FINANCE COMMISSION OF INDIA
1. Context
The sixteenth Finance Commission headed by former Niti Aayog Vice-Chairman Arvind Panagariya has begun its work by inviting suggestions from the public on the mandate set for it by the Centre. The latest Finance Commission, which consists of five members including the chairman, was constituted in December last year and is expected to submit its recommendations by October, 2025. Its recommendations will be valid for five years starting from April 1, 2026
2. What is the Finance Commission?
The Finance Commission is a constitutional body in India, established under Article 280 of the Indian Constitution. Its primary purpose is to define the financial relations between the central government and the individual state governments.
Here are some key functions and roles of the Finance Commission:
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Distribution of Taxes: It recommends how the net proceeds of taxes should be divided between the Centre and the States, and among the States themselves.
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Grants-in-Aid: It determines the principles governing Grants-in-Aid to the States from the Consolidated Fund of India.
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Augmenting State Finances: It suggests measures needed to augment the Consolidated Fund of a State to supplement the resources of the Panchayats and Municipalities in the State, based on the recommendations made by the State Finance Commissions.
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Financial Performance Review: It evaluates the financial performance of both the central and state governments and suggests corrective measures for better fiscal management.
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Any Other Matter: The Commission may also address any other matter referred to it by the President of India in the interest of sound finance.
The Finance Commission is reconstituted every five years and comprises a chairman and four other members, who are appointed by the President of India. The recommendations of the Finance Commission are advisory in nature, meaning they are not binding but are generally followed by the government
3. How does the Commission decide?
- The Finance Commission determines the percentage of the central government's net tax revenue allocated to the States overall (vertical devolution) and how this share is distributed among the individual States (horizontal devolution).
- The horizontal distribution is typically based on a formula devised by the Commission, which considers factors such as a State's population, fertility rate, income level, and geography.
- In contrast, vertical devolution does not follow a specific objective formula. Recent Finance Commissions have recommended increasing the share of tax revenues allocated to States. For instance, the 13th, 14th, and 15th Finance Commissions proposed that the Centre share 32%, 42%, and 41% of the divisible pool of funds, respectively, with the States. Additionally, the Centre may provide extra grants to States for certain jointly funded schemes.
- The 16th Finance Commission is anticipated to suggest ways to boost the revenues of local bodies, such as panchayats and municipalities. It is worth noting that, as of 2015, only about 3% of public spending in India occurred at the local body level, in contrast to countries like China, where over half of public spending happened at the local level
4. Friction between the Centre and States
Friction between the Centre and States in India arises from several factors related to the distribution of powers, financial resources, and political differences.
Here are some key reasons for this friction:
- Disagreements over the allocation of financial resources and the share of tax revenue. States often feel that they do not receive an adequate share of central taxes and grants, impacting their ability to fund local projects and services
- The central government sometimes makes decisions unilaterally, leading to perceptions of overreach and undermining the autonomy of state governments. This centralization can be seen in policy decisions, imposition of centrally sponsored schemes, and emergency provisions
- Conflicts often arise when different political parties govern the Centre and the States. Political rivalries can lead to tensions and lack of cooperation, impacting the implementation of policies and schemes
- The Constitution divides subjects into Union, State, and Concurrent Lists. Disputes can arise over subjects in the Concurrent List, where both the Centre and States have legislative powers. The Centre’s laws can sometimes override state laws, causing friction
- States may resist the implementation of central policies and reforms that they believe do not align with local needs and priorities. This resistance can lead to conflicts over policy implementation
- Disputes over the control and distribution of natural resources like water, minerals, and forests can create tensions. States often demand a greater say in the management and revenue from these resources
- Conditional grants and loans from the Centre can be a point of contention. States may feel that conditions imposed are restrictive and interfere with their autonomy
- Issues related to the appointment and control of key administrative positions, such as governors, can lead to conflicts. Governors are appointed by the Centre but play a crucial role in state administration
5.Disagreements and Agreements between States
- The States and Centre often clash over the percentage of total tax proceeds that should be allocated to the States and the actual disbursement of these funds.
- States contend that they deserve a larger share than what the Finance Commission recommends, arguing that their responsibilities are greater than those of the Centre.
- They also criticize the Centre for not even allocating the recommended amounts, which they believe are already insufficient.
- For instance, analysts note that the Centre has transferred an average of only 38% of funds from the divisible pool to the States under the current Fifteenth Finance Commission, compared to the Commission’s recommendation of 41%.
- Additionally, States dispute what portion of the Centre’s total tax revenues should be included in the divisible pool from which they are funded. It is believed that cesses and surcharges, which are not included in the divisible pool and thus not shared with the States, can account for as much as 28% of the Centre’s total tax revenues in some years, significantly reducing States' revenues.
- Consequently, the increased devolution of funds from the divisible pool recommended by successive Finance Commissions may be offset by rising cess and surcharge collections. In fact, estimates suggest that if these cesses and surcharges are considered, the States' share of the Centre’s overall tax revenues could drop to as low as 32% under the 15th Finance Commission.
- More developed States like Karnataka and Tamil Nadu have also complained that they receive less money from the Centre than they contribute in taxes. For example, Tamil Nadu received only 29 paise for each rupee it contributed to the Centre’s exchequer, while Bihar gets more than ₹7 for each rupee it contributes.
- Critics argue that more developed States with better governance are being penalized by the Centre to support States with poorer governance. Some also believe that the Finance Commission, whose members are appointed by the Centre, may not be entirely independent and free from political influence
6. Way Forward
Friction between the Centre and States over the distribution of tax proceeds and financial resources is a complex and ongoing issue. States argue for a larger share of the divisible pool to meet their greater responsibilities, while they also express concerns over the Centre's retention of significant revenue through cesses and surcharges. The perceived inequity in financial allocations, where more developed States feel penalized in favor of less developed ones, adds to the tension. Additionally, questions about the independence of the Finance Commission, given its appointments by the Centre, further complicate the trust and cooperation required for equitable fiscal federalism. Addressing these concerns is crucial for fostering a balanced and harmonious Centre-State financial relationship in India
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For Prelims: Finance Commission, Article 280, Fiscal Consolidation, Fiscal Federalism, and Alternative Dispute Resolution (ADR) mechanism.
For Mains: 1. Discuss the Role and Challenges of the Finance Commission in Promoting Fiscal Federalism and Ensuring Equitable Resource Distribution in India. (250 words).
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Previous year Question1. With reference to the Finance Commission of India, which of the following statements is correct? (UPSC 2011)
A. It encourages the inflow of foreign capital for infrastructure development.
B. It facilitates the proper distribution of finances among the Public Sector Undertaking.
C. It ensures transparency in financial administration.
D. None of the statements (a), (b), and (c) given above is correct in this context.
Answer: D
2. With reference to the Fourteenth Finance Commission, which of the following statements is/are correct? (UPSC 2015)
1. It has increased the share of States in the central divisible pool from 32 percent to 42 percent.
2. It has made recommendations concerning sector-specific grants.
Select the correct answer using the code given below.
A. 1 only
B. 2 only
C. Both 1 and 2
D. Neither 1 nor 2
Answer: A
3. Which of the following is/are among the noticeable features of the recommendations of the Thirteenth Finance Commission? (UPSC 2012)
1. A design for the Goods and Services Tax, and a compensation package linked to adherence to the proposed design.
2. A design for the creation of lakhs of jobs in the next ten years in consonance with India's demographic dividend.
3. Devolution of a specified share of central taxes to local bodies as grants
Select the correct answer using the codes given below:
A. 1 only
B. 2 and 3 only
C. 1 and 3 only
D. 1, 2 and 3
Answer: C
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Source: The Hindu
