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Finance Commission UPSC NOTE


Finance Commission
  • The Finance Commissions are commissions periodically constituted by the President of India under Article 280 of the Indian Constitution.

  • As per the constitution, the commission is appointed every five years.

  • It is constituted to define the financial relations between the central government of India and the individual state governments.

  • It is a quasi judicial body.

  • Has Powers of a Civil Court. As per Code of Civil Procedure 1908.

  • The First Commission was established in 1951 under The Finance Commission (Miscellaneous Provisions) Act, 1951.

  • Fifteen Finance Commissions have been constituted since the promulgation of Indian Constitution in 1950.


  • Chairman + 4 members (including an HC judge) appointed by President.

  • Parliament has the authority to decide qualifications 

  • Tenure — as specified by the President

  • Eligible for reappointment.

Finance Commission - Functions

  • Distribution of 'net proceeds' of taxes between Center and the States, to be divided as per their respective contributions to the taxes.

  • Determine factors governing Grants-in-Aid to the states and the magnitude of the same.

  • To make recommendations to the president as to the measures needed to augment the 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.

  • Any other matter related to it by the president in the interest of sound finance.

  • The FC evaluates the rise in the Consolidated Fund of a state in order to affix the resources of the state Panchayats and Municipalities.

  • The principles governing the grants-in-aid to the states by the Centre out of the consolidated fund of India.

Finance Commission - Importance

  • In the pre-reform period, the Finance Commission recommendations were not that critical because the Centre had other ways to compensate States, or indeed to play favourites, through plan financing and public sector undertaking (PSU) investments.

  • Post-reforms, fresh PSU investments have thinned out and the Planning Commission was abolished in 2014 with the result that the Finance Commission remains virtually the sole architect of India’s fiscal federalism. 

  • Its responsibility and influence are, therefore, much larger.

Issues facing

  • Currently, the Centre allocates 41% of its tax pool to the States. While States may demand an increase in this proportion.

  • It may be challenging to accommodate such demands due to the Centre’s own expenditure needs and borrowing limitations. 

  • Therefore, much of the debate will centre on the horizontal distribution formula.

Horizontal distribution formula:

  • During the appointment of the previous Finance Commission in 2017. 

  • It was asked to consider the 2011 population figures, deviating from the previous practice of using the 1971 population numbers.

  • States which had done well in stabilising population growth rates, typically the southern States, protested against this change in the base year, calling it a ‘penalty for good performance’.

Revenue deficit grants:

  • A similar conflict arises with regard to revenue deficit grants that the Finance Commission awards to States which remain in deficit on the current account even after tax devolution. 

  • In theory, revenue deficit grants have a neat rationale — that every State in a country should be able to provide a minimum level of service to its residents even if it involves an element of cross-subsidisation. 

  • The worry is that this too has become a perverse incentive. 

  • States are not bothered about raising revenues on their own because they think that the Finance Commission will compensate them.

Allocation for Fiscal Deficit:

  • Historically, Finance Commissions have struggled to determine how much a State’s deficit is due to its fiscal incapacity and how much is due to fiscal irresponsibility.

  • They have tried to tweak the distribution formula to support deficit States without penalising responsible States, a mathematically impossible task since you cannot give more to a State without giving less to another. 

  • Therefore every horizontal distribution formula has been criticised as being inefficient or unfair.

North-south divide:

  • Ruling party being confined to the northern States while the Opposition parties rule the southern States.

  • Southern States of the country are doing better in terms of infrastructure, private investment, social indicators and the rule of law, which has put them on a virtuous cycle of growth and prosperity and widened the north-south gap.

North-south divide:

  • The challenge for the government lies in defining the terms of reference for the Finance Commission, ensuring that richer States compensate poorer ones without exacerbating the divide.

  • The Finance Commission itself will need to deliver on these terms of reference, navigating the complexities of horizontal distribution.

Cesses and surcharges:

  • Centre increasingly resorting to a levy of cesses and surcharges rather than raising taxes.

Cesses and surcharges:

  • This practice creates a perverse incentive.

  • The straightforward option for raising revenues is to raise taxes, but if the Centre does that, it has to part with 41 (41%) paise to States. 

  • On the other hand, if Centre raises the additional rupee by way of a surcharge, it gets to keep all of it.

  • When the Constitution was amended in 2000 to allocate a share of the Centre’s tax pool to the States, it was understood that cesses and surcharges would be used sparingly, rather than as a routine practice.

Cesses and surcharges:

  • As a result of this breach of understanding, States have felt cheated out of their legitimate share of national tax revenue. 

  • The next Finance Commission should lay down guidelines for when cesses and surcharges might be levied, and also suggest a formula to cap the amount that can be raised.


  • The Fiscal Responsibility and Budget Management (FRBM) Act was intended to act as a check on populist spending, governments have found ways to raise debt without it being transparently reflected in the budget.

  • It is not easy to unambiguously define a freebie, and any check on this will be contested as infringing on the sovereignty of elected governments.

  • In the interest of long-term fiscal sustainability, Finance Commission should lay down guidelines on the spending on freebies.



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Learnerz IAS | Concept oriented UPSC Classes in Malayalam: Finance Commission UPSC NOTE
Finance Commission UPSC NOTE
Learnerz IAS | Concept oriented UPSC Classes in Malayalam
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