Contents
Introduction
Tabled in 2026 amid GST centralisation and rising State debt, the 16th Finance Commission sought to recalibrate fiscal federalism, balancing stability and incentives, yet raised questions on adequacy of incremental reform.
Fiscal Federalism under Strain
- India’s fiscal federalism is undergoing a structural stress-test. States today face a ‘triple bind’: the end of GST compensation (2022), constrained borrowing under FRBM limits, and a shrinking effective divisible pool due to expanding cesses and surcharges.
- RBI’s State Finances Report (2024) notes that States now finance even revenue expenditure increasingly through market borrowings, with State Development Loans (SDLs) rising sharply.
- Against this backdrop, the 16th Finance Commission (FC-16), chaired by Dr. Arvind Panagariya, was expected to offer not just redistribution, but restoration of balance.
The ‘Cautious Nudges’: What FC-16 Changes
The FC-16 largely favours continuity over disruption, offering calibrated adjustments rather than structural overhaul.
- Vertical Devolution Continuity: Retaining States’ share at 41% of the divisible pool for 2026–31 reflects fiscal conservatism. While this ensures Union macro-stability, it disregards States’ demand for 50%, despite expanding State responsibilities in health, education and welfare under Articles 243G–W.
- Horizontal Formula Recalibration: A notable innovation is replacing ‘tax effort’ with ‘contribution to GDP’ and raising its weight from 2.5% (FC-15) to 10%. This modestly rewards productive, industrialised States such as Tamil Nadu and Maharashtra, aligning with recommendations of the Economic Survey that incentives should reflect efficiency, not only need.
- Performance-Linked Transfers: About 20% of local body grants are now tied to outcomes like solid waste management and property tax mobilisation, nudging States towards accountability and outcome-based governance.
Why Cautious Nudges May Be Insufficient
Despite these refinements, the deeper structural distortions remain largely unaddressed.
- Vertical Imbalance and the ‘Divisible Pool Trap’: Article 270-based devolution is undermined by Article 271 cesses and surcharges, whose share in Gross Tax Revenue has risen from about 11% in 2015 to nearly 20% by 2026. The FC-16 acknowledges this erosion but stops short of recommending their inclusion in the divisible pool—arguably the most critical reform needed.
- CSS-Driven Centralisation: Nearly 42% of the increase in transfers in 2026–27 comes via Centrally Sponsored Schemes (CSS). As NIPFP studies show, CSS often convert States into implementing agencies of Union priorities, diluting fiscal autonomy and violating the spirit of cooperative federalism.
- Phasing Out Revenue Deficit Grants: The discontinuation of RDGs assumes uniform fiscal capacity, overlooking structural disadvantages of hill States, aspirational districts, and conflict-affected regions, contrary to the equity principle emphasised by earlier Commissions.
Horizontal Balance: A Zero-Sum Adjustment?
- The FC-16 attempts to bridge North–South tensions—especially amid 2027 delimitation anxieties—by balancing population weight with GDP contribution.
- However, without expanding the overall pool, horizontal rebalancing becomes a zero-sum game, intensifying inter-State contestation rather than cooperative growth.
Way Forward: Need for Structural Reset
Restoring fiscal federalism requires a ‘grand bargain’:
- Inclusion or capping of cesses and surcharges,
- Time-bound increase in vertical devolution (e.g., to 45%),
- Stricter, uniform fiscal rules for both Centre and States, and
- Greater reliance on untied transfers over CSS, as advocated by the Sarkaria and Punchhi Commissions.
Conclusion
As B. R. Ambedkar warned against excessive centralisation, durable federal balance needs structural reform; without fixing the divisible pool, FC-16’s cautious nudges may only postpone India’s fiscal reckoning.
