In News:

The 16th Finance Commission (FC), constituted under Article 280 of the Constitution in December 2023, and chaired by Arvind Panagariya, faces a formidable task: redefining the contours of fiscal federalism for the period 2026–2031 amidst growing demands for fiscal autonomy by states and mounting fiscal pressures on the Union government.

The central concern is the shrinking divisible tax pool. Though the 15th Finance Commission recommended a 41% share of the divisible pool for states (reduced from 42% due to the reorganization of Jammu & Kashmir), the effective share received by states has hovered around 32%, owing to the increasing use of cesses and surcharges, which are not shared. According to RBI data, the divisible pool has shrunk from 88.6% in 2011–12 to 78.9% in 2021–22 of the Centre’s gross tax revenue. Consequently, many states are demanding that their share be increased to 50%, and a cap be placed on cesses and surcharges.

However, expanding transfers is fiscally challenging. The Union government is already borrowing to fund grants to states, raising concerns over sustainability and fiscal priorities. States account for nearly 60% of general government expenditure, and their argument for greater fiscal autonomy is not unfounded. A possible resolution lies not in increasing total transfers, but in restructuring the composition—shifting from tied to untied transfers.

The overreliance on Centrally Sponsored Schemes (CSS), which dictate how funds must be spent, has constrained state-level innovation and discretion. Rationalizing CSS and expanding untied transfers would empower states to prioritize their unique developmental needs. However, this is politically sensitive, as CSS often serve national priorities and electoral interests.

Yet, more untied funds come with trade-offs. Several states, including Karnataka and Punjab, are grappling with rising revenue deficits, indicating growing expenditure on salaries, interest payments, and subsidies rather than capital investment. This raises the risk that untied funds may be diverted to populist schemes, such as non-merit subsidies or quasi-universal cash transfers. A report by Axis Bank notes that 14 states have launched income transfer schemes, amounting to 0.6% of GDP, raising concerns about the long-term fiscal discipline.

A key question is whether increased untied transfers will improve inter-state equity in public service delivery. Low-income states like Bihar have far lower per capita spending on health, education, and infrastructure. Without accountability frameworks, there is a risk that increased autonomy may not translate into equitable development outcomes.

Moreover, the third tier of governance—local bodies—remains underfunded. Greater untied transfers could incentivize states to empower panchayats and municipalities, aligning with the principle of subsidiarity and deepening democratic decentralization.

Conclusion

The 16th Finance Commission must strike a delicate balance—ensuring fiscal autonomy for states without jeopardizing national fiscal stability. It must consider capping non-divisible levies, reforming transfer mechanisms, and introducing performance-linked incentives to strengthen accountability. Only a recalibrated, transparent, and equitable devolution framework can advance India’s cooperative federalism in both spirit and practice.

Why is it in the News?

The recent agitations by the governments of Kerala and Karnataka, and the support extended by several State governments, have highlighted many disquieting issues in the practice of fiscal federalism in India.

Context:

• The recent protests by the governments of Kerala and Karnataka, supported by several other state governments, have brought to light several concerning issues regarding fiscal federalism in India.
• These protests underscore the pressing need for the newly constituted 16th Finance Commission (FC) to approach the matter with seriousness and innovation to address grievances related to growing vertical and horizontal inequalities in resource allocation.

What is Fiscal Federalism?

• Fiscal federalism refers to the distribution of financial authority and obligations among various tiers of government within a nation.
• It encompasses considerations like determining the roles and responsibilities of the central and state governments in delivering services, devising mechanisms for revenue generation and allocation among these entities, and establishing fair and efficient systems for transfers or grants distribution to promote equity and effectiveness.

Fiscal Federalism in India:

• The framers of the Constitution stipulated that the Central government would share its tax revenues with the states and provide grants from the Consolidated Fund based on a formula determined by the Finance Commission every five years.
• India operates under a three-tier federal tax system, delineating the powers of the Central government, state governments, and local bodies to levy taxes.
• The Central government possesses the authority to impose taxes on individual and corporate incomes, along with indirect taxes like central goods and services tax (CGST), integrated goods and services tax (IGST), and customs duties. Additionally, it collects surcharges and cesses on various taxes.
• State governments are responsible for levying state goods and services tax (SGST), stamp duties, land revenue, state excise duties, and professional taxes.
• Local bodies exercise jurisdiction over taxes such as property or house taxes, tolls, and utility taxes on services like electricity and water.

What are the Constitutional Provisions?

• The Constitution of India outlines the taxation authority of both the Union and States, categorizing them into the Union List and the State List respectively (as outlined in the Seventh Schedule under Article 246).
  • Initially, there was no taxation provision in the Concurrent List.
• However, with the introduction of GST, the need for a concurrent taxation framework arose, leading to the insertion of Article 246A (as the 101st Amendment in August 2016).
• This amendment empowered the Union to legislate for CGST (Central GST) and IGST (Integrated GST), while the States were granted the authority to enact SGST laws.
• Article 270 of the Constitution outlines the mechanism for distributing net tax proceeds collected by the Union government among the Centre and the States.

What are the Concerns with the States?

• Growing Vertical and Horizontal Inequalities: States have raised concerns about increasing disparities both vertically, pertaining to the sharing of resources between the Union and States, and horizontally.
  • The Union government's inclination to retain a larger share of its proceeds outside the divisible pool has exacerbated these inequalities.
• Retention of Proceeds: The Union government's practice of withholding a greater portion of its proceeds from the divisible pool has diminished the share allocated to States, contravening mandates from successive Finance Commissions.
• Proliferation of Cesses and Surcharges: Various cesses and surcharges, such as the Agriculture Infrastructure and Development Cess, have been introduced by the Union government, leading to an expansion of these revenue streams.
  • This expansion has resulted in a larger portion of the gross tax revenue being excluded from net proceeds, thereby depriving States of their rightful share.
• Financial Exclusion of States: Over the period from 2009-10 to 2023-24, the Union government collected a substantial cumulative amount of ?36.6 lakh crore through cesses and surcharges, all of which remained unshared with the States.
  • The imposition of cesses and surcharges has faced criticism from the Comptroller and Auditor General (CAG), further highlighting concerns about their impact on state finances.

Way Forward

• Rectifying disparities in resource sharing and addressing the proliferation of cesses and surcharges are critical imperatives for the 16th Finance Commission (FC).
• The FC should proactively address historical imbalances in vertical devolution by compensating States appropriately and ensuring accurate estimates of "net proceeds" in budgetary documents.
• Moreover, it should consider providing lump sum untied grants to States to offset shortfalls in devolution over the past decade.
• Simultaneously, legislative measures must be enacted by the Union government to impose strict limits on the collection of cesses and surcharges, ensuring their automatic expiration after a defined period and preventing their rebranding under different names.
• Furthermore, States must adhere to the principles of fiscal federalism by allocating sufficient resources to local bodies and promoting dynamic and transparent development initiatives at the grassroots level.

What is the Finance Commission?

• The Finance Commission is constituted by the President under Article 280 of the Constitution, mainly to give its recommendations on the distribution of tax revenues between the Union and the States and amongst the States themselves.
• Two distinctive features of the Commission’s work involve redressing the vertical imbalances between the taxation powers and expenditure responsibilities of the center and the States respectively and equalization of all public services across the States.

Functions of the Finance Commission:

• It is the duty of the Commission to make recommendations to the President as to the distribution between the Union and the States of the net proceeds of taxes which are to be:
  • Divided between them and the allocation between the States of the respective shares of such proceeds;
  • The principles which should govern the grants-in-aid of the revenues of the States out of the Consolidated Fund of India;
  • The measures needed to augment the Consolidated Fund of a State to supplement the resources of the Panchayats in the State based on the recommendations made by the Finance Commission of the State;
  • The measures needed to augment the Consolidated Fund of a State to supplement the resources of the Municipalities in the State based on the recommendations made by the Finance Commission of the State;
  • Any other matter referred to the Commission by the President in the interests of sound finance.
• The Commission determines its procedure and has such powers in the performance of its functions as Parliament may by law confer on them.

Appointment of the Finance Commission and Qualifications for Members:

• The Finance Commission is appointed by the President under Article 280 of the Constitution.
• As per the provisions contained in the Finance Commission Act, 1951 and The Finance Commission (Salaries & Allowances) Rules, 1951, the Chairman of the Commission is selected from among persons who have had experience in public affairs, and the four other members are selected from among persons who:
  • (a) are, or have been, or are qualified to be appointed as Judges of a High Court; or
  • (b) have special knowledge of the finances and accounts of the Government; or
  • (c) have had wide experience in financial matters and administration; or
  • (d) have special knowledge of economics

How are the recommendations of the Finance Commission implemented?

• The recommendations of the Finance Commission are implemented  as under:
  • Those to be implemented by an order of the President:
  • The recommendations relating to the distribution of Union Taxes and Duties and Grants-in-aid fall in this category.
  • Those to be implemented by executive orders:
  • Other recommendations to be made by the Finance Commission, as per its Terms of Reference

When was the first Commission Constituted and how many Commissions have been Constituted so far?

• The First Finance Commission was constituted under the chairmanship of Shri K.C. Neogy on 6th April 1952.
• 15th Finance Commissions have been Constituted so far at intervals of every five years.
• The 16th Finance Commission was constituted on 31 Dec 2023 with Shri Arvind Panagariya, former Vice-Chairman, NITI Aayog as its Chairman.
  • The 16th Finance Commission is required to submit its recommendations by October 31st, 2025.
• However, the recommendations of the 15th FC cover the six years up to 31st March 2026.

Why is it in the News?

As the union government constituted the 16th Finance Commission (FC), experts recommend including variables related to climate change, beyond forest cover.

Background:

• In the contemporary era, India has gained prominence as a key participant in global initiatives aimed at addressing climate change and promoting increased forest coverage.
• This engagement has not only positively impacted environmental sustainability but has also strengthened the adaptability of communities and ecosystems.
• In addressing the hurdles presented by climate change, the concept of fiscal federalism, with a specific focus on the role of the Finance Commission (FC), has emerged as a crucial factor in encouraging states to prioritize conservation endeavours.

Role of the Finance Commission in Fiscal Federalism and Forest Conservation:

• Promoting Conservation Initiatives: The Finance Commission's role has been pivotal in actively promoting and incentivizing state-led efforts towards forest conservation.
• Through dedicated fund allocations, the Commission acknowledges the inherent connection between vibrant forests, sustainable ecosystems, and the overall national well-being.
• Financial backing serves as a catalyst, motivating states to prioritize conservation endeavours while safeguarding their economic interests.
• Balancing Revenue Capacities and Expenditure Needs: Beyond their biodiversity significance, forest resources represent valuable economic assets for states.
• The Finance Commission recognizes that preserving existing forests and augmenting forest cover density directly impact the revenue capacities and expenditure requirements of states.
• Finding an equilibrium between economically exploiting forest resources and ensuring their conservation becomes essential for achieving both environmental sustainability and economic prosperity.

Previous Instances of Finance Commission Initiatives in Forest Conservation:

• The Finance Commission’s formulae for tax sharing have evolved since the first one, constituted in 1951, for the period 1952-1957.
  • Since then, FCs have been constituted at intervals every five years with the 16th one currently being implemented.
• Initially, the formula for distributing tax among states respectively, known as horizontal devolution, gave significant weightage, around 80% to 90%, to the population of the states, meaning states with higher populations were given a higher share of the tax.
  • Then, the 7th FC drastically reduced the weightage assigned to the population to 25% and increased the weightage given to equity, in which income, land area, and sometimes infrastructure and fiscal discipline too, played a significant role in determining how much each state would receive from the central government.
• Similarly, there have been changes in determining the funds allocation for environmental initiatives.
  • The 12th FC (2005-10) dedicated Rs 1,000 crore for forest conservation across states.
  • The 13th FC (2010-15) enhanced this allocation to Rs 5,000 crore.
    • However, it is important to note that these grants comprised less than 0.05% of the total funds transferred from the central government to the states.
• Ecological Fiscal Transfers (EFT) – where public revenue is shared based on ecological indicators – were introduced in 2015 with the 14th FC which incorporated forest cover as a criterion for tax devolution, allocating it a weightage of 7.5% in the distribution formula for the tax-transfer during the period 2015-16 to 2019-2020.
  • The 14th FC (2015 to 2020) considered several recommendations and replaced the grants with a more prominent placement for the forestry sector — it dedicated 7.5 per cent of the divisible central tax pool to ecology and forests.
    • The allocation was based on the forest cover in each state.
• The 15th FC (2021–22 to 2025–26) extended this share to 10 per cent.
• Having mobilised and distributed over Rs 4.5 lakh crore to states against not only their forest cover but also forest density, the 15th FC effectively became the largest payment for ecosystem services (PES) systems in the world.
  • The Commission also gave grants to combat air pollution.
• The fiscal transfers that are earmarked for a specific department or programme have traditionally been much smaller than fiscal transfers to the general state budget.
  • For example, the specific-purpose grants for forestry under the 12th and 13th FC were a fraction of the general-purpose transfers (those not assigned to specific purposes) that followed under the 14th and 15th FC.
• The formula-based finance commission transfers are unconditional and are not tied to the Department of Forest or Ecology.
• Whether there is a need for conditions to ensure the funds are invested in the environment, at least in principle, the enticement of receiving larger general-purpose transfers should motivate states to invest in forest protection.
• Since 2005, the central government has been sharing annual forest grants with states.
  • These grants serve as both compensation and incentive mechanisms.
  • However, it remains unclear to what extent these grants have contributed to the increased forest cover in the states.

Addressing Complexities in the Intersection of Fiscal Federalism and Environmental Conservation:

• Harmonizing Conservation Costs and Economic Imperatives: Balancing conservation expenses with economic necessities becomes challenging, particularly for states grappling with financial constraints.
  • The substantial opportunity costs linked with forest preservation may strain state budgets, presenting a hurdle in garnering widespread commitment.
• Innovating Financing Models for Conservation: Traditional financing models for conservation may prove inadequate or unsustainable in the long term.
  • Overreliance on grants can create dependencies, hindering the development of self-sustaining mechanisms for conservation.
• Addressing Climate-Induced Economic Vulnerabilities: The repercussions of climate change pose considerable threats to economic stability, especially for states heavily dependent on climate-sensitive sectors.
  • Unpredictable weather patterns, floods, and forest fires can intensify existing vulnerabilities.
• Strategically Allocating Resources: The Finance Commission encounters the intricate task of strategically allocating resources to maximize both environmental and economic advantages.
  • Ensuring targeted funding for critical conservation initiatives while aligning with state development objectives demands a nuanced approach.
• Integrating Environmental Goals with Fiscal Capacity: States may grapple with aligning their environmental objectives with fiscal capabilities, potentially creating a gap between aspirations and implementation.
• Ensuring Equitable Participation: A potential risk exists where states with greater fiscal capacities may disproportionately benefit from conservation incentives, potentially exacerbating existing economic disparities.

The Potential Role of 16th Finance Commission's:

• Integrating Climate Considerations into Tax Devolution Framework: The 16th Finance Commission has the potential to bring about a transformative shift by integrating climate vulnerability and emission intensity as pivotal factors in the tax devolution formula.
  • This alignment directly supports India's Nationally Determined Contributions (NDCs) under the Paris Agreement, providing states with robust fiscal incentives to actively contribute to national climate goals.
• Implementing Performance-Based Grants for Key Sectors: Recognizing the instrumental role of specific sectors in achieving NDCs and Sustainable Development Goals (SDGs), the 16th Finance Commission could contemplate introducing performance-based grants.
  • These grants, which are specifically designed to help areas like renewable energy, sustainable land and forest management, and air pollution efforts, provide states with focused financial assistance and motivate them to take proactive steps toward change.
• Addressing Emission Reduction Challenges: Prioritizing emission reduction, the commission can focus on decarbonizing critical sectors like energy and transport.
  • This entails incentivizing states to embrace clean energy practices and fostering innovation to tackle persistent issues like crop burning.
  • Through strategic fund allocation, the 16th Finance Commission can drive tangible progress in mitigating emission sources.
• Funding Innovations for Ecological Challenges: Allocating funds to innovative solutions for ecological challenges induced by climate change becomes a crucial role for the 16th Finance Commission.
  • Whether supporting mangrove restoration to counter weather vagaries or addressing the escalating incidents of forest fires, the commission can catalyze research, development, and implementation of sustainable strategies.
• Utilizing Scientific Data for Informed Decision-Making: Leveraging advanced technology, the 16th Finance Commission can utilize scientific data, pollution inventories, and remote sensing to assess state vulnerabilities and mitigation efforts.
  • This data-driven approach ensures that fiscal decisions are rooted in empirical evidence, enabling the commission to design an effective and equitable performance-based system for fund allocation.
• Transforming into a Leader in Climate Readiness: Going beyond its traditional fiscal role, the 16th Finance Commission has the potential to evolve into a leader in India's climate readiness.
  • This transformation involves active participation in designing and implementing a fiscal blueprint that balances economic growth with environmental imperatives, guiding policies that meet present needs without compromising the ability of future generations to meet their own.

Conclusion

In the current juncture where India grapples with the intertwined paths of economic advancement and environmental safeguarding, the Finance Commission's significance in fiscal federalism cannot be overstated.

The 16th Finance Commission, poised to influence tax distribution principles and stimulate climate-conscious endeavours, emerges as a pivotal player in fostering a harmonious equilibrium between economic progress and ecological conservation.

By adopting strategic measures and pioneering innovative strategies, the Finance Commission has the potential to evolve into a formidable catalyst in India's pursuit of climate resilience.

Why is it in the News?

The government appointed former NITI Aayog Vice-Chairman Arvind Panagariya Chairman of the 16th Finance Commission, which will recommend the tax revenue sharing formula between the Centre and States for the five-year period beginning April 2026.

Constitution of the 16th Finance Commission:

• The Government of India, with the approval of the President of India, has constituted the 16th Finance Commission, in pursuance to Article 280(1) of the Constitution.
• Dr Arvind Panagariya, former Vice-Chairman, of NITI Aayog, and Professor, at Columbia University will be the Chairman.
• Members of the 16th Finance Commission would be notified separately.
• Shri Ritvik Ranjanam Pandey has been appointed as Secretary to the Commission.
• The 16th Finance Commission shall make recommendations as to the following matters, namely:
• The distribution between the Union and the States of the net proceeds of taxes which are to be, or maybe, divided between them under Chapter I, Part XII of the Constitution and the allocation between the States of the respective shares of such proceeds;
• The principles which should govern the grants-in-aid of the revenues of the States out of the Consolidated Fund of India and the sums to be paid to the States by way of grants-in-aid of their revenues under Article 275 of the Constitution for the purposes other than those specified in the provisos to clause (1) of that article; and
• The measures needed to augment the Consolidated Fund of a State to supplement the resources of the Panchayats and Municipalities in the State on the basis of the recommendations made by the Finance Commission of the State.
• The 16th Finance Commission may review the present arrangements on financing Disaster Management initiatives, with reference to the funds constituted under the Disaster Management Act, 2005 (53 of 2005), and make appropriate recommendations thereon.
• The 16th Finance Commission has been requested to make its report available by the 31st day of October 2025 covering a period of five years commencing on the 1st day of April 2026.

15h Finance Commission Recommendations (Effective from 2021 to 2026):

• Tax Proceeds Allocation: The Commission advocates for an equitable distribution of tax proceeds between the central government and states, fostering a well-balanced fiscal sharing mechanism.
• Assessment of GST Impact: The FC underscores the importance of analyzing the impact of the Goods and Services Tax (GST) on the economy.
• This evaluation aims to comprehend the implications of GST implementation across various sectors.
• Performance-Linked Incentives: Proposed incentives are tied to states' efforts in addressing key issues like population control, ease of doing business, and other pertinent factors.
• Financial Assistance to States: The FC suggests the provision of revenue deficit grants, grants to local bodies, and disaster management grants to states.
• These grants are intended to bolster the financial requirements of the states and promote effective governance.

Proposed Recommendations for the 16th Finance Commission:

• Review of the 2018 Amendment to the Centre’s FRBM: This proposal aligns with the suggestion made by the 15th Finance Commission.
• In the fiscal year 2020-21, the combined debt-GDP ratio of the central and state governments reached 89.8%.
• While these figures have started declining, they remain significantly higher than the corresponding Fiscal Responsibility and Budget Management (FRBM) norms of 40% and 20% established in the 2018 amendment.
• With the Centre’s fiscal deficit at 9.2% of GDP and that of states at 4.1% in 2020-21, it becomes imperative to re-examine the 2018 amendment to the Centre’s FRBM, especially considering the deviations from established norms.
• Limiting Freebies: Some state governments exhibit relatively higher debt and fiscal deficit figures compared to their Gross State Domestic Products (GSDPs).
• Two primary concerns arise in this context: the widespread distribution of subsidies and the reintroduction of the previous pension scheme in states without a clear identification of funding sources and the resultant fiscal burdens.
• Often, these subsidies are financed by increasing the fiscal deficit. While advocating for safety nets for the poor is essential in a country facing economic challenges, a prudent approach is crucial.
• The next Finance Commission should provide explicit guidelines to ensure long-term fiscal sustainability and responsible spending on gratuities.

Freebies Must Be Restricted Through Reform:

• An innovative approach to address this issue is the establishment of a loan council, as suggested by the 12th Finance Commission.
• This independent body would monitor the scale and profiles of loans taken by both the central and state governments.
• The 16th Finance Commission should thoroughly scrutinize non-merit subsidies.
• It is crucial for the Finance Commission to enforce strict adherence to fiscal deficit limits by states.
• Incentives should be provided for states maintaining fiscal discipline, potentially integrating fiscal performance as a criterion in horizontal distribution.
• Conversely, measures should be imposed on states exceeding fiscal deficit limits, with appropriate actions taken on their borrowing capacities.

Conclusion

During the pre-reform era, Finance Commission recommendations held less significance, given alternative methods the Centre employed to compensate states. However, with the abolition of the Planning Commission, the Finance Commission has emerged as the primary architect of India's fiscal federalism, shouldering substantial responsibility and wielding significant influence. The recommendations provided by the 16th Finance Commission will be critical as India progresses towards becoming the world's third-largest economy.

Finance Commission:

• The Finance Commission is a constitutional body responsible for providing recommendations on the distribution of tax revenues among the Union and the States, as well as among the States themselves.
• Composition: Constituted by the President under Article 280 of the Constitution, the Finance Commission is formed at the end of every fifth year or earlier, as deemed necessary.
• Parliament has the authority to establish the requisite qualifications for commission members and determine the selection process, as enacted by The Finance Commission (Miscellaneous Provisions) Act, 1951.
• Mandate: The Commission is tasked with making recommendations to the President on various aspects, including the distribution of net tax proceeds between the Union and the States, principles governing grants-in-aid to State revenues, measures to augment a State's Consolidated Fund, and other matters referred to it by the President in the interest of sound finance.
• Composition: The Finance Commission comprises a Chairman and four other members appointed by the President.
• The Chairman is selected from individuals with experience in public affairs, while the other members may have qualifications related to judiciary, financial expertise, administration, or economics.
• Tenure: Each member serves a term specified by the President and is eligible for reappointment.
• Independence: The recommendations of the Finance Commission, although significant, are not binding on the government.