Knowledge Nugget |16th Finance Commission Report: Key highlights for UPSC and other competitive exams

Key Takeaways:

1. The Finance Commission is a constitutionally mandated body that decides, among other things, the sharing of taxes between the Centre and the states. 

2. Article 280 (1) requires the President to constitute, “within two years from the commencement of this Constitution and thereafter at the expiration of every fifth year or at such earlier time as the President considers necessary”, an FC “which shall consist of a Chairman and four other members”.

3. The commission make recommendations on:

• How to divide the net proceeds of Union taxes, commonly described as the divisible pool, between the Union and States (vertical devolution), 

• How to apportion the States’ share in this pool among them (horizontal devolution),

• What principles should govern the grants‑in‑aid of the revenues of the States out of the Consolidated Fund of India, and 

• What measures should be taken to augment the State revenues to supplement the resources of the local bodies constituting the third tier of the government during a specified period, usually five years. 

Recommendations of 16th Finance Commission

1. The 16th Finance Commission was constituted by the President on 31 December 2023 under the chairmanship of Dr. Arvind Panagariya, former Vice- chairman of NITI ayog,  The Commission was mandated to make its recommendations for the five‑year period commencing on 1 April 2026 and ending on 31 March 2031. 

16th Finance Commission chairman Arvind Panagariya (File Photo)

2. The Commission has kept the vertical devolution intact, retaining the states’ share in the divisible pool at 41 per cent. But, in determining the horizontal devolution, it has deviated from the previous Commission on the criteria and weights to be used. 

3. The change in the states’ share is due to a change in formula adopted by the 16th Finance Commission, based on six criteria, including some new ones: 

• Population (17.5 per cent weight), 

• Demographic performance (10 per cent), 

• Area (10 per cent), 

• Forest (10 per cent), 

• Per capita GSDP distance (42.5 per cent) and 

• Contributions to GDP (10 per cent).

4. Introduction of ‘contribution to GDP’ as a new criteria with 10 per cent weight and lowering the weight for ‘area’ criteria to 10 per cent from 15 per cent, seem to have worked in favour of southern states.

5. The Finance Commission has also made some welcome recommendations in areas such as state finances. For instance, it has argued that states should discontinue the practice of incurring off-budget borrowings, while keeping the deficit capped at 3 per cent of GSDP.

6. Considering the concerns over “fiscal populism”, also articulated by the Economic Survey, the Commission has recommended the rationalisation of subsidy schemes and the introduction of “sunset clauses” for schemes that give subsidies on non-merit private goods and unconditional transfers. 

7. The 16th Finance Commission has recommended privatising the country’s power distribution sector as a crucial step to modernise it and address its long-standing financial stress. It also sought to create incentives for privatisation by devising a mechanism to shield private investors from accumulated debt burden of distribution utilities after their takeover.

(Image: Generated by NotebookLM)

8. To make discoms a better investment opportunity, it puts emphasis on the state governments to create special purpose vehicles (SPV) where all the accumulated working-capital loans and other non-asset-backed debt are parked.

BEYOND THE NUGGET: Key channels through which resources flow from the Union to the States

There are three main channels through which resources flow from the Union to the States.

1. First, under Article 270(1) of the Constitution, the Union’s tax revenues, excluding cesses, surcharges, taxes accruing to the Union Territories (UTs), and the cost of collection, are shared between the Union and the States based on the recommendations of the FC.

2. Second, under Article 275(1), the FC recommends specific grants to supplement the Consolidated Funds of the States. 

3. Finally, under Article 282, the Union provides discretionary grants to States, mainly through the Centrally Sponsored Schemes (CSS). 

Post Read Question

Consider the following: (UPSC CSE 2023)

1. Demographic performance

2. Forest and ecology

3. Governance reforms

4. Stable government

5. Tax and fiscal efforts

For the horizontal tax devolution, the Fifteenth Finance Commission used how many of the above as criteria other than population area and income distance?

(a) Only two

(b) Only three

(c) Only four

(d) All five

(Sources: fincomindia.nic.in,  16th Finance Commission: Higher tax share for south states, Hindi heartland states see dip)

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