Finance Commission, fiscal federalism and the 16th FC – OPSC OAS Mains GS Paper II PYQ

📝Model Answer

Introduction

The Finance Commission is a constitutional body under Article 280, constituted by the President every five years to recommend the distribution of tax revenues between the Union and States, their allocation among States, and the principles governing grants-in-aid. It is the principal balancing institution of India’s fiscal federal structure.

Body

Role of the Finance Commission in Upholding Fiscal Federalism

1. Correcting vertical imbalance — It addresses the mismatch between the Centre’s larger revenue powers and the States’ wider expenditure responsibilities by recommending a share of the divisible tax pool.
2. Reducing horizontal imbalance — Through a formula based on income distance, population, area and demographic performance, it ensures equity between richer and poorer States.
3. Ensuring fiscal autonomy — Untied tax devolution gives States the freedom to spend according to their own development priorities, strengthening cooperative federalism.
4. Grants-in-aid mechanism — Revenue deficit grants, sector-specific and State-specific grants help fiscally weaker States meet essential needs.
5. Strengthening local governance — It recommends grants to panchayats and municipalities, deepening fiscal federalism to the third tier.
6. Neutral arbiter — As an independent constitutional body, it depoliticises Centre–State financial relations and lends credibility and stability to fiscal transfers.

Terms of Reference of the 16th Finance Commission

The 16th FC, chaired by Dr. Arvind Panagariya, covers the award period 2026–27 to 2030–31 and was mandated to recommend:

1. Tax devolution — Distribution of the net proceeds of taxes between the Union and States, and their allocation among States.
2. Grants-in-aid — Principles governing grants-in-aid to States out of the Consolidated Fund of India.
3. Local body funds — Measures to augment State funds to supplement resources of panchayats and municipalities.
4. Disaster financing — Review of arrangements for financing disaster management initiatives under the Disaster Management Act, 2005.
5. Promoting fiscal stability — Consideration of sound finance, fiscal consolidation and broader macroeconomic needs.

Key Recommendations of the 16th Finance Commission

1. Vertical devolution retained at 41% — The States’ share in the divisible pool remains unchanged from the 15th FC.
2. Performance-linked horizontal devolution — A new 10% weight for contribution to GDP was introduced, while the tax/fiscal effort criterion was removed, signalling a shift from entitlement-based to compliance-driven federalism.
3. Fiscal discipline — State fiscal deficits to be capped at 3% of GSDP, with off-budget borrowings ended and all liabilities included in fiscal deficit; combined Centre–State debt projected to fall from 77.3% to 73.1% of GDP by 2030–31.
4. Subsidy rationalisation — States urged to rationalise subsidies, set clear exclusion criteria, and exercise caution on unconditional cash transfers.
5. Power sector reforms — States encouraged to privatise DISCOMs, with legacy debt parked in a Special Purpose Vehicle.
6. Local body and disaster grants — Conditional grants tied to constitution of local bodies, audited account disclosure and timely State Finance Commission formation, alongside strengthened disaster funding.

Criticism of the 16th Finance Commission Recommendations

1. Shrinking untied funds — Greater conditionality and compliance-linked transfers reduce States’ fiscal autonomy and flexible spending space.
2. Equity concerns — Introducing a GDP-contribution weight may favour richer States and disadvantage poorer ones, undermining the redistributive purpose.
3. Southern States’ grievance — Their demand for a 50% devolution share was not met; the unchanged 41% leaves their concerns unaddressed.
4. Centralising tilt — Emphasis on fiscal discipline and compliance is seen as expanding the Centre’s leverage over State finances.
5. Cesses and surcharges untouched — The growing share of cesses and surcharges outside the divisible pool continues to shrink the effective devolvable resource base.
6. Restraint on welfare spending — Warnings against cash-transfer schemes are viewed as encroaching on States’ democratic and policy choices.

Conclusion