The 16th Finance Commission faces some daunting challenges

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Deliberations of the 16th Finance Commission (FC) are now proceeding in earnest. The appointment of the full commission only by the end of January has left it with just 19 months until end October 2025 to complete its work and submit its recommendations, well short of the full two years or so that is usually available. Fortunately, its terms of reference have been limited to the core issues mandated by the Constitution.

Unlike in the case of recent FCs, the 16th FC has not been loaded with a host of other issues under the “any other matters" clause [article 280 (3)(d)]. This gives it the opportunity to focus its deliberations on core issues without having to devote time to other issues. This is important because the commission will have to contend with some daunting challenges, a few of which are discussed here.

The first issue relates to projections of revenue, especially from taxes, for the central and state governments. Macroeconomic projections are always important inputs for economic policy decisions, but particularly so for the volume of tax devolution to the states. The FC-recommended devolution formula applied to the divisible pool of central taxes will determine the volume of tax devolution that will flow to the states.

If the actual volume of central tax revenues (except cesses and surcharges) turns out be more than the projections, then the devolution flows will provide some fiscal elbow room for both the Centre and states. But if the tax revenues turn out to be less than the projections, it will lead to fiscal stress for the central government as well as all state governments. Hence, the reliability of tax revenue projections is critical and the method adopted for making projections needs to be robust.