Under normal conditions, India distributes powers between the center and states as a federal nation.. One of the balancing wheels of federalism is the Finance Commission (FC), balancing fiscal federalism in the nation.
The President establishes the Finance Commission every five years under Article 280 of the Constitution, and it plays a crucial role in recommending the fair distribution of financial resources between the Union and states.
Composition of Finance Commission
Chairman + 4 members
Chairman: Heads the Commission and presides over the activities. He should have had public affairs experience.
Four Members: The Parliament determines legally the qualifications of the members of the Commission and their selection methods. The 4 members should be or have been qualified as High Court judges, or be knowledgeable in finance or experienced in financial matters and are in administration, or possess knowledge in economics.
All the appointments are made by the President of the country.
Grounds of disqualification of members:
Found to be of unsound mind, involved in a vile act, if there is a conflict of interest
The President of India specifies the tenure of the office of the Member of the Finance Commission, and in some cases, the President also re-appoints the members.
The members shall give part-time or service to the Commission as scheduled by the President.
Finance Commission suggestions encompass three key areas:
Vertical Devolution– determining states’ shares in the divisible pool of central taxes;
Horizontal Distribution– allocating resources based on fiscal needs, capacities, and performance; and
Grants-in-aid– providing additional transfers to states or sectors requiring assistance.
Check your understanding by taking the test.
Functions of Finance Commission:
The Finance Commission makes recommendations to the president of India on the following issues:
- The distribution of net tax proceeds between the Centre and states and their allocation among states.
- Principles governing grants-in-aid to states from the consolidated fund of India.
- Steps needed to extend a state’s consolidated fund to enhance resources for panchayats and municipalities based on state Finance Commission recommendations.
- Consideration of any matter referred by the President in the interest of sound finance.
- Determination of the basis for sharing divisible taxes and principles for grants-in-aid every five years.
- President’s authority to refer any matter in the interest of sound finance to the Commission.
- Presentation of Commission’s recommendations, along with an explanatory memorandum, to Parliament.
- Assessment of the increase in a state’s Consolidated Fund to augment resources for state Panchayats and Municipalities.
- Empowerment of the Commission with sufficient authority to fulfil its functions within its defined scope.
- The Commission, in accordance with the Code of Civil Procedure 1908, possesses the powers of a Civil Court, including the ability to call witnesses and request the production of public documents or records from any office or court.
16th FC Appointment:
On 21.11.2022, the Ministry of Finance formed the Advance Cell of the 16th FC to oversee preliminary work, pending the formal constitution of the Commission.
Shri Arvind Panagariya, former Vice-Chairman of NITI Aayog, became the Chairman of the Sixteenth Finance Commission when it was constituted on 31.12.2023.
The President of India approved the appointment of the following members to the Commission.
- Shri. Ajay Narayan Jha, former member, 15th Finance Commission and former Secretary, Expenditure (Full-Time Member)
- Smt. Annie George Mathew, former Special Secretary, Expenditure (Full-Time Member)
- Dr. Niranjan Rajadhyaksha, Executive Director, Artha Global (Full-Time Member)
- Dr. Soumya Kanti Ghosh, Group Chief Economic Advisor, State Bank of India (Part-Time Member)
Subsequently, the Ministry of Finance established a Working Group, led by the Finance Secretary and Secretary (Expenditure), and including members such as the Secretary (Economic Affairs), Secretary (Revenue), Secretary (Financial Services), Chief Economic Adviser, Adviser from NITI Aayog, and Additional Secretary (Budget), to aid in shaping the Terms of Reference (ToRs). As part of the consultation process, the Working Group actively sought input and recommendations from State Governments and Union Territories (with legislature) regarding the ToRs. The Group thoroughly discussed and considered the views and suggestions received during this consultative phase.
Key Terms of Reference for the 16th FC:
- Principles for Grants-in-Aid: The commission is responsible for establishing principles governing grants-in-aid to the States from the Consolidated Fund of India. This involves determining the amounts to be provided to the States as grants-in-aid, particularly under Article 275 of the Constitution, for purposes beyond those specified in the provisos to clause (1) of that article.
- Evaluation of Disaster Management Financing: The commission has the authority to review the existing financing structures related to Disaster Management initiatives. This includes examining funds established under the Disaster Management Act, 2005, and providing suitable recommendations for improvements or alterations.
- Augmenting State Funds for Local Bodies: The commission is mandated to identify measures for enhancing the Consolidated Fund of a State. This aims to supplement the resources available to Panchayats and Municipalities within the State, based on recommendations from the State’s own Finance Commission.
- The commission’s task is to recommend the allocation of taxes between the Union Government and the States, as outlined in Chapter I, Part XII of the Constitution. This includes determining the shares to be distributed among the States from these tax proceeds.
Challenges facing the 16th FC:
- Cess and Surcharge: The share of States in the Centre’s gross tax revenues (GTR) has decreased, averaging around 31% from 2020-21 to 2023-24, a significant drop from the previous share of nearly 35% observed from 2015-16 to 2019-20. This decline is attributed to a considerable increase in cess and surcharge, rising from 12.8% in 2015 to 18.5% in 2020.
- GST Collection: The performance of the Goods and Services Tax (GST) has been a cause for worry in recent years, leading to a decline in the total divisible pool. Despite relatively buoyant GST collections in the last two years, there remains a need for restructuring the GST to ensure it functions as a good and straightforward tax system.
- Income Weightage Issue: The income distance criterion, constituting 45%, allocates a larger share to states with relatively lower income. However, many affluent states argue for a reduction in the weightage assigned to this criterion, highlighting the need for a more balanced distribution.
- Implementation Challenges: FCs have to ensure that their recommendations are feasible, acceptable and effective in achieving the desired objectives. However, the Union and state governments do not directly control how they implement or monitor the recommendations made by the Finance Commission. They also have to deal with issues such as delays, deviations, non-compliance or misuse of funds by the recipients.
- Evaluation Difficulties: FCs have to assess the impact and outcomes of their recommendations on various indicators of fiscal health, governance quality and development performance. However, they face difficulties in attributing causality, isolating effects, measuring outcomes and attributing value to their interventions.
- Choice of Census: 15th Finance Commission gave weightage to 2011 census which was a cause of worry for many states due to family planning and population controlling measures, creating unbiased division of funds between states who had successfully controlled growing population back in 2000’s.
Apart from certain challenges and limitations, the Finance Commission plays a key role in distributing the funds between centre and state and balancing fiscal federalism. As the Chairman of the 15th Finance Commission rightly asserted, the history of the Finance Commission is embedded in a legacy of unalloyed confidence and trust.
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