16th Finance Commission

Finance Commission may also study and examine major overhauls in the revenue structure of Revenue laws of the Centre and the states and recommend major changes as the Centre and States have been silent on amendments in tax structure except peripheral tax rate changes, which is not enough. Fiscal indiscipline needs to be tamed. — Vinod Johri

 

The Government of India, with the approval of the President of India, has constituted the Sixteenth Finance Commission, in pursuance to Article 280(1) of the Constitution. Dr Arvind Panagariya, former Vice-Chairman, NITI Aayog, and Professor, Columbia University will be the Chairman.  Members of the Sixteenth Finance Commission would be notified separately. Shri Ritvik Ranjanam Pandey has been appointed as Secretary to the Commission.  Detailed terms of reference for Sixteenth Finance Commission have also been spelt out in the notification issued today.

The Sixteenth Finance Commission shall make recommendations as to the following matters, namely: —

1.    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;

2.    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

3.    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. 

The Sixteenth Finance Commission may review the present arrangements on financing Disaster Management initiatives, with reference to the funds constituted under the Disaster Management Act, 2005 (53 of 2005), and make appropriate recommendations thereon.

The Sixteenth Finance Commission has been requested to make its report available by 31st day of October, 2025 covering a period of five years commencing on the 1st day of April, 2026.

The terms of reference (ToR) of the 16th Finance Commission can be considered as a fresh and welcome departure from the earlier practice of giving a detailed set of considerations. This implies that the Commission is free to determine scope of its work, approach and methodology. The Commission would be free to choose the Census year for state-wise population without any direction from Government of India (GoI) through the ToR. It may be noted, however, that the 2021 Census has not been carried out and the latest available Census data pertains to 2011. 

The subject of determination of grants and tax devolution in India requires consideration of three types of imbalances namely, vertical, horizontal, and fiscal. Fiscal imbalance deals with the borrowing undertaken by Central and State governments to fill up part of the resource gap, which is not met by the availability of resources after transfers from the GoI.

In the context of vertical imbalance, Chart shows a convergence between the Centre’s net tax revenue and states’ tax revenues post tax devolution during FY 2001 to FY 2008. These years were covered largely by the recommendations of 11th and 12th Finance Commissions. After FY 2010, the gap between the two started to increase with states’ post devolution tax-GDP ratio exceeding that of the Centre by a wide margin, resulting in a squeezing of fiscal space for the Centre.

Apart from the key recommendation on distribution of net proceeds of taxes between the Centre and States and allocation among States of the respective share of such proceeds, the panel will also prescribe measures needed to augment the Consolidated Fund of a State to supplement resources of the panchayats and local bodies on the basis of recommendations made by the respective State Finance Commissions.

Under the ToR, the panel will recommend principles that 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. Also, it may review the existing arrangements on financing Disaster Management initiatives and make appropriate recommendations.

Some criticism was also made about lack of clarity on whether the proposed commission would give recommendations based on criteria and weights assigned for horizontal devolution. The previous 15th Finance Commission had retained the criteria and weights according to which 15 per cent weight each is for population and area, 10 per cent for forest and ecology, 45 per cent of income distance, 2.5 per cent for tax and fiscal efforts and 12.5 per cent for demographic performance.

This is a point of discomfort for the southern States which have higher human development indices and low population. In the fiscal redistribution process based on weightage to population, their shares get reduced. 

Over the years, Finance Commissions have influenced public finance, governance, and development in India significantly. Following their recommendations, tax devolution became a major component of vertical transfers, increasing states’ shares progressively from 10% to 42%. The commissions have also encouraged performance-based incentives for states in areas like fiscal discipline, population control, forest conservation, and power sector reforms. To strengthen public trust and ensure effective implementation of its recommendations, the Finance Commission should prioritise transparency and accountability in its operations. This could involve publishing detailed reports on its deliberations, making data and analysis readily accessible to the public, and establishing clear mechanisms for stakeholder engagement. By fostering openness and accountability, the commission can enhance the credibility and legitimacy of its work.

The 16th finance Commission headed by Shri Arvind Pangarhia has in a departure from recent history, not been issued any specific tasks leaving it free to determine the scope off its recommendations. This gives the Commission more elbow room to go about strengthening fiscal federalism. Its job is to ensure balance in resource transfers between the Centre and states and among states. But the task is nuanced. States grudgingly relinquish their resource raising capacity and resent any loss of agency over expenditure. The Centre on its part would like to see the larger devolution to the states put to responsible use and tries to nudge states towards fiscal responsibility. States also need to be convinced that the formula for dividing resources does not disincentive outperformance and delivers on curbing unwanted migration. 

The 16th finance Commission has the freedom to choose its population data. But it will not have the 2021 census data to go by. Population is a key determinant of how much a state received as its share of the divisible pool of government resources. States that have stabilised their population growth, and, thereby bumped up their per capita income, would have gone further down that path between 2011 and 2021. Without the 2021 data, however there would have to be an approximation of the performance of lagging states. The extent of migration over a decade would also involve an element of uncertainty. This makes assessment of social sector spending outcomes more difficult than it should be. The Centre now draws less from the combined resource pool then the states, but is directing spending through Capex and welfare payments. 

The past experience over a decade shows that the states lack resource mobilisation initiatives and depend more on taxes and revenues charged on citizens. Finance Commission should incentivise the lagging states with resource generation with industrialisation and business creation in backward areas for job creation and zero poverty in such areas. Without job creation and upliftment of the poor, the high GDP or third slot in the global economy are meaningless and will end up widening the gap in rich and the poor.  Development is itself major job creator. Populism and freebies culture have reached retrograde. Major infrastructure projects are executed by the Centre while poor states even lack initiatives on development. Finance Commission may also study and examine major overhauls in the revenue structure of Revenue laws of the Centre and the states and recommend major changes as the Centre and States have been silent on amendments in tax structure except peripheral tax rate changes, which is not enough. Fiscal indiscipline needs to be tamed.         

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