Role of Finance Commission
Context
India’s fiscal landscape is marked by the intricate relationship between the Centre and the States, particularly concerning the sharing of tax revenues. The Finance Commission, a constitutional body, plays a crucial role in mediating this relationship.
- The sixteenth Finance Commission, chaired by Arvind Panagariya, has recently commenced its work, inviting public suggestions on its mandate set by the Centre.
- Constituted in December last year, it is expected to submit its recommendations by October 2025, which will be applicable for five years starting April 1, 2026.
Relevance:
GS-02 (Polity)
Dimensions of the Article:
- About the Finance Commission
- Functions of Finance Commission
- Issues Surrounding the Finance Commission
- What is the Friction Between the Centre and States?
- How Does the Commission Decide?
About the Finance Commission
- The Finance Commission is a constitutionally mandated body that recommends the distribution of tax revenues between the Centre and the States.
- Article 280 of the Constitution of India provides for a Finance Commission as a quasi judicial body.
- Typically reconstituted every five years, the Commission’s recommendations guide fiscal federalism in India.
- The Centre, however, is not legally obligated to implement these recommendations, although they are usually taken seriously due to their importance in maintaining fiscal balance and equity among States.
- It is constituted by the president of India every fifth year or at such earlier time as he considers necessary.
- COMPOSITION
- The Finance Commission consists of a chairman and four other members to be appointed by the president.
- President determines the tenure of the members.
- They are eligible for reappointment.
Functions of Finance Commission:
- The Finance Commission is required to make recommendations to the president of India on the following matters:
- The distribution of the net proceeds of taxes to be shared between the Centre and the states
- The principles that should govern the grants-in-aid from CFI to the states
- The measures needed to strengthen the consolidated fund of a state to supplement the resources of the local self-governments.
- The commission submits its report to the president and he lays it before both the Houses of Parliament
Issues Surrounding the Finance Commission
- The main task of the Finance Commission is twofold: vertical devolution, which decides the share of the Centre’s net tax revenue that goes to the States, and horizontal devolution, which distributes this share among various States based on a formula.
- This formula considers factors such as population, fertility rate, income level, and geography.
- Recent Finance Commissions have recommended increasing the share of tax revenues for the States. For instance, the 13th, 14th, and 15th Finance Commissions suggested that 32%, 42%, and 41%, respectively, of the divisible pool be allocated to the States. In addition, the Commission can recommend grants for specific schemes jointly funded by the Centre and States.
- The 16th Finance Commission is also expected to suggest ways to enhance the revenues of local bodies, such as panchayats and municipalities. Currently, only about 3% of public spending in India occurs at the local body level, compared to over half in countries like China.
What is the Friction Between the Centre and States?
- A persistent issue between the Centre and States revolves around the distribution of tax revenues. The Centre collects major taxes like income tax, corporate tax, and GST, while States primarily rely on taxes on goods outside GST, such as liquor and fuels. States argue that their responsibilities in delivering services like education, healthcare, and policing require more funds than they currently receive.
- This situation leads to several points of contention:
- Percentage of Tax Proceeds: States demand a higher share of tax revenues than what is recommended by the Finance Commission. They argue that their fiscal responsibilities far exceed the Centre’s.
- Actual Delivery of Funds: There is a perception that the Centre does not fully devolve the recommended share of funds. For instance, under the 15th Finance Commission, the Centre devolved an average of only 38% of funds, against the recommended 41%.
- Divisible Pool Composition: States are concerned about what constitutes the divisible pool of taxes. Cesses and surcharges, which are not shared with States, can account for up to 28% of the Centre’s tax revenues, significantly reducing the States’ share.
- Equity Issues: More developed States like Karnataka and Tamil Nadu feel they are penalized for their better governance. For example, Tamil Nadu receives only 29 paise for every rupee it contributes, while less developed States like Bihar receive more than ₹7 for each rupee contributed.
How Does the Commission Decide?
- The Finance Commission uses a formula to decide on the horizontal distribution of funds among States. This formula takes into account multiple criteria:
- Population: Larger populations typically require more resources.
- Income Levels: Poorer States may receive more funds to bridge development gaps.
- Geography: States with challenging terrains or extensive rural areas might get additional support.
- The vertical distribution, or the share of the Centre’s revenue to be divided among the States, is decided based on negotiations and broader economic considerations, without a fixed formula. However, the trend has been towards increasing the States’ share over successive Finance Commissions.
Significance
- The Finance Commission’s role is vital in ensuring a balanced fiscal federalism in India. It aims to address disparities among States, enabling equitable development.
- The Commission also seeks to ensure that local bodies are adequately funded, which is crucial for grassroots development.
- By recommending the distribution of funds and grants, it helps align fiscal resources with the responsibilities of different levels of government.
Way Forward
To resolve the friction and improve fiscal federalism, several steps can be taken:
- Enhanced Devolution: The Centre should consider increasing the share of tax revenues devolved to the States, aligning with their fiscal responsibilities.
- Transparent Allocation: Clear guidelines on what constitutes the divisible pool, including a possible reduction in cesses and surcharges, can help improve trust.
- Performance-Based Incentives: Introducing performance-based grants can reward States for good governance and efficient use of funds.
- Strengthening Local Bodies: Increasing the share of funds for local bodies can enhance public spending at the grassroots level, promoting decentralized development.
- Collaborative Approach: Continuous dialogue between the Centre and States, facilitated by the Finance Commission, can help address grievances and ensure a fair distribution of resources.
