State Finance Commission

Introduction
As a unique federal feature, the Constitution of India unmistakably demarcates the areas of
financial responsibility among the Union and state governments. This broadly covers expenditure
authority and revenue levyingmechanisms, as also the required legislative framework to
implement these arrangements. Two separate lists, called Union and State Lists
defineexpenditure and functional responsibilities specified in each list, whereas the areas of joint
responsibility and authorities are outlined in a Concurrent List. The residual expenditure
responsibilities falling outside and beyond these lists will unequivocally be responsibility of the
center. A number of individual provisions specify revenue raising powers of centre and state
government respectively. Similar arrangement exists for law-making and legislative processes of
the two levels of the federal structure. These processes have clearly been delineated by the
constitution for the purposes of budgets and appropriations. With the constitutional entitlement
as third tier of government the institutions of local governance were also included in this
resource sharing arrangement. According to the 74th Constitutional Amendment Act it is
mandated that each State shall also constitute a Finance Commission which shall review the
financial position of the urban local bodies and recommend the principles which should govern
the devolution of resources, including grant-in-aid from the Consolidated Fund of the State of
these bodies.

Financial Relations between Centre and State in India

Both the Union and the State have been provided with independent sources of revenue by the
Constitution. The Parliament can levy taxes on the subjects included in the Union List. The
States can levy taxes on the subjects in the State List. By and large taxes that have an inter-state
base are levied by the Centre and those with a local base by the State. The Union List consists of
items of taxation which fall under the following categories:

(i) Taxes levied by the Union but collected and appropriated by the State such as stamp
duties and duties of excise on medicinal and toilet preparations etc.
(ii) Taxes levied and collected by the Union but assigned to the States viz. railways, sea
or air etc.
(iii) Taxes levied and collected by the Central and may be distributed between the Central
and the states if the Parliament by law so provides, such as union excise duties, excise
on toilet preparations etc.
 (iv) Taxes levied and collected and retained by the Centre such as customs, surcharge on
income tax etc.
(v) Taxes levied and collected by the Centre and distributed between the union and the
states such as taxes other than agriculture etc.
Since the Centre is the major provider of funds to the constituent states it has a major say in
financial arrangements. The Centre can exercise control over the state finances and grants-in-aid
both general and special to meet the expenditure on developmental schemes.Development plans
for the states are usually formulated within the framework of the central plan and these are
implemented by the states with the approval of the Planning Commission. Besides the states also
have certain centrally sponsored schemes for which all or a large chunk of money is granted by
the central government with the stipulations of rolling out such schemes
The multiplicity of taxing and spending activities in a federal setup like India necessitates
formulation of a rational principle for appropriation and allocation of functions between the
centre and the state governments.
Central Finance Commission1
The Indian Constitution provides for an institutional mechanism to facilitate such transfers. The
institution assigned with such a task under Article 280 of the Constitution is the Finance
Commission, which is to be appointed at the expiration of every five years or earlier. Under the
Constitution, the main responsibilities of a Finance Commission are the following.
1. The distribution between the Union and the States of the net proceeds of taxes which are
to be divided between them and the allocation between the States of the respective shares
of such proceeds. Determination of principles and quantum of grants-in-aid to States
which are in need of such assistance.
2. Measures needed to augment the Consolidated Fund of a State to supplement the
resources of the Panchayats and Municipalities in the State on the basis of the
recommendations made by the Finance Commission of the State.
The last function was added following the 73rd and 74th amendments to the Constitution in 1992
conferring statutory status to the Panchayats and Municipalities. These Constitutionally
mandated functions are the same for all the Finance Commissions and mentioned as such in the
terms of reference (ToR) of different Finance Commissions. To enable the Finance Commission
to discharge its responsibilities in an effective manner, the Constitution vests the Finance
Commission with power to determine its procedures. Under the Constitution, the President shall
cause every recommendation made by the Finance Commission together with an explanatory
memorandum as to the action taken thereon to be laid before each House of Parliament. So far,
twelve Finance Commissions have given their reports. The Union government has always been

1
As per the website of Finance Commission
http://fincomindia.nic.in/ShowContent.aspx?uid1=2&uid2=1&uid3=0&uid4=0
accepting the recommendations of the Finance Commissions, exception being the recommend-
dations of the Third Commission relating to Plan grants. There have been major changes in the
public finances of the Union and the States during the period of over 65 years covered by the
Finance Commissions. A number of new matters have been referred to the Commissions in
consonance with these developments.
It is the duty of the Commission to make recommendations to the President regarding:
 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;
 the principles which should govern the grants-in-aid of the revenues of the States out of
the Consolidated Fund of India;
 the measures needed to augment the Consolidated Fund of a State to supplement the
resources of the Panchayats in the State on the basis of the recommendations made by the
Finance Commission of the State;
 the measures needed to augment the Consolidated Fund of a State to supplement the
resources of the Municipalities in the State on the basis of the recommendations made by
the Finance Commission of the State;
 any other matter referred to the Commission by the President in the interests of sound
finance.
The Commission determines its procedure and have such powers in the performance of their
functions as Parliament may by law confer on them. State Finance Commissions are modelled on
the lines of Central Finance Commission.
Need for State Finance Commission
Political thinkers had anticipated the necessity of multi-level government entities for the sake of
preserving social, cultural and linguistic diversities in a society or country. Principles of federal
finance were enunciated by the economists of the earlier says when social, political and
economic scenario was much simpler and different than what it grew to be as the years passed.
So were their concept and practice of multi-level governments and the resultant ideas relating to
fiscal federalism. Based upon the experiences gained in functioning of a federal set-up, there
grew a need to periodically review and revise such an arrangement, in order to address the ever
emerging relationships among layers of government, which also get reflected in social, political
and economic conditions. These developments have brought issues in their wake which at times
defy solution often causing imbalances between functions and finances of different layers of
government, ominous of socio-political conflicts which may also threaten the very fabric that
holds a federation together.
Fiscal federalism is an indispensable constituent of the model of multi-level government in any
federal set-up. Since, several levels of government function in their respective jurisdictions as
part of a federation, there is the need for creating a principal institutional arrangement which can
combine the merits of decentralisation with the economies of scale, so typical of a centralised
form of government. Principles and prudence of fiscal federalism was put to a new challenge by
creation of a new constitutional layer of government at the tertiary level. The very legislative
enactments that bestowed legitimacy to the local governments also, simultaneously provided for
the financial empowerment, preservation and persistence of local bodies.
For inclusive growth there is a need to have inclusive governance by restructuring the fiscal
architecture for the PRIs and ULBs in a more equitable and efficient manner. The hallmark of
any self-government is the degree of financial autonomy it enjoys in formulating and
implementing public policies in regard to those functional responsibilities assigned to it. The
amendments to 280(3)(bb&c) is a firm affirmation of the organic link between the Centre and the
State - sub-State public finance. The task of restructuring public finance substantially depends on
streamlining the multiple channels of resource flow from the Union to the local governments
through the States.
New arrangement mandated every State under articles 243(I&Y) to constitute, at regular interval
of five years, a state finance commission (SFC), and assign it the task of reviewing the financial
position of PRIs and ULBs and making recommendations on the sharing and assignment of
various taxes, duties, tolls, fees, etc. as also the grants-in-aid to be given to the local bodies from
the Consolidated Fund of a State.
Financial Empowerment of Institutions of Local Governments
Panchayati Raj Institutions (PRIs) and municipalities, as providers of basic services at the
grassroots levels, are the primary interface between citizens and government. Accordingly, they
need to be empowered and given adequate functionally and financial support to ensure that they
can fulfil the constitutional roles assigned in the Constitution. As a corollary to the 73rd and 74th
amendments to the Constitution in 1993, the Tenth Finance Commission made a provision for
adequate financial allocations and grants.
The 74th Constitutional Amendment Act (CAA) in statement of its objectives observes that,“In
many States local bodies have become weak and ineffective on account of a variety of
reasons, including the failure to hold regular elections, prolonged supersessions and inadequate
devolution of powers and functions. As a result, Urban Local Bodies are not able to perform
effectively as vibrant democratic units of self-government.” It further added that it is considered
necessary that provisions relating to urban local bodies are incorporated in the Constitution
particularly, inter alia, for functions and taxation powers and arrangement for revenue sharing.
Accordingly a provision was sought to be made in the state law pertaining to levy of taxes and
duties by the municipalities and for making grants-in-aid by the state government to the
municipalities. For this purpose it laid down provision of State Finance Commission (SFC). The
Commission is mandated to review the finances of the Municipalities and to recommend
principles for:
 (1) Determining the taxes which may be assigned to the Municipalities;
(2) Sharing of taxes between the State and Municipalities; and
(3) Grants-in-aid to the Municipalities from the Consolidated Fund of the State.
By way of amendment to the clause (3) of article 280 of the Constitution, sub-clause (c) is re-
lettered as sub-clause (d) and before sub-clause (d) as so re-lettered, another sub-clause is
inserted, which says: “the measures needed to augment the Consolidated Fund of a State
to supplement the resources of the Municipalities in the State on the basis of the
recommendations made by the Finance Commission of the State"
Setting up and Tenure
The conformity Acts of the CAA provide for the composition of the commission, the
qualifications for its members and the manner of their selection. Every recommendation of the
commission together with an explanatory memorandum is to be laid before the legislature of the
state.
As per the article 243 (I) of Constitution of India, the governor of the state shall set up the
Finance Commission within one year of 25th April 1993, i.e. the date on which the Seventy-
Third Amendment Act of the Indian Constitution, 1992 came into force and after that at the end
of every five years. Article 243Y of the Constitution further provides that the Finance
Commission constituted under Article 243 I shall make similar recommendation vis-a-vis
municipalities. The principles which should govern the setting up of SFCs are:
i. the distribution between the State and the Panchayats of the net proceeds of the taxes,
duties, tolls and fees leviable by the State, which may be divided between them under this
Part and the allocation between the Panchayats at all levels of their respective shares of
such proceeds;
ii. the determination of the taxes, duties, tolls and fees which may be assigned to, or
appropriated by, the Panchayats;
iii. the grants-in-aid to the Panchayats from the Consolidated Fund of the State;
iv. the measures needed to improve the financial position of the Panchayats;
v. any other matter referred to the Finance Commission by the Governor in the interests of
sound finance of the Panchayats.

Composition of State Finance Commission

The Legislature of a State may, by law, provide for the composition of the Commission, the
qualifications which shall be requisite for appointment as members thereof and the manner in
which they shall be selected.
The Finance Commissions in the states comprises of (i) Chairman, (ii) member secretary, and
other members. State Finance Commissions receive grants from the Central Finance Commission
set up by the Union government. The Commission shall determine their procedure and shall have
such powers in the performance of their functions as the Legislature of the State may, by law,
confer on them
Terms of Reference
The Constitutional mandate for SFCs is broad enough that it would seem to invite states to tailor
their Terms of Reference so that an SFC could focus on crucial policy choices likely to come
before the state in establishing its approach to fiscal devolution. In practice, however, most states
have merely reproduced the Constitutional description of the assignment to be undertaken by the
SFC as per the Constitutional Amendments.
However a few states have framed the terms of reference for the respective SFCs in a more
focused way that identify specific issues that need to be prioritized in the state’s policymaking.
In their TOR for the third State Finance Commissions Tamil Nadu and Kerala, have elaborated
the meaning of “suggest measures to improve the financial performance of local bodies” to give
the SFCs more specific direction in their understanding of finance and revenue realities of the
states. Kerala’s TOR mandates the SFC to examine the “need to improve [local body] financial
position with respect to” the certain specific items.
Function of State Finance Commission
The constitutional amendments have placed crucial responsibilities on the new institution of the
finance commission of states. Over and above recommending the principles that should govern
state local fiscal relations, SFCs are expected to undertake a review of the finances of
municipalities; estimate the future financial requirements of municipalities; and suggest
measures for strengthening the finances of municipalities.
The most critical function of the State Finance Commissions is to determine the fiscal transfer
from the state to local governments in the form of revenue sharing and grants-in-aid. Since the
80th Constitutional amendment, following the recommendation of the 10th Finance Commission
(1995–2000), a certain percentage of all union taxes has been devolved to the states. Many SFCs
have also adopted this system for the following reasons:
i. The system has a self-policy feature; the local body automatically shares in the buoyancy
of state taxes and levies.
ii. The system has built-in transparency, objectivity, and certainty; local bodies can
anticipate, at the beginning of each fiscal year, their share in the divisible pool.
iii. It system enables local bodies to understand the entire economy and take considered
views to make their own annual budgetary exercises.
In other words, it induces local bodies to generate their own revenue generation and to mobilize
additional resources. The state government can be neutral in pursuing tax reforms without
considering whether a particular tax is sharable with local bodies. Briefly the SFCs are mandated
to carry out following functions:
 i. Periodical review of the economic status of the various Panchayati raj institutions and
municipal bodies functioning in the state
ii. To take necessary steps to help in improving the financial condition of the various
municipal bodies and Panchayati raj institutions
iii. Allocation of funds to the panchayat raj institutions and municipal bodies in the state
from the Consolidated Fund of the State
iv. To act as an intermediary between the central and the state governments regardingmatters
of financial nature
v. To transfer and channelize the funds granted by the central government to the state
government
vi. To disburse among various municipal bodies and Panchayati raj institutions the state
government’s revenuesfrom the proceeds of taxes, fees, tolls, and duties charged by the
respective state government
vii. To determine the taxes, tolls, duties, and fees that may be levied by the various
Panchayati raj institutions and municipal bodies within their jurisdiction
viii. Grant-in-aid to the local bodies

Besides, the State Finance Commission shall also take the measures needed to improve the
financial position of the local government institutions and any other matter referred to the
Finance Commission by the Governor in the interests of sound finance of the Panchayats.
The Governor is required to ensure that every recommendation made by the State Finance
Commission together with an explanatory memorandum as to the action taken thereon to be laid
before the Legislature of the State.
Resource Sharing Mechanism
An unambiguous revenue sharing mechanism is required to meet the constitutional obligations of
the various levels of government. Finance Commission at the Union level and State Finance
Commissions for the states are meant to end the divergence between the sources of revenue and
functional expenditure commitments among the respective levels of governments.
Financial Allocation areas for SFCs
The various other sectors under the state jurisdiction that receive grants from State Finance
Commissions are:

 Administration of prisons
 Health care services
  Public libraries
 Administration of districts
 Administration of police
 Elementary education
 Fire services
 Infrastructure development
 Training in computers for school children
 Fiscal administration
 Heritage protection

Importance of State Finance Commission

As a constitutional institution the State Finance Commission has a great potentialities for
streamlining democratic decentralization and pave way for efficient and more people-centric
service delivery at the grassroots level.The State Finance Commissions (SFCs), which are
expected to support and strengthen the functioning of local bodies, also need to be reinforced so
as to function in a predictable and pro-active manner. It is also necessary that their
recommendations are implemented in a transparent and effective manner.

The Eleventh Finance Commission In its report noted the following features of SFC reports:
i) Lack of synchronicity in the periods covered by the reports of the SFCs and the Finance
Commission.
ii) Extreme diversity in the approach, the content, the period covered as well as quality of
the reports of the different SFCs.
iii) Delay on the part of the State Governments in finalising Action Taken Reports (ATRs)
and placing them in the state legislatures.

As an offshoot of the 73rd and 74th CAA, the State Finance Commissions are assigned the
arduous task of designing and structuring a fiscal system that can meet the financial requirements
of rural and urban local bodies. The mainstay of such a fiscal system would be (i) tax assignment
or devolution to the PRIs and ULBs, (ii) determining and putting in place a revenue-sharing
system, (iii) grants-in-aid for the urban and rural bodies, and (iv) principles of managing
important assets, like public land and infrastructure. The State Finance Commissions are
expected to arrive at a rational revenue instruments which addresses the financial requirements
of local governments.
The state governments are required to promote State Finance Commissions, for this will help in
improving the economic condition of the states by ensuring adequate funds from the center for
the states. Also it will help in improving the financial condition of the various Panchayati raj
institutions and municipal bodies that are there in the states. All these will help in the all-round
development of the states.

Summing up

The SFCs play a critical and significant role in intergovernmental fiscal relationsin the Indian
Union. In many of the federal countries, state assistance to local governments is primarily a
political decision, made by state legislatures in in consultation with or on the recommendation of
state executive authority. By establishing SFCs for the purpose of financial devolution among
various units India avowedly kept this critical function beyond political domain, by placing it in
the hands of financial and technical experts of SFCs who are expected to adopt a professional
and scientific approach for arriving at a workable and realistic revenue-sharing strategyamong
other aspects of intergovernmental finance. The non-political nature of this institution bodes well
for the robust functioning of PRIs and municipalities in different states of India often operating
in unique milieu dictated by regional social and economic factors.
Further Readings:
NIPFP (1993), The Ninth Finance Commission: Issues and Recommendations, New Delhi:
National Institute of Public Finance and Policy.
Rao, M. Govinda, and Nirvikar Singh (2005), Political Economy of Federalism in India, New
Delhi, Oxford University Press.
Wallack, Jessica and T.N. Srinivasan (2005), ed., Federalism and Economic Reform:
International Perspectives, Cambridge, UK, Cambridge University Press.
World Bank (2005), State Fiscal Reforms in India: Progress and Prospects (A World Bank
Report), New Delhi: Macmillan India.
Sury, M.M. (2010)Finance Commissions and Fiscal Federalism in India : First Finance
Commission (1952-53 to 1956-57) to Thirteenth Finance Commission(2010-11 to 2014-15),New
Century Publications, Delhi
Sury, M.M. (2008)Centre - State Financial Relations in India - 1870 to 2010, New Century
Publications
Tbiaunaiah, G. and Hemlata Rao, (1986), Finance CommissionandCentre-State Financial
Relations, AshishPublishing House, New Delhi.