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Terms of Reference (ToR) for the Sixteenth Finance Commission

GS2/GS3 Paper 

 Syllabus: Constitutional and non-constitutional bodies


Source: PIB

 Context: Recently, the Union Cabinet, chaired by the Prime Minister approved the Terms of Reference (ToR) for the Sixteenth Finance Commission.


  • The commission will make recommendations on the distribution of net proceeds of taxes between the Union and the States, allocation among the States, grants-in-aid, and measures to supplement Panchayats’ resources for a five-year period starting April 1, 2026


What is a Finance Commission?

The Finance Commission has been established by Article 280 of the Indian Constitution The Finance Commission is a cornerstone of India’s fiscal federalism, playing a pivotal role in ensuring the equitable distribution of resources between the central government, states and Local bodies.


Major Terms of Reference for the 16th Finance Commission:

Terms of Reference (ToR)Details
Division of Tax Proceeds:Recommending the distribution of taxes between the Union Government and the States under Chapter I, Part XII of the Constitution. This includes the allocation of shares among the States from these tax proceeds.
Principles for Grants-in-Aid:Establishing the principles governing grants-in-aid to the States from the Consolidated Fund of India.
This encompasses determining the amounts to be provided to the States as grants-in-aid, specifically under Article 275 of the Constitution.
Enhancing State Funds for Local BodiesIdentifying measures to enhance the Consolidated Fund of a State. This is aimed at supplementing the resources available to Panchayats and Municipalities within the State, based on recommendations made by the State’s own Finance Commission.
Evaluation of Disaster Management Financing:The Commission may review the current financing structures related to Disaster Management initiatives. This involves examining the funds created under the Disaster Management Act, 2005, and presenting suitable recommendations for improvements or alterations.


Key Recommendations of 15th Finance Commission (2020-2026):

  1. Share of States in Central Taxes: Maintain states’ share at 41%, a 1% adjustment to accommodate Jammu and Kashmir and Ladakh.
  2. Fiscal Deficit and Debt Levels: Advise the Centre to limit fiscal deficit to 4% of GDP by 2025-26. States have specific fiscal deficit limits as a percentage of Gross State Domestic Product (GSDP) for different years in 2021-26.
  3. Other Recommendations:
    • Defence and Internal Security Funding: Propose establishing a Modernisation Fund for Defence and Internal Security (MFDIS).
    • Centrally Sponsored Schemes (CSS): Recommend a threshold for annual CSS allocations, third-party evaluations, transparent funding patterns, and stable financial allocations to phase out redundant schemes.


*Note: The 14th Finance Commission considered ‘Population (1971)’, while the 15th introduced ‘Population (2011)’ and ‘Tax and fiscal efforts


Finance Commission’s Role as a Balancing Wheel of Fiscal Federalism:

1. Vertical and Horizontal Distribution
a. Vertical ShareThe Finance Commission determines the vertical share, ensuring a fair allocation of the Centre’s tax revenue to the States. This vertical distribution safeguards the financial interests of the States and prevents fiscal centralization.
Increase in the devolution of taxes: 32% to 42% by the 14th Finance Commission and 41% by the 15th FC
b. Horizontal Sharing FormulaFormulates the horizontal sharing formula, guiding how revenue is distributed among the States and with the local bodies
2. Addressing Fiscal Disparities
a. Financial Transfers to Less Economically Developed StatesThrough mechanisms like revenue deficit grants, it bridges the fiscal gap and supports states with limited revenue-raising capacity.
E.g., The 15th FC gave revenue deficit grants of about Rs 3 lakh crore, including special grants for Hill States like Himachal Pradesh.
3. Promoting Cooperative Federalism
a. Facilitating Intergovernmental Fiscal TransfersFoster’s cooperative federalism by facilitating intergovernmental fiscal transfers
The Finance Commission conducts extensive consultations with States to understand their unique needs and challenges.
4. Five-Year Review Cycle
a. Periodic Review of Fiscal ArrangementsThe 14th, 15th, and upcoming 16th Finance Commissions allow for a periodic review of fiscal arrangements.
This ensures that fiscal transfers remain relevant and effective in light of evolving economic and social realities.
5. Expertise and Recommendations
a. Composition of ExpertsComprising experts in economics, finance, and public administration, the Finance Commission’s recommendations are based on rigorous analysis, consultations, and assessments of various factors.
6. Resolving Fiscal Conflicts
a. Platform for Conflict Resolution between Centre and States– The Finance Commission serves as a platform for resolving conflicts and disputes between the Centre and the States concerning fiscal matters
7. Strengthening Fiscal Discipline
a. Assessing Fiscal Performance and NeedsBy assessing the fiscal performance and needs of the States, the Finance Commission encourages responsible fiscal behaviour and discourages imprudent spending practices, thus contributing to fiscal discipline.
The 14th FC introduced fiscal deficit targets and debt-GSDP ratios to encourage fiscal prudence by States.


Measures to Strengthen the Finance Commission

  1. Regularization of Appointments
    1. Implement the recommendations of the Punchhi Commission, which suggested that the Finance Commission’s appointment should be regularized to ensure its autonomy and periodic review.
  2. Enhanced Consultations:
    1. Encourage the Finance Commission to conduct extensive consultations with state governments, local bodies, and other stakeholders, as recommended by the NITI Aayog.
  3. Fiscal Responsibility Legislation:
    1. Promote the implementation of Fiscal Responsibility and Budget Management (FRBM) Acts at the state level, as suggested by the Fourteenth Finance Commission.
  4. Greater Transparency:
    1. Implement the recommendations of the Raghuram Rajan Committee by enhancing transparency in the Finance Commission’s decision-making process. Publish detailed reports and rationale behind resource allocation to promote accountability.
  5. Horizontal Devolution Formula:
    1. Review and update the horizontal devolution formula periodically, as suggested by the C. Pant Committee. This will ensure that the formula remains relevant and responsive to changing economic realities.
  6. Timely Implementation
    1. Ensure timely implementation of the Finance Commission’s recommendations, as emphasized by various committees. Delays can disrupt state budget planning and hinder development projects.
  7. Periodic Review
    1. Continuously review the Finance Commission’s functioning and effectiveness through parliamentary committees, as suggested by the Sivaraman Committee. Regular evaluations can lead to improvements.



By adopting these measures, India can strengthen the Finance Commission’s role as a ‘balancing wheel of fiscal federalism,’ ensuring fair and equitable resource distribution, fiscal discipline, and cooperative governance across states and local bodies.


Mains Links:

Discuss the recommendations of the 13th Finance Commission which have been a departure from the previous commissions for strengthening the local government finances. (UPSC 2013)


Consider the following: (UPSC 2023)

  1. Demographic performance
  2. Forest and ecology
  3. Governance reforms
  4. Stable government
  5. Tax and fiscal efforts


For the horizontal tax devolution, the Fifteenth Finance Commission used how many of the above as criteria other than population area and income distance?

(a) Only two
(b) Only three
(c) Only four
(d) All five


Ans: B