Making State Finance Commissions work

Much needs to be done beyond the 15th Union Finance Commission’s recommendations to make State Finance Commissions effective

State Finance Commissions (SFC), constitutional bodies that recommend allocating resources between state and local governments, have had a chequered history in India. In yet another attempt to revive these institutions, the Fifteenth Union Finance Commission (15th UFC) recommended that the submission of SFC reports be a precondition for local governments to receive additional grants. The intention here is to nudge state governments to take SFCs seriously. In this article, we look at how this attempt might play out.

The past

A general principle underpinning good fiscal decentralisation is "finance should follow functions". It means local governments should mobilise adequate revenue sources as they get tasked with additional responsibilities. However, the Constitutional framing ignored this principle, and local governments were not given any Constitutional right to the money. It instead left it to state governments to decide how local governments should be financed.

While state governments opposed the Union government's encroachment in their domain, they were disinclined to devolve finance and the local governments' functions. SFCs, one of the central pillars of devolution, are a testimony of this neglect.

SFCs have the critical task of deciding the principles for assigning taxes, fees etc., to local governments. They review local governments' financial position and determine the principles that govern the distribution (between state and local bodies) of proceeds levied by states. They can also suggest measures to improve the financial position of local governments.

But these institutions have not been given due importance by the states. As per Constitutional provisions, each state should have had the 5th SFC by 2014-15 (one every five years starting 1993). But only 15 states had constituted their 5th or 6th SFC as of 2019-20. There are states where even the second and third SFCs haven't submitted recommendations. A NIPFP paper points out that the average delay by SFCs in submitting their reports is 16 months. Moreover, state governments' average time to submit an action taken report on SFC recommendations is 11 months. This is in sharp contrast to Finance Commissions at the Union level (UFCs), which are regularly constituted every five years and have quicker turnaround times.

The present

A long-standing demand has been that the Union government or UFCs must do something to rescue the SFCs from their sorry state. The 14th UFC recommended strengthening of SFCs and stressed on timely constitution and provisioning of administrative support. It chose not to force the state governments' hand beyond this recommendation.

The 15th UFC has gone one step further. It has made the release of local grants, amounting to a total of Rs. 4,36,361 crore for the period 2021-26 conditional on states forming the SFCs. The 15th FC report says, "After March 2024, no grants should be released to a State that has not complied with the Constitutional provisions in respect of the SFC and these conditions".

Implications of the 15th UFC recommendations

The 15th UFC's recommendation put the onus on the states to form the SFCs, but it doesn't penalise them for non-compliance. Instead, the local bodies can get punished and might be denied local grants for non-compliance by the states. This skewed incentive structure might be a bottleneck to achieve the intended outcomes. A lot might depend on the bargaining power of the existing local bodies.

Even if this recommendation leads to the setting up of SFCs in all states, it might not imply higher devolution of funds and powers to local bodies. SFCs are likely to remain handicapped by state governments. State governments have truncated the pool of resources that the SFC is allowed to consider for distribution between state and local governments. The NIPFP study points out that for the period 2015-16 to 2019-20, the average per capita recommended devolution for Odisha was Rs 147, while for Karnataka, it was Rs 6,101. Most states are just devolving meagre amounts to local governments even with SFCs in place. Thus, the mere formation of SFCs does not imply better governance outcomes.

Neither can these recommendations guarantee the expertise or independence of SFCs. They need, among other things, the right mix of skills and knowledge related to economics and administration, given the formidable task they are entrusted with. For example, UFC only has 28 states and one union government to consider in its distribution formula. Compare that with the thousands of local bodies every state has. Analysing the demands of each local body is no easy task. Moreover, existing and past SFCs are typically composed of state-level bureaucrats and politicians, who might not have the expertise or need to favour local governments.

The way forward

It is unlikely that the 15th UFC recommendations will lead to higher money at the discretion of the local governments. But these recommendations have shone light on the dysfunctional nature of SFCs. Where do we go from here?

First, local governments need to organise themselves and have platforms for deliberations. They need to collectively bargain for more devolution of finance and functions from their state governments. For strengthening local bodies' voice, the Second Administrative Reforms commission suggested setting up legislative councils with one-third of its members comprising representatives from local bodies. If not legislative councils, some mechanisms on inter-state councils or zonal councils should be formed among local bodies.

Second, engaged citizens need to scrutinise SFC reports and hold state governments accountable for their actions concerning SFCs. This requires citizen energy to be channelled towards the root problem of poor governance — the anaemic local government finances.

Third, academics need to capture lessons from states that have done relatively well with SFCs, such as Karnataka and Kerala. While the average of all states per capita SFC recommended devolution for 2015-16 to 2019-20 was just Rs 1,136, the per capita devolution for Karnataka, Kerala was Rs 6,101 and Rs 3,004, respectively.

In sum, the 15th UFC’s recommendation to incentivise the formation of SFCs seems well-intentioned. But good intentions alone are no guarantee for sound policies. How things change on the ground depends on a host of factors outside the ambit of present recommendations.

(Sarthak Pradhan and Pranay Kotasthane conduct research on public finance at the Takshashila Institution, an independent centre for research and education in public policy)

Disclaimer: The views expressed above are the authors’ own. They do not necessarily reflect the views of DH.