Balancing Act: The 16th Finance Commission and India’s Tax Devolution

The 16th Finance Commission of India, set to be established in November 2023, has a critical mandate in addressing several key aspects of fiscal federalism and tax devolution. The Finance Commission, a constitutionally mandated body under Article 280 of the Indian Constitution, is responsible for recommending the distribution of tax revenues between the Centre and the states, and among the states themselves. This includes determining the division of net proceeds of taxes and the allocation of grants-in-aid to the states from the Consolidated Fund of India​​​​.

The terms of reference (ToR) for the 16th Finance Commission have been approved by the Union Cabinet, chaired by Prime Minister Narendra Modi. The Commission will review the devolution of taxes between the Centre and states for the five-year period from April 1, 2026, to March 31, 2031. Its report is expected to be submitted by October 31, 2025​​​​.

Key points to be addressed by the 16th Finance Commission include:

  1. Vertical Fiscal Imbalance: This refers to the mismatch between revenue collection and expenditure responsibilities between the central and state governments. Currently, the central government has a larger share in tax revenue collection, while states bear more significant expenditure responsibilities. The Commission will look into this imbalance and recommend measures for a more equitable distribution of resources​​.
  2. Horizontal Fiscal Imbalance: This pertains to the differences in tax bases and the varied needs and costs of providing public goods among states. The Commission is expected to modify the criteria for tax devolution to better target the distribution of transfers among states. A significant portion of state transfers currently comes from tax devolution, which requires refined targeting to address state-specific needs and circumstances​​.
  3. Tax Devolution Criteria: The Commission needs to objectively determine the criteria for tax devolution and their relative weights to reduce disparities in service standards among states. This involves balancing considerations of equity and efficiency in the distribution of resources​​​​.
  4. Restoration of Fiscal Balance: In light of the rising fiscal imbalances, the Commission must also re-examine the 2018 Fiscal Responsibility and Budget Management Act (FRBMA). Key areas of focus include the consistency of debt and fiscal deficit targets, the impact of non-merit subsidies provided by states, and the introduction of mechanisms to penalize states not adhering to fiscal norms. One proposed solution is the establishment of a ‘Loan Council’ to oversee the debt and fiscal deficit profiles of central and state governments​​.

The 16th Finance Commission’s role is crucial in ensuring a balanced and equitable fiscal framework that addresses the contemporary economic and fiscal realities of India. As it prepares to undertake this task, the Commission will need to consider various factors, including the evolving nature of the Indian economy, the fiscal pressures faced by both the Centre and states, and the need for sustainable and inclusive growth across all regions of the country.



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