Role of Finance Commission in Fiscal Federalism

Fiscal federalism refers to a country’s financial infrastructure related to assigning responsibilities and functions to different levels of government, such as central and state governments. Fiscal arrangements are an important administrative requirement to build a strong inter-governmental fiscal structure through revenue instruments. The role of the finance commission is to focus on the proper distribution of tax and expenditure authority between different levels of government. The federal or central government is authorised for tax collection, money supply, or borrowing decisions. In contrast, state governments are assigned service providers in social and economic sectors at the sub-national level. 

Role of Finance Commission

In India, the finance committee was formed with the core responsibility to evaluate the state of finances of the central and state governments, decide on the sharing pattern of taxes, and lay down the guidelines for distributing the taxes among states. The role of the finance commission involves effective coordination with all levels of government to carry out the decision-making and thus strengthen the structure of fiscal federalism. The commission’s recommendations aim toward maintaining the balance in public spending between central and state governments. The need for a finance commission is important because of taking care of the issues concerning the financial relationship between the central and state governments.

Duties of the Finance Commission

The commission is entrusted with the authority and responsibility to formulate and implement fiscal policies considering the centre-state financial relations. The role of the finance commission is to evaluate the financial position of states and offer suggestions for improvement. The need for a finance commission is felt in terms of appropriate actions in this regard which are mentioned as follows:

• Sharing of taxes collected by the central government with various states.

• Distribution pattern of central taxes to different states.

• Fiscal measures to improve the finances of the states. 

Role of Finance Commission in Fiscal Federalism

The role of the finance committee as an apex body is to take control over sharing and distribution of fiscal powers while addressing the issues related to imbalance and disparity. There can be instances where states incur higher expenditures than the revenue generated. Again, some states have inadequate access to resources due to regional limitations. Considering this situation, it recommends guidelines about the extent of central funds shared by the states, thus maintaining equalisation in fiscal federalism. The different roles of the finance commission in fiscal federalism include the following:

Tax Revenue Sharing

The commission recommends sharing central taxes with the states based on some justifiable criteria to minimise the disparity between states, vital for fiscal federalism. The parameters for tax sharing are mentioned as follows:

• Population: The expenditure needs of a state are indicated by its population.

• Area: The administrative cost incurred by the state will be proportional to its area.

• Per capita Income: The states with lower per capita income will be eligible to receive higher tax sharing and grants.

• Economic Activities: Some states may have more coverage of farming land or forests, thereby restricting opportunities for other economic activities, and hence a higher share may be allocated to them.

Handling Horizontal Imbalance

The finance commission plays a significant role in addressing the imbalances generated due to differences in the extent of financial benefits achieved by different states. It reviews the growth rates and developmental status of different states and assesses capital requirements. It also makes recommendations to minimise capital deficits and the availability of adequate public goods and services.

Addressing Vertical Imbalance

The finance commission also takes responsibility for handling the vertical imbalances arising out of asymmetry in the distribution of taxation power between different levels of government (central government, state governments, and the local bodies). The tax collected by the central government involves a larger domain. The state governments make large expenditures for developing social and economic sectors at the sub-national level. The role of the finance commission is to provide mechanisms in the form of shared tax revenue and grants-in-aid as per requirement.

Review and Progress 

An important role of the finance commission is to review the impact of the recommendations made by the previous finance commission. The need for a finance commission is felt in reviewing the fiscal status of the centre and state government and recommending a roadmap for improvement and progress. It also studies the impact of new taxes at the central and state level and on the economy. 

Conclusion

The Indian federal system allows division of power and responsibilities between the centre and states regarding financial matters. This includes expenditure, revenue generation, and tax collection powers. In an effective structure of fiscal federalism, it is very important to make provisions for a balanced distribution of fiscal authority. In general, all levels of administration should be given the responsibility to achieve specific targets of fiscal stability at the individual level. The role of the finance committee as a guide to improving intergovernmental fiscal structure and efficiency of the economy is quite important.