The 16th Finance Commission must address fiscal equity concerns

The 16th Finance Commission needs to address the complaints from the southern states
The 16th Finance Commission needs to prioritise transparency and accountability, enhance trust, and ensure effective implementation of its recommendations.

The government has released some technical details about the Terms of Reference for the 16th Finance Commission, set to operate for five years starting April 1, 2026. This release includes information on the distribution ratio of tax net proceeds between the Centre and states and the financing of disaster management initiatives. 

Beyond determining tax devolution and revenue augmentation measures for states, the commission will review existing arrangements for funding disaster management initiatives, as established under the Disaster Management Act, 2005. Although the Union Cabinet, led by Prime Minister Narendra Modi, has approved the Terms of Reference, the government has not yet accepted them.

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Role of the Finance Commission

The Finance Commission, a constitutional body established under Article 280 of the Indian Constitution, oversees the allocation of certain revenue resources between the Union and State Governments. Its primary responsibilities include determining the Centre’s tax revenue share for States (the vertical share) and its distribution among States (the horizontal sharing formula).

In the Indian federal system, where the Centre and States share powers and responsibilities, taxation powers are also divided. State legislatures may transfer some of their tax powers to local bodies. The Finance Commission’s recommendations are advisory and not obligatory for the government. The Fifteenth Finance Commission, under NK Singh, made significant changes in November 2017, addressing COVID-19 and geopolitical challenges.

The North-South divide

Southern states have expressed dissatisfaction with the Finance Commission. The 15th Finance Commission had no representatives from the southern peninsula and lacked clarity on criteria for horizontal devolution. Despite having high human development indices but lower populations, southern states find the population-based fiscal redistribution unfair.

The 15th Finance Commission recommended various weightages for demographic performance, income, population, area, forest and ecology, and tax and fiscal efforts in horizontal devolution. It suggested allocating 41% of the Centre’s divisible tax pool to states for 2021–22 to 2025–26, consistent with the 14th Finance Commission’s recommendation. The 15th Commission estimated the Gross Tax Revenue (GTR) for five years to be Rs 135.2 lakh crore, with a divisible pool of Rs 103 lakh crore, resulting in Rs 42.2 lakh crore for states.

The government has not yet finalised the chairperson and members of the 16th Finance Commission. This Commission will also recommend principles for state revenue grants from the Consolidated Fund of India and suggest ways to augment state consolidated funds to support local governments. The commission’s final report was submitted to the President on November 9, 2020. Typically, it takes about two years for the Finance Commission to formulate its recommendations.

The way ahead for 16th Finance Commission

Over the years, Finance Commissions have influenced public finance, governance, and development in India significantly. Following their recommendations, tax devolution became a major component of vertical transfers, increasing states’ shares progressively from 10% to 42%. The commissions have also encouraged performance-based incentives for states in areas like fiscal discipline, population control, forest conservation, and power sector reforms.

To strengthen public trust and ensure effective implementation of its recommendations, the Finance Commission should prioritise transparency and accountability in its operations. This could involve publishing detailed reports on its deliberations, making data and analysis readily accessible to the public, and establishing clear mechanisms for stakeholder engagement. By fostering openness and accountability, the commission can enhance the credibility and legitimacy of its work.

State governments face increasing fiscal pressures due to rising expenditure on social welfare schemes, infrastructure development, and other essential services. The Finance Commission should consider recommending measures to alleviate this burden, such as expanding the scope of tax devolution, providing targeted grants for specific developmental programs, and incentivising states to adopt fiscal reforms that promote efficiency and resource optimisation.