Chapter I INTRODUCTION The Finance Commission of India came into existence in 1951. The Finance Commission is established under article 280 of the Indian Constitution by the President of India. The Indian Finance Commission Act was passed to give a structured format to the Finance Commission of India as per the world structure of the modern Act was laid in the early 1920’s. The Finance Commission is formed to define the financial relations between the centre and the state. The Finance Commission Act of 1951 tells about the qualification, appointment, term, eligibility, disqualification and powers etc. The Finance Commission of India and also discuss about the constitution of Finance Commission. The four southern states of India are Andhra Pradesh, Karnataka, Tamil Nadu and Kerala. All the four states are classified as general category middle income states. Taken together, these four states contribute more than a quarter of output in India. Their share in the sum of GSDPs of all the states has also been large and growing. Even while their tax bases have been increasing and correspondingly their contribution to the base for the central taxes has also been growing, their share in the tax devolution and in the grants given by the central government has been coming down. This has significantly affected their capacity to provide services at an adequate level in terms of quantity and quality, particularly in relation to public goods like law and order and justice and merit goods like health and education. 2 Vertical fiscal transfers and horizontal fiscal transfers Vertical fiscal transfers arise when there is a simultaneous transfers between means and responsibilities, in two different tiers of government. In one tier the means will exceed the needs of the Finance Commissions. These transfers include state’s share in central taxes and statutory grants and grants for natural calamities. Vertical transfers are given in equal percapita amount to all states including the highest fiscal capacity states. Horizontal fiscal transfers relates to the same level of governments. This refers to the differences in the fiscal capacity of the states. Horizontal fiscal transfers can be improved by the process of redistribution of resources. Aggregate fiscal transfer exists if the surplus of one tier cannot eliminate the deficit of the other. It arises to the fiscal needs. This analysis has been done for the periods covered by the Ninth, Tenth, Eleventh and Twelfth Finance Commissions both in aggregate and state specific needs. Need for the study The present study attempts to analyse the Finance Commission’s fiscal transfers to the Southern States in India. In this context the study aims to analyse the various issues of Finance Commissions Fiscal transfers to southern states in India viz. Tamil Nadu, Karnataka, Kerala and Andhra Pradesh. This study highlights the emerging controversies among states and the financial transfer to the states. The need for the study is important, especially in the context of present controversies regarding Financial transfer between the states will also be examined in the present study. 3 Statement of the problem Finance Commission Fiscal Transfer It plays a vital role in Indian Federal Finance system. The constitution of India came into force in 1950. The Government act of 1935 divides the functions and financial powers of the Government into Central and States spheres together with the concurrent areas. The Finance Commission is a salient feature of the India’s constitution. It is an advisory body which deals with the transfer of resources from the centre to the states. The Finance Commission is established by the President of India for every five years to review the finances of the Union and States and recommend devolution of taxes and grants-in-aid of revenues to the states. Income tax sharing between the Centre and the states underwent a fundamental transformation with the Constitution in 2000. The net process of income tax are shared with States on a mandatory basis. The commission made recommendations regarding the combined share of states out of the “divisible pool” of the net income tax proceeds and the proportionate share of each indivisible state within the combined share of all States. Union excise duties – The President of India has the discretion to refer the question of sharing of excise duties with the states to the commission. In effect, this matter was always included in its terms of references. Here, again the Finance Commission recommended the sharing of net proceeds of union excise duties between the Centre and 4 States and the distribution of their collective share between individual States. Grants-in-aid The Finance Commission is asked by the President to estimate the revenue needs of states and recommends grants-in-aid of their revenues. It also lays down the principles which should govern three grants from the Centre to the States. Therefore, all the States need not receive their grants and different states may receive different level of amounts. The Finance Commission can also recommend special purpose grants to any state which may be included in its terms of reference. This type of grants may include grants for helping the local bodies, grants for relief in the case of natural calamities, grants for upgradation of state activities and so on. States get grants from the Finance Commission, Planning Commission and other Central Ministries. The Finance Commission grants are for meeting the assessed revenue gap of the states as also for various other purposes including for special needs and upgradation of standards. From a methodological viewpoint, the determination of the revenue-gap grants are the most important. It is the determination of these grants that necessitates the Finance Commission to undertake a comprehensive examination of both central and state finances. It is, in this context that the Finance Commissions have often been accused of following a gap-filling approach, which leads to significant adverse incentives. 5 Finance Commissions, particularly from the Ninth Finance Commission onwards, have attempted to apply to some extent normative principles for making an assessment of state’s own tax and non-tax revenues as well as revenue expenditures. This is done in two steps. The first step requires the estimation of the variables for the base year. Secondly, projections for the recommendation period are made. While the Ninth Finance Commission used a panel data modeling approach to determine the tax base in the base year, some of the more recent Finance Commissions have used partial adjustments in respect of those states whose tax-GSDP ratios were below the average tax-GSDP ratio for the relevant group of general and special category states. Trends in Fiscal Transfers The finances of the central and state governments went into revenue deficit on permanent basis since 1979-80 for the centre, 1987-88 for the states considered together, and 1982-83 for their joint account. These accounts have remained in such deficit until now. The states appear to be emerging into revenue account surplus once again. As its peak, the combined revenue deficit was close to 6.9 per cent of GDP in 2001-02. After that there has been an improvement. Large revenue deficits have made the task of achieving vertical balance through fiscal transfers quite difficult. There is a steady improvement in the share of transfers to the states as percentage of centre’s gross revenue receipts. From the level of about 25 per cent under the Third Finance Commission, this share increased to 6 39.1 per cent for the Ninth Finance Commission period and may turn out to be above 40 per cent for the Twelfth Finance Commission period. The share of centre and states in the combined revenue receipts before transfers and after transfers get completely reversed. Before transfers, centre’s share has been in the range of 61-66 per cent from the Second Finance Commission period onwards. However, after transfers, centre’s share in combined receipts has fallen to 36.37 per cent. State’s share, on the other hand, has increased from 56 to 64 per cent between the Seventh and the Twelfth Finance Commission periods. The relative shares of the centre to the states in the combined revenue expenditures however, have remained stable throughout the period covered by the First to Twelfth Finance Commission periods. States’ share in the combined revenue expenditures throughout this period has been on average about 57 per cent whereas that of centre has been at 43 per cent with small variations. A falling share in revenue receipts after transfers for the centre while maintaining a stable share in revenue and total expenditure can only imply that centre’s share in borrowing has increased over these years. Measuring Forecast Accuracy Finance Commissions in India are required to make their recommendations for a period of five years based on information about central and state fiscal aggregates. Between the last year of the recommendation period and the last year for which accounts data are available, the gap could be seven to eight years. The Finance Commissions have to make forecasts for various fiscal aggregates and 7 then determine grants that are specified in absolute amounts. We have looked at the nature of forecast error in one crore determinant of grants, viz., forecast of central revenues. In turns out that among the four recent Finance Commission, viz., Ninth, Tenth, Eleventh and Twelfth have underestimated the central tax revenues. Dependence of States on Central Transfers We have also looked at the pattern of dependence of the states on central transfers. This analysis is done with respect to the revenue receipts of the states as also their revenue expenditures. We have looked at the pattern of dependence both in terms of the aggregate account of the states and for individual states.