Briefly, Finance Commission reviews the financial requirements of the governments at various levels and determines the available funds and allocates the available resources among the Central and State governments. Of course, as yet most of the Finance Commissions’ terms of reference allowed them to consider only the revenue expenditure of the states. The terms and conditions of the Finance Commission are really fixed by the Central Government, though formally President of India appoints the Commission. Historically Central government is vested with the most productive and buoyant tax instruments. Consequently some of the tax proceeds are shared with the State governments. On the basis of an assessment of the needs of State governments, Finance Commission recommends how much of the Central government resources to be shared with the state (the size of the divisible pool) and in what manner it will be distributed among the states.

To look at the problem of federal finance in totality, one must recognize that there is, at any given time, an upper limit of the resources that can be tapped from the economy by the government given the socio-political setup. It is a different question how the resources can be efficiently mobilised through tax and other instruments, assigned to governments at various levels. The available resources are to be shared among the governments according to their needs. The recurring gap between the revenue resources and revenue expenditure at almost all Governments indicate that perhaps the upper limit of the resources that can be mobilised by the government has been reached. And therefore it is now imperative to look at the revenue expenditures made by the government – both the committed and uncommitted revenue expenditures, which are rising both at the central and the state level.

The way Finance Commission treat the expenditure side of the federal finance, is possibly based on the implicit assumptions that all the expenditures made by the Central government are sacrosanct, and it is the state governments who must be more judicious in their revenue expenditure. However, in a situation where government spending is an instrument for wining political support from various interest groups, the central government is as prone to wasteful spending as is the case with some state governments. Thus while central government increases pay of its staff, the states also have to revise the pay of their employees. The central and state governments are not just institutions to govern but institutions inseparably linked to political rivalry. Therefore the finance commission terms of reference should be such that it can examine the expenditure pattern of the Central government too.

Secondly, it has been found in the past that the share of the states in the total resources mobilized by the Centre and State governments together decrease in the years following the year in which the recommendation of a Finance Commission is first implemented. Which indicates that through deficit financing and other means the Central Government had raised additional resources, but not shared with the states. Besides the inflationary impact of the deficit financing, being countrywide, not only erodes the resource base in real terms but also forces the state government made additional expenditure in committed heads. Finance Commission therefore may be allowed to examine the deficit financing by the Central government along with their critical appraisal of the overdraft and debt aspects of the state governments.

A mechanism should be evolved such that the loss of state resources in real terms due to inflation resulting from deficit financing must be compensated by the central government. The relative share of the states in the total resources accruing to the government sector as a whole should be maintained through out the period for which Finance Commission recommendation is made.