Q.13. What are the functions of Finance Commission? Examine its emerging role in Fiscal Federalism.

The Finance Commission of India is a constitutional body established under Article 280 of the Indian Constitution. Its primary functions include:

• Distribution of Revenue: Recommending the distribution of the net proceeds of taxes between the Union and the States, and among the States themselves.
• Grants-in-Aid: Determining the principles governing the allocation of Grants-in-Aid to the states from the Consolidated Fund of India.
• Financial Assessments: Assessing the financial relations between the Union and the States and suggesting measures for maintaining a stable financial system.
• Resource Allocation: Setting up rules regarding the distribution of tax revenues and determining the magnitude of Grants-in-Aid allocated to states and local bodies.

In terms of Fiscal Federalism, the Finance Commission plays a pivotal role in:

• Balancing Resources: It ensures a fair allocation of financial resources between the Centre and the States, which is essential for maintaining the federal structure of governance.
• Addressing Disparities: By recommending financial transfers to less economically developed states, the Commission helps bridge fiscal gaps and supports states with limited revenue-raising capacity.
• Promoting Cooperative Federalism: The Commission acts as an institutional mechanism that fosters cooperation between the Centre and the States, encouraging shared responsibility in fiscal matters.
• Adapting to Changes: The Commission’s role is evolving with the changing dynamics of the Indian economy and governance, ensuring that the principles of fiscal federalism remain relevant and effective.

The Finance Commission’s recommendations are crucial for the equitable distribution of finances, which in turn supports various states in meeting their fiscal needs and promotes overall economic growth and stability within the federal structure of India.

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How does the Finance Commission determine its recommendations?

The Finance Commission of India determines its recommendations through a comprehensive process that involves several steps:

• Assessment of Financial Health: The Commission assesses the financial health of the Union and the States, examining their revenue and expenditure patterns.
• Stakeholder Consultations: It conducts extensive consultations with the Central government, State governments, local bodies, and other stakeholders to understand their financial positions and needs.
• Expert Analysis: The Commission also engages with experts and academicians to get insights into the macroeconomic trends and fiscal policy matters.
• Terms of Reference (ToR): The Commission follows its Terms of Reference as provided by the President of India, which outlines the specific areas the Commission must cover in its recommendations.
• Equity and Efficiency: It aims to balance equity and efficiency in the distribution of resources, ensuring fairness while promoting fiscal discipline and incentivizing states to improve their performance.
• Use of Formulas: The Commission often employs formulas that consider factors like population, area, fiscal capacity, and fiscal effort to determine the distribution of taxes and grants among the states.
• Performance-Based Incentives: It may also recommend performance-based incentives for states to reward efforts in areas such as population control, fiscal management, and social sector performance.
• Final Report: After thorough analysis and deliberations, the Commission prepares a report with its recommendations and submits it to the President. The report is then laid before the Parliament and the state legislatures.

The recommendations of the Finance Commission are typically valid for a period of five years, and they play a crucial role in shaping the fiscal landscape of the country.

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The Finance Commission normally takes about two years to make their recommendations. As per the clause (1) of article 280 of the Constitution, the Finance Commission is to be constituted every fifth year or earlier. However, as the recommendations of the 15th FC cover the six-year period up to 31st March 2026, the 16th FC is proposed to be constituted now. This will enable the Finance Commission to consider and appraise the finances of the Union and the States for the period immediately, preceding the period of its recommendations. In this context, it is pertinent to mention that there are precedents where the Eleventh Finance Commission was constituted six years after the Tenth Finance Commission. Similarly, the Fourteenth Finance Commission was constituted five years and two months after the Thirteenth Finance Commission.

The Advance Cell of the 16th FC was formed in Ministry of Finance on 21.11.2022, to oversee preliminary work, pending formal constitution of the Commission.

Terms of Reference for the Sixteenth Finance Commission:

The 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 may be, 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.

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