Finance Commission and Fiscal Federalism for UPSC

Constitutional Basis of the Finance Commission

The makers of the Constitution recognised that India's vast size and diversity called for a system that balances national priorities with regional needs. This balance is achieved through fiscal federalism: the central government collects broad-based taxes like income tax and customs duties, while state governments manage many expenditure-heavy sectors such as education, health and agriculture. To bridge the gap between revenue capacity and spending obligations, the Constitution created the Finance Commission.

Article 280 and Composition

Article 280 directs the President to constitute a Finance Commission at least once every five years or earlier if necessary. The Commission is quasi-judicial and consists of a Chairman and four other members appointed by the President. Parliament has specified that the Chairman should be a person with experience in public affairs, while the members must include a judge of a High Court or someone qualified to be one, a person knowledgeable in government finance and accounts, one with wide experience in financial matters and administration, and one with special knowledge of economics. Members are eligible for re-appointment.

Duties under Article 280(3)

The Commission's mandate includes:

• Recommending the distribution of the net proceeds of taxes between the Union and the States (vertical devolution) and determining the share of each State (horizontal devolution).
• Suggesting principles governing grants-in-aid to States from the Consolidated Fund of India under Article 275.
• Proposing measures to augment the Consolidated Fund of a State to supplement the resources of panchayats and municipalities based on recommendations of the State Finance Commission.
• Advising on any other matter referred by the President in the interest of sound finance, such as disaster management, defence funding or public finance reforms.

Although the Commission's recommendations are advisory, successive central governments have generally accepted them because they uphold the spirit of cooperative federalism.

Evolution of the Finance Commission

Since the First Finance Commission was constituted in 1951, fifteen commissions have submitted reports. Each commission responded to the political and economic context of its time. Early commissions focussed on balancing revenue shortfalls of newly formed states. Later commissions tackled issues like the abolition of the Planning Commission, the introduction of the goods and services tax (GST), and the need to incentivise demographic performance and environmental conservation.

The abolition of the Planning Commission and the emergence of the NITI Aayog shifted the focus of the Finance Commission from segregated plan and non-plan funding towards an integrated fiscal framework. The Fourteenth Finance Commission (2015-20) increased the share of states in the divisible tax pool from 32 % to 42 %, signalling a move towards greater fiscal autonomy. The Fifteenth Finance Commission was constituted on 27 November 2017 under the chairmanship of N. K. Singh to recommend transfers for 2020-21 and for the five-year period 2021-26. Its terms of reference were broader and more contentious because they required it to consider the use of the 2011 population data for devolution and address the funding needs of defence and internal security.

Terms of Reference of the Fifteenth Finance Commission

The President's notification constituted the Fifteenth Finance Commission with the following broad terms of reference (ToR):

• Recommend the distribution of net proceeds of taxes between the Centre and the States for 2021-26 and allocate shares among the States by taking into account the 2011 census population and fiscal performance.
• Advise on the principles governing grants-in-aid to States and measures to augment State resources so that rural and urban local bodies can deliver constitutionally assigned functions.
• Examine whether revenue deficit grants should be provided to States and to what extent.
• Consider the impact of the abolition of the Planning Commission and the introduction of the GST on the finances of the Centre and the States.
• Review the present arrangements for financing defence and internal security, including a possible separate funding mechanism.
• Evaluate the performance of States on a broad range of parameters such as population control, infrastructure, environmental sustainability and ease of doing business, and explore incentives for fiscal discipline.

The Union government later amended the ToR to allow the Commission to examine the possibility of setting up a dedicated non-lapsable fund for defence and internal security. Some States raised concerns that the ToR favoured the Centre by emphasising fiscal consolidation and using the 2011 census population, which penalises States that have successfully controlled fertility rates. Despite these debates, the Fifteenth Finance Commission submitted its final report in January 2021, covering the award period 2021-22 to 2025-26.

Key Recommendations of the Fifteenth Finance Commission (2021-26)

The Fifteenth Finance Commission's recommendations can be grouped into tax devolution, grants, fiscal roadmap and sector-specific reforms. The central theme is to maintain fiscal consolidation while ensuring adequate resources for States and local bodies.

Vertical Devolution

The Commission retained the States' share in the net proceeds of Union taxes at 41 % for 2021-26. This is 1 percentage point lower than the 42 % recommended by the Fourteenth Commission, a reduction made to provide for the newly created Union Territories of Jammu and Kashmir and Ladakh. The decision reflects a balance between fiscal consolidation at the Centre and the need to give States adequate untied funds. Over the five years, the divisible tax pool is projected to be around Rs 103 lakh crore (about US$1.24 trillion), implying that States will receive roughly Rs 42 lakh crore as their share.

Horizontal Devolution Criteria

After determining the overall States' share, the Commission distributed it among individual States using a formula based on need, equity and performance. The table below summarises the weightage assigned to each criterion:

States with lower per capita incomes and larger populations thus receive a higher share. The inclusion of demographic performance and tax effort incentivises family planning and revenue mobilisation. The use of the 2011 census population sparked controversy because it reduces the weight of States that have successfully curbed population growth, especially in southern India. Nevertheless, the Commission argued that it balanced both need and performance through the formula.

Grants-in-Aid

Grants supplement tax devolution to address specific needs and correct both vertical and horizontal imbalances. The Fifteenth Finance Commission recommended the following major grants:

• Revenue deficit grants (Rs 2.94 lakh crore): Seventeen States with estimated revenue shortfalls receive grants to eliminate their deficits. These grants fill the gap between States' projected revenue and their expenditure on core functions, ensuring basic levels of service delivery.
• Grants to local bodies (Rs 4.36 lakh crore): The Commission's biggest innovation is the large allocation to rural and urban local bodies, including district and block panchayats. Of the total, Rs 2.40 lakh crore is earmarked for rural local bodies, Rs 1.20 lakh crore for urban local bodies and Rs 70,051 crore for health grants through local governments. These grants are partly untied and partly tied to specific activities like sanitation, drinking water and primary health care.
• Sector-specific grants (Rs 1.29 lakh crore): Grants targeted at eight sectors - health, school education, higher education, agricultural reform, judiciary, statistics and administration, transport and aspirational districts. A portion of these grants is performance-linked to encourage improvements in outcomes.
• State-specific grants (Rs 49,599 crore): These grants address unique needs of individual States, such as preservation of historical monuments, development of high-cost infrastructure, promotion of tourism, and strengthening of governance and administrative capacity.
• Disaster management grants (Rs 1.22 lakh crore): Funds for State Disaster Response Funds and the National Disaster Response Fund, to be shared between the Centre and States in a ratio of 90:10 for north-eastern and Himalayan States and 75:25 for other States. The grants support both disaster response and mitigation activities.

The Commission also proposed establishing a Modernisation Fund for Defence and Internal Security (MFDIS) with a corpus of Rs 2.4 lakh crore over 2021-26, of which Rs 1.5 lakh crore would come from the Consolidated Fund of India and the rest from proceeds such as disinvestment of defence public sector enterprises. This non-lapsable fund aims to supplement budgetary allocations for critical defence and internal security needs without affecting transfers to States.

Conditions and Implementation of Local Body Grants

To ensure transparency and accountability in the utilisation of local body grants, the Commission laid down entry-level conditions:

• All local bodies must publish provisional accounts and audited annual accounts in the public domain.
• States must notify minimum floor rates for property taxes and show progress in increasing property tax collections; urban local bodies failing to meet this condition in later years would face reduced grants.
• The grants (except health grants) will cease after March 2024 if a State fails to constitute a State Finance Commission (SFC) and act upon its recommendations. States are thus compelled to respect constitutional mandates under Articles 243-I and 243-Y.

These conditions reflect the Commission's intent to strengthen grassroots finances and improve revenue mobilisation at the local level.

Fiscal Roadmap and Reforms

The Commission provided a fiscal glide path to ensure debt sustainability:

• Fiscal deficit targets: The Centre should reduce its fiscal deficit from 6.8 % of GDP in 2020-21 to 4 % by 2025-26. States should restrict deficits to 4 % of their gross state domestic product (GSDP) in 2021-22, 3.5 % in 2022-23 and 3 % during 2023-26. States unable to fully utilise permitted borrowing in the first four years may carry forward the unutilised amount to subsequent years.
• Borrowing flexibility: States undertaking power sector reforms (reducing technical and commercial losses, narrowing the revenue gap and shifting to direct benefit transfers for subsidies) may borrow an extra 0.5 % of GSDP annually during 2021-25.
• Fiscal responsibility laws: A high-powered inter-governmental group should review the Fiscal Responsibility and Budget Management (FRBM) Act and recommend a new framework that applies to both the Centre and the States. An independent Fiscal Council should be established to assess budget forecasts and monitor compliance.
• Revenue mobilisation and GST: States should broaden their tax base by strengthening income and asset-based taxation (for example, by expanding tax deduction at source and improving property valuation). The inverted duty structure in GST must be resolved, the number of rate slabs should be rationalised (merging the 12 % and 18 % slabs), and the tax base should be widened through better enforcement.
• Transparency: Both Centre and States should adopt uniform, accrual-based accounting standards, avoid off-budget borrowings and report contingent liabilities in a standard format.

On the social sector, the Commission asked States to increase their health expenditure to more than 8 % of their budget, with two-thirds of spending on primary healthcare. It emphasised flexibility in centrally sponsored schemes so that States can innovate and focus on outcomes.

Understanding Fiscal Federalism

Fiscal federalism deals with how different levels of government raise resources and spend them. In India, the Constitution clearly demarcates legislative powers in the Union List, State List and Concurrent List. However, revenue assignments do not match expenditure responsibilities. While the Union controls buoyant taxes like income tax, corporation tax and customs duties, States are responsible for large social and economic sectors. As a result, States depend heavily on transfers from the Centre.

Vertical and Horizontal Fiscal Imbalances

Vertical fiscal imbalance occurs when one tier of government (usually the Centre) has more revenue-raising power than expenditure responsibilities, while another tier (States) has larger expenditure responsibilities relative to its own revenues. In 2024-25, States accounted for about 61 % of public expenditure but raised only about 38 % of total revenues, highlighting this imbalance. Horizontal fiscal imbalance refers to differences among States in their capacity to raise revenue and their cost of delivering services. Wealthier States like Maharashtra and Tamil Nadu mobilise more taxes, whereas poorer or sparsely populated States like Bihar or the northeastern States have limited fiscal capacity but high needs.

The Finance Commission helps correct these imbalances. Vertical devolution transfers a share of centrally collected taxes to States as untied funds, allowing them flexibility. Horizontal devolution uses a formula to distribute that share among States based on need and performance. Grants further target specific gaps. States also receive funds through centrally sponsored schemes (Article 282), which are tied to central priorities; these transfers can sometimes undermine fiscal autonomy and are not recommended by the Finance Commission.

Role of the State Finance Commission

The State Finance Commission (SFC) was created under the 73rd and 74th Constitutional Amendments to strengthen local self-governance. Article 243-I directs the Governor of each State to constitute an SFC every five years to recommend how state revenues should be shared with panchayats and municipalities. Despite this mandate, many States delay the formation of SFCs or do not act on their recommendations, leading to chronic underfunding of local bodies. The Fifteenth Finance Commission's condition that no further grants be released after March 2024 to States that fail to constitute SFCs underscores the importance of empowering local governments.

Issues in Current Fiscal Devolution

While tax devolution and grants have improved state finances, several issues persist:

• Cesses and surcharges: A growing share of Union tax revenue (around 23 % in 2024-25) comes from cesses and surcharges, which are not part of the divisible pool. Consequently, States receive only around 32 % of total Union tax receipts, far below the 41 % share recommended by the Fifteenth Commission. This undermines the spirit of cooperative federalism and reduces States' fiscal space.
• Unequal returns: States differ sharply in how much they receive per rupee contributed to the Centre's taxes. Highly industrialised States often receive less than a rupee back, while poorer States receive more. The formula aims to equalise but can sometimes discourage better tax effort.
• Population versus performance: Southern States argue that using the 2011 census penalises them for controlling population growth. The demographic performance criterion partly addresses this concern, but many urge greater weight to performance.
• Tied grants: A large portion of central transfers now comes via centrally sponsored schemes with stringent guidelines, reducing the autonomy of States. The Commission suggested rationalising centrally sponsored schemes and encouraging outcome-based funding.
• Fiscal discipline: Both Centre and States face high debt levels; strict adherence to fiscal responsibility laws is essential. Off-budget borrowings and contingent liabilities need to be transparently reported.
• Infrastructure needs of progressive States: States like Tamil Nadu and Karnataka face rapid urbanisation and ageing populations. They need more resources for urban infrastructure and elder care, but the current formula emphasises population and income distance rather than urbanisation.

The upcoming Sixteenth Finance Commission, constituted in November 2023 under the chairmanship of Arvind Panagariya, will consider these issues for the five-year period starting 1 April 2026. Many States have demanded raising tax devolution to 50 % and including cess and surcharge in the divisible pool. The ToR also asks the Commission to address climate resilience and disaster management financing.

For UPSC Prelims vs Mains

Prelims Pointers

• Article 280 provides for the Finance Commission, a quasi-judicial body constituted every five years by the President.
• The Fifteenth Finance Commission retained the States' share of the divisible tax pool at 41 % for 2021-26; the Fourteenth Commission had raised it to 42 %.
• Horizontal devolution criteria include income distance (45 %), population (15 %), area (15 %), demographic performance (12.5 %), forest and ecology (10 %) and tax effort (2.5 %).
• Total grants to local bodies recommended by the Fifteenth Commission amount to Rs 4.36 lakh crore: Rs 2.40 lakh crore for rural local bodies, Rs 1.20 lakh crore for urban local bodies and Rs 70,051 crore for health grants.
• The Commission recommended revenue deficit grants of Rs 2.94 lakh crore to 17 States and sector-specific grants of Rs 1.29 lakh crore.
• State Finance Commissions are mandated under Articles 243-I and 243-Y to be constituted every five years by the Governor; failure to do so may lead to suspension of local body grants.
• Cesses and surcharges are not part of the divisible pool and therefore not shared with States.
• The Modernisation Fund for Defence and Internal Security (MFDIS) envisages a corpus of Rs 2.4 lakh crore to bridge defence funding gaps without affecting states' shares.

Mains Notes

• Analyse the role of the Finance Commission in correcting vertical and horizontal fiscal imbalances. Discuss whether the current weightages for horizontal devolution achieve equity without disincentivising population control or tax effort.
• Critically examine the conditions attached to local body grants. Do the requirements for publishing accounts and improving property tax collection strengthen local governance, or do they impose unrealistic burdens on resource-poor bodies?
• Discuss the implications of cesses and surcharges being outside the divisible pool. Should they be included in future devolution calculations? How can the Finance Commission address this issue within constitutional constraints?
• Evaluate the fiscal glide path recommended by the Fifteenth Commission. In light of the pandemic and global uncertainties, are the deficit targets feasible? What institutional reforms (Fiscal Council, revised FRBM) are needed to enforce fiscal discipline?
• Explain the significance of State Finance Commissions in deepening fiscal federalism. Why have many States failed to constitute SFCs regularly? Suggest measures to strengthen SFCs and ensure timely devolution to local bodies.
• Examine the debate around using the 2011 census population for devolution. Should performance in controlling population be rewarded more? Propose an alternative formula that balances need and performance.
• Assess the challenges of cooperative fiscal federalism in the context of GST, centrally sponsored schemes and inter-state equity. How can the Sixteenth Finance Commission foster better collaboration between the Centre and States?

Quick Facts

• The Fifteenth Finance Commission was constituted on 27 November 2017 with N. K. Singh as Chairman and members Ajay Narayan Jha, Prof. Anup Singh, Dr. Ashok Lahiri and Dr. Ramesh Chand.
• It submitted two reports: an interim report for 2020-21 tabled in February 2020 and the final report for 2021-26 tabled on 1 February 2021.
• The divisible tax pool for 2021-26 is estimated at Rs 103 lakh crore; States' share at 41 % yields about Rs 42 lakh crore over five years.
• Seventeen States qualify for revenue deficit grants, including Kerala, Andhra Pradesh, Punjab, Himachal Pradesh and all north-eastern States.
• States must publish provisional and audited accounts and improve property tax collection to receive local body grants; failure to constitute State Finance Commissions by March 2024 disqualifies them.
• As of early 2025, cesses and surcharges constituted about 23 % of the Centre's gross tax receipts, significantly reducing the divisible pool.
• The Sixteenth Finance Commission, chaired by Arvind Panagariya, will submit its report by October 31, 2025, covering the period 2026-31.
• States undertake about 61 % of public expenditure but mobilise only about 38 % of total revenues, underscoring the importance of tax devolution and grants.

UPSC Previous Year Questions (Selected)

The following paraphrased questions reflect how UPSC has tested candidates on the Finance Commission and fiscal federalism:

1. 2019 Prelims: Consider the following statements regarding the Finance Commission: (1) It is a statutory body appointed by the Parliament. (2) Its recommendations are binding on the government. Which of the statements given above is/are correct? Answer: Neither; the Finance Commission is a constitutional body appointed by the President and its recommendations are advisory.
2. 2020 Mains (GS II): "India's fiscal federalism is marked by vertical and horizontal imbalances." Discuss the role of the Finance Commission in addressing these imbalances. Answer: Candidates should explain the concepts of vertical and horizontal fiscal imbalance and describe how the Commission recommends tax devolution and grants to bridge them. They should also mention issues like cesses and surcharges and suggest reforms.
3. 2021 Prelims: With reference to the State Finance Commission, which of the following statements is correct? (a) It is constituted by the President every five years. (b) It recommends how State revenues should be shared with local bodies. (c) Its recommendations are binding on the Governor. Select the correct answer using the code. Answer: Only (b); it is constituted by the Governor and its recommendations are advisory.
4. 2023 Mains (GS II): Analyse the main recommendations of the Fifteenth Finance Commission relating to grants to local bodies. How do these recommendations seek to strengthen local governance? Answer: Candidates should mention the quantum of grants, conditions for release, focus on health and sanitation, inclusion of all tiers and scheduled areas, and the link with constituting SFCs.

Practice MCQs

1. Which Article of the Constitution provides for the establishment of the Finance Commission?
   1. Article 246
   2. Article 280
   3. Article 275
   4. Article 356
2. The Fifteenth Finance Commission recommended that the share of States in the net proceeds of central taxes for 2021-26 should be:
   1. 32 %
   2. 42 %
   3. 41 %
   4. 50 %
3. Which of the following is not a criterion used by the Fifteenth Finance Commission for horizontal devolution?
   1. Income distance
   2. Population (2011)
   3. Forest and ecology
   4. Per capita debt
4. Under the recommendations of the Fifteenth Finance Commission, grants to local bodies (other than health grants) are distributed among States based on:
   1. Income and debt
   2. Population and area
   3. Population and forest cover
   4. Area and tax effort
5. State Finance Commissions are constituted under which Articles of the Constitution?
   1. Articles 280 and 281
   2. Articles 72 and 74
   3. Articles 243-I and 243-Y
   4. Articles 368 and 369

Answer Key: 1 - B; 2 - C; 3 - D; 4 - B; 5 - C.

Frequently Asked Questions

What is the Finance Commission and why is it important?

The Finance Commission is a constitutional body that recommends how taxes collected by the Union should be shared with the States and how grants-in-aid should be provided. It ensures that States have adequate resources to discharge their functions and helps correct imbalances between different levels of government. Without it, some States would struggle to deliver basic services while others would accumulate surplus funds, undermining national unity and development.

Are the recommendations of the Finance Commission binding?

No. The recommendations are advisory. However, they carry significant moral and political weight because they are based on extensive consultations and expert analysis. Successive governments have largely accepted them to preserve cooperative federalism.

What is the difference between the Finance Commission and the State Finance Commission?

The Finance Commission is appointed by the President under Article 280 to recommend sharing of taxes between the Union and the States and among the States. The State Finance Commission, appointed by the Governor under Articles 243-I and 243-Y, recommends how State revenues should be shared with panchayats and municipalities. Both aim to strengthen fiscal federalism, but at different tiers.

Why is population control an issue in tax devolution?

The Fifteenth Finance Commission used the 2011 census population to determine States' shares. States that controlled population growth, especially in southern India, fear being penalised because a lower population means a smaller share of untied funds. To address this, the Commission introduced a demographic performance criterion. The debate will likely continue in the Sixteenth Finance Commission.

What are cesses and surcharges, and why are States concerned about them?

Cesses and surcharges are additional levies on top of existing taxes for specific purposes (such as education cess or health cess). They form part of the Union's gross tax revenue but are not included in the divisible pool to be shared with States. With cesses and surcharges forming a growing portion of tax receipts, the divisible pool shrinks, reducing States' share. Many argue that future Finance Commissions should recommend including at least some cesses in the divisible pool.

How does the Finance Commission support local governments?

Under Article 280(3), the Commission suggests measures to augment the Consolidated Fund of the States to supplement the resources of panchayats and municipalities. The Fifteenth Commission allocated Rs 4.36 lakh crore to local bodies, provided performance-linked health grants, insisted on publishing accounts and improved property tax collection, and required States to constitute State Finance Commissions. These steps aim to strengthen grassroots governance and improve service delivery.

What can we expect from the Sixteenth Finance Commission?

The Sixteenth Finance Commission, to be chaired by Arvind Panagariya, will make recommendations for the five years starting April 1, 2026. It will likely review the share of States in tax devolution, consider including cesses and surcharges in the divisible pool, address emerging priorities such as climate resilience and disaster management, and refine the criteria for horizontal devolution. Its report is due by October 31, 2025.