The Finance Commission and vertical devolution

Detail

1. Why a Finance Commission is needed

• Fiscal federalism means taxing and spending powers are divided between the Union and the states.
• Vertical fiscal imbalance: the Union collects most of the tax money. The states carry out most of the spending, such as health, police, agriculture and schools. So there is a gap between what states earn and what they must spend.
• Horizontal fiscal imbalance: some states are richer than others. Poorer states cannot raise enough money to give their people the same level of services.
• The Finance Commission (FC) corrects both gaps every five years. That is why it is called the "balancing wheel of fiscal federalism".

2. Constitutional basis: Art. 280

• Art. 280(1): the President sets up a Finance Commission every five years, or earlier if needed.
• Composition: a chairman and four other members.
• Finance Commission (Miscellaneous Provisions) Act 1951: Parliament passed this law under Art. 280(2). It sets out who can be chairman or a member.
• Chairman: a person with experience in public affairs.

• The four members come from four backgrounds:

  • a High Court judge, or a person qualified to become one;
  • a person with special knowledge of government finance and accounts;
  • a person with wide experience in financial matters and administration;
  • a person with special knowledge of economics.

• Nature of the body: it is a constitutional body (created by the Constitution itself). It is set up again for each award period. It is not a permanent office.

3. The mandate: Art. 280(3)

Clause	Duty	Note
(a)	Distribute the net proceeds of shareable taxes between the Union and the states (vertical), and among the states (horizontal, §4)	The core task
(b)	Lay down the principles for grants-in-aid under Art. 275 (§5)	Grants from the Consolidated Fund of India to states that need help
(bb)	Suggest measures to increase a state's Consolidated Fund so it can support panchayats	Added by the 73rd Amendment (1992)
(c)	Same, for municipalities	Added by the 74th Amendment (1992)
(d)	Any other matter the President refers to it	15th FC: a defence and internal-security fund. 16th FC: financing disaster management

• Net proceeds: tax collected minus the cost of collection.
• Shareable taxes / divisible pool: the part of central taxes that must be shared with states. It leaves out cesses and surcharges and the cost of collection [3].
• Cess: a tax charged for a stated purpose, such as the Health and Education Cess.
• Surcharge: an extra tax charged on top of a tax, such as on high incomes.
• The Centre keeps 100% of both.

4. Report, action taken and status

• Art. 281: the President has the report laid before both Houses of Parliament. It comes with an explanatory memorandum (a note from the government saying which recommendations it accepts, and why it rejects any others).
• For the 16th FC, the government laid the report and the explanatory memorandum under Art. 281 [2].
• Status: its advice is advisory, not binding in law.
• Convention: in practice, the Union has always accepted the devolution share that the FC recommends.

5. Vertical devolution: meaning and formula

• Vertical devolution = the share of the divisible pool that goes to all states together.
• Formula:
• Divisible pool = Gross Tax Revenue (GTR) − cesses and surcharges − cost of collection

• States' devolution = Vertical share (%) × Divisible pool

• Worked example (illustrative numbers):

• Centre's GTR = ₹100.
• Cesses and surcharges = ₹15. Cost of collection = ₹1.
• Divisible pool = 100 − 15 − 1 = ₹84.
• States get 41% × 84 = ₹34.4.

• So a "41%" share is only about 34% of GTR.

• Real data: the 41% share worked out to only 32% of the Centre's gross tax revenue in 2024-25 (Budget Estimates) [4].

6. Vertical devolution: timeline

FC	Chair	Period	States' share
1st	K.C. Neogy	1952-57	A share of income tax and some excise duties only
10th	K.C. Pant	1995-2000	29% of all central taxes ("alternative scheme"). This became law through the 80th Amendment (2000)
11th	A.M. Khusro	2000-05	29.5%
12th	C. Rangarajan	2005-10	30.5%
13th	Vijay Kelkar	2010-15	32%
14th	Y.V. Reddy	2015-20	42%
15th	N.K. Singh	2020-21 and 2021-26	41%
16th	Arvind Panagariya	2026-31	41%

• Early FCs (1st to 9th): only certain taxes were shared, mainly income tax and Union excise duties.
• 10th FC "alternative scheme": states get a fixed share of the whole pool of central taxes, instead of tax-by-tax sharing.
• The 80th Amendment (2000) rewrote Art. 270 to make this law.

• Benefit: states share in the growth of all taxes, so their income is steadier.

• 14th FC jump (32% → 42%):

• This was the largest single rise. The report was tabled in Parliament, and the 42% was recommended by majority decision [5].

• It was a structural shift towards untied transfers. Tax devolution is untied money: states can spend it on anything they choose. Scheme grants are tied money: they must be spent on a fixed purpose.

• 15th FC (41%): the share was cut by 1 percentage point. That 1% covers the needs of the new Union Territories of Jammu & Kashmir and Ladakh (created in 2019). UTs are funded by the Centre.

7. The 16th Finance Commission (2026-31)

• Constituted: 31 December 2023. Chair: Arvind Panagariya.
• Report submitted to the President: 17 November 2025 [2].
• Tabled in Parliament: 1 February 2026, together with Budget 2026-27 [3].
• Vertical share: 41%, the same as the 15th FC [3].
• Government response:
• It accepted the 41% vertical share [2].

• It provided ₹1.4 lakh crore as FC grants for 2026-27. These cover rural local body, urban local body and disaster management grants [2].

• Grants over the full period 2026-31: ₹9.47 lakh crore [3]:

• rural local bodies: ₹4.35 lakh crore
• urban local bodies: ₹3.56 lakh crore

• disaster management: ₹1.55 lakh crore

• Grants dropped: the 16th FC stopped three kinds of grants that the 15th FC had given [3]:

• revenue deficit grants (help for states whose regular income is lower than their regular spending);
• sector-specific grants;

• state-specific grants.

• Conditions for local body grants: the local bodies must be constituted as the Constitution requires; their audited accounts must be published; and State Finance Commissions must be set up on time [3].

• Horizontal criteria (link to §4):
• Population (2011 Census).
• Income distance: the gap between a state's per capita GSDP and the average of the top three large states. Poorer states get more.
• Demographic performance: now measured by population growth between 1971 and 2011, instead of the change in the fertility rate [3].

8. The debate over the vertical share

• Many states' demand: raise the share to 50%.
• The Centre's case: it needs money for defence, interest payments, central schemes and fiscal space (room in the budget for new spending or emergencies).
• The cess and surcharge problem:
• The chain: cesses and surcharges are not shared → when the Centre raises more money through them, the divisible pool shrinks → states get a smaller real share, even though the "41%" does not change.
• Cesses and surcharges were 2.3% of GTR in 1980-81 and 15% in 2019-20 [6].
• More than 15% of GTR was raised as cesses and surcharges between 2020-21 and 2022-23 [4].
• Result: 41% of the pool was only about 32% of GTR (2024-25 BE) [4].

Prelims Hooks

• Art. 280: the President constitutes the FC every five years or earlier. It has a chairman + 4 members. Their qualifications come from the FC (Miscellaneous Provisions) Act 1951, not from the Constitution.
• Art. 281: the FC report and an explanatory memorandum are laid before Parliament. The FC's advice is not binding.
• Art. 280(3)(bb) and (c) (panchayats and municipalities) were added by the 73rd and 74th Amendments (1992).
• The divisible pool leaves out cesses, surcharges and the cost of collection. Trap: "41% of all central tax revenue" is wrong.
• 10th FC (K.C. Pant) gave the "alternative scheme" of 29% of all central taxes. It became law through the 80th Amendment (2000).
• Highest vertical share: 42%, by the 14th FC (Y.V. Reddy, 2015-20), up from 32% under the 13th FC.
• The 15th FC cut the share to 41% because of the new UTs of J&K and Ladakh.
• 16th FC: chair Arvind Panagariya; period 2026-31; share 41%; report submitted 17 Nov 2025; tabled 1 Feb 2026.
• The 16th FC discontinued revenue deficit grants, as well as sector-specific and state-specific grants.
• 16th FC grants for 2026-31: ₹9.47 lakh crore. Rural local bodies get the largest part, ₹4.35 lakh crore.

Mains Points

• "Balancing wheel" under strain: the headline vertical share has stayed at 41-42% since 2015. But the growth of cesses and surcharges (2.3% of GTR in 1980-81 → 15% in 2019-20) means states actually receive only about 32% of GTR (2024-25 BE) [4][6]. Possible reforms:
• put a cap on cesses and surcharges; or

• bring them into the divisible pool once they cross a set limit.

• Untied versus tied transfers: the 14th FC's 42% gave states more freedom to spend (cooperative federalism). The Centre, however, then made more use of centrally sponsored schemes, which are tied to fixed purposes. This limits how much of that freedom states really get (GS-II: Centre-state relations).

• Stability versus need (16th FC): the 16th FC kept 41% and dropped revenue deficit grants [3]. This rewards states that manage their money well and cuts soft-budget dependence (states running deficits because they expect the Centre to cover them). But weaker states lose a safety net, and states' demand for 50% remains unmet.
• Local governments: ₹7.91 lakh crore of the 16th FC grants goes to local bodies (rural + urban). The grants carry conditions: audited accounts and State Finance Commissions set up on time [3]. This links the FC to the goals of the 73rd and 74th Amendments.