Introduction

The Sixteenth Finance Commission, led by former Niti Aayog Vice-Chairman Arvind Panagariya, has commenced its work by seeking public input on its mandate from the Centre. Constituted in December last year, this latest Commission, which includes five members, is expected to submit its recommendations by October 2025. These recommendations will guide the distribution of tax revenues for five years starting from April 1, 2026.

Understanding the Finance Commission

• The Finance Commission is a constitutional body responsible for recommending how tax revenues collected by the Central government should be distributed between the Centre and the States.
• Although the Centre is not legally obligated to implement its recommendations, the Commission plays a critical role in ensuring fiscal balance within the country.
• Reconstituted every five years, the Commission typically takes a couple of years to formulate its recommendations.

Decision-Making Process

• The Finance Commission’s decisions revolve around two main aspects: vertical and horizontal devolution. Vertical devolution determines the overall share of the Centre’s net tax revenue that goes to the States, while horizontal devolution decides how this share is distributed among individual States.
• The latter is based on a formula that considers factors such as population, fertility levels, income levels, and geography.
• While there is no set formula for vertical devolution, recent Commissions have advocated for a higher share of tax revenues for States.
• For instance, the 13th, 14th, and 15th Finance Commissions recommended that 32%, 42%, and 41% of the divisible pool, respectively, be shared with the States.

Enhancing Local Revenues

• The Sixteenth Finance Commission is also expected to propose measures to boost the revenues of local bodies like panchayats and municipalities.
• As of 2015, local bodies in India account for only about 3% of public spending, significantly lower than countries like China, where over half of public spending occurs at the local level.

Centre-State Tensions

• Tensions between the Centre and States over tax revenue sharing have been longstanding.
• The Centre collects major taxes such as income tax, corporate tax, and GST, while States rely mainly on taxes from goods like liquor and fuel, which are outside the GST framework.
• States argue that despite their significant responsibilities in delivering services like education, healthcare, and policing, the Centre has curtailed their tax-collecting powers and does not allocate sufficient funds.

Points of Contention

• States often demand a higher share of tax proceeds than what the Finance Commission recommends, citing their greater responsibilities.
• They also contend that the Centre does not always allocate the recommended funds.
• Analysts note that under the current Fifteenth Finance Commission, the Centre has devolved an average of only 38% of funds from the divisible pool to the States, compared to the Commission’s recommendation of 41%.
• States also dispute what portion of the Centre’s overall tax revenues should be considered part of the divisible pool.
• Cesses and surcharges, which are not shared with States, can account for up to 28% of the Centre’s tax revenues in some years, leading to significant revenue loss for States.
• As a result, even with increased devolution from the divisible pool, the overall share of States in the Centre’s tax revenues could fall to as low as 32% under the 15th Finance Commission.
• Additionally, more developed States like Karnataka and Tamil Nadu argue that they receive less money from the Centre relative to their tax contributions.
• For example, Tamil Nadu receives only 29 paise for each rupee it contributes to the Centre, while Bihar receives more than ₹7 per rupee contributed.
• This disparity is seen as a penalty for better-governed States to support those with poorer governance.
• Critics also question the independence of the Finance Commission, given its members are appointed by the Centre, potentially exposing it to political influence.

Conclusion

The Sixteenth Finance Commission faces the challenging task of balancing the fiscal needs and responsibilities of both the Centre and the States. By seeking public input and considering expert recommendations, it aims to create a more equitable and efficient framework for tax revenue distribution that supports both national and local development.