Source: TH
Why in News?
The 16th Finance Commission of India has submitted its recommendations for the period 2026–31. It retained the States’ share in tax devolution at 41%, while introducing changes in the horizontal distribution formula and proposing reforms such as merging cesses and surcharges into the divisible pool.
Constitutional Background
The Finance Commission is constituted under Article 280 of the Constitution of India to recommend:
- Distribution of tax revenues between the Centre and States (vertical devolution).
- Distribution of funds among states (horizontal devolution).
- Grants-in-aid under Article 275 of the Constitution of India.
The certification of the net proceeds of taxes is done by the Comptroller and Auditor General (CAG) under Article 279 of the Constitution of India.
Key Recommendations of the 16th Finance Commission
1. Vertical Devolution
The Commission retained the states’ share at 41% of the divisible pool, continuing the arrangement recommended by the 15th Finance Commission of India.
Grand Bargain Proposal
To address concerns about the rise of cesses and surcharges, the Commission proposed a “grand bargain”:
- The Centre should merge most cesses and surcharges into shareable taxes.
- States accept a smaller share of a larger divisible pool.
This aims to expand the total pool of shareable taxes.
Horizontal Devolution Formula
The Commission introduced a revised formula to distribute funds among states.
| Criterion | Weight |
|---|---|
| Income Distance | 42.5% |
| Population (2011 Census) | 17.5% |
| Demographic Performance | 10% |
| Forest & Ecology | 10% |
| Area | 10% |
| Contribution to GDP | 10% |
Key Changes
- Contribution to GDP (10%) introduced as a new criterion.
- Replaces earlier tax effort/fiscal discipline parameter.
- Slight reduction in income distance weight.
This shift rewards economic performance while maintaining redistribution goals.
Grants-in-Aid
Total grants recommended: ₹9.47 lakh crore
1. Local Body Grants – ₹8 lakh crore
Split between:
- Rural local bodies: ₹4.4 lakh crore
- Urban local bodies: ₹3.6 lakh crore
Conditions include:
- Timely constitution of State Finance Commissions
- Audited accounts
- Functional local governance institutions.
New Initiatives
- Urbanisation Premium Grant: ₹10,000 crore
- Infrastructure Grants for wastewater management: ₹56,100 crore
2. Disaster Management Grants – ₹2.04 lakh crore
Funds allocated for State Disaster Relief and Management Funds.
Cost sharing:
- 90:10 for Northeastern and Himalayan states
- 75:25 for other states.
Fiscal Roadmap and Reform Recommendations
Fiscal Deficit Targets
- Centre: Reduce fiscal deficit to 3.5% of GDP by 2030–31.
- States: Maintain fiscal deficit at 3% of GSDP.
Off-Budget Borrowings
The Commission recommended ending off-budget borrowings and including them in fiscal deficit calculations.
Power Sector Reforms
Encouraged privatisation of DISCOMs to improve efficiency.
Subsidy Rationalisation
Suggested rationalising subsidies, especially unconditional cash transfers enabled by the JAM Trinity (Jan Dhan–Aadhaar–Mobile).
Unconditional cash transfers now account for 20.2% of subsidy spending, up from 3% in 2018–19.
Public Sector Enterprise Reforms
Recommended:
- Closure of 308 inactive State PSEs
- Review of loss-making enterprises.
Key Issues and Criticisms
1. Retaining 41% Devolution
States had demanded 50% share in central taxes.
Critics argue the recommendation:
- Favours the Centre’s fiscal priorities
- Limits states’ untied fiscal resources.
2. Rising Cesses and Surcharges
Cesses and surcharges:
- Are not shared with states.
- Now account for nearly 20% of gross tax revenue.
The Commission did not impose firm limits, which may weaken fiscal federalism.
3. Shift Toward Performance-Based Transfers
The introduction of GDP contribution criterion benefits economically advanced states such as:
- Tamil Nadu
- Karnataka
- Maharashtra
This may reduce redistribution to poorer states.
4. Removal of Revenue Deficit Grants
The Commission discontinued revenue deficit grants, affecting:
- Hill states
- Northeastern states
- Structurally weaker economies.
5. Fiscal Discipline Conditions
Recommendations like:
- 3% deficit limit
- Ending off-budget borrowings
- Subsidy rationalisation
may limit fiscal flexibility of states.
Impact on States
Major Losing States
- Uttar Pradesh
- Bihar
- West Bengal
- Madhya Pradesh
- Odisha
- Several Northeastern states.
Implication
Reduced fiscal transfers could widen regional inequality, especially for states requiring higher public investment.
Steps Needed to Strengthen Fiscal Federalism
1. Increase Vertical Transfers
States’ share in tax revenue should be increased beyond 41%.
2. Limit Cesses and Surcharges
A legal cap (e.g., 10% of gross tax revenue) could prevent excessive centralisation.
3. Ensure Floor Guarantee
No state should receive less than its allocation under the 15th Finance Commission.
4. Strengthen Local Governments
Empower Panchayats and Urban Local Bodies through:
- Greater taxation powers
- Matching grants.
5. Revive Federal Dialogue
Regular meetings of the Inter-State Council of India under Article 263 of the Constitution of India can help resolve fiscal disputes.
