Fiscal Federalism and the 16th Finance Commission

Source: The post “Fiscal Federalism and the 16th Finance Commission has been created, based on “Fiscal Federalism and the 16th Finance Commission” published in “The Hindu ” on  13th February 2026.

UPSC Syllabus: GS Paper-2- Polity

Context: The 16th Finance Commission, chaired by Arvind Panagariya, has submitted its recommendations for the award period 2026–31, and the Union government has accepted them. The key issue is whether the recommendations have enhanced the fiscal space and autonomy of States within India’s federal framework.

Constitutional Background

1. Article 270 of the Constitution provides for the distribution of the net proceeds of certain Central taxes between the Union and the States.
2. Article 280 mandates the constitution of a Finance Commission every five years to recommend the principles governing such distribution.
3. The divisible pool includes corporation tax, personal income tax, Central Goods and Services Tax (CGST), and the Centre’s share of Integrated GST (IGST).
4. Cess and surcharge levied by the Union government are excluded from the divisible pool.
5. For 2025–26, the divisible pool constitutes about 81% of the Centre’s gross tax revenue after excluding cess and surcharge.

Past Trends in Devolution

1. The 13th Finance Commission had fixed vertical devolution at 32% of the divisible pool.
2. The 14th Finance Commission increased vertical devolution to 42% and reduced tied transfers under Centrally Sponsored Schemes, thereby strengthening fiscal federalism.
3. The 15th Finance Commission reduced the share to 41% due to the reorganisation of the erstwhile State of Jammu and Kashmir into Union Territories.

Demands of States Before the 16th FC

I. Vertical Devolution

1. 1. Eighteen States demanded that the share of States be increased from 41% to 50%.
   2. Some States demanded an increase to a range between 45% and 48%.
   3. Many States demanded that cess and surcharge be included in the divisible pool.
   4. Several States sought the imposition of a cap on cess and surcharge to prevent erosion of the divisible pool.

II. Horizontal Devolution

1. 1. Many States demanded that equity-based parameters such as income distance, population, and area should continue to dominate the distribution criteria.
   2. Some States recommended reducing the weight assigned to income distance.
   3. Industrialised States such as Maharashtra, Gujarat, Tamil Nadu, Karnataka and Telangana demanded the inclusion of States’ contribution to GDP as a criterion for horizontal devolution.

Key Recommendations of the 16th Finance Commission

I. On Vertical Devolution

1. The Commission has retained the States’ share at 41% of the divisible pool.
2. It has rejected the demand to include cess and surcharge in the divisible pool.
3. It has also rejected the proposal to impose a cap on cess and surcharge.
4. The Commission has justified its decision by stating that the present constitutional framework does not permit inclusion of cess and surcharge in the divisible pool.
5. It has further stated that the Union government requires adequate fiscal space to meet national priorities such as defence and infrastructure.
6. It has also observed that a significant portion of Union expenditure under Centrally Sponsored Schemes is ultimately routed to the States.

II. On Horizontal Devolution

1. The Commission has followed the principle that changes in State shares should be gradual and not disruptive.
2. It has recognised the need to give due importance to efficiency and growth performance.
3. It has introduced a new criterion, namely States’ contribution to GDP, in the horizontal devolution formula.
4. It has assigned weights to various criteria in a manner that produces a directional change without causing drastic redistribution.
5. As a result, the share of southern and western States has marginally increased.
6. The share of large northern and central States has marginally decreased.

Assessment of the Impact on States

1. The States have not gained significantly in terms of vertical devolution, as the share remains unchanged at 41%.
2. Industrialised and growth-oriented States have gained marginally through the recognition of their contribution to GDP.
3. The overall framework reflects continuity rather than a major restructuring of fiscal federalism.
4. Therefore, the outcome represents a status quo with incremental reform rather than a substantial fiscal gain for States.

Way Forward

1. The Union government should progressively reduce its reliance on cess and surcharge to strengthen the divisible pool.
2. A transparent and consultative mechanism should be institutionalised in future Finance Commissions to enhance cooperative federalism.
3. Greater weight may gradually be assigned to efficiency and tax effort while preserving equity concerns.
4. States should improve the targeting and efficiency of subsidies, especially in sectors such as power.
5. Both Centre and States should pursue fiscal consolidation to ensure long-term macroeconomic stability.
6. Public sector enterprise reforms at both levels should be accelerated to improve resource mobilisation and reduce fiscal stress.

Conclusion: The 16th Finance Commission largely maintains the existing fiscal architecture by retaining the 41% vertical devolution. However, the inclusion of States’ contribution to GDP as a criterion signals a calibrated shift towards performance-based distribution. Thus, while States have not gained substantially in terms of quantum, the recommendations introduce a gradual move towards balancing equity with efficiency within India’s federal fiscal framework.

Question: Have States gained from the 16th Finance Commission? Discuss.

Source: The Hindu