An innovation called ‘Finance Commission’

It is unfortunate but true: One of the most important constitutional institutions is also one of the lesser known and studied -- the Finance Commission. Unlike the Supreme Court or the Election Commission, the FC is not a permanent body. It is constituted once every five years for a specific task and once that task is complete, it is dissolved. This specific task, however, is among the most important in keeping India’s federal system together -- how to distribute tax revenue between the Union and the states.

The FC is an innovation found in the Constitution that has no precedent in the Government of India Act, 1935, or in other federal constitutions that existed then. A non-partisan body that is set up by the President, the institution of the FC was added to the Constitution in view of the need to integrate not just British Indian provinces of various levels of economic development but also the 565 princely states with equally varying levels of development.

The FC’s primary job, as laid out in Article 280, is to make ‘recommendations’ on the distribution of tax revenue earned by the Union government between the Union and the states. While states get to keep tax revenue collected under state tax laws (such as excise on alcohol), the Union has to share the tax revenue collected under Union tax laws (such as income tax and excise duty). Even with the GST, while the state gets to keep its share of GST revenue, the Union shares its GST revenue with the states in accordance with the FC recommendations. The FC recommendations cover not just how much money should be split between Union and states but also how much between each state. This is done by applying a formula to ensure that poorer states get relatively more money than the better-off states.

Not everyone in the Constituent Assembly was happy with the Constitution’s scheme of distributing revenues. Some members complained that states were being short-changed. This scheme was defended in a brilliant speech by the future Finance Minister of India, T T Krishnamachari on November 25, 1949. While explaining the structure of Part XII, which deals with finances, and agreeing that there was a need to increase the revenues of states and the Union, he pointed out that world over, central governments had more taxing powers than the states. This arrangement, he argued, was the best in the circumstances then, and one which was necessary given that state governments would have to go from being police states (under colonial rule) to welfare states (under the Constitution). With all the changes and challenges to federalism in India, TTK’s words have proven to be true -- no one has found a better way to distribute revenue between the Union and the states.

There is one more thing remarkable about the FC. The Constitution does not say that recommendations of the FC are binding on the President or the Union government, and it is a temporary body with no powers to enforce its recommendations. Yet, every Union government has accepted its recommendations and carried them out in distributing revenues to the states. While there have been occasional hiccups in the implementation of the recommendations, no Union government has said that the FC has given too much to the states or tried to ignore the recommendations.

While there are complaints about how much money certain states get based on the FC’s formula (mostly from the richer, southern states) this is one of those parts of the Constitution that have remained unchanged and worked as intended from the start. It is a remarkable tribute not only to the genius of our Constitution framers but also to successive political leaders who appreciated the wisdom of the founders.