What is the role of the Finance Commission? | Explained

The sixteenth Finance Commission's role in distributing tax revenues among the Centre and States, with public input and recommendations.

The story so far: The sixteenth Finance Commission headed by former Niti Aayog Vice-Chairman Arvind Panagariya has begun its work by inviting suggestions from the public on the mandate set for it by the Centre. The latest Finance Commission, which consists of five members including the chairman, was constituted in December last year and is expected to submit its recommendations by October, 2025. Its recommendations will be valid for five years starting from April 1, 2026.

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The Finance Commission is a constitutional body that recommends how tax revenues collected by the Central government should be distributed among the Centre and various States in the country. The Centre, however, is not legally bound to implement the suggestions made by the Finance Commission. The Commission is reconstituted typically every five years and usually takes a couple of years to make its recommendations to the Centre.

The Finance Commission decides what proportion of the Centre’s net tax revenue goes to the States overall (vertical devolution) and how this share for the States is distributed among various States (horizontal devolution). The horizontal devolution of funds between States is usually decided based on a formula created by the Commission that takes into account a State’s population, fertility level, income level, geography, etc. The vertical devolution of funds, however, is not based on any such objective formula. Nevertheless, the last few Finance Commissions have recommended greater vertical devolution of tax revenues to States. The 13th, 14th and 15th Finance Commissions recommended that the Centre share 32%, 42% and 41% of funds, respectively, from the divisible pool with States. It should be noted that the Centre may also aid States through additional grants for certain schemes that are jointly funded by the Centre and the States.

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The 16th Financial Commission is also expected to recommend ways to augment the revenues of local bodies such as panchayats and municipalities. It should be noted that, as of 2015, only about 3% of public spending in India happened at the local body level, as compared to other countries such as China where over half of public spending happened at the level of the local bodies.

The Centre and the States have been at loggerheads over the issue of sharing tax revenues for a while now. The Centre collects major taxes such as the income tax, the corporate tax, and the goods and services tax (GST) while the States primarily rely on taxes collected from the sale of goods such as liquor and fuels that are beyond the ambit of GST. The States, however, are responsible for the delivery of many services to citizens, including education, healthcare and the police. This has led to complaints that the Centre has reduced the power of the States to collect taxes and that it does not give enough funds to the States to match with the scale of their responsibilities.