16th Finance Commission (FC) Recommendations for Strengthening Local Bodies

Syllabus: GS2/ Polity and Governance

Context

• The 16th Finance Commission chaired by Arvind Panagariya, recommended ₹7,91,493 crore in grants to rural and urban local bodies along with structural reforms to strengthen local governance.

What is the Finance Commission?

• The Finance Commission is a constitutional body  constituted by the President of India under Article 280, that recommends how tax revenues collected by the Central government should be distributed among the Centre and various States in the country. 
• The Commission is reconstituted every five years and usually takes a couple of years to make its recommendations to the Centre.
• The Centre is not legally bound to implement the suggestions made by the Finance Commission. 

Tax Devolution 

• The Finance Commission decides what proportion of the Centre’s net tax revenue goes to the States overall (vertical devolution) and how this share for the States is distributed among various States (horizontal devolution). 
• The horizontal devolution of funds between States is usually decided based on a formula created by the Commission that takes into account a State’s population, fertility level, income level, geography, etc. 
• The Centre also aids States through additional grants for certain schemes that are jointly funded by the Centre and the States.

Challenges in Local Bodies Financing

• Low own revenue: Local bodies’ revenue constitutes only around 0.4% of GDP, which is very low compared to global standards. Property tax collection remains inefficient and under-assessed.
• Heavy Dependence on Grants: Most local bodies rely overwhelmingly on transfers from the Centre and states, limiting fiscal autonomy and long-term planning capacity.
• Irregular State Finance Commissions: Many states fail to constitute SFCs on time, disrupting predictable fiscal devolution and weakens local governance.
• Capacity Constraints: Limited administrative and technical expertise affects budgeting, financial management, and efficient utilisation of funds.

Key recommendations for strengthening local bodies

• Financial Allocations:₹7,91,493 crore allocated for the 2026–31 period.
  • Rural-Urban Split: The grant is divided in a 60:40 ratio between Rural Local Bodies (RLBs) and Urban Local Bodies (ULBs).
• Mandatory Entry-Level Conditions: Grants are only released if states meet three critical governance criteria:
  • Constitutional Compliance: Proper constitution of local bodies.
  • Financial Transparency: Timely public disclosure of provisional and audited accounts.
  • Timely constitution of State Finance Commissions (SFCs).
• Urbanisation & Infrastructure Reforms:
  • Urbanisation Premium: A ₹10,000 crore one-time grant to incentivize states to merge peri-urban villages into larger ULBs (population >1 lakh) and formulate a Rural-to-Urban Transition Policy.
  • Special Infrastructure Component: ₹56,100 crore for wastewater management in cities with a population between 10–40 lakh.

Way Ahead

• Local bodies must be empowered to expand their own revenue base through rationalisation of property tax, improved GIS-based assessment, and better user charge recovery.
• The constitution and implementation of State Finance Commission recommendations should be made time-bound and rule-based.
• Dedicated municipal cadres and continuous capacity-building programmes should be institutionalised.
• Digital accounting systems, real-time auditing, and public disclosure portals should be standardised across states.

Source: DTE