6.3] Finance Commission of India

The Finance Commission (FC) of India is a unique constitutional body established under Article 280 of the Indian Constitution. The primary mandate of FC is to recommend the distribution of tax revenues between the central government and the state governments. This recommendation is crucial for maintaining fiscal balance and addressing disparities in fiscal capacity among different states.

The Commission’s recommendations are based on factors like population, income disparities, infrastructure development, and other socio-economic indicators. These recommendations are influential in shaping the financial relations between the union and the states, aiming to promote cooperative federalism and balanced development across the country.

1. Functions

Finance commission is required to make recommendations to the President of India on the following matters.

1. The distribution of the net proceeds of taxes to be shared between the Centre and the States, and the allocation between the states of the respective shares of such proceeds. (Vertical and horizontal distribution).
2. The principles that should govern the grants-in-aids to the states by Centre. (i.e. out of consolidated fund of India.
3. The measures needed to augment the consolidated fund of a state to supplement the resources of the panchayats and the municipalities in the state on the basis of recommendations made by the state finance commission.
4. Any other matter referred to it by president in the interests of sound finance.

Recommendations made by FC are only advisory in nature and hence not binding on government. However as suggested by Dr. P V Rajamannar, the Chairman of the Fourth Finance Commission, ‘Since the Finance Commission is a constitutional body, expected to be quasi-judicial, its recommendations should not be turned down by the Government of India unless there are very compelling reasons’.

2. Need of Finance Commission

It acts as the balancing wheel of fiscal federalism in India.

1. It leads to rational distribution of tax revenue between Centre and states. The Indian federal system provides for division of powers and responsibilities between centre and states. The Constitution assigned taxes with a nation-wide base to the Union to make the country one common economic space unhindered by internal barriers to the extent possible. States being closer to people and more sensitive to the local needs have been assigned functional responsibilities involving expenditure disproportionate to their assigned sources of revenue resulting in vertical imbalances.
2. This situation leads to states incurring expenses higher than the revenue generated by them. Thus, comes the need of devolution of central taxes to states and hence the need of finance commission to determine the basic principles for this devolution.
3. Further, there are horizontal imbalances across States are on account of factors, which include historical backgrounds, differential endowment of resources, and capacity to raise resources. Unlike in most other federations, differences in the developmental levels in Indian States are very sharp. The Commission, through its recommendation tries to ensure a sense of equality in public service across the states. This helps in promoting balanced regional development.
4. The finance commission also ensures the evolution of the devolution mechanism with changing times

3. Recommendation of Fifteenth Finance Commission

Distribution of the net proceeds of taxes to be shared between the Centre and the States

The below table shows the criteria used by the Commission to determine each state’s share in central taxes, and the weight assigned to each criterion.

The share of states in the central taxes for the 2021-26 period is recommended to be 41%, same as that for 2020-21. This is less than the 42% share recommended by the 14th Finance Commission for 2015-20 period.  The adjustment of 1% is to provide for the newly formed union territories of Jammu and Kashmir, and Ladakh from the resources of the centre.

Principles that should govern the grants-in-aids to the states by Centre

1. Grants to local bodies: A portion of these grants is to be performance-linked including: (i) Rs 2.4 lakh crore for rural local bodies, (ii) Rs 1.2 lakh crore for urban local bodies, and (iii) Rs 70,051 crore for health grants through local governments. The grants to local bodies will be made available to all three tiers of Panchayat- village, block, and district. No grants will be released to local bodies of a state after March 2024 if the state does not constitute State Finance Commission and act upon its recommendations by then.
2. Revenue deficit grants: 17 states will receive grants worth Rs 2.9 lakh crore to eliminate revenue deficit.
3. Sector-specific grants: Sector-specific grants of Rs 1.3 lakh crore will be given to states for eight sectors: (i) health, (ii) school education, (iii) higher education, (iv) implementation of agricultural reforms, (v) maintenance of PMGSY roads, (vi) judiciary, (vii) statistics, and (viii) aspirational districts and blocks.  A portion of these grants will be performance-linked.
4. Disaster risk management:  The Commission recommended retaining the existing cost-sharing patterns between the centre and states for disaster management funds.  The cost-sharing pattern between centre and states is: (i) 90:10 for north-eastern and Himalayan states, and (ii) 75:25 for all other states.  State disaster management funds will have a corpus of Rs 1.6 lakh crore (centre’s share is Rs 1.2 lakh crore).
5. State-specific grants: The Commission recommended state-specific grants of Rs 49,599 crore.  These will be given in the areas of: (i) social needs, (ii) administrative governance and infrastructure, (iii) water and sanitation, (iv) preservation of culture and historical monuments, (v) high-cost physical infrastructure, and (vi) tourism.  The Commission recommended a high-level committee at state-level to review and monitor utilisation of state-specific and sector-specific grants.

4. Sixteenth Finance Commission

The government has recently approved the ‘Terms of Reference’ for the 16 Finance Commission. The sixteenth FC would cover a five-year period commencing April 1, 2026, and the commission would submit its report by October 31, 2025.

Terms of Reference for the Sixteenth Finance Commission:

The Finance Commission shall make recommendations as to the following matters, namely:

• The distribution between the Union and the States of the net proceeds of taxes… and the allocation between the States of the respective shares of such proceeds;
• The principles which should govern the grants-in-aid of the revenues of the States out of the Consolidated Fund of India…
• The measures needed to augment the Consolidated Fund of a State to supplement the resources of the Panchayats and Municipalities in the State on the basis of the recommendations made by the Finance Commission of the State.

The Commission may review the present arrangements on financing Disaster Management initiatives, with reference to the funds constituted under the Disaster Management Act, 2005 (53 of 2005), and make appropriate recommendations thereon.

The Commission shall make its report available by 31st day of October, 2025 covering a period of five years commencing on the 1st day of April, 2026.

5. Issues Associated with Finance Commission

Constitution envisages FC as the balancing wheel of fiscal federalism in India. However, its role in the centre-state fiscal relations was undermined by erstwhile Planning Commission, a non-constitutional and a non-statutory body. Dr. P V Rajamannar, the Chairman of 4th FC, had highlighted the overlapping of functions and responsibilities between FC and PC in fiscal federal transfers.

States also have concern with the finance commission itself. It is entirely a Union body. Neither in the selection of the members nor in deciding terms of reference, state governments have any say. We can discuss following related to Finance Commission.

Using 2011 Census for revenue distribution

The objection is often raised by southern states which have worked more effectively towards population control. There is feeling that they are being penalized for their population control. So, the southern states are demanding that the 1971 census be used for Finance Commission’s revenue distribution formula instead of the 2011 census. There is also objection since Fifteenth FC increased the weightage of population to 15% from earlier 10%.

• However, we can say that the objective of the general-purpose transfer is to ensure comparable level of public services at comparable tax rates. And if comparable level of service is the aim, it is only fair that the latest population data should be used.
• Using the 1971 data has not served as levers for family planning. Family planning and population are better managed through initiatives by state governments under different schemes.
• Idea of punishing individuals elsewhere in the country just because these areas continue to languish on major indicators goes against the Indian Republic Spirit.
• It should also be noted that the population is not the only criteria in the horizontal devolution formula. Income distance, area, forest cover etc. were also used in 15th FC recommendation.