Finance Commission – Issues related to devolution of resources

Cabinet clears terms of reference for 16th Finance Commission


From UPSC perspective, the following things are important :

Prelims level: Finance Commission

Mains level: Read the attached story

Central Idea

  • The Union Cabinet approved the terms of reference (ToR) for the Sixteenth Finance Commission.
  • The Commission will devise a formula for revenue sharing between the Centre and the States for the period starting April 1, 2026.

About Finance Commission

  • Establishment: The Finance Commission (FC) of India was established by the President in 1951 under Article 280 of the Indian Constitution.
  • Purpose: Its primary role is to define and regulate the financial relations between the central government and the individual state governments.
  • Legislative Framework: The Finance Commission (Miscellaneous Provisions) Act, 1951, further outlines the qualifications, appointment, disqualification, term, eligibility, and powers of the Finance Commission.
  • Composition: Appointed every five years, the FC comprises a chairman and four other members.
  • Evolution: Since the First FC, changes in India’s macroeconomic landscape have significantly influenced the Commission’s recommendations.

Constitutional Provisions

  • Article 268: Facilitates the levy of duties by the Centre, with collection and retention by the States.
  • Article 280: Outlines the FC’s composition, qualifications for members, and its terms of reference. It mandates the FC to recommend the distribution of net tax proceeds between the Union and States and the allocation among States. It also addresses the financial relations between the Union and States and the devolution of unplanned revenue resources.

Key Functions of the Finance Commission

  • Tax Devolution: Recommends how net tax proceeds should be distributed between the Center and States.
  • Grants-in-Aid: Determines the principles governing these grants to States.
  • Augmenting State Funds: Advises on measures to enhance the States’ Consolidated Funds to support local bodies and panchayats, based on State Finance Commissions’ recommendations.
  • Other Financial Functions: Addresses any other financial matters referred by the President.

Members of the Finance Commission

  • Structure and Standards: The Finance Commission (Miscellaneous Provisions) Act, 1951, provides a structured format and global standards for the FC.
  • Qualifications and Powers: Specifies rules for members’ qualifications, disqualification, appointment, term, eligibility, and powers.
  • Composition: The Chairman is chosen for their experience in public affairs. The other members are selected based on their judicial experience, knowledge of government finances, administrative and financial expertise, or special economic knowledge.

Challenges for the 16th Finance Commission

  • Overlap with GST Council: The coexistence with the GST Council, a permanent constitutional body, presents a new challenge.
  • Conflict of Interest: Decisions by the GST Council on tax rates could impact the FC’s revenue-sharing calculations.
  • Feasibility of Recommendations: While the Centre often adopts the FC’s suggestions on tax devolution and fiscal targets, other recommendations may be overlooked.

Major Outstanding Recommendations

  • Fiscal Council Creation: The 15th FC proposed a Fiscal Council for collective macro-fiscal management, but the government has shown reluctance.
  • Non-Lapsable Fund for Internal Security: Though the Centre agreed ‘in principle’ to establish this fund, its implementation details are pending.

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