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.
What are the Key Recommendations of the 16th Finance Commission (2026–31)?
- Vertical Devolution and a ‘Grand Bargain’:
- The Commission kept the States’ share in the divisible pool at 41%, the same as recommended by the 15th Finance Commission.
- Grand Bargain Proposal:
- To address the states’ concerns that their fiscal space is shrinking due to rising cesses and surcharges (which are not part of the divisible pool), the 16th Finance Commission suggested a ‘grand bargain’. Under this idea, states may accept a smaller share of a larger divisible pool if the Centre merges most cesses and surcharges into taxes that can be shared.
- Horizontal Devolution:
- The Commission introduced an important change by giving more importance to economic performance in the formula used to distribute funds among states.
- Income Distance (42.5%):
- This is based on the difference between a state’s income and the average income of the top three states, which helps ensure equity among states.
- Population (2011 Census) (17.5%):
- This factor is based on population as per the 2011 Census and reflects the expenditure needs of states.
- Demographic Performance (10%):
- This criterion rewards states that have achieved lower population growth between 1971 and 2011.
- Forest & Ecology (10%):
- This criterion now includes open forests in addition to dense forests, recognizing the ecological contribution of states.
- Area (10%):
- This factor remains unchanged at 10%, the same as in the 15th Finance Commission.
- Contribution to GDP (10%):
- This is a new criterion that measures a state’s share in the total GSDP of all states. The square root method is used to reduce the dominance of larger economies, and it replaces the earlier tax effort/fiscal discipline criterion.
- Grants-in-Aid (Rs 9.47 Lakh Crore):
- Local Bodies (Rs 8 Lakh Cr):
- This amount is divided between rural local bodies (Rs 4.4 lakh crore) and urban local bodies (Rs 3.6 lakh crore). These grants will be given only if certain conditions are met, such as proper constitution of local bodies, availability of audited accounts, and timely formation of State Finance Commissions.
- New Initiatives:
- The Commission proposed an Urbanisation Premium Grant (Rs 10,000 crore) to support areas moving from rural to urban status. It also recommended Special Infrastructure Grants (Rs 56,100 crore) for wastewater management.
- Disaster Management (Rs 2.04 Lakh Cr):
- Funds will be provided for State Disaster Relief and Management Funds. The cost-sharing pattern will be 90:10 for northeastern and Himalayan states, and 75:25 for other states.
Fiscal Roadmap and Reforms
- Fiscal Deficit: The Commission recommended that the Central government reduce its fiscal deficit to 3.5% of GDP by 2030–31, while states should maintain their fiscal deficit at 3% of GSDP.
- Off-Budget Borrowings: It suggested ending off-budget borrowings and including all such liabilities in fiscal deficit and debt calculations.
- Power Sector: The Commission encouraged the privatisation of DISCOMs to improve efficiency in the power sector.
- Subsidies: It recommended rationalising subsidies, particularly unconditional cash transfers. These transfers now account for 20.2% of total subsidy spending, compared to 3% in 2018–19, partly due to the use of the JAM trinity (Jan Dhan, Aadhaar, Mobile).
- Public Sector Enterprise (PSEs) Reforms: The Commission recommended the closure of 308 inactive State PSEs and suggested creating a review mechanism for enterprises that are consistently making losses.
- Transparency Measures: It recommended the annual disclosure of CAG-certified data on net tax proceeds under Article 279, which would help clarify the actual size of the divisible pool.
- Article 279 of the Constitution: This Article defines the “net proceeds” of a tax as the gross revenue minus the cost of collection, and the certification of these proceeds by the Comptroller and Auditor General (CAG) is considered final.
What are the Key Issues with the 16th Finance Commission Recommendations?
- Status Quo vs. Growing Imbalances:
- The Commission kept the states’ share in the divisible pool at 41%, rejecting the states’ demand to increase it to around 50%. Critics say this decision gives priority to the Centre’s fiscal needs such as defence and infrastructure, rather than the requirements of states. As a result, states may have less untied revenue, and the issue of growing vertical fiscal imbalance remains unaddressed.
- Unchecked Cesses and Surcharges:
- The Commission did not suggest any limits on cesses and surcharges, which are not shared with states. These levies have increased significantly, reducing the shareable tax base. Many experts believe this practice weakens fiscal federalism by concentrating more financial resources with the Centre.
- Rewarding Contribution over Need:
- The new 10% weight for ‘contribution to GDP’ (which replaced the earlier tax effort criterion) tends to benefit more industrialised states such as Tamil Nadu, Karnataka, and Maharashtra. At the same time, the weight of income distance was reduced from 45% to 42.5%, and area from 15% to 10%, which reduces the focus on redistribution. Critics say this change tilts the formula toward richer states, even as regional economic disparities continue to grow.
- Discontinuation of Revenue Deficit Grants:
- The decision to remove revenue deficit grants has been strongly criticised, especially by hill states, northeastern states, and other states with structural deficits and difficult geographical conditions.
- Conditional Fiscal Discipline:
- The recommendations to limit state fiscal deficits to 3% of GSDP, stop off-budget borrowings, rationalise subsidies, and move toward DISCOM privatisation are viewed by some states as strict conditions that reduce their financial flexibility.
- The Equity Gap:
- Compared with the 15th Finance Commission, several states are expected to lose out, including Uttar Pradesh, Bihar, West Bengal, Madhya Pradesh, Odisha, and many northeastern states such as Arunachal Pradesh, Meghalaya, Manipur, Nagaland, Tripura, Sikkim, along with Goa. Meanwhile, the benefits gained by richer states have not been evenly distributed among them either.
- Risk of Regional Inequality:
- This reduction in fiscal support could trap populous northern and eastern states in a difficult situation where they receive fewer resources at a time when they need greater investment, which may increase regional economic inequality in India.
- Missed Opportunity under Article 275:
- The Commission could have addressed some of these concerns through Article 275 grants, which are meant for state-specific needs such as health and education, separate from revenue deficit support. By not providing such grants, critics say the Commission missed an opportunity to balance efficiency with the goal of equalisation among India’s very diverse states.
What Steps can be Taken to Bolster Fiscal Federalism in India?
- Enhance Vertical Transfers:
- Increase the states’ share in the divisible pool beyond 41% and place a legal cap on cesses and surcharges (for example, 10% of Gross Tax Revenue (GTR), while currently they are close to 20% of GTR). This would help restore predictability in transfers and provide states with more untied financial resources.
- Ensure Phased Transition:
- Introduce a “Floor Guarantee” so that no state’s absolute share falls below the level it received under the 15th Finance Commission during the transition toward a performance-based transfer system.
- Balance Equity with Efficiency:
- Continue to use progressive criteria such as income distance and forest cover, while also introducing elasticity-linked transfers that reward revenue growth and performance in areas like social indicators and climate action.
- Empower Local Bodies:
- Strengthen Panchayati Raj Institutions (PRIs) and Urban Local Bodies (ULBs) by providing matching grants to states that implement State Finance Commission (SFC) recommendations. Also give local bodies real taxation powers, such as the ability to collect property taxes effectively.
- Strengthen Federal Dialogue:
- Reactivate meetings of the Inter-State Council (Article 263) to promote “real-time federalism”, allowing the Centre and states to discuss and resolve fiscal issues through dialogue instead of litigation.
Conclusion
The 16th Finance Commission tried to manage a complicated fiscal federal system by keeping the states’ share in the divisible pool at 41% and introducing new measures that reward economic performance and efficiency. These steps were intended to encourage states to improve revenue generation and economic contribution while maintaining the existing framework of fiscal transfers between the Centre and the states.
However, several concerns have been raised about its recommendations. The Commission did not place limits on the growing use of cesses and surcharges, which are not shared with states and therefore reduce the effective share of states in central taxes. In addition, the removal of revenue deficit grants has created worries among poorer and geographically disadvantaged states that depend on such support to manage their finances. Critics also argue that the new formula, which gives weight to contribution to GDP, may benefit economically stronger states more than less developed ones.
Because of these factors, many experts believe the recommendations may increase concerns about fiscal equity among states. Going forward, the biggest challenge for India’s fiscal federalism will be to strike a balance between rewarding performance and ensuring fair redistribution of resources, so that both efficiency and regional equality are maintained in the country’s financial governance.
FAQ’s
1. What is the vertical devolution recommended by the 16th Finance Commission?
The 16th FC retained the States’ share in the divisible pool of central taxes at 41% , unchanged from the 15th FC, imparting it a “semi-permanence.”
2. What is the ‘grand bargain’ proposed by the 16th Finance Commission?
It proposed that States accept a smaller share of a larger divisible pool if the Centre merges a large part of the cesses and surcharges into the regular tax base, ensuring no revenue loss to either side.
3. What is the new criterion introduced in the horizontal devolution formula?
The Commission introduced a 10% weight for ‘contribution to GDP’ (measured by share in all-State GSDP), replacing the tax effort/fiscal discipline criterion, to reward economic performance.
