Role of the Finance Commission

The Sixteenth Finance Commission has begun its work by inviting suggestions from the public on the mandate set for it by the Centre. 

• The latest Finance Commission was constituted in December last year and is expected to submit its recommendations by October, 2025 that will be valid for five years starting from April 1, 2026.

Role of the Finance Commission

The Finance Commission is a constitutional body and provided by Article 280 of the Indian Constitution as a quasi-judicial body.

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• Appointing Authority: The President of India constitutes a Finance Commission every fifth year or at such a time that is considered necessary.
• Composition: The Finance commission composition consists of a chairman and four other members.
• Tenure: For the duration specified in Presidential order. The Commission is reconstituted typically every five years and usually takes a couple of years to make its recommendations.
  • Members are eligible for reappointment.
• Qualifications: The Parliament has been authorized by the constitution to determine the qualifications of the members and the manner in which they are to be appointed.
  • Specifications: Based on these powers, the Parliament has given the following specifications for appointing the members.
  • The chairman must have experience in public affairs while the other four members should be selected from amongst the following criteria:
    • A High Court judge or one qualified to become one
    • An individual having specialised knowledge of finance and accounts of the government
    • A person who possesses experience in financial matters and administration
    • A person who has special knowledge of economics
• Powers: Based on the Code of Civil Procedure 1908, the Finance Commission of India has all the powers of a Civil Court. 
  • Evidence Demand: The commission has powers to call witnesses, and ask for the production of a public document or record from any office or court.
• Mandates: 
  • Tax Distribution: Distributing shares of net proceeds of tax between the Union and the States and the allocation between the States of the respective shares of such proceeds.
    • The Centre, however, is not legally bound to implement the suggestions made by the Finance Commission. 
  • Rules for Grants-in-Aid: The rules that govern grant-in-aid to the states by the Centre from Consolidated Fund of India.
  • Tax Devolution at State Level: Augmenting the consolidated fund of the state to supply resources to panchayats and municipalities based on recommendations of the State Finance Commission.
  • Miscellaneous Matter: Any other matter referred by the President to the Commission in the interests of sound finance.
  • Submit Report: A report is submitted to the President, who lays it before both houses of the Parliament. The report is followed by an explanatory memorandum on the actions taken on its recommendations.

About the Distribution of Funds by the Finance Commission

The Finance Commission decides what proportion of the Centre’s net tax revenue goes to the States overall (vertical devolution) and how this share for the States is distributed among various States (horizontal devolution). 

• Horizontal Devolution: This devolution of funds between States is usually decided based on a formula created by the Commission that takes into account a State’s population, fertility level, income level, geography, etc. 
• Vertical Devolution: This devolution of funds however, is not based on any such objective formula. 
  • Nevertheless, the last few Finance Commissions have recommended greater vertical devolution of tax revenues to States. 
  • The 13th, 14th and 15th Finance Commissions recommended that the Centre share 32%, 42% and 41% of funds, respectively, with States. 
• Additional Aid: The Centre may also aid States through additional grants for certain schemes that are jointly funded by the Centre and the States.
• For Local Bodies: The 16th Financial Commission is also expected to recommend ways to augment the revenues of local bodies such as panchayats and municipalities.
  • As of 2015, only about 3% of public spending in India happened at the local body level, as compared to other countries such as China where over half of public spending happened at the level of the local bodies.

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Disagreements and Friction between the Centre and States

The Centre and the States have been at loggerheads over the issue of sharing tax revenues for a while now. 

• Inadequate Funds: The Centre collects major taxes such as the income tax, the corporate tax, and the goods and services tax (GST) while the States primarily rely on taxes collected from the sale of goods such as liquor and fuels that are beyond the ambit of GST. 
  • The States, however, are responsible for the delivery of many services to citizens, including education, healthcare and the police. 
  • This has led to complaints that the Centre has reduced the power of the States to collect taxes and that it does not give enough funds to the States to match with the scale of their responsibilities.
• On Distribution Percentage: The States and Centre often disagree on what percentage of the total tax proceeds should go to the States and about the actual delivery of these funds.
  • States argue that they should receive more funds than what is recommended by the Finance Commission as they have greater responsibilities to fulfil than the Centre. 
  • They also point out that the Centre does not even share the amount of funds recommended by the Finance Commissions, which they believe is already too low. 
  • Example: The Centre has devolved an average of only 38% of funds from the divisible pool to the States under the current Fifteenth Finance Commission as against the Commission’s actual recommendation of 41%.
• On Distribution Pool: States have complaints about what portion of the Centre’s overall tax revenues should be considered as part of the divisible pool out of which the States are funded. 
  • It is believed that cesses and surcharges, which do not come under the divisible pool and hence not shared with the States, can constitute as much as 28% of the Centre’s overall tax revenues in some years, causing significant revenue loss for States. 
• On Governance by the States: It is argued that more developed States with better governance are being penalised by the Centre to help States with poor governance. 
  • States such as Karnataka and Tamil Nadu have also complained that they receive less money from the Centre than what they contribute as taxes. 
  • Example: Tamil Nadu received only 29 paise for each rupee that the State contributed to the Centre’s exchequer while Bihar gets more than ₹7 for each rupee it contributes. 
• Political Influence: Some critics also believe that the Finance Commission, whose members are appointed by the Centre, may not be fully independent and immune from political influence.

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