining grants-in-aid. The most important recommendation
of the Commission was that States backward in standards of general
administration should be enabled to come upto a certain national minimum.
The Seventh Finance Commission recognized the past practice but it tried to
include as many of the poorer states as possible with surpluses to plough
back for fresh development. The Commission emphasized the point that the
role of a Finance Commission should not be negative to fill up the revenue
gaps between the States, but positive in that, since its scheme development
might give a better start for development outlay. The Eighth Finance
Commission recommended grants-in-aid to the States to cover the deficits on
revenue account, to meet the margin money requirements of States and to
give debt-relief.
The first eight Finance Commissions confined themselves to the non­
plan revenue account of the States. They determined the grants equal to deficit
 //112//

of each State so that the non-Plan revenue account of all the States were balanced
or left with a surplus every year. This was called the gap filling approach
meaning that the deficits on non-Plan revenue account which remained under
tax devolution were covered through grants. However, the main disadvantage
of the gap filling approach was that it encouraged wasteful expenditure and
discouraged revenue efforts on the part of the State Governments.
In order to overcome the shortcomings of the gap-filling approach the
Ninth Finance Commission adopted a normative approach to make the States
more revenue conscious. The Commission assessed revenue receipts of the
States normatively and applied certain norms to assess expenditure. Therefore,
it recommended grants to fill the normative gaps as opposed to traditional
budgetary needs. Secondly, it dealt with total revenue account (including
Plan revenue account) and worked to eliminate revenue deficits as a whole.3
Reverting back to the gap filling approach, the Tenth Finance
Commission recommended grants-in-aid equal to the amount of residual
deficit, emerging after taking into account the transfer pertaining to taxes and
duties, for each of the years during 1995-96 to 1999-2000. Hence, no State
has a post-devolution deficit on the non-Plan revenue account in the terminal
year. The total amount of grants on account of non-Plan revenue deficit for the
period 1995-2000 was Rs.7,582 crore.4 Table no VI: 1 gives a picture of the
recommendations of the different Finance Commissions on Grants-in-Aid,
Table No.: VI: 1
Recommendations of the Finance Commissions on GRANTS-IN-AID5
Finance Commission (F.C.)
First F.C. : (i) for 8 States to improve primary education facilities.
(ii) for 7 States, in order to cover their deficits during
the period 1951-56.
Second F.C. : (i) larger volume of grants-in-aid for meeting
development needs of states.
Third F.C. : (i) Rs.550crores provided to all states except Maharastra
in order to cover a part of their revenue expenditure,
(ii) Rs.45 crores provided for improvement of
communication.

3. M.M. Sury (ed) Finance Commissions of India, I to XII, (1952-57 to 2005-10),

New Century Publication, 2005, p.75.
4. Ibid., p.75
5. Finance Commission Reports.
 limn

Fourth F.C. (i) to provide total grant of Rs. 610 crores for covering
deficit.
Fifth F.C. (i) to provide Rs.638 crores for covering deficits of
states during the period 1969-74.
Sixth F.C. (i) Recommended Rs.2510 crores for 14 out of 21
states so as to cover their non-Plan deficits during
the period 1974-79.
Seventh F.C (i) Recommended Rs. 1600 crores to cover deficits as
well as to upgrade the administrative standard of
few backward states during the period, 1980-85.
Eighth F.C. (i) Recommended a grant of Rs. 1556 crores to cover
deficits during the period 1985-90; and
(ii) another grant of Rs.915 crores to some states for
upgrading the administrative standards.
Ninth F.C. (i) Recommended a grant of Rs. 15,017 crores to cover
deficits on Plan and non-Plan revenue account
during the period of 1990-95; and
(ii) providing a special annual grant of Rs.603 crores
as Centre’s contribution towards Calamity Relief
Fund, i.e., total of Rs.3015 crores for entire 5 year
period, 1990-95.
(iii) providing a special grant of Rs.122 crores to
Madhya Pradesh in order to meet its expenditure
on rehabilitation and relief of victims of Bhopal
Gas tragedy.
Tenth F.C. (i) The quantum of the grant in lieu of the Railway
Passenger Fares Tax for 1995-2008 should be
Rs.380 crore annually.
(ii) A total sum of Rs.2,608.50 crore as grant for
upgradation and special problems for the period
1995-2000.
(iii) The size of Calamity Relief Fund will be
Rs.6304.27 crores, out of which the Centre will be
required to contribute Rs.4728.19 crores (75%) and
States Rs. 1576.08 crores (25%).
(iv) Grants of Rs. 1,000 crores for period of 1995-2000
to enable local bodies- Municipalities and
Panchayats - to meet their primary obligations.
 //114 //

The above table no. VI: 1 indicates that the different Finance
Commissions accept different criteria for providing grants to the States. The
First Finance Commission gave grants to States to improve primary education
facilities and to cover the deficits of the States during the period 1951 to
1956. The Second Finance Commission gave grants-in-aid for meeting
development needs of the States. The Third Finance Commission provided
grants to the States to cover a part of their revenue expenditure and for
improvement of communication. The Fourth Finance Commission provided
grants to the States for servicing of their debt, to create a fund out of part of
the proceeds of Estate Duty and scope for economy consistent with efficiency
which may be effected by the States in their administrative expenditure. The
Fifth Finance Commission provided grants to the States mostly to cover the
deficits during the period 1969 to 1974. But the Fifth Finance Commission
expressed the view that “As the language of Article 275 stands, there is nothing
to exclude from its perview, grants for meeting revenue expenditure on plan
scheme, nor is there any explicit ban against grants for Capital purposes.”6
The terms of reference of subsequent Finance Commissions make it clear
that expenditure on plan is outside their jurisdiction. By practice and
convention, the scope of Article 275 has been restricted only to the needs of
the States on revenue account on non-plan commitments and liabilities.7
Therefore, no grant need to be given to a State which does not need assistance
nor is it necessary that a State should get grants in aid every year. The Sixth
Finance Commission recommended grants for the States so as to cover their
non-plan deficits during the period 1974 to 1979. The Seventh Finance
Commission took into consideration the case of the backward states and
recommended grants to cover deficits as well as to upgrade the administrative
standard of backward States. The Eighth Finance Commission accepted the
same principles and recommended grants to cover deficits as well as for
upgrading the administrative standards of the States. Ninth Finance
Commission provided grants to cover deficits on plan and non-plan revenue
account. But it recommended the grants as centre’s contribution towards
calamities relief fund. A special grant was made to Madhya Pradesh in order
to meet its expenditure on rehabilitation and relief victims of Bhopal Gas
Tragedy. Grants for calamity relief fund was also recommended by the Tenth

6. Report of the Fifth Finance Commission, (1969), p.12.

7. R.C.S. Sarkar, Union State Relations in India, National, 1985, p.117.
 //115 //

Finance Commission, where the Centre will contribute 75% and the States
will contribute 25% of the fund. The Tenth Finance Commission made grants,
as per the Constitution Amendment Acts of 1992 and 1993, to States to enable
local bodies- Municipalities and Panchayats to meet their primary obligations.
Thus in making the statutory non-plan grants the Finance Commissions take
into consideration the different variables as criteria as per the exigencies of
the time.
Table No.VI:2 and VI:3 indicate that the Finance Commissions bring
into its fold the States for grants, whose numbers are not the same for all the
Commissions. The maximum number of States were recommended for the
grants by the Ninth Finance Commission whose number was 21, The Seventh
Finance Commission gave grants only to 8 States (see Table Nos. VI:2 &
VI:3). This shows that the Finance Commissions do not take the case of all
the States for giving grants to them.
Table No. VI:2
Number of States and Amount of Grants Recommended By Finance
Commissions.
Finance Commission (F.C.) No. of States Amount
Covered (in crores of rupees)
First F.C. (1952-57) 13 34.25
Second F.C. (1957-62) 11 187.75
Third F.C. (1962-66) 15 244.00
Fourth F.C. (1966-69) 10 609.45
Fifth F.C. (1969-74) 10 637.85
Sixth F.C. (1974-79) 14 2509.06
Seventh F.C. (1979-84) 8 1173.12
Eighth F.C. (1984-89) 11 2200.22
Ninth F.C.(1989-90) and (1990-95) 21 15017.18
Tenth F.C. (1995-2000) 16 7582.68
Source : Reports of Finance Commissions in India.
 //116//

Table No. VI:3

The States Covered By Different Finance Commissions For Grants
Finance States Covered
Commission (F.C.)
First F.C. West Bengal, Orissa, Saurastra, Punjab, Assam,
Mysore, Travancor and Cochin, Bihar, Madhya
Pradesh, Hyderabad, Rajasthan, Madhya Bharat,
Patiala and East Punjab States Union.
Second F.C. Andhra Pradesh, Assam, Bihar, Kerala, Madhya
Pradesh, Mysore, Orissa, Punjab, Rajasthan, West
Bengal, Jammu and Kashmir.
Third F.C. Andhra Pradesh, Assam, Bihar, Gujurat, Jammu and
Kashmir, Kerala, Madhya Pradesh, Madras,
Maharastra, Mysore, Orissa, Punjab, Rajasthan, Uttar
Pradesh, West Bengal.
Fourth F.C. Andhra Pradesh, Assam, Jammu and Kashmir, Kerala,
Madhya Pradesh, Madras, Mysore, Nagaland, Orissa,
Rajasthan.
Fifth F.C. Andhra Pradesh, Assam, Jammu and Kashmir, Kerala,
Mysore, Nagaland, Orissa, Rajasthan, Tamil Nadu,
West Bengal.
Sixth F.C. Andhra Pradesh, West Bengal, Uttar Pradesh, Bihar,
Assam, Kerala, Orissa, Rajasthan, Jammu and
Kashmir, Himachal Pradesh, Manipur, Meghalaya,
Nagaland.
Seventh F.C. Himachal Pradesh, Jammu and Kashmir, Manipur,
Meghalaya, Nagaland, Orissa, Sikkim, Tripura.
Eighth F.C. Assam, Himachal Pradesh, Jammu and Kashmir,
Manipur, Meghalaya, Nagaland, Orissa, Rajasthan,
Sikkim, Tripura, West Bengal.
Ninth F.C. Andhra Pradesh, Arunachal Pradesh, Assam, Bihar,
Goa, Himachal Pradesh, Jammu and Kashmir, Kerala,
Madhya Pradesh, Manipur, Meghalaya, Mizoram,
Nagaland, Orissa, Punjab, Rajasthan, Sikkim, Tamil
Nadu, Tripura, Uttar Pradesh, West Bengal:
Tenth F.C. Andhra Pradesh, Arunachal Pradesh, Assam, Bihar,
Goa, Himachal Pradesh, Jammu and Kashmir,
Manipur, Meghalaya, Mizoram, Nagaland, Orissa,
Rajasthan, Sikkim, Tripura, Uttar Pradesh.
Source : Reports of the Finance Commissions in India,
 uni h

Planning Commission:

Apart from grants through Finance Commission, grants are also

provided on the recommendations of the Planning Commission to the States
to correct mostly the horizontal imbalances among the States. Article 282
provides that the Centre or a State may make grants for any public purpose.
These grants which are given at the discretion of the Government are different
from the grants made under Article 275. The logical inference is that Article
282 was intended not to enable the Centre to make regular grants to a State,
but to serve as a residuary provision enabling the Centre as well as the States
to make grants for any public purpose.8

The provision of Central assistance to the States for Plan purpose is

given by the Central Government on the recommendation of the Planning
Commission. However, no specific provision exists in the Constitution for
setting up an appropriate planning machinery. In the absence of any such
constitutional provision, the Government of India decided in 1950 to set up
the Planning Commission merely by an Executive Order and accordingly, the
Planning Commission was set up by a Resolution of the Cabinet to act in
close understanding and consultation with the Ministries of Central
Government and Governments of the States.9 The Planning Commission is a
permanent body which formulates Five Year Plans and recommends resource
transfer in the form of grants and loans from Centre to State to carryout plan
schemes. The devolution of resources from the Centre to States by the Planning
Commission is known plan transfer.

Determination of Central assistance for the State Plan was based on

the size of the State Plan until the beginning of the Fourth Plan. As no clearly
stated principles existed even for this State Plan, outlays were determined
some how by the Planning Commission after consultation with the individual

8. Administrative Reform Commission, Report of the Study Team on Centre-State

Relationship. Vol.I, 1968, p.73.
9. Government of India Resolution (Cabinet-Secretariate) No.l-P(c)/50, dt.March 15,
1950.
 //118 //

State. The gap between these outlays and own resources of the States was
filled through Central assistance.

The Planning Commission is composed of the Prime Minister as the

Chairman, four full time members including Deputy Chairman, Minister of
Planning, Minister of Finance, and Minister of Defence as its members.
However, there was resentment among the States, regarding the composition
of the Commission. The ARC and its Study Team considered this question
and after considering their two Reports, the Planning Commission was
reconstituted in July, 1967. In the reorganized Planning Commission the
Prime Minister continued to be the Chairman and the Finance Minister became
a member. No other Minister was formally associated with the Commission.
But the Prime Minister could invite any Minister to attend any meeting of the
Commission, if considered desirable. The composition of the Commission
has thus undergone changes from time to time. With the changes in the
Government at the Centre a new Planning Commission is formed.

The Planning Commission does the following functions; (i) makes

assessment of various resources and investigates into the possibilities of
augmenting the resources, (ii) formulates a plan, (iii) defines strategies of
plan implementation and determines plan priorities, (iv) identifies the factors
of retarding economic growth and determines conditions for its successful
implementation, (v) determines plan machinery at each stage of planning
process, (vi) makes periodic assessment of the progress of the achievements
and recommends necessary changes in policy measures to achieve objectives
and targets of plan and (vi) finally makes ancillary recommendations as and
when necessary. The Planning Commission is, however, only an advisory
body.

The National Development Council (NDC) was constituted since 1952

to work as the highest national forum for economic planning in India. The
NDC represents both the Centre and State Governments to make all important
decisions relating to planning. It was not given any statutory status deliberately
 //119 //

perhaps in order that planning may be flexible and informal. It was criticized
that it was not functioning as an effective body. It has not succeeded in securing
the participation of the people in the formulation and implementation of plans.
The matter was referred to ARC on whose recommendations the Council was
reconstituted with redefined functions. The NDC is composed of the Prime
Minister of India, Chief Ministers of all States, and members of Planning
Commission. It works as an advisory council to make periodical review of
the national plan at different times, to consider important questions related to
social and economic policy affecting national development, to recommend
various measures for achieving the objectives of national plan, to take decision
regarding allocation of central assistance for planning among different states
and finally it approves the draft plan by the Planning Commission. The Council
has to meet as often as necessary but atleast twice a year. The Constitution
and functioning of NDC facilitate the Centre-State cooperation in the fields
of planning, development and financial equity. This results in establishing
cooperative federalism in India.

Plan Transfer of Resources Through Grants:

With the establishment of Planning Commission grants are provided

by the Centre to the States on its recommendation under Article 282. These
grants have occupied an important place in central financial transfers to the
States. These grants are intended to meet unforceable emergencies like
droughts, famines, flood, cyclone and other natural calamities and are not
envisaged as part of normal centre-state financial relations. These grants,
meant for emergency purposes, and therefore, kept outside the perview of the
Finance Commission.

Plan transfer by the Planning Commission are made in accordance with

the objective criteria approved by the National Development Council and are
subject to review of it. So plan transfers are not totally discretionary power
of the Centre as supposed to be. Even incase of emergency transfers there are
 //120 //

standardized procedures as recommended by the Seventh and Eights Finance

Commissions. However, the total amount of plan assistance to the States
each year is determined by the Centre that is, the Parliament of India. As
regards the nature of Plan transfers, the Sarkaria Commission observed, “the
Plan and other transfers which are labelled discretionary do not amount to
subversion of the constitutional scheme. They cannot be considered either
unreasonable or discretionary in a literal sense as their allocations follow
predetermined criteria, or is tied to meet the specific requirements of the
States.10 The Commission further observed that the controversy regarding
statutory versus discretionary transfer was more theoretical than realistic in
nature. However, there are no fixed rules regarding the subjects of
development for which plan assistance is to be given. But considering
allocation of plan resources by different Planning Commissions, it is found
that allocation of Plan resources has been assessed by broadly classifying
Plan expenditure into following five broad categories, namely, (a) Education
and Health, (b) Agriculture and Industry, (c) Infrastructure, (d) Other Social
and Economic Services and (e) General Services.

The grants through Planning Commission are meant for Central

Schemes, Centrally Sponsored Schemes and States’ Schemes. Different Plan
Schemes carried different patterns of assistance. The Central Schemes are
concerned with the activities falling in the jurisdiction of Central Government
but carried on by the States. The States Schemes usually relate to the activities
which constitutionally fall in the perview of the State Government but are
approved by the Central Government. There is another category namely
Centrally Sponsored Schemes that are sponsored by the Centre to be carried
by the States and accordingly financed by the Centre fully or partly. Grants
for the Central Sector Schemes are given to the States to undertake certain
agency function and are therefore financed by the Central Government. The
concept of Centrally Sponsored Schemes originated at the end of the First
Five Year Plan. At the beginning of the First Five Year Plan the States were
10. Report of the Commission on Centre-State Relations, Part-I, 1988, p.279.
 //121 //

executing several schemes under direct managements with the concerned

Central Ministries and it remained in the Centre’s Plan. At the end of First
Plan several of these schemes were transferred to the State Plan as “Centrally
aided” schemes. The remaining schemes were treated as Centrally Sponsored
Schemes. These schemes require specific approval of the concerned Ministry
before these can be undertaken. The payment of Centre’s share are made on
the basis of expenditure actually incurred by the State Governments. In view
of the national importance, these schemes are launched by the Centre and
implemented by the State Government with Central assistance. The Central
Ministries concerned propose and formulate the schemes which are approved
by the Planning Commission. The States execute these schemes under the
technical guidance and supervision of the Centre which also issues guidelines
regarding the contents, coverage, expenditure, pattern and staffing of such
schemes. The assistance given for the schemes on matching basis is over and
above the assistance given for State Plan and the provision for it is made in
the budgets of the Central Ministries.

Gadgil Formula:

During the first three Five Year Plans and three Annual Plans there
after, it was observed that the distribution of Central assistance was not based
on any clear-cut principles, giving the Planning Commission considerable
discretion in allocating funds.

In view of demand from the States for the adoption of a clear-cut

formula, the entire issue was discussed on the eve of the formulation of the
Fourth Five Year Plan. The formula approved by the NDC known as the Gadgil
Formula was as follows;

(i) The Special Category States should first receive the assistance
out of the total pool of Central assistance to meet their
requirements.

(ii) The balance of assistance should be distributed among the

remaining States on the basis of the following criteria.
 //122 //

• 60% on the basis of population,

• 10% on the basis of per capita State income of those States,

the per capita income of which is below the national level,

• 10% on the basis of tax effort,

• 10% on the basis of major irrigation and power projects,

• 10% for special problems for individual States.

Central Plan assistance during the Fourth and Fifth Plans was distributed
in accordance with the provisions of Gadgil Formula. The adoption of the
formula reduced the scope of discretion of the Planning Commission and
instead introduced objectivity and transparency in the allocation of plan
assistance to the States.11 Gadgil Formula was modified on the eve of the
formulation of the Sixth Plan to make it more progressive for the benefit of
economically backward States.

But the Gadgil Formula was declared as defective by the Chief Ministers
at the NDC meeting in 1985. The Chief Ministers pointed out that the formula
gave priority to needs of Special Category States only, while ignoring the
needs of Non-Special Category States. Another criticism was also that
according to this formula the Centrally Sponsored Schemes went largely to
better off States and the backward States did not get priority. They suggested
a reduction in the weight allotted to the population factor and fix a national
minimum in terms of important economic and social indicator for determining
the relative shares of the States. The Gadgil formula was then revised with
effect from Sixth Plan. The modified formula approved by the NDC in 1980
and applied for the Sixth and Seventh Plans was different from the original
formula. But again there was no unanimity among the States for Central
assistance, each State suggested a formula which best suited to its interest.
This led to further modifications in the Gadgil Formula. The revised Gadgil

11. M.M. Sury (ed), Finance Commissions of India, I to XII, (1952-57 to 2005-10), New
Century Publication, 2005, p.38.
 //123 //

Formula meant for the Eighth Plan, was discussed and approved by the NDC
at its meeting held on Dec.23-24, 1991. The table given below indicates the
principles of Plan Grants in accordance with Gadgil Formula in its original
form as well as revised forms.
Table No. VI:4
Original, Modified, and Revised Gadgil Formula for Central Plan
Assistance to States.
(Weight percent)
SI. Criterion Original Modified Revised
No. formula formula formula
(Fourth and (Sixth and (Eighth and
Fifth Plans) Seventh Subsequent
Plans) Plans)
1. Population 60 60 60
2. Per capita income 10 20 25*
below the national
average (deviation)
3. Per capita tax effort 10 10 -

4. Outlay on continuing 10 - -
irrigation and power projects.
5. Performance - - 7.5
6. Special problem 10 10 7.5
Total 100 100 100
* 5 percent was allotted to all the States on distance method.
Source: Report of Sarkaria Commission, Part-I, 1988, p.277 and decision of
the NDC held in 1991.

Despite the process regulated planned development under active state

intervention and predominance of public investment, socio-economic
inequalities between place and people have sharpened over the years. As a
result even after more than fifty years of planning, the absolute number of
 //124 //

poor population living below the poverty line is on an increase. In order to

overcome the problem of low economic growth calculated on the basis of
existing poverty as well as increasing external debt burden and balance of
payment crisis, the Government of India has taken to recourse to Structural
Adjustment Programme (SAP), economic liberalization and globalisation
measures since early 1990’s. The measures popularly known as NEP (New
Economic Policy) put emphasis on the primacy of the market in regulating
the economy and the role of the State in shaping the economy and society are
progressively curtailed. However, the market mechanism may not improve to
access to available facilities or folly meet the essential needs of the population
living below the poverty line. Hence, realizing the limitations of the market
economy and its effects on the living of the poor, the Government of India in
its Ninth Five Year Plan put emphasis on social sector planning with
appropriate policy and programme initiatives.12

While the Planning Commission makes recommendations for providing

grants to States it divides the States into different groups on the basis of their
per capita Gross State Domestic Product (GSDP) and accordingly decides
the amount of grants. All the States are categorized broadly into two- General
Category States and Special Category States. Again General Category States
are grouped into three namely, High Income States, Middle Income States
and Low Income States. The table given below indicates the States of different
categories with poverty ratio. (Also see Appendix).

12. Planning Commission Government of India, ORISSA DEVELOPMENT REPORT, 2002,

pp.2-80-281.
 //125 //

Table No. VI:5

Categories of States with Poverty Ratio
(in per cent)
States Poverty ratio % 1990-2000
High Income State 17.83
Gujurat 14.07
Haryana 8.74
Maharastra 25.02
Goa 4.4
Punjab 6.16
Middle Income States 20.3
Andhra Pradesh 15.77
Karnataka 20.44
Kerala 12.72
Tamil Nadu 21.12
West Bengal 27.02
Low Income States 34.28
Bihar 42.6
Chattisgarh NA
Jharkhand NA
Madhya Pradesh 37.43
Orissa 47.15
Rajasthan 15.28
Uttaranchal NA
Uttar Pradesh 31.15
Special Category States
Arunachal Pradesh 33.47
Assam 36.09
Himachal Pradesh 7.63
Jammu & Kashmir 3.48
Manipur 28.54
Meghalaya 33.87
Mizoram 19.47
Sikkim 36.55
Tripura 34.44
All States 26.1
Notes : NA - Not Available
Sources : Nirvikar Singh, India's System ofIntergovernmental Fiscal Relations,
2004, p.18 (Internet).
 //126 //

Table No.VI:6
Overall Plan Resource and its Funding
(As a percentage of GDP)
Overall Plan States’ own Revenue Plan Net debt
Resource Non-Debt Transfer from Receipts
Contribution Centre
V Plan 4.3 1.2 1.1 2.0
(27.9) (25.6) (46.5)
VI Plan 5.1 0.6 1.5 3.0
(11.8) (29.4) (58.8)
VII Plan 5.1 0.4 1.7 3.0
(7.8) (33.3) (58.9)
VIII Plan 4.2 0.0 1.6 2.6
(0.0) (38.1) (61.9)
IX Plan 3.7 (-) 1 ■ 5 1.2 4.0
[(-) 40.5] (32.4) (108.1)
Note : Figures in parenthesis indicates percentage share in over all plan
resources.

Source: (i) Reserve Bank of India (RBI) documents on state finances.

(ii) Planning Commission, Government of India, Tenth Plan

Document, ch.2, p.7 (Internet).

The table given above indicates the funding pattern of plan resources
during the last Five Plan periods. It is inferred from the table that as a
percentage of GDP the revenue plan transfer from the Centre and the net debt
receipts constitute a major bulk of the pattern outlays. This indicates the
magnitude of State’s dependence upon the Centre in the financial matters for
development purposes. This is also supported from the statistical statement
of the Central assistance to the States in different plan periods as given in
Table No.VI:7.
 //127 //

Table No. VI:7

The Grants to States As Central Assistance During Different Plans
(Rupees in Crores)
First Five Year Plan (1951-56) 104
Second Five Year Plan (1956-61) 892
Third Five Year Plan (1961-66) 1,272
Three Annual Plans (1966-69) 1,648
Fourth Five Year Plan (1969-74) 4,949
Fifth Five Year Plan (1974-79) 3,761
Sixth Five Year Plan (1980-85) 16,557.06
Seventh Five Year Plan (1985-90) 31,424.80
Eighth Five Year Plan (1992-97) 93,833.81
Ninth Five Year Plan (1997-2002) 185,259.63
Source: (i) Seventh Finance Commission Report, 1978, App.IVl (IV), p.177,
From First Five Year Plan to Fifth Five Year Plan.
(ii) Tenth Five Year Plan Report, p.118, From Sixth Five Year Plan
to Ninth Five Year Plan.
Loans:

The third instrument for financial adjustment is that of resource transfer

through loans from Centre to the State Governments. Loans are given for
various purposes both developmental and non-developmental as also for plan
and non-plan schemes. The States are authorized to raise a good amount of
loans from the market as well as from the Union Government (Art.293).

Under Article 293, the Central Government may grant loans to the
States or give guarantees in respect of loans raised by them. The State
Governments borrow only limited amounts from the market; but they have
been extensively borrowing from the Central Government and as a result
have become heavily indebted to Central Government. A State cannot raise a
loan without the consent of the Centre as long as a central loan is outstanding
or a guarantee given by the Centre is in operation. In giving its consent the
 //128 //

Centre can impose such condition it thinks fit. In practice, every State has to
borrow regularly from the Centre so that at no time it is free from indebtedness
to the Centre. Consequently, the entire borrowing operation of the States are
under the central control. Borrowing by the Union has no restriction but when
it is permitted to the States, it is regulated. The Union Government has given
a right to regulate the borrowing of the States and the State is to borrow under
certain situation, a pre-condition is that the Union of India must have agreed
to it. Therefore, the power that is now conceded to the State is essentially a
regulated power and that power is controlled by the Centre.

The State can borrow from the Centre upon the securities of revenue
of the State but it cannot borrow from the international market. It is inconsistent
with the Sovereignty of India. However, in the Government of India Act,
1935, there was provision that provincial government may raise loans from
outside from the international money market with the prior approval of
Government of India. But that has been deliberately deleted in the Constitution
of India 1950.

The Second Finance Commission recommended a long term and

medium term loan but the Fourth Finance Commission suggested to set-up a
competent body to study the entire problem of indebtedness of States. The
Fifth Finance Commission strongly recommended that the State should as a
matter of necessary fiscal discipline balance their budgets and manage their
affaires within the resources available to them. So the Commission did not
favour the borrowing of the States from Centre. The Sixth Finance Commission
made a detailed study of the debt position of the States and recommended the
consolidation and the repayment of their debts over fifteen to thirty years.
The Seventh Finance Commission however, recommended relief to the States.
But the Ninth Finance Commission objected against such steps and asked the
States to be vigilant and exercise restraint in raising additional debts. The
Tenth Finance Commission has expressed serious concern over the
deteriorating debt position of the States. The Commission suggested that the
States should make serious efforts to meet the loan repayment and interest
 //129 //

obligation of such debts. The Commission has recommended a scheme of

general debt relief for all states linked to its fiscal performance.

However, the problem has occurred relating to the massive indebtedness

of the States to the Centre, though the States’ power to borrow is limited (Art.293).
The size of the loans has grown over the years as stated in Table No. VI:8.
Table No. VI: 8
Capital Receipts of States Through Loan/Debt
(Rupees Crore at current price)
Year Loan / Debt
1974-75 1293.02
1975-76 1375.15
1976-77 1673.08
1977-78 1588.30
1978-79 2878.67
1979-80 2536.91
1980-81 3158.74
1981-82 3537.30
1982-83 4099.23
1983-84 5574.20
1984-85 6679.13
1985-86 8595.13
1986-87 8128.36
1987-88 9312.88
1988-89 10445.10
1989-90 13883.72
1990-91 17441.12
1991-92 18179.87
1992-93 20648.83
1993-94 17538.15
1994-95 26979.04
1995-96 31424.59
1996-97 23815.34
1997-98 39967.36
1998-99 67631.86
1999-2000 82840.29
Source : Various Issues of RBI Bulletin on State’s Budget.
 //130 //

The loans for financing State Plans are tied loans given under auspices
of the Planning Commission at the discretion of the Central Government.
There is no set formula or agreed code of principles for the grant of such
loans or their terms. Hence these loans imply dependence and client role on
the part of the States. The enormous increase in the size of the loans has
created a further problem of repayment of loans. With such successive plans,
central assistance has to be on a larger scale because repayment of past loans
from the Centre observes a significant portion of the central assistance. The
burden of debt has become too heavy for the State to bear and this has caused
hardship to all the States.13 This leads to the problems of fiscal deficit of the
States, which has got a rising trend over the years (see Appendix-4). In regard
to repayment of central loans the Finance Commissions particularly the Sixth
and Seventh Finance Commissions recommended to cover non-plan gap on
revenue account and also recommended relief in relation to repayment of
central loans and the subsequent Commissions followed the same principle.

In the beginning of the Tenth Five Year Plan the interest burden arising
out of past borrowings has added significantly to an already existing large
overhang of administrative and establishment costs. The Centre which directly
as well as indirectly determines the borrowings of States has already indicated
its resolve of reducing the fiscal deficit of the entire system. A favourable
implication arising out of moderate growth of borrowing will be a restraint
on the growth of interest burden of the States.14

The Finance Commission, while recommending grants to the States

considers the ‘need’ factor of the States. The ‘need’ of the States has been
interpreted widely and it includes not only current expenditure on
administration, law and order etc., but also current expenditure for the
maintainance and running of all kinds of social and economic activities
previously developed by investment financed under the Plans which are known

13. For details see R.C.S. Sarkar, Union-State Relations in India, National, 1985, p. 136.
14. Planning Commission, Government of India, Tenth Plan Document, p.4 (Internet).
 //131 //

as committed expenditure. It also includes increasing interest liability of the

States. There is a tendency among the States, while presenting their case
before the Commission, to deflate their resources and inflate their needs. It is
not possible for the Commission to determine whether the States have made
all possible efforts to mobilize their resources. Nor is it possible for the
Commission to determine accurately the needs of the States. Hence the Finance
Commission have to rely on the estimate supplied by the States.

A Critical Estimate:

Financial imbalances-vertical and horizontal - is a recurring

phenomenon in India even before independence. Through a method of trial
and error, the framers of the Constitution has incorporated two principles in
the Constitution -one is distribution of revenue between the Union and the
States through tax sharing and the other is transfer of resources from the
Centre to States through grants and loans. The intention behind these two
principles is to bring financial balance between the Centre and the States and
amongst the States on one hand and to bring all the States at par so far as
development is concerned. Keeping the intention and principles before them,
the framers made provisions for creation of a statutory institution- the Finance
Commission and the Government created two more institutions- the Planning
Commission and the National Development Council - by a Resolution and
Executive Order. The last two institutions have only advisory role to play in
fiscal matters.

Hence these three institution are working since 1952 and have taken
many important decisions to make the finance of the Centre and the States
strong and viable. But so far as functioning of these institutions are concerned,
it is not considered as a perfect one and many criticisms have been put against
these institutions. Critical estimate of the Finance Commission as a
functioning body for distribution of resources through tax-sharing has already
been discussed in the preceeding chapter. But in recommending grants from
Centre to the States the Finance Commission has also been put to criticism.
 // uz u

The revenue gap-filling process adopted by the Finance Commission

for recommending different grants to different states has been criticized as it
has tended to encourage unsound fiscal policies and wasteful expenditure on
the part of the States. This system has a built-in tendency to weaken the will
of the States to resists additional expenditure commitments. They hesitate to
take unpopular measures to mobilize their resources. It is therefore, suggested
that the Ministry of Finance should in cooperation with the States, organize
comprehensive studies on trends in the growth of public expenditure in
different States and refer the same to the respective Finance Commissions.15
Dr. V.K. R.V. Rao in 1983 had suggested a formula known as ‘fiscal
deficiency’. Under this formula, a certain percentage of national revenue will
be set aside for implementing an agreed national minimum equalization
programme among different States. However, this suggestion has not yet been
implemented.

The function of the Finance Commission, as some scholars see, have

unduely criticized. It is one sided in its approach in recommending grants.
While it can examine the financial needs of the States, it lacks authority to
look into the financial requirements of the Centre and to allocate funds to it
accordingly. The Centre also forces the States to accept a discipline which
does not come under its perview.

The difficulty which the Finance Commission faces is that expenditure

on Plan investments and Central financial assistance to the States on account
of State Plans and Centrally Sponsored Plans are outside its scope. These
grants are given by Planning Commission under Article 282. The grants meant
for plan purposes under Article 282 on the recommendation of Planning
Commission are conditional and tied grants. In providing these grants the
central share is liberal, the degree of supervision and control is detailed and
uniformity is insisted upon. They are also discretionary grants which are
given solely at the discretion of the Central Government. Thus there exists

15. R.C.S. Sarkar, Union State Relations in India, National, 1985, p.120.
 //133 //

two high power bodies, the Finance Commission and Planning Commission,
to give financial assistance to the States, one for non-Plan expenditure and
other for plan expenditure and this complicates the determination of financial
assistance to the States, The Finance Commission reviews the revenue segment
of the budget while the Planning Commission takes an overall review
embracing both capital and revenue requirements of the States. While Finance
Commission looks into the ‘fiscal needs’ of States only for five years, the
Planning Commission looks to that over a long period. This resulted in
overlapping of functions and responsibility of two Commissions.

The Planning Commission was created as a body subservient to the

Union and having an advisory role only. The intention was that the State
should give the fullest measure of help to the Commission so as to ensure
maximum coordination in policy and unity in effort. But the Commission,
since its institution has been working as an agency for centralizing power at
New Delhi. Its composition is being criticized as antifederal. The working of
the Planning Commission also results in centralization of power as, through
Planning, the Centre extends its long arm to the spheres of activities of the
State Governments.16 Further the functions of the Finance Commission become
complementary to those of the Planning Commission. Article 282, as
Santhanam points out, was inserted in the Constitution as a residuary provision
and was not intended to be one of the major provisions for making financial
adjustments between the Union and the States.17 Hence the functioning of the
Planning Commission and over increasing sweep of economic and financial
responsibilities have disturbed the original scheme. Plan assistance has
assumed greater importance and there is of repeated criticism about the erosion
in the importance of the Finance Commission in the total picture of the transfer
of resources from the Centre to the States. A comparative statement of the
grants given by the Finance Commission and the grants by the Planning

16. Sharada Rath, Federalism Today, Approaches,'Issues and Trends, Sterling Publishers
Private Limited, 1984, pp.48-49.
17. K. Santhanam, Union-State Relations in India, Asia Publishing House, 1967.
 //134 //

Commission is stated in the Table No.VI:9.

Table No. VI:9
Grants to States As Central Assistance by the Finance Commission and
Planning Commission During 1951-2000.
Finance Commissions Amount of Five Year Plans Amount of
with periods Grants with periods Grants
(in crores (in crores
of rupees) of rupees)
First Finance Commission 34.25 First Plan 104
(1952-57) (1951-56)
Second Finance Commission 187.75 Second Plan 892
(1957-62) (1956-61)
Third Finance Commission 244.00 Third Plan 1,272
(1962-66) (1961-66)
Fourth Finance Commission 609.45 Three Annual Plans 1,648
(1966-69) (1966-69)
Fifth Finance Commission 637.85 Fourth Plan 4,949
(1969-74) (1969-74)
Sixth Finance Commission 2509.06 Fifth Plan 3,761
(1974-79) (1974-79)
Seventh Finance Commission 1173.12 Sixth Plan 16,557.06
(1979-84) (1980-85)
Eighth Finance Commission 2200.22 Seventh Plan 31,424.80
(1984-89) (1985-90)
Ninth Finance Commission 15017.18 Eighth Plan 93,833.81
(1989-95) (1992-97)
Tenth Finance Commission 7582.68 Ninth Plan 185,259.63
(1995-2000) (1997-2002)
Source : Reports of the Finance Commission.
Reports of the Planning Commission.

The above table gives two observation points, namely (i) the Plan
Assistance is increasing geometrically over the year since inception of the
working of the Planning Commission and (ii) grants provided by the Planning
Commission is much more than that provided by the Finance Commission.
 //135 //

Though the statutory grants provided by the Finance Commission are rising
every period except the Seventh Finance Commission period, but they are
much less than the discretionary grants provided by the Planning Commission!
The Third Finance Commission observed that “the functions of Finance
Commission have been reduced to merely undertaking an arithmetical exercise
of devolution” and suggested two alternatives either to enlarge the functions
of the Finance Commission to embrace total financial assistance to be offered
to the States, whether by devolutions, grants or loans, or in the alternative, to
abolish the Finance Commission altogether and entrust its junction to the
Planning Commission.18 The overlapping of functions by the two Commissions
has been observed by the several Finance Commissions from time to time.

Another suggestion is that for healthy inter-governmental financial

relations, the Finance Commission should decide grants-in-aid to each State
under Article 282 of the Constitution. The Planning Commission should assist
the Finance Commission by drawing up a priority list of projects, that costs,
locational feasibility and other technical matters.19

The National Development Council, which is expected to be the highest

policy making body in the affair of the financial grants to the States and to
function almost as Super-Cabinet in economic affairs, has not been functioning
as an effective instrument for ensuring all-India support for the plans along
with the cooperation of the States. It is found that NDC meetings are not held
regularly to recommend plan proposals and to review plan work. Further, in
NDC meeting, which is the meeting of the Prime Minister and Finance Minister
representing the Centre and the State Chief Ministers and Finance Ministers
representing the States, politics become more dominant than the economic
and developmental problems. Cooperation of states remain behind and central
dominance again came to picture.

18. R.C.S. Sarkar, Union-State Relations in India, National, 1985, p,125.

19. M.M. Sury (ed), Economic Planning in India, 1951-56 to 2002-07, New Century
Publication, 2005, p.7.
 //136 //

So far as the Centrally Sponsored Schemes are concerned the State

Governments are not happy with the recommendations of the Planning
Commission. The States are less involved in the formulation of Centrally
Sponsored Schemes which mainly pertain to subjects included in the State
List. Sponsoring of the Schemes by the Centre is also considered as an intrusion
into subjects reserved for the States. The Administrative Reform Commission
(1968) has also pointed out that Centrally Sponsored Schemes are not
unconstitutional as they come under Art. 282 but the question arises whether
“with the help of financial carrot such intrusion is desirable and conducive to
the growth of healthy federal relationship”. It is true that the Centrally
Sponsored Schemes have grown considerably in number and magnitude.
However, at the meeting ofNDC in December, 1991, it was decided to transfer
113 Sponsored Schemes to the States along "with the allocations being made
for these schemes. In this context the Ninth Finance Commission observed,
“Centrally Sponsored Schemes have grown in volume and number over the
years. As of April, 1985, the schemes under implementation were as many as
262. The outlay of Rs. 18,000 Crores approximately of these schemes
accounted for about 80% of central assistance, provides for the State Plans
during the Seventh Five Year Plan”.20

The States have also complained against Centrally Sponsored Schemes

on the ground that the system of matching grants involved in the schemes
favours the richer states because they are better placed to provide matching
funds to avail central assistance. Because of such schemes the poor states
remain poorer as they cannot provide matching grants for availing central
assistance.

It has also been criticized because of the Planning Commission, the

socio-economic development has become more politically oriented than
development oriented. Because the Planning Commission recommends

20. First Report of Ninth Finance Commission, 1988, p.24.

 //137 //

discretionary grants in the sense that they are issued by different Union
Ministries. Here politics counts much than the bargaining on the developmental
needs of the States.

Again it was pointed out that not only had the size of the Planout lay at
the Centre been increasing more rapidly than that of all the States taken
together, but the manner in which the State should undertake the development
efforts had also been more or less dictated by the Central authorities. The
Centre can, through conditional financial assistance, impose its own policies
and programmes on the States, irrespective of the relevance or priorities of
the proposal given by a particular State. As a result, development needs of a
particular region are not properly assessed nor are they effectively met.21
Consequently, for maintainance of existing capacities suffered both on account
of lower devolution by Central Finance Commission and limited availability
of Plan resources.22

Regarding the amount of central transfer to states neither the Centre

nor the States are happy (see Appendix-7). The States complain that resources
allocated to them are inadequate to enable them to discharge their
responsibilities. They complain against widening gap between their own
resources and needs, a trend indicating their increasing dependence on the
Centre for resources. Similarly the Centre also feels constrained at the
widening gap between its resources and needs as reflected in the budgetary
deficit (see Appendix-5). Since the early 1980’s the Centre has been running
considerable deficit on its revenue account. In the First Plan Report deficit
financing was defined as Government spending in excess of Government
receipts in the shape of taxes, earnings from state enterprises, loans from the
public, deposits and funds and other miscellaneous sources.

21. Sharada Rath, Federalism Today, Approaches, Issues and Trends, Sterling Publisher
Private Limited, 1984, p.50.
22. Planning Commission, Government of India, Tenth Plan Document, p.3, (Internet).
 //138 //

The State gets the bulk of their loans from the Centre. But this possess
a problem. The Centre gives loans to the States for functioning State Plans
and also for non-Plan purposes. The size of the loans has grown over the
years. It rose from Rs.799 Crores in the First Five Year Plan to Rs.82840.29
Crores in 1999-2000. The loans for financing State Plan are tied loans given
under the auspices of the Planning Commission at the discretion of the Central
Government. As there is no set formula or agreed code of principles for the
grant of such loans or their terms, dependence of the States on the Centre
becomes inevitable. The central loans are increasing in each successive Plan
and have created a further problem of repayment of loans on the part of the
States. In regard to repayment of central loans, the Finance Commission takes
into consideration the existing debt burden and recommend relief in relation
to repayment of Central loans. In a situation where, due to a tight budgetary
constraints at the situation, central revenue transfer cannot augment a rapidly
deteriorating State’s own non-debt contribution, States took up to debt receipts
for protecting their Plan sizes. In the Eighth Plan, however, net debt receipts
fell along with non-debt contribution which resulted in a fall of Plan resources
as well. During the Ninth Plan, net debt receipts climbed significantly and
was entirely due to a rise in State’s own capital receipts. Net debt receipts
reflect gross fiscal deficit out of which the States cannot free themselves to
be financially sound.23

To conclude, it may be said that the Centre-State financial relations in

India is a very complicated matter. The institutions of Finance Commission,
Planning Commission, National Development Council dealing with financial
relations are unique and novel intended to create a relationship of cooperation
and harmony between the Centre and States on the one hand and to make the
Centre and the States financially strong and viable so far as development of
the country as a whole is concerned. But as the study shows the Centre, because

23. Planning Commission, Government of India, Tenth Plan Document, p.8, (Internet).
 // 139 //

of the financial resources at its hand and resource transfer through shares,
grants and loans, is becoming more dominant over the States. Particularly, as
discretionary grants are becoming more important than the statutory grants,
State’s role becomes subservient to that of the Centre. What is needed is that
there should be assured devolution of resources to the States and their
dependence on the discretionary grants should be reduced. Loans and debts
of the States are also mounting over the years for which fiscal deficits of the
States are always in a rising trend making the States financially weak. However
in a federal set-up, grants and loans are necessary to a limited extent as they
help the Centre to keep financial control over the States and also help in
effecting national coordination of policies and further enable the fulfillment
of priorities laid down in the Plan.