The State Finance Commission Explained

The State Finance Commission (SFC) is a constitutional body that the Governor of an Indian state sets up every five years, under Articles 243I and 243Y, to recommend how the state’s tax revenues should be shared with its panchayats and municipalities. It is the state-level counterpart of the Finance Commission of India, which does the same job for the Union and the states, and it is the main instrument for fiscal devolution to the third tier of government.

The State Finance Commission was created by the 73rd and 74th Constitutional Amendments of 1992, which gave local governments constitutional status. Without a predictable share of money, panchayats and urban local bodies would remain dependent on the goodwill of the state government, and the SFC was designed to remove that dependence.

Key Takeaways

• The State Finance Commission is constituted by the Governor of a state at intervals of five years under Article 243I for panchayats and Article 243Y for municipalities.
• A State Finance Commission recommends how the net proceeds of state taxes, duties, tolls and fees should be divided between the state government and its local bodies, and how the local share should be distributed among them.
• The recommendations of a State Finance Commission are advisory, but the Governor must lay each recommendation before the State Legislature together with an explanatory memorandum on the action taken.
• The Finance Commission of India is directed by Article 280(3) to recommend measures to supplement the resources of panchayats and municipalities on the basis of State Finance Commission reports.
• The common problems of the State Finance Commission system are delayed constitution, late or unpublished reports, untabled action taken reports and the rejection of key recommendations by state governments.
• Fiscal devolution through the State Finance Commission matters because panchayats and municipalities handle the services citizens see every day, such as drinking water, sanitation, roads and street lighting.

What is the State Finance Commission?

The State Finance Commission is a body that reviews the finances of a state’s local governments and advises the Governor on how money should flow to them. Article 243I(1) requires it to be appointed to review the financial position of the panchayats, and Article 243Y extends the same commission’s review to the municipalities.

The idea comes from the Finance Commission of India, which Article 280 of the original Constitution provides for. When the 73rd and 74th Amendments created Part IX (Panchayats) and Part IXA (Municipalities), they copied the model at state level so that the sharing of money between a state and its local bodies would be governed by rules and not by discretion.

Which articles of the Constitution create the State Finance Commission?

Article 243I creates the State Finance Commission for panchayats, and Article 243Y applies it to municipalities. Article 243I sits in Part IX of the Constitution, alongside Article 243H on the finances of panchayats, while Article 243Y is in Part IXA, which deals with municipalities.

• Article 243H allows a state legislature to authorise panchayats to collect taxes, duties, tolls and fees, to assign some state taxes to them and to give grants-in-aid.
• Article 243I requires the Governor to constitute the Commission and sets out what it must consider.
• Article 243X gives similar powers to the legislature in relation to municipalities.
• Article 243Y states that the same Finance Commission will also review the finances of municipalities.
• Article 280(3)(bb) and (c) require the Finance Commission of India to recommend measures to augment the Consolidated Fund of a state so as to supplement the resources of panchayats and municipalities.

Who constitutes the State Finance Commission and who sits on it?

The Governor constitutes the State Finance Commission, acting on the advice of the state government, and the legislature of the state decides its composition by law. Article 243I(2) leaves it to the state legislature to define the qualifications of the members and the way in which they are selected.

In practice, the Commission is usually headed by a chairperson who is a senior politician, retired civil servant, economist or judge. The other members commonly include economists, finance specialists and officers with experience in local government, and a member-secretary, normally a serving government officer, handles the day-to-day work. The choice of members differs from state to state, which affects how independent the Commission appears.

The state legislature can also decide the powers of the Commission, the staff it will have and how it will conduct its enquiry. Most commissions collect data from departments, hold hearings with panchayat and municipal representatives and visit districts before they submit their reports.

What does the State Finance Commission recommend?

The State Finance Commission recommends the principles under which state revenues are shared with local governments, the taxes that can be handed to them and the grants they receive. Article 243I(1) lists these matters, and the Governor can add any other matter in the interest of sound finance.

The main areas of recommendation

• The principles governing the distribution between the state and the local bodies of the net proceeds of taxes, duties, tolls and fees that the state levies, and the allocation of the local share among the panchayats or municipalities at all levels.
• The determination of taxes, duties, tolls and fees that may be assigned to, or appropriated by, local bodies.
• Grants-in-aid to local bodies from the Consolidated Fund of the State.
• Measures needed to improve the financial position of the panchayats and municipalities.
• Any other matter referred to the Commission by the Governor.

The “net proceeds” are the revenue left over after the costs of collection. Many commissions have suggested that a fixed percentage of the state’s own tax revenue form a divisible pool for local bodies. They then distribute this pool among rural and urban bodies using factors such as population, area, poverty, backwardness and the fiscal effort of the local body itself.

How does the State Finance Commission work?

The State Finance Commission works by collecting financial data, consulting stakeholders and then writing a report with recommendations that cover a five-year period. The terms of reference are issued by the state government through the notification that sets up the Commission.

The process runs through several steps:

• The Governor issues a notification that constitutes the Commission and gives its terms of reference and the period it must cover.
• The Commission collects accounts and other information from the finance, rural development and urban development departments, as well as from local bodies.
• The Commission consults elected representatives, experts and the Finance Commission of India, and it studies the practices of other states.
• The Commission submits a report to the Governor with its recommendations.
• The Governor lays the report before the State Legislature along with a memorandum explaining what action has been taken on each recommendation, as Article 243I(3) requires.

The state government then decides which recommendations to accept. Because the Constitution says that the Governor must lay “every recommendation” together with an explanatory memorandum, the state government is expected to explain its reasons in writing for rejecting any part of the report.

How is the State Finance Commission different from the Finance Commission of India?

The State Finance Commission is different from the Finance Commission of India because it deals with the relationship between a state and its local bodies, while the Finance Commission of India deals with the relationship between the Union and the states. The first is appointed by a Governor under Articles 243I and 243Y, and the second is appointed by the President under Article 280.

The two commissions are linked. Article 280(3)(bb) and (c) direct the Finance Commission of India to recommend measures to supplement the funds of panchayats and municipalities on the basis of the recommendations of each State Finance Commission. This makes the quality of the SFC report important, because the Union body relies on it when deciding the central grants for local bodies.

Why does the State Finance Commission matter for local governments?

The State Finance Commission matters because it is the only constitutional mechanism that gives panchayats and municipalities a rule-based claim on state revenue. Local governments are responsible for the 29 subjects in the Eleventh Schedule and the 18 subjects in the Twelfth Schedule, including water supply, sanitation, public health, roads, markets and local planning.

These responsibilities cost money, but the local bodies have limited ways to raise it. Their own taxes, such as property tax, fees for services, market fees and licence fees, seldom cover their needs, particularly in poor rural areas. Without a formula-based transfer, funds would move only through schemes designed by the state or Centre, with conditions attached.

An effective State Finance Commission supports three goals in particular. It makes local government finances predictable, helps panchayats and municipalities plan for the long term and promotes equity between richer and poorer local bodies.

How does the Union Finance Commission support local bodies?

The Union Finance Commission supports local bodies by recommending grants from the Union Government, which are given to the states for passing on to panchayats and municipalities. This work started with the Tenth Finance Commission, which covered 1995 to 2000, and it has grown with later commissions.

Over the years, the central commissions have made some grants conditional on state-level reforms. Recent commissions have linked the release of local body grants to the constitution of State Finance Commissions, the tabling of action taken reports in the legislature and the holding of local body elections on schedule. They have also required states to maintain audited accounts of local bodies, to publish them and to improve the collection of property taxes.

This conditionality has given states a strong financial reason to follow the constitutional timetable. It also highlights the central issue in the system, which is that State Finance Commission recommendations are advisory while central grants come with enforceable conditions.

What problems does the State Finance Commission face?

The State Finance Commission faces several recurring problems, mainly delays in its constitution, delays in its reports and the failure of states to act on its recommendations. These problems have been pointed out repeatedly by the Finance Commission of India, expert committees and audit bodies.

Common difficulties

• Delayed constitution: Some states have set up their commissions late, leaving gaps between one commission’s period and the next.
• Delayed reports: Commissions are sometimes given long extensions, and their reports then arrive after the period they were meant to cover has begun.
• Untabled reports: The action taken report is not always placed before the legislature within the time that the Constitution implies.
• Selective acceptance: A state government may accept recommendations on grants and reject those that require sharing of its tax revenue.
• Weak data: Many local bodies do not maintain reliable, up-to-date accounts, which makes it hard to estimate their needs.
• Limited capacity: Commissions often have small secretariats and short working periods.
• Weak link with budgets: Even accepted recommendations are not always reflected in the state budget.

Another challenge is the absence of an enforcement mechanism. The Constitution says that the report must be laid before the legislature, but it does not say that the government must implement it, and courts have generally been reluctant to direct financial decisions that belong to the executive and the legislature.

Where does the State Finance Commission not apply?

The State Finance Commission does not apply to areas excluded from the local government provisions of Parts IX and IXA, such as the Scheduled Areas and tribal areas in certain states. Article 243M excludes the Scheduled Areas under the Fifth Schedule and the tribal areas under the Sixth Schedule from the direct application of Part IX, although Parliament can extend it with changes.

Part IX also does not apply to Nagaland, Meghalaya and Mizoram, which have their own arrangements for traditional institutions and autonomous councils, nor to the hill areas of Manipur that have District Councils and the hill areas of Darjeeling district in West Bengal. The Panchayats (Extension to the Scheduled Areas) Act, 1996, known as PESA, was passed to extend panchayat provisions to Fifth Schedule areas with special features.

Union Territories are covered differently. Articles 243L and 243ZB allow the President to apply the panchayat and municipal provisions to a Union Territory with exceptions and modifications, so local finance there depends on the laws and arrangements made for that territory.

What has been the history of State Finance Commissions in India?

The history of State Finance Commissions began in 1993 and 1994, when states were required to constitute their first commissions after the 73rd and 74th Amendments came into force. The first round of commissions submitted their reports in the mid-1990s, and states have since formed several successive commissions.

Over time, the commissions have grown in influence. Several states have taken up the idea of devolving a share of their own revenue to local bodies, with the extent of devolution varying widely from state to state.

Bottom Line

The State Finance Commission turns the promise of local self-government into a financial reality by setting rules for sharing state revenue with panchayats and municipalities. The system works best where governors constitute commissions on time, legislatures debate their reports and governments accept their key recommendations. Where those steps are missed, the third tier of government remains financially weak despite its constitutional status.

Frequently Asked Questions

What is the State Finance Commission in simple words?

The State Finance Commission is a body appointed by a state’s Governor to advise how the state’s tax money should be shared with village panchayats and city municipalities. It is required by Articles 243I and 243Y of the Constitution. It reviews the finances of local bodies every five years and recommends how much money they should get.

Who appoints the State Finance Commission?

The Governor of the state appoints the State Finance Commission, usually on the advice of the state government. The first commissions were required within one year of the 73rd and 74th Amendments taking effect, and new commissions are to be appointed at the end of every fifth year. The state legislature decides the qualifications of the members and how they are chosen.

Are the recommendations of the State Finance Commission binding?

The recommendations of the State Finance Commission are not legally binding on the state government. However, Article 243I(3) requires the Governor to lay every recommendation before the State Legislature, with a memorandum explaining the action taken. This gives the legislature and the public an opportunity to question a decision to reject the recommendations.

How is the State Finance Commission related to the Finance Commission of India?

The Finance Commission of India uses the reports of State Finance Commissions when it recommends measures to supplement the resources of panchayats and municipalities. Article 280(3)(bb) and (c) of the Constitution require this. In recent years, the Union Finance Commission has also linked central grants to local bodies to the proper constitution of State Finance Commissions by states.

How often is the State Finance Commission constituted?

A State Finance Commission must be constituted at the expiry of every fifth year, as laid down in Article 243I. The first commissions were to be formed within a year of the commencement of the 73rd Amendment. In practice, some states have formed commissions late, leaving gaps between successive commission periods.

What are the main problems with State Finance Commissions?

The main problems are late constitution of commissions, delayed reports, failure to table action taken reports in the legislature and the selective acceptance of recommendations by state governments. Limited data on local body finances and small commission staff add to the difficulty. Because the recommendations are advisory, there is no direct legal remedy when a state government ignores them.

{“@context”:”https://schema.org”,”@graph”:[{“@type”:”FAQPage”,”mainEntity”:[{“@type”:”Question”,”name”:”What is the State Finance Commission in simple words?”,”acceptedAnswer”:{“@type”:”Answer”,”text”:”The State Finance Commission is a body appointed by a state’s Governor to advise how the state’s tax money should be shared with village panchayats and city municipalities. It is required by Articles 243I and 243Y of the Constitution. It reviews the finances of local bodies every five years and recommends how much money they should get.”}},{“@type”:”Question”,”name”:”Who appoints the State Finance Commission?”,”acceptedAnswer”:{“@type”:”Answer”,”text”:”The Governor of the state appoints the State Finance Commission, usually on the advice of the state government. The first commissions were required within one year of the 73rd and 74th Amendments taking effect, and new commissions are to be appointed at the end of every fifth year. The state legislature decides the qualifications of the members and how they are chosen.”}},{“@type”:”Question”,”name”:”Are the recommendations of the State Finance Commission binding?”,”acceptedAnswer”:{“@type”:”Answer”,”text”:”The recommendations of the State Finance Commission are not legally binding on the state government. However, Article 243I(3) requires the Governor to lay every recommendation before the State Legislature, with a memorandum explaining the action taken. This gives the legislature and the public an opportunity to question a decision to reject the recommendations.”}},{“@type”:”Question”,”name”:”How is the State Finance Commission related to the Finance Commission of India?”,”acceptedAnswer”:{“@type”:”Answer”,”text”:”The Finance Commission of India uses the reports of State Finance Commissions when it recommends measures to supplement the resources of panchayats and municipalities. Article 280(3)(bb) and (c) of the Constitution require this. In recent years, the Union Finance Commission has also linked central grants to local bodies to the proper constitution of State Finance Commissions by states.”}},{“@type”:”Question”,”name”:”How often is the State Finance Commission constituted?”,”acceptedAnswer”:{“@type”:”Answer”,”text”:”A State Finance Commission must be constituted at the expiry of every fifth year, as laid down in Article 243I. The first commissions were to be formed within a year of the commencement of the 73rd Amendment. In practice, some states have formed commissions late, leaving gaps between successive commission periods.”}},{“@type”:”Question”,”name”:”What are the main problems with State Finance Commissions?”,”acceptedAnswer”:{“@type”:”Answer”,”text”:”The main problems are late constitution of commissions, delayed reports, failure to table action taken reports in the legislature and the selective acceptance of recommendations by state governments. Limited data on local body finances and small commission staff add to the difficulty. Because the recommendations are advisory, there is no direct legal remedy when a state government ignores them.”}}]}]}