Finance Commission – Issues related to devolution of resources

Finance Commission and the Challenges of Fiscal Federalism


From UPSC perspective, the following things are important :

Prelims level: Finance commission and its role, Concepts: Cess, surcharges, grants, freebies etc

Mains level: Fiscal Federalism, challenges and the role of Finance commission

Finance Commission

Central Idea

  • The government is set to appoint a Finance Commission in the coming months to address the crucial matter of distributing the Centre’s tax revenue among the States. This article examines the significance of the Finance Commission in India’s fiscal federalism, highlighting the changing dynamics post-reforms and the ensuing debates surrounding the horizontal distribution formula.

Evolution of the Finance Commission

  • Constitutional Provision: The Finance Commission is a constitutional body established under Article 280 of the Indian Constitution. It was first constituted in 1951.
  • Primary Objective: The primary objective of the Finance Commission is to recommend the distribution of financial resources between the Union (Centre) and the States.
  • Five-Year Cycle: The Finance Commission is appointed every five years, or as specified by the President of India. The recommendations of the Commission cover a five-year period.
  • Composition: The Commission consists of a Chairman and other members appointed by the President. The Chairman is usually a person with a background in economics, finance, or public administration.
  • Terms of Reference: The President determines the terms of reference for each Finance Commission, which guide the Commission in its deliberations and recommendations.

Significance of the Finance Commission in India’s fiscal federalism

  • Vertical and Horizontal Distribution: The Finance Commission determines the vertical share, which is the proportion of the Centre’s tax revenue that should be given to the States, ensuring a fair allocation of resources. It also formulates the horizontal sharing formula, which determines how this revenue should be distributed among the States.
  • Addressing Fiscal Disparities: The Finance Commission plays a crucial role in addressing these disparities by providing financial transfers to less economically developed states. Through revenue deficit grants and other means, the Commission helps bridge the fiscal gap and supports states with limited revenue-raising capacity.
  • Promoting Cooperative Federalism: The Finance Commission acts as an institutional mechanism that fosters cooperative federalism by facilitating intergovernmental fiscal transfers. It encourages collaboration and coordination between the Centre and the States, fostering a sense of shared responsibility in fiscal matters.
  • Constitutional Mandate: The Finance Commission is constitutionally mandated under Article 280 of the Indian Constitution. Its existence and functioning are enshrined in the constitutional framework, ensuring its independence and impartiality in making recommendations.
  • Five-Year Review Cycle: The regular appointment of the Finance Commission every five years ensures a periodic review of the fiscal arrangements between the Centre and the States. This allows for adjustments and revisions based on evolving economic and social realities, ensuring that fiscal transfers remain relevant and effective.
  • Expertise and Recommendations: The Finance Commission comprises experts in the fields of economics, finance, and public administration. Its recommendations are based on in-depth analysis, consultations, and assessments of various factors, including population, fiscal capacity, and development needs. These recommendations provide valuable insights and guidance to the Centre and the States in fiscal decision-making.
  • Resolving Fiscal Conflicts: The Finance Commission helps resolve conflicts and disputes between the Centre and the States regarding fiscal matters. By providing an independent and objective platform for negotiation and deliberation, it promotes a sense of fairness and transparency in fiscal resource allocation.
  • Strengthening Fiscal Discipline: The Finance Commission plays a role in promoting fiscal discipline and accountability. By assessing the fiscal performance and needs of the States, it encourages responsible fiscal behavior and discourages imprudent spending practices

Facts for Prelims

Aspect Vertical Distribution Horizontal Distribution
Definition Allocation of the Centre’s tax revenue between the Centre and the States Allocation of funds among the States
Determined by Finance Commission Finance Commission
Factors considered Fiscal capacity, needs of the States, population figures, and relevant indicators Population, area, fiscal capacity, demographic trends, development indicators, and relevant parameters
Objective Provide a fair and equitable share of revenue to the States Promote equitable development and address regional imbalances
Purpose Ensure States have sufficient resources for expenditure requirements and promote balanced development Provide greater financial support to States with lower fiscal capacity and greater development needs
Focus Centre-State distribution of revenue State-State distribution of funds
Outcome Ensures fair allocation of revenue between the Centre and the States Reduces disparities and fosters balanced growth among the States

Finance Commission

Changing dynamics post reforms

  • Decreased Role of Plan Financing: In the pre-reform era, the Centre had the flexibility to compensate States through plan financing. However, post-reforms, there has been a decline in fresh investments in public sector undertakings (PSUs) and the abolition of the Planning Commission in 2014. As a result, the Finance Commission has become the primary mechanism for the vertical and horizontal distribution of resources, making its role more critical.
  • Devolution of Tax Revenues: With the amendment of the Constitution in 2000, States were given a share in the Centre’s tax revenue pool. This devolution of tax revenues has increased the significance of the Finance Commission in determining the distribution of funds between the Centre and the States.
  • Shift in Population Figures: The use of population figures in determining the distribution of resources has seen a shift from the earlier practice of using 1971 census data to considering 2011 census data. This shift has led to debates and controversies, particularly among States that have successfully controlled population growth rates, as it can affect their share of devolution.
  • Deepening Faultlines: In recent years, faultlines between States have deepened along political, economic, and fiscal dimensions. The outcome of elections and regional disparities in terms of infrastructure, private investment, social indicators, and the rule of law have widened the north-south gap and brought regional imbalances into focus. Managing these faultlines while ensuring equitable distribution poses challenges for the Finance Commission.
  • Concerns of Fiscal Incapacity vs. Fiscal Irresponsibility: The Finance Commission faces the challenge of determining the extent to which a State’s deficit is due to its fiscal incapacity or fiscal irresponsibility. Striking a balance between supporting deficit-ridden States without penalizing fiscally responsible ones is a complex task, as providing more to one State would mean giving less to others.
  • Changing Economic Landscape: The post-reform period has witnessed shifts in India’s economic landscape, with some states experiencing higher growth rates and greater fiscal capacity compared to others. This dynamic requires the Finance Commission to consider the changing economic realities and ensure that the distribution formula reflects the current context

Addressing the concerns related to cesses and surcharges

  • Clear Guidelines: The Finance Commission should lay down clear guidelines on when and under what circumstances cesses and surcharges can be levied. These guidelines should ensure that cesses and surcharges are not used as routine measures but rather as exceptional instruments to address specific needs or challenges.
  • Cap on Amount Raised: The Finance Commission can suggest a formula or mechanism to cap the amount that can be raised through cesses and surcharges. This would prevent excessive reliance on these instruments and ensure that they do not become a substantial portion of the Centre’s total tax revenue.
  • Transparency and Accountability: The government should enhance transparency and accountability in the utilization of funds generated through cesses and surcharges. It should provide regular reports on the utilization of these funds, demonstrating how they contribute to the intended purposes and benefit the states and the overall economy.
  • Consultation with States: The Finance Commission should engage in extensive consultations with states while formulating guidelines regarding cesses and surcharges. States should have the opportunity to provide their input, share their concerns, and suggest ways to strike a balance between the Centre’s revenue requirements and the states’ financial autonomy.
  • Alignment with Fiscal Responsibility: Any levies on cesses and surcharges should be in line with the principles of fiscal responsibility and budget management. The Finance Commission can ensure that these instruments are used judiciously and do not undermine the fiscal discipline goals set by the FRBM Act.
  • Review and Evaluation: Regular review and evaluation of the impact of cesses and surcharges should be conducted to assess their effectiveness in achieving the intended objectives. The Finance Commission can play a crucial role in monitoring the usage of these instruments and recommending necessary adjustments based on the evaluation outcomes.

Finance Commission

Implementing restraint on freebies

  • Clear Definition: Establishing a clear definition of what constitutes a freebie is crucial to avoid ambiguity and misuse of resources. It should encompass measures that go beyond essential public services and infrastructure development and instead focus on non-essential giveaways or subsidies.
  • Fiscal Responsibility and Budgetary Constraints: The Finance Commission can emphasize the importance of adhering to fiscal responsibility guidelines and staying within budgetary constraints. This ensures that resources are allocated judiciously and in a sustainable manner, avoiding the accumulation of unsustainable debt.
  • Prioritization of Essential Services: Encouraging governments to prioritize essential public services, such as healthcare, education, and infrastructure, over non-essential freebies. This ensures that resources are allocated to areas that have a more significant and long-lasting impact on the overall well-being and development of the population.
  • Evaluation of Impact: Regular evaluation of the impact of freebies on the economy, fiscal health, and the intended beneficiaries is essential. This evaluation can help identify any unintended consequences, potential wastage of resources, or negative effects on economic growth.
  • Public Awareness and Discourse: Creating public awareness about the implications of excessive freebies and the importance of responsible fiscal management. Encouraging open discourse and dialogue among citizens, policymakers, and experts can foster a deeper understanding of the long-term consequences of unsustainable giveaways.
  • Role of the Finance Commission: The Finance Commission can play a pivotal role in setting guidelines and recommendations for restraint on freebies. This includes providing advice on responsible fiscal management and ensuring that resource allocation aligns with long-term development goals.


  • The Finance Commission plays a crucial role in India’s fiscal federalism. To address concerns regarding cesses, surcharges, and freebies, the Commission must provide clear guidelines, ensure transparency, and emphasize long-term fiscal sustainability. Stakeholder consultation, periodic evaluation, and public awareness are key to maintaining a balance between meeting welfare needs and promoting responsible fiscal management.

Also read:

The curious case of Fiscal Federalism in India


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