The Role of the Finance Commission in India’s Fiscal Federalism

India’s federal structure requires careful balancing of financial powers between the Union and the 28 states and 8 union territories. The Centre collects the bulk of major taxes, yet states shoulder most of the responsibility for delivering public services like education, healthcare, and policing. This mismatch is the classic problem of fiscal federalism, and the Finance Commission is the constitutional body tasked with solving it. Every five years, this expert panel recommends how tax revenues should flow between the Centre and states, making it one of the most consequential institutions you’ve probably never heard of.

What is the Finance Commission? 🔗

The Finance Commission is a quasi-judicial body established under Article 280 of the Constitution. The President constitutes it every five years, or earlier if circumstances demand, to recommend how the net proceeds of central taxes should be divided between the Union and the states, and how that share should be allocated among individual states.

The Commission has five members: a Chairman and four others, all appointed by the President. Parliament sets the qualifications through the Finance Commission (Miscellaneous Provisions) Act, 1951. Members typically have backgrounds in public finance, economics, administration, or law, which gives the body both technical credibility and political neutrality.

Since 1951, fifteen Finance Commissions have completed their work. The 16th Finance Commission, chaired by Dr. Arvind Panagariya (former Vice-Chairman of NITI Aayog), was constituted on 31 December 2023, and its recommendations cover the period from April 1, 2026 to March 31, 2031.

Why fiscal federalism needs a referee 🔗

To understand why the Finance Commission matters, you need to understand the two imbalances it addresses: vertical and horizontal.

Vertical imbalance 🔗

The Union Government has been assigned the most lucrative and buoyant revenue sources, including income tax, corporate tax, customs, and its share of GST. States, however, are responsible for public services that demand heavy spending. This mismatch, where the Centre has more money and states have more responsibilities, is known as vertical fiscal imbalance. Without a mechanism to redistribute resources, states simply could not function.

Horizontal imbalance 🔗

Not all states are equally placed. A state like Bihar has different fiscal needs and revenue-raising capacity than Karnataka or Maharashtra. Horizontal imbalance refers to these disparities among states themselves. The Finance Commission designs a formula that gives poorer and less-developed states a larger share of the pie, so that citizens across the country can access broadly comparable levels of public services.

What the Finance Commission actually does 🔗

Article 280(3) sets out the Commission’s core responsibilities, and the 73rd and 74th Constitutional Amendments of 1992 expanded its scope to include local bodies.

Recommending tax devolution 🔗

This is the Commission’s most important function. It decides what percentage of the divisible pool of central taxes should go to states collectively (vertical devolution) and how to divide that share among individual states (horizontal devolution). The divisible pool consists of all central taxes except cesses, surcharges, and cost of collection.

Laying down principles for grants-in-aid 🔗

Beyond tax sharing, the Commission recommends grants from the Consolidated Fund of India to states under Article 275. These include revenue deficit grants for states whose revenues fall short of their expenditures, sector-specific grants (for health, education, disaster management), and state-specific grants for unique needs.

Strengthening local bodies 🔗

Following the 73rd and 74th Amendments, the Commission also recommends measures to augment state funds for Panchayats and Municipalities, based on the recommendations of each State Finance Commission. This extends fiscal federalism to the grassroots level.

Other matters referred by the President 🔗

The President can refer additional matters concerning sound finance. Recent commissions have examined issues like disaster management financing, fiscal consolidation, and even the financial implications of new policies like GST.

How the devolution formula works 🔗

The Commission uses a set of weighted criteria to determine each state’s share of the divisible pool. This formula is the heart of horizontal equalization.

The 15th Finance Commission formula (2021-26) 🔗

The 15th Finance Commission, chaired by N.K. Singh, used six criteria: income distance (45%), population as per 2011 Census (15%), area (15%), forest and ecology (10%), demographic performance (12.5%), and tax and fiscal efforts (2.5%).

Income distance measures how far a state’s per capita income is from the state with the highest income. Poorer states get a larger share. Demographic performance, computed using the reciprocal of the Total Fertility Rate, rewards states that have successfully controlled population growth, an important concession to southern states that feared being penalized for using 2011 Census data.

The 16th Finance Commission’s shift (2026-31) 🔗

The 16th Finance Commission has kept the vertical devolution at 41% but tweaked the horizontal formula meaningfully. According to recent analyses of the 16th FC report, the new weights are: income distance (42.5%), population 2011 (17.5%), demographic performance (10%), area (10%), forest and ecology (10%), and a brand-new criterion, contribution to GDP (10%), while the earlier tax and fiscal effort parameter has been dropped.

The introduction of a GDP contribution parameter represents a shift toward rewarding economically productive states. According to ICRA’s analysis, this change is expected to benefit economically stronger states while slightly reducing the share of very large or very small states because of adjustments to the area criterion.

Grants-in-aid: plugging specific gaps 🔗

Tax devolution is broad and untied. Grants-in-aid, on the other hand, are targeted instruments. The 15th Finance Commission recommended total grants to local bodies of Rs 4.36 lakh crore for 2021-26, split between rural local bodies, urban local bodies, and health grants channelled through local governments. It also recommended revenue deficit grants of around Rs 2.94 lakh crore over the award period for seventeen states.

The 16th Finance Commission has gone further, recommending a sharp increase in local body grants to Rs 7.9 trillion for FY2027-FY2031. Importantly, 60% of these local body grants are conditional but untied, giving local governments flexibility, while 40% are tied to sanitation, solid waste, and water management, ensuring focused outcomes.

The evolving fiscal landscape 🔗

The Finance Commission operates in a dynamic environment. Several recent developments have made its job harder and more consequential.

The GST disruption 🔗

The introduction of the Goods and Services Tax in 2017 fundamentally altered India’s fiscal architecture. GST took away many taxation powers from states, leaving them more dependent on transfers from the Centre. GST now accounts for around 35 per cent of Union gross tax revenue and around 44 per cent of states’ own tax revenue, which is why Finance Commission recommendations are scrutinized more closely than ever.

Cesses and surcharges controversy 🔗

A growing concern is that the Centre has increasingly relied on cesses and surcharges, which are not part of the divisible pool. This has meant that even though states’ formal share stands at 41%, the effective share can fall to around 32%, triggering friction with states who argue they are being short-changed.

Fiscal discipline and sustainability 🔗

Recent commissions have also had to balance devolution with concerns about overall fiscal health. The 16th Finance Commission has emphasized fiscal discipline by capping state fiscal deficits at 3% of GSDP, discouraging off-budget borrowings, and targeting a decline in combined public debt. It has also expressed concerns about rising unconditional cash transfer schemes, which now form a sizeable part of state subsidy spending.

Criticisms and ongoing debates 🔗

Despite its constitutional stature, the Finance Commission has faced substantive criticism.

Advisory, not binding: Its recommendations are not legally enforceable. The Union government can selectively accept or modify them. While this has rarely happened in dramatic fashion, state-specific and sector-specific grants recommended by the 15th FC were not always accepted.

North-South tensions: Southern states, which have performed better on population control and economic growth, have complained that the devolution formula penalizes their success. The introduction of demographic performance was a partial response, but the debate continues.

Shrinking divisible pool: As discussed, the rise in cesses and surcharges reduces what is actually available for sharing. Some commentators argue for a constitutional amendment to include at least part of these in the divisible pool.

Overlap concerns: With the abolition of the Planning Commission and creation of NITI Aayog, some argue the Finance Commission should take on a larger developmental role, while others want it to stick strictly to revenue-sharing.

Why this matters for every citizen 🔗

The Finance Commission’s work may seem like arcane fiscal arithmetic, but its consequences are felt in everyday life. When a primary health centre in rural Odisha gets funds for medicines, or when a municipal corporation in Pune upgrades its solid waste management, the money trail often leads back to a Finance Commission recommendation. The Commission is, in effect, the silent architect of India’s welfare delivery.

It also plays a stabilizing role in India’s federal politics. By providing a rule-based, expert-driven mechanism for resource sharing, the Commission reduces the scope for political bargaining between the Centre and states. This gives states predictable revenues to plan their budgets and pursue development goals without being entirely dependent on the Centre’s discretion.

What do you think? As the 16th Finance Commission begins its five-year award period from April 2026, do you believe the new GDP contribution criterion strikes the right balance between rewarding economic performance and ensuring equity for poorer states? And should cesses and surcharges be brought into the divisible pool to protect states’ rightful share?

References

1. https://fincomindia.nic.in/
2. https://www.pib.gov.in/PressReleaseIframePage.aspx?PRID=1980688&reg=3&lang=2
3. https://vajiramandravi.com/upsc-exam/16th-finance-commission/
4. https://www.ey.com/en_in/insights/tax/economy-watch/16-th-finance-commission-the-benefits-of-brevity-in-terms-of-reference
5. https://www.manoramayearbook.in/current-affairs/india/2025/01/11/tax-devolution-upsc-explained.html
6. https://www.drishtiias.com/daily-news-analysis/15th-finance-commission-recommendations-resource-allocation
7. https://www.drishtiias.com/daily-updates/daily-news-analysis/16th-finance-commission-report
8. https://www.icra.in/Research/ViewResearchReport/6763
9. https://prsindia.org/policy/report-summaries/report-15th-finance-commission-2021-26
10. https://byjus.com/free-ias-prep/issues-in-news-15th-finance-commission/
11. https://vajiramandravi.com/upsc-exam/finance-commission/