Finance Commission (FC): Composition, Role and Issues | 16th Finance Commission

• Context (TH): The GoI appointed the 16^th Finance Commission (FC) to determine the vertical distribution of revenue between the Centre and the States and the horizontal devolution between states.

About Finance Commission (FC)

• The Finance Commission (FC) is a constitutional body constituted by the President under Article 280 of the Constitution.
• It is a Quasi-Judicial body constituted every 5^th year or at such earlier time as the President deems necessary.
• It consists of a chairman and 4 other members to be appointed by the President. They are eligible for re-appointment.

Qualifications of the members of the Finance Commission (FC)

• Qualifications of the members are to be decided by the Parliament, as provided in the Constitution.
• Accordingly, the Parliament has specified the following specifications:
  • The Chairman should be a person with experience in public affairs.
  • The members should be selected from amongst:
    • A Judge of the High Court or one qualified to be appointed as one.
    • A person who has specialized knowledge of finance and accounts of the government.
    • A person who has wide experience in financial matters and administration.
    • A person who has special knowledge of economics.

Recommendations of the Finance Commission (FC)

• The Finance Commission makes recommendations to the President on
  • Distribution of net tax proceeds between the Centre and States and allocation between the states of respective shares of such proceeds.
  • Principles that govern grants-in-aid to the States by the Centre.
  • Measures needed to augment the Consolidated Fund of State to supplement resources of Panchayats and municipalities in the state.
  • Any other matter referred to it by the President in the interests of sound finance.
• The Commission submits its report to the President, who lays it before both houses of the Parliament.
• The recommendations made by the Finance Commission are only advisory in nature and not binding on the government.

State Finance Commission

• Constitutional Basis: The SFC was established under the 73rd and 74th Constitutional Amendments in 1992 which aimed to strengthen local self-governance in India by providing constitutional status to panchayati raj institutions and municipalities.
• Appointment: The Governor of each state is responsible for appointing the State Finance Commission every five years, as mandated by Article 243-I of the Constitution.
• Responsibilities: Financial Assessment, Resource Allocation, Grants and Aid, Disaster Management, Policy Recommendations.

16^th Finance Commission

• The Government of India has established the 16^th Finance Commission under Article 280(1) of the Constitution. Dr. Arvind Panagariya is appointed as Chairman.

Terms of Reference for 16^th Finance Commission

• Distributing taxes between the Union and States and allocating State shares.
• Principles governing grants-in-aid from the Consolidated Fund of India to States and grants under Article 275 (empowers Parliament to make law to provide financial assistance to States in the form of grants-in-aid charged to the revenue of India) for specific purposes.
• Measures to boost State Consolidated Funds for supporting Panchayats and Municipalities based on State Finance Commission recommendations.
• Review current financing structures related to disaster management under the Disaster Management Act of 2005, proposing improvements or changes.

Mandate of the 16^th FC

• Historical Role: FC has focused on equitable resource redistribution through vertical and horizontal allocations to less-developed states since 1951.
• Tax revenue sharing: Recommend how to distribute tax revenues between the Union government and the states for the five-year period starting April 1, 2026.
• Grants-in-aid: Determine the principles for granting aid from the Consolidated Fund of India to states.
• Urban local govt: Recognise their contribution to economic development & increase allocations to them.
• Beyond Fiscal Arithmetic: The FC’s role is to plan a future where all States contribute to national growth, addressing challenges such as urbanisation and climate resilience.
• Disaster management: Propose improvements to the financing structures for disaster management.
• Climate change: Provide funds for climate mitigation and adaptation measures.
• Fiscal discipline: Advise on fiscal discipline and public expenditure.
• Impact on Growth: The FC’s decisions will influence millions of lives and determine India’s ascent to a leading global economy.

Issues in Financial Devolution

• Firstly, cess and surcharge, estimated at around 23% of its gross tax receipts, are not shared with the States.
  • The total tax revenue for the years 2022-23 (actual), 2023-24 (revised estimates) and 2024-25 (Budget estimates) of the Union government is (₹30.5, ₹34.4, and ₹38.8 lakh crore), respectively.
  • The State’s share was (₹9.5, ₹11.0, and ₹12.2 lakh crore), respectively, which constitutes around 32% of the total tax receipts of the Centre. This is way less than the 41% recommended by the 15th FC.
  • Cess, like the GST compensation cess, is also used for centrally sponsored schemes that benefit the States. However, the States have no control over these components.
• Secondly, the amount each State gets back for every rupee they contribute to Central taxes shows steep variation.
  • Industrially developed states received much less than a rupee for every rupee they contributed against states like Uttar Pradesh and Bihar.
  • This is because many corporations are headquartered in these state capitals, where they would remit their direct taxes, and there is a difference in GST collection among various states.

• Thirdly, the percentage share in the divisible pool of taxes has been reducing for southern States over the last six FCs.
  • This is due to the higher weightage being given to equity (income gap) and needs (population, area, and forest) than efficiency (demographic performance and tax effort).
• Finally, grants-in-aid varies among various States.
  • As per the 15th FC, there are revenue deficits, sector-specific and State-specific grants given to various States, and grants to local bodies. It is based on population and area of States.

  

Issues with Current Redistribution Policies

• Horizontal Devolution Challenge: Balancing equitable shares for less-developed states with policies that ensure overall national economic growth and fair distribution.

Challenges for Progressive States

• Demographic Changes: Progressive States like Tamil Nadu face declining tax revenues due to an ageing population, necessitating strategies to manage the rising costs and avoid the “middle-income trap.”
• Urbanisation: Tamil Nadu’s rapid urbanisation, expected to reach 57.3% by 2031, requires dedicated funding for infrastructure to sustain growth and meet urban demands.

Need for Progressive Resource Allocation

• Present Shortcomings: Despite the 15th FC recommending 41% vertical devolution, actual devolution dropped to 33.16% due to rising cess and surcharges by the Union.
• Proposed Reforms: Advocate for a 50% devolution of gross central taxes to empower states with greater fiscal autonomy and promote local development.

Way Forward

• Enhanced Resource Allocation: A performance-based resource allocation approach will empower States to drive national growth.
• Urban and Demographic Strategies: Allocating resources for urban infrastructure and demographic adjustments will ensure progressive States like Tamil Nadu remain growth engines.
• Balanced Strategy: A focus on expanding the national economy with equitable distribution ensures benefits for all States, allowing progressive States to continue driving growth.
• Strengthening Policy Frameworks: A balanced distribution policy and targeted support for high-performing States will foster sustained economic development across India.