This document discusses the workings of State Finance Commissions (SFCs) in India. Some key points: 1) SFCs were established via constitutional amendments to address fiscal relations between states and local governments and improve finances of local bodies. 2) SFCs have taken different approaches to resource sharing, with some recommending sharing of tax revenues and others focusing on grants. Implementation of SFC recommendations has also varied across states. 3) Issues identified with SFCs include weak implementation, lack of tax assignments to local bodies, inadequate incentives for efficiency, and failure to address accountability. Reforms are needed to strengthen the role and functioning of SFCs.

1. Working of State
Finance
Commission
Presentation to Indian School
of Public Policy Scholars
March 26, 2021
Dr. Ravikant Joshi

2. Workings of SFCs - Introduction
– CAA – 1992 (Article 243 - I (1) 73rd CA and Article 243 –
Y (1) of 74th CA) envisaged following roles to SFC
– Assignment of taxes duties levies & tolls
– Transfers on account of
– Revenue sharing
– Grant in aid
– The measures needed to improve the financial position of
the local governments; though CAA has not mentioned, this
involves
– Undertake a review of the finance of LSG

3. Workings of SFCs - Introduction
– Estimate the future financial requirements;
– Suggest measures for the strengthening of the finances of
municipalities.
– Any other matter referred to the Finance Commission by the
Governor
– SFC is the only channel to address issues of
state-local fiscal relations
– SFCs thus acquire unique place in present fiscal
decentralisation

4. Workings of SFCs – Aspects of Inquiry
– To what extent have the SFCs followed CAA envisaged
role / provisions?
– To what extent SFCs have changed pre-CAA situation of
local bodies?
– What approaches of fiscal decentralisation SFCs have
adopted?
– What were the issues associated with workings of SFCs?
– How far SFCs succeeded in addressing local finance
issues?
– These are the certain aspect this paper has tried to
examine along with decentralisation issues

5. States and constitution of SFCs
– Where 6th SFC is constituted - Assam, Bihar, Punjab, Rajasthan
– Where 5th SFC is constituted –Haryana, Himachal, Kerala, MP,
Maharashtra, Odisha, Sikkim, Tamil Nadu, Tripura, Uttarakhand, UP,
– Where 4th SFC is constituted – Andhra, Karnataka, Delhi, Telangana,
West Bengal
– Where 3rd SFC is constituted – Arunachal, Chhattisgarh, Goa,
Gujarat, Jharkhand, Manipur,
– Where 2nd SFC is constituted - Jammu and Kashmir, Nagaland,
– Where 1st SFC is constituted – Mizoram
– Exempt – Meghalaya under Article – 243 M

6. Workings of SFCs – Mechanism for
Sharing of Resources
– Development of multi-level fiscal allocation framework
– 1st level- sharing between state & LSG
– 2nd level- sharing between rural & urban govts
– 3rd level - sharing between three tires of rural and urban local
governments
– 4th level - sharing between local governments –(inter-se) within
each tier of rural & urban local governments
– Clear Move towards formulae based fiscal allocation
framework

7. Criteria Used for Horizontal
Distribution
– Significant differences in the criteria used by SFCs to distribute funds among
urban local governments.
– While population is a universally applied factor,
– some SFCs have used slum population,
– below poverty line (BPL) population and
– proportion of Scheduled Castes and Scheduled Tribes in the urban population.
– constructed indices such as infrastructure index, deprivation index and remoteness
index to allocate funds.

8. Workings of SFCs – Approaches for
Sharing of Resources – Up to 2 SFCs
– Sharing of Net Proceeds of State Taxes – Rajasthan Tamil Nadu, Uttar
Pradesh, West Bengal
– Tax and Non-tax Revenue – A P; Madhya Pradesh
– Tax Revenue only – Assam
– Non-loan Gross Own Receipts – Karnataka
– State Revenues (excluding certain sources)- Kerala
– Share of Certain Identified Taxes –
– Maharashtra – 25% to 100 % of entertainment taxes , 25% of vehicle tax and 10
% of professional tax -
– Punjab – 20% of the net proceeds of 5 taxes (stamp duty, motor vehicle tax,
electricity duty, entertainment tax and cinematograph tax)
– Concept of Global Sharing & divisible pool is taking roots – nine SSFCs
have recommended its adoption

9. Workings of SFCs-Other Innovative
Policy Initiatives – up to 2nd SFCs
– Normative approach to arrive at resource needs of local
government – Karnataka, TN
– Concept of untied grant for fiscal devolution – West
Bengal,
– Concept of Block Grant - Karnataka
– District level planning & fiscal devolution in place of rural-
urban classification – W B
– Concept of Equalization Grant – Tamil Nadu
– Fiscal Responsibility Norms –Tamil Nadu
– Self Reliance Index – Tamil Nadu
– Incentive Grant – WB, TN, Karnataka

10. Divisible / Revenue Pool
Definitions
– Assam, Bihar, Haryana, Himachal Pradesh, Haryana, Himachal, Karnataka, Bengal, Odisha, Uttar Pradesh,
Tamil Nadu, Manipur, Mizoram, Punjab, Sikkim, Tripura, Uttarakhand
– Net proceeds of all state taxes and duties other than entry tax, entertainment tax and electricity duty
(Assam, 4th FC)
– Tax revenues minus collection cost (Bihar, 4th FC; Haryana, 3rd FC @ 2%)
– State tax and non-tax Revenue (Himachal Pradesh, 3rd FC)
– Non loan Net own revenue receipts (Karnataka, 4th FC @ 10%);
– Net tax revenue/SOTR - (Madhya Pradesh- 4 FC @ 2%) (West Bengal-4FC @ 2.5% and 15% increase p.a.)
(Kerala 5th FC @ 9 % plus Deve Fund) (Mizoram 1 FC @ 15%) (Punjab 2 to 5 FC @ 4%) (Sikkim 5FC @ 4.5%)
(Tripura 3FC @ 7.5%) (Uttarakhand 4FC @ 11%)
– Gross tax revenue (Orissa, 3rd FC)
– Revenue from State taxes excluding entertainment tax and land revenue (Uttar Pradesh 3-4 FC @15% )
– State own tax revenue net of entertainment tax (Tamil Nadu, 3rd FC)
– State's own revenue including State's share in Central Taxes and Duties. (Manipur 3 FC @ 10%)

11. Quantum of Revenue Sharing
– The SFCs have been conservative on devolution and the variations observed are
large.
– 4th SFC of Karnataka recommended 10.7 per cent of the divisible pool for urban
local governments while the 5th SFC of Kerala recommended 5.5 per cent and 4th
SFC of West Bengal recommended a mere 1 per cent of the divisible pool for urban
local governments.
– The revenue sharing in West Bengal is poor and nearly all transfers from the state
government are in the form of grants-in-aid.
– Revenue sharing was a more prevalent mode of transfer of resources in states with
better functioning SFCs, such as Karnataka and Tamil Nadu, while states such as
Gujarat which had weak SFCs were more dependent on grants.

12. Workings of SFCs – Weak Policy Aspects
– Status quo regarding tax assignments and powers,
emphasis on transfers, sharing
– Doing away with normative approach
– Not much attention to measure expenditure
responsibility or fiscal gap
– Isolated approach for rural & urban
– Selection of second rung indicators for composite index
– Per capita income or population below poverty line or slum
population could have been better indicators

13. Workings of SFCs-Weak Policy
Aspects
– Confusion while sharing resources between tiers of rural local
governments
– Karnataka GP received less than 5 % against 25 % allotted
– WB allotted highest share to GP – 50 % to 60 %
– No attempt to measure non-formulae based devolution to local govt.
and total local expenditure
– Not much attention to Fiscal Autonomy, Financial Management,
accounting, auditing issues
– Uniform block grant without linkage to population, size or service
responsibility
– No input on policy of debt financing
– No attention to performance or efficiency based criteria for fiscal
allocation
– No attention to create fiscal accountability

14. Workings of SFCs – Implementation Issues
– Very weak or no real implementation
– No correspondence to devolution formula
– Non availability of data
– No sanctity to SFC recommendations
– Devolution is linked to salary commitment – staff strength
has no link to size, area, service responsibilities of local
governments
– Practice of making gross deductions from the overall sum of
devolution – biased towards local bodies with high payables

15. Workings of SFCs – Implementation Issues
– Sizeable fiscal transfers outside SFC framework – SSFCs
reported but did not calculate its impact
– Central finance commission grant is treated as part of
SFC devolution
– Allocation criteria worked out for EFC grant yet not
implemented
– Chief minister’s special development grant is part of
the total divisible allocation but distributed at the sole
discretion of CM
– Incentive fund – narrow and meager

16. Workings of SFCs –
Emerging Local Finance Issues
– Improved marginally budgetary certainty and a degree of
predictability
– Not much improvement in finances of local governments, No tax
assignments
– Inadequate incentives for expenditure efficiency
– No improvement in budgetary autonomy
– ULB budgets fail to reflect deduction made at state level – 34 %
underreporting of expense
– No granting of significant legal autonomy
– Soft approach towards State Government’s attitude/approach
towards LSG Institutes

17. Issues with SFC Reports
– Successive Central Finance Commissions have reported their inability to make
use of the reports of SFCs.
– The recommendations made by SFCs are largely ad hoc and not based on sound
public finance principles.
– The reports are not available on a timely basis and their period is not synchronized
with that of the Central Finance Commission.
– Several states have formed their successive SFC while the action taken report
for the previous SFC was still under consideration by the state government.
– The definition of revenue pool has also varied across SFCs which complicates
the task of the Central Finance Commissions

18. Issues with SFC Reports
– In most cases, no standardized norms (Zakaria 1963) have been used for
assessing the municipalities’ expenditure requirements.
– Not addressed the challenges posed by the multiple channels of devolution to
local bodies -line departments, erstwhile Planning Commission, State Planning
Board, district agencies, Members of Parliament/Members of Legislative
Assembly, centrally-sponsored and state plan schemes, SFC, CFC, etc.
– Not addressed the weaknesses in the accounting & budgetary practices of local
governments.
– Not adopted a Standard Format for Report so the 13th Finance Commission has
provided but

19. Workings of SFCs – Suggestions
– Follow a normative approach in the assessment of revenues and expenditure to
arrive at the revenue gap which is then considered by the CFC.
– They may consider sharing of a higher percentage of state’s own revenues, as done
by Karnataka’s 4th SFC.
– While SFCs may follow different approaches, their recommendations regarding
devolution may be benchmarked to state’s own revenues or some other similar
parameters to facilitate the Central Finance Commission in developing a
comparative perspective.
– The states should constitute SFCs with members of eminence and competence and
provide them with technical support through State Municipal Finance Cell. They
should ensure synchronizing the time period of SFC with CFC.

20. Workings of SFCs – Suggestions
– There is urgent need for national consensus on
role, relevance of SFC and then adherence to that
by all the parties especially by States
– If present situation of ignoring SFCs continues
then issues of local finance may not get properly
addressed
– Need for broad uniformity in policies of SFCs
otherwise they may lead to asymmetrical
decentralisation

21. Workings of SFCs – Suggestions
– Need to have more thrust on tax assignments, tax
powers
– Concept of Global Sharing for forming divisible pool of
resources
– Non-loan grant own revenue receipts of state plus share
in central devolutions should form divisible pool
– Quantum of sharing based on factual assessment of fiscal
gap of local bodies
– Composite index for inter-se sharing

22. Workings of SFCs – Suggestions
– The indicators should capture nature & size of
expenditure responsibility and socio-economic
backwardness
– Devolutions should become more & more formulae
based-capping non-formula based devolutions
– Devolution of adequate authority to local bodies
– Due weightage to Efficiency Criteria
– Due importance to untied or block grants
– Professional, independent approach by SFCs
– Thrust to create financial responsibility

23. Workings of SFCs – Suggestions
– Creation of Permanent Administrative Set up for SFC
– Creation of centralised data base
– Synchronisation of SFCs with CFC and five year plans
– Creation of Statutory mechanism to monitor
implementation of SFCs
– Capping non-formula based transfers

24. Working of
State Finance
Commissions
Thank You