Subject: Finance Commission

The Finance Commission of India (FC), established under Article 280 of the Constitution, is a quasi-judicial body. It plays a vital role in maintaining the fiscal federal balance envisioned by the Constitution.

Constitution of the Finance Commission

Constitutional Provision- As per Article 280(1), the President of India constitutes the Finance Commission every five years or earlier if necessary.

Composition-

Consists of a Chairperson and four other members, appointed by the President.

Their qualifications and terms of service are determined by the Finance Commission (Miscellaneous Provisions) Act, 1951.

Tenure- The Commission usually has a tenure of five years, extendable by Presidential order.

Terms of Reference (ToR) of the Recently Constituted Finance Commission

The 16th Finance Commission was constituted in December 2023, chaired by Dr. Arvind Panagariya.
Its recommendations will apply for the period 2026-2031.

Division of Tax Proceeds

Recommend the distribution of net tax proceeds between the Union and the States under Chapter I, Part XII of the Constitution.

Determine the allocation of shares among individual States from the total divisible pool of central taxes.

Principles for Grants-in-Aid

Lay down the principles governing grants-in-aid to States from the Consolidated Fund of India.

Recommend the amounts to be provided to States as grants under Article 275, for purposes other than those specified in the provisos to clause (1).

Enhancing State Funds for Local Bodies

Suggest measures to increase the Consolidated Fund of States to supplement resources of Panchayats and Municipalities.

Base these recommendations on the inputs of respective State Finance Commissions, ensuring fiscal strengthening of local governance.

Evaluation of Disaster Management Financing

Review existing funding mechanisms for Disaster Management, particularly those created under the Disaster Management Act, 2005.

Recommend improvements in the structure, sharing pattern, and utilization of National and State Disaster Response Funds.

Any Other Matters Referred by the President

Examine and recommend on additional fiscal issues to ensure “sound finance,” including fiscal consolidation, resource augmentation, and expenditure efficiency.

Challenges Ahead

Data Gaps and Quality Issues- Relies on outdated and inconsistent official data, affecting fiscal assessments.

Political Factors- Faces pressure to balance conflicting interests of Centre, States, and political stakeholders.

Overlap with GST Council- GST decisions affect revenue flows and reduce FC’s fiscal autonomy.

Limited Role in Local Governance- Depends on weak or irregular State Finance Commissions for data and recommendations.

FCs have no enforcement power, as their recommendations are advisory in nature.

Way Forward

Ensuring state representation in decision making

Permanence- Make FC a permanent body for continuous review and coordination. (Rajamannar Committee)

Addressing Emerging Issues and Challenges – Factor in digital transformation and green financing for sustainable growth.

Build data-driven analytical capacity with reliable and updated fiscal databases.

The Finance Commission remains the keystone of India’s fiscal federalism, ensuring both equity and efficiency in resource distribution.

The Constitution of India envisages the Finance Commission under Article 280 as the ‘balancing wheel of fiscal federalism’ in India.

Key Recommendations & Impact

Tax Devolution Raised to 42% – Increased untied resources, enhanced fiscal autonomy.

Reduced Dependence on Central Grants – Gave States more predictable, formula-based transfers.

Greater Spending Autonomy – Fewer tied schemes allowed States to set local priorities.

Plan vs Non-Plan Expenditure removed – Simplified budgeting, better fiscal management.

Incentives for Fiscal Discipline – FRBM compliance encouraged prudent debt management.

Support to Local Bodies – Higher allocations improved grassroots fiscal health.

Special Grants for Environment & Judiciary – Helped States strengthen governance and green initiatives.

GST Compensation Mechanism (recommended later) – Protected States from revenue loss during tax transition.

Positive Impact

Strengthened fiscal federalism

Improved fiscal indicators of states

Encouraged competitive federalism

Concerns

Rise in Cesses & Surcharges – Cesses & surcharges rising from 12.8% (2015-20) to 18.5% (2020-24).

States’ effective share shrank – Fell from 35% (2015-20) to ~31% (2020-24) of Centre’s gross tax revenue.

GST Compensation Delays – Especially during COVID, strained States’ finances.

Reduced Central Grants – Decline in discretionary and plan-based transfers cut flexibility.

Borrowing Restrictions (Art. 293, FRBM) – Limited States’ ability to raise resources.

High Centrally Sponsored Schemes (CSS) – Continued tied funds reduced States’ expenditure autonomy.

Way Forward

Increase Devolution to 50% under 16th FC.

Include Cess/Surcharge in divisible pool

Restructure CSS – Consolidate into fewer umbrella schemes

As the Punchhi Commission noted, “true federalism requires fiscal autonomy alongside political autonomy.”