👉 Finance Commission of India: Structure, Functions & Impact on Fiscal Policy

The Finance Commission of India: The Balancing Wheel of Fiscal Federalism

1. Introduction: The Cornerstone of India's Fiscal Architecture

In the intricate federal machinery of India, where powers and responsibilities are divided between the Union and the States, a critical question arises: how are the financial resources distributed to match these responsibilities? The framers of the Indian Constitution, with remarkable foresight, devised a unique mechanism to address this potential friction point: The Finance Commission.

The Finance Commission is not merely an advisory body; it is the institutional cornerstone of India's fiscal federalism. Enshrined in Article 280 of the Constitution, it is a quasi-judicial body constituted periodically to recommend the distribution of financial resources between the Centre and the States, and among the States themselves. Its primary role is to act as a "balancing wheel," ensuring vertical equity (between the Union and States) and horizontal equity (among the States) in fiscal matters. This prevents the lopsided accumulation of resources at one level of government and ensures that states have adequate funds to discharge their constitutional duties, thereby fostering cooperative federalism.

These notes will provide a comprehensive, multi-dimensional analysis of the Finance Commission, covering its historical evolution, constitutional mandate, structure, functions, landmark recommendations, impact on fiscal policy, and contemporary challenges.

Key Takeaway: The Finance Commission is a constitutionally mandated, quasi-judicial body under Article 280, central to ensuring a fair and equitable distribution of revenue between the Union and the States. It is the principal instrument for mediating the financial relations in India's federal system.

2. Historical and Constitutional Background

The genesis of the Finance Commission lies in the fiscal imbalances inherent in the Government of India Act, 1935, which created a federal-like structure but concentrated most of the elastic revenue sources with the Centre, while assigning major expenditure responsibilities (like agriculture, education, and health) to the provinces.

Constituent Assembly Debates: The Original Intent

The framers of the Constitution were acutely aware of this structural imbalance. During the Constituent Assembly debates, members like Dr. B.R. Ambedkar, N. Gopalaswami Ayyangar, and Dr. P.S. Deshmukh engaged in profound discussions on ensuring the financial autonomy and stability of the States.

• Dr. B.R. Ambedkar emphasized the need for an independent body to adjudicate on the distribution of revenues, free from political pressures. He envisioned the Finance Commission as a robust, impartial arbiter that would make recommendations based on objective criteria.
• The debates revealed a consensus that a statutory, periodic body was preferable to a purely political or executive arrangement for resource sharing. The idea was to create a system that was both predictable and flexible, capable of adapting to the changing economic realities of the nation.
• The inclusion of Article 280 was a deliberate move to institutionalize this process, making the Finance Commission a permanent feature of India's constitutional framework, thereby guaranteeing a periodic review of Centre-State financial relations.

Constitutional Foundation: The Core Articles

The mandate and functioning of the Finance Commission are primarily governed by two key articles of the Constitution:

• Article 280: The Finance Commission:

  • Clause (1): Mandates the President of India to constitute a Finance Commission within two years of the commencement of the Constitution, and thereafter every fifth year, or at such earlier time as the President considers necessary. It specifies that the Commission shall consist of a Chairman and four other members.
  • Clause (2): Empowers the Parliament to determine the qualifications for the appointment of the Commission's members and the manner of their selection.
  • Clause (3): Outlines the core duties of the Commission, which are to make recommendations to the President on:
    • (a) The distribution of the net proceeds of taxes between the Union and the States (Vertical Devolution) and the allocation among the States (Horizontal Devolution).
    • (b) The principles that should govern the grants-in-aid to the States out of the Consolidated Fund of India.
    • (c) Measures needed to augment a State's Consolidated Fund to supplement the resources of Panchayats and Municipalities (added by the 73rd and 74th Constitutional Amendments).
    • (d) Any other matter referred to it by the President in the interests of sound finance.

• Article 281: Recommendations of the Finance Commission: This article mandates that the President shall cause every recommendation made by the Finance Commission, along with an explanatory memorandum as to the action taken thereon, to be laid before each House of Parliament. It is important to note that the recommendations are advisory in nature and not binding on the government. However, they are treated with great respect and have traditionally been accepted by the Union Government, establishing a strong convention.

3. Structure and Composition of the Finance Commission

The structure of the Finance Commission is designed to ensure a blend of expertise from various fields, lending credibility and objectivity to its recommendations.

Appointment and Tenure

• Appointing Authority: The President of India.
• Composition: A Chairman and four other members.
• Tenure: The members hold office for such period as specified in the presidential order and are eligible for reappointment.

Qualifications of Members

As per the Finance Commission (Miscellaneous Provisions) Act, 1951, passed by Parliament under Article 280(2), the qualifications for the members are:

• Chairman: A person with experience in public affairs.
• Four Other Members:
  1. A person who is qualified to be appointed as a Judge of a High Court.
  2. A person with specialized knowledge of the finance and accounts of the government.
  3. A person with wide experience in financial matters and administration.
  4. A person with special knowledge of economics.

This composition ensures that the Commission possesses legal, administrative, financial, and economic expertise.

Diagram: Composition of the Finance Commission

graph TD
    A[President of India] -- Appoints --> B{Finance Commission};
    B --> C[Chairman <br> (Experience in Public Affairs)];
    B --> D[Member 1 <br> (High Court Judge Qualification)];
    B --> E[Member 2 <br> (Specialized knowledge of Govt. Accounts)];
    B --> F[Member 3 <br> (Experience in Financial Administration)];
    B --> G[Member 4 <br> (Special knowledge of Economics)];

• Explanation: This organogram clearly illustrates the appointing authority and the diverse expertise mandated by Parliament for the composition of the Finance Commission, ensuring a well-rounded and competent body.

4. Key Functions and the Principles of Devolution

The core function of the Finance Commission is to make recommendations that address the vertical and horizontal fiscal imbalances.

A. Vertical Devolution: Sharing between Union and States

This refers to the distribution of the "divisible pool" of central taxes between the Union government and the States as a collective whole.

• The Divisible Pool: This includes all central taxes, except cesses and surcharges, which the Centre retains exclusively. The increasing reliance of the Union on cesses and surcharges is a major point of contention, as it shrinks the size of the divisible pool available for states.
• The Process: The Commission recommends a specific percentage of the net proceeds of central taxes that should be devolved to the states. This recommendation is a cornerstone of its report.

Table: Vertical Devolution Recommended by Recent Finance Commissions

B. Horizontal Devolution: Allocation Among the States

Once the states' collective share is determined, the next crucial task is to decide the formula for distributing this share among the individual states. This is a highly complex and often contentious process, as it directly impacts each state's finances. The Commission uses a criteria-based formula to ensure equity and efficiency.

The criteria have evolved over time, balancing the principles of need (population, area), equity (income distance), and performance (demographic performance, fiscal effort).

Comparative Table: Horizontal Devolution Criteria (14th vs. 15th FC)

C. Grants-in-Aid

Beyond tax devolution, the Finance Commission recommends Grants-in-Aid under Article 275 of the Constitution. These are grants given to states that are deemed to be in need of financial assistance, over and above their share in taxes.

Types of Grants recommended by the 15th Finance Commission include:

1. Revenue Deficit Grants: To states that face a revenue deficit even after receiving their tax share.
2. Sector-Specific Grants: For critical sectors like health, education, and agriculture.
3. Performance-Based Grants: Linked to reforms in areas like power sector, agriculture, etc.
4. Grants to Local Bodies: To augment the resources of Panchayats and Municipalities.
5. Disaster Management Grants: For strengthening the disaster response funds of the states.

5. Judicial Interpretations and Landmark Cases

Direct judicial challenges to the recommendations of the Finance Commission are rare. The Supreme Court has generally practiced judicial restraint, viewing the Commission's recommendations as part of the executive's economic policy domain, which is non-justiciable. The advisory nature of the recommendations (under Article 281) means they do not create a binding legal right for states to claim a specific amount.

However, the judiciary has played a crucial role in shaping the broader landscape of fiscal federalism, which indirectly impacts the environment in which the Finance Commission operates.

• General Stance of the Judiciary: The Supreme Court has consistently held that it will not interfere in the economic policy decisions of the government, which includes the acceptance or rejection of the Finance Commission's report. The wisdom behind a formula devised by an expert body like the FC is not subject to judicial review unless it is proven to be arbitrary, mala fide, or unconstitutional.

• State of Kerala vs. Union of India (2024): While not directly about the Finance Commission, this ongoing case is significant. Kerala has challenged the Union's imposition of a net borrowing ceiling, arguing it infringes upon the state's fiscal autonomy under Article 293. The Supreme Court referring the matter to a Constitution Bench indicates the judiciary's willingness to delve into complex questions of fiscal federalism. The outcome could have profound implications for Centre-State financial relations and the principles the Finance Commission might need to consider in the future.

• Mineral Area Development Authority vs. Steel Authority of India (2024): In this landmark 8:1 judgment, the Supreme Court upheld the power of states to levy taxes on mineral rights, reinforcing the states' legislative domain in fiscal matters. The Court's powerful observations on the importance of protecting states' taxation powers to fund welfare schemes strengthens the principles of fiscal federalism. This judgment empowers states and provides a backdrop for future Finance Commissions to consider the independent revenue-generating capacities of states.

Key Takeaway on Judiciary: While there is no landmark case that directly alters the powers of the Finance Commission, the judiciary acts as a guardian of the federal structure. Its recent judgments on fiscal matters signal a strong commitment to protecting states' financial autonomy, which is the very principle the Finance Commission is designed to uphold.

6. Impact on Fiscal Policy and Contemporary Relevance

The recommendations of the Finance Commission have a profound and direct impact on the fiscal policies of both the Union and the States.

Impact on State Finances:

• Enhanced Fiscal Autonomy: The 14th FC's recommendation to increase the devolution to 42% was a watershed moment. It significantly increased the flow of "untied" funds to states, giving them greater flexibility to design and fund schemes according to their own priorities, rather than being dependent on centrally sponsored schemes.
• Budgetary Planning: The five-year award period of the Commission provides a predictable and stable resource envelope for states, enabling better long-term fiscal planning.
• Increased Expenditure on Development: Studies have shown that following the 14th FC's recommendations, states increased their developmental expenditure, particularly in sectors like rural and urban development.
• Fiscal Stress and Debt: While greater devolution provides resources, it also places the onus of fiscal discipline on states. Post the 14th FC award, the average fiscal deficit and debt-to-GSDP ratios of states saw an increase, highlighting the challenge of balancing autonomy with responsibility.

Impact on Union Finances:

• Shrinking Fiscal Space: Higher tax devolution to states reduces the net revenue available to the Union government. This has led the Centre to increasingly rely on cesses and surcharges (which are not part of the divisible pool) to fund its own expenditure, a practice widely criticized by states.
• Shift from Plan to Non-Plan Grants: With the abolition of the Planning Commission, the Finance Commission has become the primary body for determining most financial transfers to states, simplifying the process.

Contemporary Issues and Criticisms:

1. Cesses and Surcharges: The Union's increasing use of cesses and surcharges undermines the spirit of fiscal federalism by reducing the size of the divisible pool. This is a major source of friction between the Centre and states.
2. Use of 2011 Census Data: The 15th FC's use of the 2011 population data (instead of 1971) was heavily criticized by southern states, who argued it penalized them for successfully implementing population control policies. The introduction of the "Demographic Performance" criterion was a direct response to this concern.
3. GST Regime: The introduction of the Goods and Services Tax (GST) has fundamentally altered Centre-State financial relations. The Finance Commission now has to operate in a landscape where tax rates are decided by the GST Council, a separate constitutional body. The end of the GST compensation period has put many states under severe fiscal stress.
4. Conditionalities on Grants: The 15th FC introduced a higher share of conditional grants tied to specific reforms. While this can incentivize good governance, it is also seen by some states as an infringement on their autonomy and a move towards recentralization.
5. Emerging Challenges for the 16th FC: The newly constituted 16th Finance Commission, chaired by Dr. Arvind Panagariya, will face a complex set of challenges, including addressing the post-GST compensation fiscal cliff for states, the financing of climate action, and the growing trust deficit in fiscal relations.

7. A Comparative Perspective

While India's Finance Commission is a unique constitutional body, other federal countries have their own mechanisms for fiscal equalization.

• Australia: The Commonwealth Grants Commission (CGC) is a non-statutory, expert body that advises the government on the distribution of GST revenue among the states and territories. Its principle is "horizontal fiscal equalisation," aiming to provide states with the capacity to deliver services at a comparable standard. Unlike India's FC, its focus is purely horizontal.
• Canada: Canada uses a system of Equalization Payments, which are unconditional transfers from the federal government to lower-income provinces to help them provide public services that are reasonably comparable to those in other provinces, at reasonably comparable levels of taxation. The formula is determined by the federal government after consultations, lacking the quasi-judicial and independent nature of India's FC.
• USA: The US has a more "competitive federalism" model with no formal equalization body like India's. Federal grants to states are largely specific and conditional, often with matching requirements, giving the federal government significant leverage over state policies.

India's model, with a constitutionally mandated, independent, and periodic Finance Commission, strikes a balance between formula-based transfers and expert judgment, making it a robust pillar of its cooperative federal system.

8. Conclusion & Summary

The Finance Commission of India stands as a testament to the constitutional wisdom of its framers. It is more than just a fiscal body; it is a political institution that nurtures the delicate balance of a federal polity. By periodically recalibrating the financial relations between the Union and the States, it provides a mechanism for peaceful negotiation and resolution of fiscal conflicts.

From the landmark increase in devolution by the 14th FC to the complex balancing act of the 15th FC in the post-GST, pandemic-era economy, the Commission has consistently adapted to the nation's evolving needs. While it faces significant contemporary challenges—such as the shrinking divisible pool due to cesses, the politics of devolution criteria, and the need to incentivize fiscal discipline—its role as the "balancing wheel" of fiscal federalism remains indispensable. The success of the upcoming 16th Finance Commission will be crucial in restoring trust and strengthening the fabric of cooperative federalism in India.

Final Key Takeaway: The Finance Commission is a dynamic, adaptive, and essential institution that operationalizes fiscal federalism in India. Its recommendations, though advisory, have a profound impact on governance, public service delivery, and the political economy of Centre-State relations.

9. Practice Questions & Answers

✅ Multiple-Choice Questions (MCQs)

Q1. Under which Article of the Constitution of India is the Finance Commission constituted? (a) Article 275 (b) Article 280 (c) Article 281 (d) Article 293

Answer: (b) Article 280

• Explanation: Article 280 explicitly mandates the President to constitute a Finance Commission every five years or earlier. Article 275 deals with grants-in-aid, Article 281 with the laying of the Commission's report in Parliament, and Article 293 with borrowing by states.

Q2. Which of the following criteria was given the highest weightage by the 15th Finance Commission for horizontal tax devolution? (a) Population (2011) (b) Area (c) Income Distance (d) Demographic Performance

Answer: (c) Income Distance

• Explanation: The 15th Finance Commission allocated 45% weightage to the 'Income Distance' criterion, making it the single most important factor in its horizontal devolution formula, emphasizing the principle of equity.

Q3. The recommendations of the Finance Commission are: (a) Binding on the Government (b) Advisory in nature (c) Binding for a period of one year only (d) Binding only if approved by the Supreme Court

Answer: (b) Advisory in nature

• Explanation: As per constitutional convention and Article 281, the recommendations are advisory. However, they are generally accepted by the Union government to maintain fiscal discipline and cooperative federalism.

Q4. The 73rd and 74th Constitutional Amendments expanded the scope of the Finance Commission to recommend measures for: (a) Funding of defence expenditure (b) Managing disaster relief funds (c) Augmenting the resources of Panchayats and Municipalities (d) Reviewing the fiscal deficit of the Union government

Answer: (c) Augmenting the resources of Panchayats and Municipalities

• Explanation: These amendments strengthened local self-governance and tasked the Finance Commission with recommending measures to bolster the financial resources of local bodies, based on the reports of the State Finance Commissions.

🔍 Scenario-Based Question

Scenario: A group of Southern states argues that the 16th Finance Commission should not use the latest population data as a primary criterion for resource allocation, as it would penalize them for their successful population control measures. As a constitutional expert, what counter-arguments and balancing mechanisms could the Finance Commission employ to address this concern while still upholding the principle of 'need'?

Answer Framework: This question requires applying the principles of horizontal devolution. The Finance Commission needs to balance the 'need' principle (represented by population) with the 'performance' and 'equity' principles.

1. Acknowledge the Concern: The Commission should acknowledge the validity of the states' argument that they should not be penalized for good performance in socio-economic indicators like population control.
2. Introduce/Retain Performance-Based Incentives: The Commission can retain or enhance the weightage for the 'Demographic Performance' criterion, as introduced by the 15th FC. This would directly reward states with lower fertility rates.
3. Balance Multiple Criteria: Emphasize that population is only one of several criteria. The Commission can balance any potential loss from the population criterion by adjusting the weightage of other criteria like 'Income Distance' (which benefits poorer states, irrespective of population size) and 'Tax and Fiscal Efforts' (which rewards well-managed states).
4. Use of Sector-Specific Grants: The Commission can use targeted grants (under Article 275) for sectors like elderly care or urbanization in states with aging populations, thereby addressing their specific needs without altering the main devolution formula.
5. Constitutional Mandate: The Commission must ultimately base its recommendations on a holistic assessment that reflects the needs of the entire country, ensuring that states with larger populations (and thus, higher expenditure needs on public services) are not unduly deprived of resources. The key is to create a balanced and equitable formula that is seen as fair by all stakeholders.

🔄 Match the Following

Codes: (a) A-3, B-4, C-2, D-1 (b) A-4, B-3, C-1, D-2 (c) A-3, B-2, C-4, D-1 (d) A-1, B-4, C-2, D-3

Answer: (a) A-3, B-4, C-2, D-1

• Explanation:
  • 12th FC (Dr. C. Rangarajan) was instrumental in recommending the Fiscal Responsibility and Budget Management (FRBM) framework.
  • 13th FC (Dr. Vijay Kelkar) recommended a 32% share.
  • 14th FC (Dr. Y.V. Reddy) made the historic recommendation of a 42% share for states.
  • 15th FC (N.K. Singh) introduced 'Demographic Performance' and 'Tax Effort' as new criteria.

Recommended Books

You can explore these highly recommended resources for a deeper understanding.

• Indian Polity (English) by M Laxmikanth for UPSC CSE 2025 | 7th edition (latest) | Civil Services Exam - Prelims, Mains and Interview | State PSCs exams/ PCS exams - by M Laxmikanth
• Oswaal NCERT One For All Book for UPSC & State PSCs | Indian Polity Classes 6-12 - by Oswaal Editorial Board
• Bharat Ki Rajvyavastha (भारत की राजव्यवस्था) - M Laxmikanth for UPSC CSE