The State Finance Commission (SFC) is a constitutional body established to institutionalize the mechanism of fiscal decentralization in India. Its origin lies in the 73rd and 74th Constitutional Amendment Acts of 1992, which gave constitutional status to Panchayati Raj Institutions (PRIs) and Urban Local Bodies (ULBs). The SFC was created to solve the problem of inconsistent and discretionary financial relations between state governments and local bodies, ensuring they had the necessary funds to discharge their new responsibilities under the 11th and 12th Schedules.
The mechanism for the SFC is laid out in Article 243-I and Article 243-Y of the Constitution. Article 243-I mandates that the Governor of a state must constitute an SFC within one year from the commencement of the 73rd Amendment Act (which came into force on April 24, 1993) and thereafter at the expiration of every five years, to review the financial position of the Panchayats. Article 243-Y extends this mandate, requiring the same SFC to review the financial position of Municipalities (ULBs). The SFC's primary function is to recommend the principles governing the distribution of the net proceeds of taxes, duties, and fees between the state government and its local bodies. It also recommends the determination of taxes, duties, and fees that may be assigned to local bodies, and the grants-in-aid to be provided to them from the Consolidated Fund of the State. The Governor must lay every SFC recommendation, along with an action taken memorandum, before the State Legislature.
The SFC connects directly to the Central Finance Commission (CFC), which is constituted under Article 280. The CFC is mandated to recommend measures to augment the Consolidated Fund of a State to supplement the resources of Panchayats and Municipalities based on the recommendations of the SFC. Recently, the 15th Finance Commission recommended that states not only establish SFCs and implement their recommendations but also submit an action report to the legislature, with non-compliance potentially resulting in the withholding of certain grants. Furthermore, the 16th Finance Commission has recommended reconsidering the constitutional requirement that links CFC recommendations for local bodies to SFC reports, citing persistent data and quality issues.