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Finance Commission

GS II>> Polity>> Constitutional Bodies

Context: The Union Cabinet has given its approval for the terms of reference (ToR) of the Sixteenth Finance Commission.

• This commission is tasked with suggesting the formula for sharing revenues between the Central government and the States for the upcoming five-year period beginning on April 1, 2026.
• The government has set a deadline of October 31, 2025, for the commission to submit its recommendations.

About Finance Commission:

• The Finance Commission of India, operating under the provisions of Article 280 of the Indian Constitution, serves as a constitutional body with over 50 years of existence.
• Established as a quasi-judicial body, its primary function is to determine methods and formulas for the equitable distribution of tax proceeds between the Central government and the states.
• Historical background of the Finance Commission:
• The Finance Commission’s origins trace back to its establishment in 1951 by Dr B.R. Ambedkar, the then law minister, addressing fiscal imbalances between the Centre and States.
• The Constitution of India, through various articles such as 268, 269, 270, 275, 282, and 293, provided provisions for resource-sharing mechanisms.
• Roles and Responsibilities:
• The Commission plays a pivotal role in determining the allocation of tax revenues among states, ensuring compliance with the constitutional framework and meeting current requirements.
• Additionally, it is responsible for defining taxes and grants allocated to local bodies within states, essential for their effective functioning.

Functions of Finance Commission:

• Distribution of Tax Proceeds: The Finance Commission is tasked with recommending the fair distribution of net proceeds of taxes between the Union and the states, as well as determining the inter-state distribution of these proceeds.
• Principles governing Grants-in-Aid: The Commission formulates and recommends principles that govern grants-in-aid to states and Union Territories from the Consolidated Fund of India.
• Measures for augmenting State Consolidated Funds: To facilitate the functioning of panchayats and local bodies within a state, the Finance Commission suggests measures to augment the consolidated fund of a state.
• Presidential mandate and reporting: Under Article 281 of the Constitution, the President of India is mandated to present the Finance Commission’s report to each House of Parliament. This report includes a comprehensive note explaining the government’s actions based on the Commission’s recommendations.

Composition of Finance Commission:

• Composition: The Finance Commission consists of five members, including one Chairman and four other members.
• The President of India appoints all members, and their terms are determined by the President, with the possibility of reappointment as needed.
• Qualifications for four members: The four members of the Commission are chosen from a pool with diverse expertise:
• A high court judge or an individual qualified for such a position.
• An expert in finance and government accounts.
• Someone with varied experience in financial and administrative matters.
• An individual with special knowledge of economics and related studies.

About 15th Finance Commission and its recommendations:

• The 15th Finance Commission, chaired by Mr. N. K. Singh, is a constitutional body formed by the President of India. Two reports were submitted, with recommendations for the financial year 2020-21 and the period 2021-26.
• Share of states in Central Taxes: The recommended share of states in central taxes for 2021-26 is 41%, a slight decrease from the 42% suggested by the 14th Finance Commission for 2015-20. The adjustment accounts for the creation of the union territories of Jammu and Kashmir and Ladakh.
• Criteria for Devolution: The 15th Finance Commission maintained the criteria for 2021-26, with adjustments in the reference periods.
• Grants: Performance-linked grants for health, education, agriculture, and other sectors are emphasized.
• Fiscal Roadmap: The Commission recommends a fiscal deficit target of 4% of GDP for the centre by 2025-26. For states, fiscal deficit limits are suggested as 4% in 2021-22, 3.5% in 2022-23, and 3% during 2023-26. States undertaking power sector reforms are allowed extra annual borrowing of 0.5% of GSDP.
• Disaster Risk Management: State disaster management funds will have a corpus of Rs 1.6 lakh crore, with defined sharing ratios.
• Financial Management Practices: The Commission proposes the establishment of an independent Fiscal Council.
• Other Recommendations: Emphasis on increasing health spending, restructuring CSS, and creating a Modernisation Fund for Defence and Internal Security.

 Challenges for 16th Finance Commission:

• Global Macroeconomic Uncertainty and Policy Considerations: 15th FC recognition of the complications in fiscal management due to the pandemic, emphasizing the need for a fiscal stimulus and a credible exit plan.
• Normalization of the base year: Advocating for a normalized base year for projections, considering global macroeconomic uncertainties, fiscal shocks from COVID, and emerging scenarios’ impact.
• Policy changes and comparability of data: Highlighting important policy changes during COVID and the need for comparable data across states and time.
• Adjustments required for revenue side data, including GST compensation and COVID fiscal stimulus.
• Assumption about growth: Stressing the importance of a realistic growth assumption for predictable resource availability.
• Proposing a mechanism to estimate growth for 2026-27 to 2030-31, considering economic uncertainty and fiscal prudence.
• Framework for Fiscal Sustainability: Emphasizing the importance of a credible and implementable fiscal restructuring plan considering the post-COVID fiscal landscape.
• Welfare Schemes Vs Freebies: Arguing against mandating the Finance Commission to suggest what states should do regarding redistributive fiscal interventions.
• Off-Budget Borrowing and Fiscal Responsibility: Cautioning against merging budget and off-budget borrowing without revising deficit targets appropriately.
• Restructuring of Centrally Sponsored Schemes: Recognizing the progress in reducing the number of centrally sponsored schemes.
• Highlighting the complexity of managing CSS and suggesting greater state involvement in design, flexibility, and implementation.

Way forward:

• Advocating for strict fiscal deficit limits for states, incentivizing compliance with fiscal performance criteria. Balancing stringent guidelines with simplicity and practicality in implementation.
• Recommending guidelines for the imposition of cesses and surcharges, including a formula for capping the amount raised.
• Proposing the establishment of a loan council, following the Twelfth Finance Commission’s recommendation, to oversee central and state government loan magnitudes and profiles.
• Areas to be covered are given below:
• Cess and Surcharges: The decline in States’ effective share in the Centre’s gross tax revenues (GTR), attributed to a rise in non-shareable cesses and surcharges, requires attention.
• Per Capita Income Criteria: Weighing the need for a lower criterion weight, as desired by richer states, against the contribution of lower-income states to India’s future ‘demographic dividend.’
• Freebies: Emphasizing the 16th Finance Commission’s role in setting stringent guidelines for state spending on freebies, aligning with long-term fiscal sustainability.
• Equalisation Principle: Prioritizing equal provision of education and health services in resource transfers.

Source: www.thehindu.com