UPSC Syllabus: Gs Paper 2- Functions and responsibilities of the Union and the States, issues and challenges pertaining to the federal structure, devolution of powers and finances up to local levels and challenges therein.
Introduction
The Sixteenth Finance Commission worked with unusual flexibility because its terms of reference flowed directly from constitutional provisions. It examined both vertical devolution and horizontal devolution. It retained the States’ share at 41%, yet important design choices and omissions have raised concerns about constitutional balance, effective transfers, and equalisation across States. The core issue is not only the percentage share but the overall structure of fiscal transfers.
Constitutional Role and Background of the Sixteenth Commission
- Duty under Articles 270 and 280:
Articles 270 and 280 of the Indian Constitution establish the framework for India’s fiscal federalism.
Article 270 mandates the distribution of net tax proceeds (divisible pool) between the Centre and States, while
Article 280 provides for the constitution of a Finance Commission every five years to recommend the manner of this distribution and grants-in-aid.
- Shift after the Fourteenth Commission: The share of States increased from 32% to 42% because State plan grants, which were about 3% of the divisible pool, were discontinued. It was later reduced to 41% due to the change in the status of Jammu and Kashmir.
- Centre’s concern over fiscal space: The Centre expressed concern about reduced fiscal space after the increase to 42%.
- Retention of 41% share: The Sixteenth Commission retained 41%, giving it a semi-permanent character.
What the Sixteenth Finance Commission Misses
- No clear recommendation on cesses and surcharges: Non-shareable cesses and surcharges should be limited and for specific purposes. The Commission made no direct recommendation to restrict their increase.
- Grand bargain proposal instead of correction: It recommended a ‘grand bargain’ (paragraph 7.67) between the Centre and States saying that ‘States would agree to a smaller share in the resulting larger divisible pool, with no loss of revenues to either side’ provided the Centre agreed to merge a large part of the cesses and surcharges in the regular taxes.
- Weak assertion of constitutional responsibility: The Commission did not clearly state that the steep increase in cesses and surcharges was not warranted or not in the spirit of the Constitution.
- Discontinuation of revenue deficit and specific grants: It stopped revenue deficit grants and did not recommend State-specific or sector-specific grants. This reduced an important balancing tool.
- No adjustment for GST reforms: It did not factor in the revenue-reducing impact of major GST reforms undertaken in September 2025.
- Optimistic growth assumption: It assumed 11% nominal GDP growth for 2026-27, higher than the Budget estimate of 10%, which may lead to overestimation of projections.
Major Concerns in Design and Outcomes
- Effective transfers show decline: Transfers as a share of the Centre’s pre-transfer gross revenue receipts were 27.0%, 27.2%, and 28.3% in the 11th, 12th, and 13th periods. They rose to 35.6% in the 14th and fell slightly to 34.4% in the 15th. For 2026-27, the estimate is 32.7%, indicating a decline.
- Centre’s response after 14th Commission: The Centre increased non-shareable cesses and surcharges, reduced its share in centrally sponsored schemes, and did not accept some sector-specific and State-specific grants recommended by the Fifteenth Commission.
- Introduction of contribution criterion: A new efficiency criterion was added based on a State’s share in total GSDP. The square root of GSDP was used to reduce excessive impact.
- Production efficiency versus fiscal efficiency: GSDP depends on movement of capital and labour and market concentration. It does not directly measure fiscal effort.
- Opposite use of GSDP in formula: Lower per capita GSDP increases share under income distance. Higher per capita GSDP increases share under contribution. This creates internal tension.
- Dropping tax effort criterion: The fiscal discipline or tax effort criterion was removed, even though it directly measured fiscal efficiency.
- Purely judgemental weight changes: Weights of some criteria were altered without objective justification.
- Distributional losses and gains: Madhya Pradesh, Uttar Pradesh, West Bengal, Bihar, Odisha, Chhattisgarh, and Rajasthan lost share compared to the Fifteenth Commission. Arunachal Pradesh, Meghalaya, Manipur, Nagaland, Tripura, Sikkim, and Goa also lost. Gains among richer States were not uniform.
Way Forward
- Use Article 275 for needs-based transfers: Grants for State-specific needs can equalise standards in health and education. These should not be confused with revenue deficits.
- Restore normatively determined revenue gap grants: If devolution formula changes cause losses, revenue gap grants can neutralise them.
- Limit and earmark cesses and surcharges: These should remain finite and purpose-specific rather than merged into general funds.
- Balance performance and equalisation: Efficiency concerns of richer States can be accommodated while still protecting the equalisation objective.
- Devolution alone cannot capture cost and need differentials: India’s highly differentiated States require tools beyond formula-based devolution to address variations in costs and service needs.
Conclusion
The Sixteenth Finance Commission retained the 41% share but allowed effective transfers to decline. It avoided a firm position on rising cesses and discontinued revenue gap grants. The contribution criterion created internal inconsistencies. Equalisation remains essential in a diverse federation. Fiscal design must protect constitutional balance, fairness, and objective determination of States’ share.
Question for practice:
Examine the major misses and concerns associated with the Sixteenth Finance Commission, particularly in relation to vertical and horizontal devolution, effective transfers, and the equalisation objective.
Source: The Hindu
