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16th Finance Commission and Local Government Finances

19 Nov 2025 GS 3 Economy
16th Finance Commission and Local Government Finances Click to view full image

Context:

  • The 16th Finance Commission (FC) submitted its report to the President on November 17.

  • Main expectations from the FC:

    • Decide vertical devolution (share of Union taxes going to States).

    • Determine horizontal distribution (formula to divide resources among States).

  • These functions are mandated under Article 280 of the Constitution.

Expectations Related to Local Governments

  • Under Articles 280(3)(bb) and (c), the FC must recommend measures to strengthen panchayat and municipal finances.

  • Local bodies deliver essential services:

    • drinking water, sanitation, public health, rural roads, community assets, etc.

  • They can collect:

    • property tax, advertisement tax, market fees, tolls, and other non-tax revenues.

  • However, large mismatches exist between their revenue powers and expenditure responsibilities across States.

Problem: Variation in Fiscal Powers of Local Bodies

  • After the 73rd and 74th Amendments, States decide what powers (financial and functional) to assign to panchayats and municipalities.

  • This leads to wide variation across States.

  • Key issue:

    • There is no separate functional list or revenue list exclusively for local governments.

  • Schedules:

    • 11th Schedule: 29 subjects for panchayats (illustrative, not binding)

    • 12th Schedule: 18 subjects for municipalities (also illustrative)

  • Union and State governments design schemes; local bodies mostly implement them without adequate fiscal backing.

Fiscal Stress on Local Governments

  • States often assign functions to local governments without giving adequate funds, taxation powers, or staff.

  • Result:

    • Local bodies face financial strain,

    • Poor service delivery,

    • Weak operational efficiency.

Role of the State Finance Commission (SFC)

  • Every 5 years, States must set up an SFC.

  • SFC recommends:

    • Sharing of State revenues with local bodies,

    • Assigning tax powers,

    • Grant-in-aid (conditional/unconditional),

    • Delegation of civic functions and staff.

  • Over 100 SFC reports submitted, but very few are implemented seriously.

Why UFC (Union Finance Commission) Matters

  • Due to weak implementation of SFC recommendations, local governments rely mostly on Union transfers.

  • Therefore, the Union Finance Commission must recommend measures to augment State finances for local bodies under Article 280.

Performance of Previous UFCs (13th, 14th, 15th)

Issue 1: Quantum of Grants

  • Earlier FCs gave lump sum grants because resource needs weren’t fully assessed.

  • The 13th FC changed this:

    • Recommended grants as a percentage of the divisible pool (neutral to inflation, benefits from tax buoyancy).

  • But the 14th and 15th FCs reversed this — again went back to lump sum grants.

Issue 2: Conditional Grants

  • All three FCs (13th, 14th, 15th) divided grants into:

    • Basic grants (unconditional)

    • Performance grants (conditional)

  • But the conditions kept changing:

    • The 13th FC set 6 conditions—most States failed to fulfil them.

    • The 14th FC replaced them with entirely new conditions.

    • The 15th FC again set different conditions.

  • No continuity, leading to constant resets and ineffective reform.

Expectations from the 16th Finance Commission

  • Expected to move beyond ad hoc arrangements.

  • Should calculate actual resource requirements of:

    • 2.7 lakh panchayats,

    • around 5,000 municipalities.

  • Aim: enable local governments to genuinely function as institutions of economic development and social justice.

Prelims Practice MCQs

Q. With reference to the functions of the Finance Commission under Article 280, which of the following are included?

  1. Determining the percentage share of States in the divisible pool of central taxes

  2. Recommending measures to augment the Consolidated Fund of a State to supplement the resources of panchayats

  3. Assigning taxation powers to Panchayati Raj Institutions and municipalities

Select the correct answer:
A. 1 only
B. 1 and 2 only
C. 2 and 3 only
D. 1, 2 and 3

Answer: B
(Assigning taxation powers to local bodies is under State jurisdiction, not a Finance Commission mandate.)

Q. Which of the following are correct regarding the 11th and 12th Schedules of the Constitution?

  1. They contain binding functional responsibilities for panchayats and municipalities.

  2. They are illustrative lists that States may choose to devolve.

  3. The 11th Schedule has more subjects than the 12th Schedule.

Select the correct answer:
A. 1 and 2 only
B. 2 and 3 only
C. 1 and 3 only
D. 1, 2 and 3

Answer: B
(Statement 1 is incorrect. The lists are NOT binding; they are illustrative.)

Q. Consider the following statements regarding State Finance Commissions (SFCs):

  1. SFCs are mandated to be constituted every five years.

  2. Their recommendations are binding on the State Legislature.

  3. They may recommend both conditional and unconditional grants to local bodies.

Which of the statements given above is/are correct?
A. 1 and 2 only
B. 1 and 3 only
C. 2 and 3 only
D. 1, 2 and 3

Answer: B
(Statement 2 is incorrect — SFC recommendations are advisory, not binding.)

Q. The 13th Finance Commission made which of the following innovations in local government financing?

A. Recommended lump-sum grants for local bodies
B. Recommended grants to local bodies as a fixed percentage of the divisible pool
C. Removed all performance-based conditions
D. Introduced a new separate functional list for Panchayati Raj Institutions

Answer: B



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