DEST Practice 4

The Finance Commission is a constitutional body established under Article 280 of the Constitution of India, which requires the President to constitute a Finance Commission every five years for the purpose of making recommendations on the distribution of the net proceeds of taxes between the Union and the states, the principles that should govern the grants-in-aid to the revenues of states out of the Consolidated Fund of India, and any other matter referred to the Commission by the President in the interest of sound finance. The Commission, which typically consists of a Chairman and four members appointed by the President and possessing expertise in public finance, economics, or administration, conducts extensive consultations with Union ministries, state governments, local bodies, academic institutions, and other stakeholders before finalising its recommendations, which cover a five-year award period. The Fifteenth Finance Commission, chaired by N K Singh and covering the period from 2021-22 to 2025-26, recommended that states receive forty-one percent of the divisible pool of central taxes and duties, which is the net of collection charges and assignment to union territories, with each state's share determined by a formula that takes into account income distance from the state with the highest per capita income, population as recorded in the 2011 census, demographic performance as measured by the total fertility rate, forest and ecology as measured by the area under dense forests, tax effort as measured by the ratio of own tax revenue to gross state domestic product, and area. The Commission also recommended sector-specific grants to states for health, education, agriculture, pre-disaster management, disaster relief, maintenance of central and state roads, and improving the statistical systems of state governments, recognising that mere tax devolution without sector-specific support may leave critical gaps in the delivery of essential services in fiscally weaker states. The Finance Commission framework is the institutional cornerstone of fiscal federalism in India, addressing the fundamental vertical imbalance that arises because the central government's constitutional assignment of major tax handles including income tax, corporation tax, customs duties, and central excise gives it a larger revenue share than is needed for its own direct expenditure responsibilities, while states are constitutionally assigned larger shares of spending responsibility in areas such as education, health, agriculture, police, and irrigation that are proximate to citizens but more expensive to provide. Without the Finance Commission's devolution, most states would be unable to maintain even minimal levels of public services from their own revenues alone. The horizontal distribution formula, which determines how the overall devolution is shared among the twenty-eight states, is contested among states because the choice of formula variables and their weights can significantly affect the allocation received by each state. States with large populations argue for higher weight on population, while economically advanced states with high tax effort argue for greater reward for fiscal performance, and states with large forest cover press for stronger recognition of the environmental services they provide. The grant for local bodies recommended by successive Finance Commissions has strengthened the resource base of urban local bodies and gram panchayats, enabling them to deliver services more effectively, though the capacity constraints of elected local governments in smaller states and remote districts remain a challenge for the optimal utilisation of these funds. The Sixteenth Finance Commission, constituted in late 2023 under the chairmanship of Arvind Panagariya, has been mandated to make recommendations covering the period from 2026-27 to 2030-31 and is expected to address new challenges including the fiscal implications of climate change expenditures, the changing structure of the economy, and the need to incentivise states to adopt better governance and development outcomes.