Finance Commission and Centre-state financial relations

What does the Constitution say about the Finance Commission?

Article 280 requires the President to constitute a Finance Commission within two years from the commencement of the Constitution and then at the end of every fifth year, or earlier if the President thinks necessary. It has a chairman and four other members. Parliament decides their qualifications by law.

The Commission advises on the sharing of net tax proceeds between the Union and the states, the principles for grants-in-aid from the Consolidated Fund of India, measures to supplement state funds for panchayats and municipalities, and any other matter the President refers to it. Under Article 281 the President lays each recommendation before Parliament with an explanatory memorandum on the action taken.

The Commission is advisory. Its recommendations bind no one in law, yet under Article 281 the President lays each one before Parliament with a memorandum on the action taken, which gives the award strong political weight.

How are taxes shared: vertical and horizontal devolution

Vertical devolution decides the share of the divisible pool that goes to all states together. Horizontal devolution decides how that share is split among individual states. The Commission uses indicators such as population, area, income distance from the best-off state, forest and ecological cover and a demographic performance measure, with weights that change from one Commission to the next.

Successive Commissions have changed the states' share of the divisible pool and the mix of grants, so the exact percentages should be read from each Commission's report. The present Sixteenth Commission covers 2026-31 and recommended grants of Rs 4,35,236 crore for panchayati raj institutions and rural local bodies in all 28 states.

Alongside tax devolution, the Commission recommends revenue-deficit grants, sector-specific grants and performance-linked grants, so that poorer states can still offer a comparable level of public services.

Timeline of the Commissions and common issues

1. Union sets up the Commission ↓
2. Commission studies needs of Union and states ↓
3. Report with recommendations is submitted ↓
4. Union lays report and action taken in Parliament ↓
5. States receive shares and grants as awarded

The Commission also looks at the effect of the Goods and Services Tax, because the new indirect tax regime changed which levies feed the divisible pool and how states raise their own revenue.

The main tension is the gap between where taxes are raised and where spending duties lie. The Union holds the more elastic tax bases, while states carry large responsibilities such as health, education, police and agriculture. This gap is called vertical imbalance and the Commission exists to close it.

Common issues are listed below.

• Cesses and surcharges are outside the divisible pool, which shrinks what states receive.
• Centrally sponsored schemes can tie state money to Union priorities.
• Rewarding population control can penalise populous states.
• Borrowing limits restrict states even when they hold fiscal space.
• Grants must reach local bodies on time and in full.

A good answer also notes that equity and efficiency pull in different directions: formulas that favour poorer states can weaken the incentive of richer states to grow, so Commissions try to blend need with performance. Predictable transfers help states plan multi-year spending, while timely release of grants prevents local bodies from stalling works.

Points to use in answers

• Article 280 and Article 281 give the Commission a constitutional base and a duty of reporting to Parliament.
• Earlier Commissions changed the states' share and the grant mix; quote exact figures only from their reports.
• Sixteenth Commission: Rs 4,35,236 crore recommended for rural local bodies for 2026-31.
• Article 243I links the Union system to a State Finance Commission for panchayats.