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16th Finance Commission

GS Paper 2

 Syllabus: Powers, Functions and Responsibilities of various Constitutional Bodies


Source: TH

 Context: Soon the government will appoint a Finance Commission to determine how much of the Centre’s tax revenue should be given away to States (the vertical share) and how to distribute that among States (the horizontal sharing formula).


What is the Finance Commission?

  • It is a constitutional body constituted every 5 years by the President of India under Article 280 of the Indian Constitution to define the Centre-states financial relations.
  • The First Commission was established in 1951 under The Finance Commission (Miscellaneous Provisions) Act, 1951.
  • Individual commissions operate under the terms of reference (ToR) which are different for every commission, and they define the terms of qualification, appointment and disqualification, the term, eligibility and powers of the Finance Commission.
  • As per the constitution, the Commission consists of a chairman and four other members.


Each FC is required to make recommendations on:

  • Sharing of central taxes with states,
  • Distribution of central grants to states,
  • Measures to improve the finances of states to supplement the resources of panchayats and municipalities, and
  • Any other matter referred to it.


Why is there a need for an FC?

  • The Indian federal system allows for the division of power including the taxation powers between the Centre (collects the majority of the tax revenue) and states (responsible for delivering public goods in their areas).
  • Sometimes, this (and also due to vast regional disparities) leads to states incurring expenditures higher than the revenue generated by them.
  • To address these imbalances, the FC recommends the extent of central funds to be shared with states.
  • In the pre-reform period, the FC recommendations were not that critical because the Centre had other ways to compensate States (such as plan financing).
  • Post-reforms (after 1991), fresh PSU investments have been reduced and the Planning Commission was abolished in 2014 making FC the sole architect/balancing wheel of India’s fiscal federalism.



Issues with the horizontal distribution:

  • The ToR of the 15th FC became quite contentious because it referred to the 2011 population figures in determining the expenditure needs of a State.
  • This was a departure from the standard practice to use the 1971 population numbers.
  • States (particularly the southern States) which had done well in stabilising population growth rates, protested against this change calling it a ‘penalty for good performance’.


Issues with the revenue deficit grants that the FC awards to States:

  • The rationale of revenue deficit grants is that every State should be able to provide a minimum level of service to its residents.
  • Historically, FCs have struggled to determine how much a State’s deficit is due to its fiscal incapacity and how much is due to fiscal irresponsibility.
  • They have tried to tweak the distribution formula to support deficit States without penalising responsible States.


Areas on which the 16th FC should concentrate:

  • Horizontal distribution:
    • The very nature of the horizontal distribution is that richer States compensate poorer States.
    • The challenge of the government before defining the ToR of the 16th FC is to ensure that this happens without further deepening the divide between States (North-South).
  • Restraining levying of cesses and surcharges:
    • Raising taxes is the obvious choice for increasing revenue, but doing so would require the Centre to provide the States 41 paise (for every Rs raised).
    • On the other hand, it gets to retain every rupee if it raises it through a surcharge.
    • The FC should specify conditions under which cesses and surcharges may be imposed as well as a mechanism for capping the amount that may be raised.
  • Restraint on freebies
    • In theory, the restraints imposed by the Fiscal Responsibility and Budget Management (FRBM) Act should have acted as a check on such populist spending.
    • Governments have, however, devised innovative methods to increase debt without it showing up in the budget books.
    • The FC, in the interest of long-term fiscal sustainability, should lay down guidelines on the spending on freebies.


Insta Links:

Centre to roll out process to set up 16th Finance Commission soon


Mains Links:

How have the recommendations of the 14th France Commission of India enabled the States to improve their fiscal position? (UPSC 2021)


Prelims Links: (UPSC 2014)

Q.Which of the following are associated with ‘Planning’ in India?

  1. The Finance Commission
  2. The National Development Council
  3. The Union Ministry of Rural Development
  4. The Union Ministry of Urban Development
  5. The Parliament

Select the correct answer using the code given below:

  1. 1, 2 and 5 only
  2. 1, 3 and 4 only
  3. 2 and 5 only
  4. 1, 2, 3, 4 and 5


Ans: 3