A cautious nudge: On the 16th Finance Commission’s recommendations

Introduction

The Finance Commission is a constitutional body established under Article 280 of the Constitution to recommend tax devolution, grants-in-aid, and fiscal reforms to maintain balance in India’s federal structure. The Sixteenth Finance Commission, constituted for the period 2026–27 to 2030–31, submitted its recommendations amid growing fiscal stress faced by States due to post-GST revenue constraints and rising expenditure responsibilities, necessitating a recalibration of Centre–State fiscal relations.

16th Finance Commission

Period and leadership: The Sixteenth Finance Commission covers the five-year period from 2026–27 to 2030–31. It is chaired by Dr. Arvind Panagariya, and its report was tabled in Parliament on February 1, 2026.

Recognition of State fiscal stress: The Commission acknowledges that States face shrinking fiscal space under the GST framework. It notes a growing mismatch between expenditure obligations and assured revenues, which has increasingly pushed States towards market borrowings.

Key recommendations of the 16th Finance Commission

A. Vertical Devolution

Devolution Continuity: The Commission recommends retaining the States’ share in the divisible pool of Central taxes at 41% for the period 2026–31, ensuring continuity with the Fifteenth Finance Commission.

B. Horizontal Devolution Criteria

1. Income Distance: Income distance is calculated using the gap between a State’s per capita GSDP and the average of the top three large States, directing higher transfers to relatively poorer States.
2. Population Weight: Population share is based on Census 2011 data, with its weight modestly increased to reflect present expenditure and service delivery needs.
3. Demographic Performance: Demographic performance is measured using population growth between 1971 and 2011, aligning transfers with long-term demographic trends.
4. Forest Coverage: The forest criterion is expanded to include total forest area, increase in forest cover, and open forests, recognising ecological services provided by States.
5. Economic Contribution: The earlier “tax effort” criterion is replaced by a broader “contribution to GDP” parameter, with its weight increased to 10%, rewarding productive and economically efficient States.
6. Gradual Transition: The Commission recommends that changes in horizontal devolution be implemented gradually, to ensure stability in inter-State fiscal transfers.
7. Performance Recognition
   The revised formula provides incremental gains to high-contributing States, introducing a measured performance linkage in fiscal transfers.

C. Grants-in-Aid Structure

1. Grant Allocation: The Commission recommends ₹9.47 lakh crore as grants-in-aid over five years, primarily for local bodies and disaster management.
2. Grant Rationalisation: Revenue deficit grants and sector-specific grants are discontinued to simplify and streamline the grants architecture.
3. Local Government Finance

• Rural Support: A total of ₹4.4 lakh crore is recommended for rural local bodies to ensure predictable and stable funding.
• Urban Support: An allocation of ₹3.6 lakh crore is recommended for urban local bodies.
• Conditional Grants: All local body grants will be made available upon fulfilment of three entry-level criteria: (i) constitution of he local bodies as per the Constitution, (ii) publication of provisional and audited accounts of the local bodies in the public domain, and (iii) timely constitution of the State
• Basic Services: 50% of the basic grant will be untied and the rest 50% will be tied to: (i) sanitation and solid waste management, and/or (ii) water management.

4. Disaster Management grants:

• The Commission has recommended disaster management corpus of Rs 2,04,401 crore for State Disaster Relief and Management Funds (SDRF and SDMF).
• The cost-sharing pattern between the centre and states is recommended to be: (i) 90:10 for north-eastern and Himalayan states, and ii) 75:25 for all other states. Centre’s share in total will be Rs 1,55,916 crore.

D. Fiscal Roadmap:

• The Commission has recommended that the Centre should bring down fiscal deficit to 3.5% of GDP by 2030-31.
• It recommended the annual fiscal deficit limit for states to be 3% of GSDP.
• It also recommended strictly discontinuing the practice of off-budget borrowings for states and bringing all such borrowings onto their budgets.

E. Power-sector reforms: The Commission recommended that states should actively pursue privatisation of electricity distribution companies (DISCOMs).

F. Subsidy Reforms

• Subsidy Review: The Commission recommends States review and rationalise subsidy expenditure, particularly schemes involving unconditional cash transfers.
• Targeted Delivery: It advises setting clear exclusion criteria and adopting rigorous review mechanisms to ensure effective targeting.
• Off-Budget Ban: The Commission recommends discontinuing off-budget borrowings for financing subsidies.
• Accounting Uniformity: A standardised framework for accounting and disclosure of subsidies and transfers is recommended to address misclassification across States.

G. Public Enterprise Reforms

• Inactive Closure: The Commission recommends review and closure of 308 inactive State Public Sector Enterprises (SPSEs).
• Disinvestment Policy: States are advised to formulate State-level disinvestment policies targeting inactive and underperforming SPSEs.
• Loss Criteria: State or Union PSEs incurring losses for three out of four consecutive years should be placed before the respective Cabinet for decision-making.

Major Concerns Related to the Sixteenth Finance Commission

1. Static Devolution: The States’ share in the divisible pool remains at 41% for 2026–31, despite States demanding 50%, limiting fiscal autonomy.
2. GST Constraints: The Commission itself notes tighter fiscal space under GST, forcing States to rely increasingly on market borrowings.
3. Limited Signal: FC-16 avoided a phased rise in devolution, missing an opportunity to commit to a higher share, such as 45% by 2031.
4. Restrained Incentives: The weight for “contribution to GDP” rose sharply from 2.5% (FC-15) to 10%, yet gains for productive States remain modest.
5. Demographic Shift: Weight for demographic performance was reduced, while population size weight increased, diluting reform incentives.
6. Cess Shrinkage: Although it flags shrinking pools due to cesses and surcharges, FC-16 does not recommend their inclusion.
7. Centralised Transfers: Total transfers rise 12.2% (2025-26 RE to 2026-27 BE), but ₹1.2 lakh crore (42%) comes via Centrally Sponsored Schemes, reinforcing Centre-led control.

Conclusion

Overall, the Sixteenth Finance Commission combines continuity with calibrated reform. While it strengthens performance-linked transfers, local government financing, and fiscal discipline, it adopts a cautious approach on vertical devolution and structural federal reforms. The recommendations seek to balance equity, efficiency, and stability, even as concerns persist regarding State fiscal autonomy and centralisation of transfers.

Question for practice:

Discuss the key recommendations of the Sixteenth Finance Commission and the major concerns arising from its approach to Centre–State fiscal relations.

Source: The Hindu