Constitutional Basis

The Finance Commission is established under Article 280 of the Constitution. The President is required to constitute it within two years of the Constitution's commencement and thereafter at the expiration of every fifth year or at such earlier time as the President considers necessary.

It is a constitutional body, not a statutory or permanent body — a fresh Commission is constituted every five years.

Article Provision
Art. 280 Constitution, composition, and functions of the Finance Commission
Art. 281 Recommendations of the Commission laid before each House of Parliament

Composition

The Finance Commission consists of a Chairman and four other members, all appointed by the President. Parliament is empowered to prescribe qualifications for members and the manner of selection.

Qualifications prescribed under the Finance Commission (Miscellaneous Provisions) Act, 1951:

  • Chairman: Person with experience in public affairs
  • Four members drawn from among persons who are / have been:
    • A judge of a High Court, or
    • Have knowledge of finance / accounts of government, or
    • Have wide experience in financial matters and administration, or
    • Have special knowledge of economics

Members serve until the Commission submits its report. The Commission is not a permanent body.

Functions

The Finance Commission recommends to the President:

  1. Distribution of net proceeds of taxes between the Union and the States (vertical devolution) and the allocation of each State's share among the States (horizontal devolution)
  2. Principles governing grants-in-aid to States from the Consolidated Fund of India (Article 275)
  3. Measures to augment the Consolidated Fund of a State to supplement resources of Panchayats and Municipalities
  4. Any other matter referred to it by the President in the interest of sound finance

The Commission's recommendations are advisory, not binding, but are accepted by convention.

Vertical and Horizontal Devolution

Vertical Devolution — the share of the divisible pool of central taxes that goes to all States collectively.

Horizontal Devolution — the formula for distributing the States' aggregate share among individual States.

The divisible pool consists of all central taxes and duties after excluding cesses and surcharges and the cost of collection.

Concept Description
Vertical devolution Total % of central tax revenue transferred to States collectively
Horizontal devolution Criteria for sharing among individual States (population, area, income distance, forest cover, etc.)
Grants-in-aid Revenue deficit grants, sector-specific grants, performance incentive grants

Key Criteria Used for Horizontal Devolution (15th FC)

Criterion Weight
Income distance (fiscal equalisation) 45%
Population (2011 Census) 15%
Area 15%
Forest and ecology 10%
Demographic performance 12.5%
Tax effort 2.5%

15th Finance Commission (2021–26)

Chairman: N. K. Singh
Period covered: 2021–22 to 2025–26
Report submitted: February 2021

Key Recommendations

  • Vertical devolution: States' share in central taxes set at 41% of the divisible pool (same as for 2020-21; reduced from 42% recommended by the 14th FC to account for newly formed UTs of Jammu & Kashmir and Ladakh)
  • Revenue deficit grants: Recommended for 17 States in 2021–22 (tapering over the award period)
  • Sector-specific grants: Allocated across 8 sectors — health, school education, higher education, agriculture reforms, maintenance of PMGSY roads, judiciary, statistics, and aspirational districts/blocks
  • Performance-based grants: A portion of grants linked to measurable outcomes to incentivise states

14th FC vs 15th FC

Feature 14th FC (2015–20) 15th FC (2021–26)
Vertical devolution 42% 41%
Population data used 1971 Census 2011 Census
Chairman Y. V. Reddy N. K. Singh
Special grants Revenue deficit grants Revenue deficit + sector-specific + performance grants

Grants-in-Aid (Article 275)

Grants-in-aid from the Consolidated Fund of India to States are of two types:

  • Statutory grants (Art. 275): Recommended by Finance Commission — for states whose revenues are inadequate to meet the costs of general administration
  • Discretionary grants (Art. 282): Given by Union or States for any public purpose — not based on FC recommendation

Finance Commissions at a Glance

Commission Period Chairman Vertical Devolution
1st FC 1952–57 K. C. Neogy 55.55% (of income tax)
11th FC 2000–05 A. M. Khusro 29.5%
13th FC 2010–15 Vijay Kelkar 32%
14th FC 2015–20 Y. V. Reddy 42% (historic high)
15th FC 2021–26 N. K. Singh 41%

Exam Relevance

Prelims traps:

  • Finance Commission is a constitutional body (Article 280), not a statutory body
  • Its recommendations are advisory — not legally binding on the government
  • It is not a permanent body — reconstituted every 5 years
  • 15th FC used 2011 Census data (not 1971) for population criterion — a deliberate policy shift rewarding states that achieved demographic transition

Mains angles:

  • Tension between vertical and horizontal equity in devolution
  • Role of Finance Commission in cooperative federalism vs Centre-State fiscal asymmetry
  • Criticism: cesses and surcharges are excluded from the divisible pool, reducing States' effective share
  • 16th Finance Commission (constituted 2023, to cover 2026–31, Chairman: Arvind Panagariya) — significance of using updated demographic data