Finance Commission of India

Slides – Teaching Aid

1. Introduction: The Bedrock of Indian Fiscal Federalism

The Finance Commission of India is a constitutional body established under Article 280 of the Indian Constitution. It is a cornerstone of India’s fiscal federalism, designed to define and periodically readjust the financial relations between the central government (the Union) and the individual state governments.

Constituted by the President of India every five years, or earlier if necessary, its primary role is to make recommendations on the distribution of tax revenues between the Union and the States and among the states themselves. The Commission functions as a quasi-judicial body, and its recommendations are intended to ensure financial stability, equity, and efficiency in the allocation of national resources.

2. Composition of the Finance Commission

The Finance Commission consists of a Chairman and four other members, all appointed by the President. The qualifications for these members are determined by an Act of Parliament. Traditionally, the composition is as follows:

• Chairman: A person with proven experience in public affairs.
• Four Members:
  1. A judge of a High Court or someone qualified to be appointed as one.
  2. An individual with specialized knowledge of the finances and accounts of the government.
  3. A person with wide experience in financial matters and in administration.
  4. An expert with special knowledge of economics.

This structure ensures that the Commission possesses a blend of judicial, administrative, and economic expertise.

3. Core Functions and Mandate

The Finance Commission’s primary duty is to make recommendations to the President on the following key matters:

1. Vertical Devolution: The distribution of the net proceeds of taxes that are to be shared between the Union and the States. This determines what percentage of the central government’s tax revenue is given to the states.
2. Horizontal Devolution: The principles and formula for allocating the states’ collective share of tax revenue among the individual states. This ensures an equitable distribution based on various criteria.
3. Grants-in-Aid: The principles that should govern the grants-in-aid to be provided to the states from the Consolidated Fund of India. These are funds given to states that may need further assistance after tax devolution.
4. Augmenting State Funds for Local Bodies: Recommending measures to supplement the resources of Panchayats (rural local bodies) and Municipalities (urban local bodies) based on the recommendations of the State Finance Commissions.
5. Other Matters: Any other matter referred to the Commission by the President in the interest of sound finance.

4. The Process: From Recommendation to Implementation

1. Submission: The Commission submits its report containing its recommendations to the President of India.
2. Tabling in Parliament: The President lays the report before both Houses of Parliament—the Lok Sabha and the Rajya Sabha. An “Explanatory Memorandum” detailing the action taken by the government on the recommendations is also presented.
3. Nature of Recommendations: The recommendations of the Finance Commission are advisory in nature and not legally binding on the government. However, as a matter of convention and constitutional propriety, the central government almost always accepts the core recommendations, especially those concerning the distribution of tax revenues.

5. Illustrative Example: The 15th Finance Commission (2021-2026)

To understand its function in practice, let’s examine the key recommendations of the 15th Finance Commission, chaired by N.K. Singh.

• Vertical Devolution (Share of States):
  • The Commission recommended that states be given 41% of the divisible pool of central taxes.
  • This was a slight reduction from the 42% recommended by the 14th Finance Commission. The 1% adjustment was made to account for the newly created Union Territories of Jammu & Kashmir and Ladakh, whose funding would now be directly managed by the Centre.
• Horizontal Devolution (Criteria for Distribution among States):
  • This is often the most debated part of the recommendations. The 15th FC used the following criteria and weights to decide each state’s share from the 41% pool:

Criterion	Weightage	Rationale
Income Distance	45%	To help states with lower per capita income catch up with those that are better off.
Population (2011 Census)	15%	Reflects the expenditure needs of a state based on its population size.
Area	15%	Larger states have higher administrative costs.
Forest and Ecology	10%	To reward states for maintaining forest cover, which is a national public good.
Demographic Performance	12.5%	To reward states that have been successful in controlling their population growth.
Tax Effort	2.5%	To incentivize states that are more efficient in their own tax collection.

6. Significance and Importance in the Indian Polity

• Pillar of Fiscal Federalism: It is the primary institutional mechanism for balancing the fiscal powers and expenditure responsibilities between the Centre and the states.
• Ensures Equity: By using criteria like “income distance,” it facilitates the transfer of resources from more prosperous states to less prosperous ones, promoting balanced regional development.
• Promotes Stability: It provides a predictable and transparent framework for resource sharing, reducing financial uncertainty for the states.
• Strengthens Local Governance: By recommending grants for local bodies, it promotes fiscal decentralization and empowers grassroots democracy.

7. Criticisms and Contemporary Challenges

• Advisory Role: Its non-binding nature can sometimes allow political considerations to influence the government’s acceptance of certain recommendations.
• Increasing Cess and Surcharges: A growing portion of the Centre’s revenue comes from cesses and surcharges, which are not part of the divisible pool shared with states. This has been a major point of contention for many states.
• Contentious Criteria: The choice of criteria for horizontal devolution (e.g., using the 2011 census over the 1971 census) often leads to disagreements among states, particularly between northern and southern states.