India’s system of fiscal transfers rests on two foundational pillars: the vertical division of resources between the Union and the States, and the horizontal distribution of States’ shares among themselves. The recommendations of the Sixteenth Finance Commission (FC-16) have once again brought these dimensions into sharp focus, particularly the implications of freezing the vertical devolution ratio while significantly reshaping horizontal criteria.
Vertical Devolution: A Ratio Frozen in Time
The most consequential change in vertical devolution came with the Fourteenth Finance Commission, which raised the States’ share in the divisible pool of Central taxes from 32% (recommended by FC-13) to 42%. This sharp 10-percentage-point increase, introduced in 2015-16, surprised the Union government and effectively reset Centre–State fiscal relations.
Since then, this ratio has acquired a quasi-permanent character. The Fifteenth Finance Commission reduced it marginally to 41% following the conversion of Jammu & Kashmir into a Union Territory, but subsequent Commissions have largely treated this figure as immutable. Under FC-16, the 41% share will continue at least until 2030-31.
With tax devolution entrenched as the primary transfer mechanism, the Centre has responded by gradually withdrawing from grant-based transfers. FC-16 has now eliminated three important grant channels: revenue-need grants under Article 275, sector-specific grants, and State-specific grants. This marks a structural shift in the architecture of fiscal transfers.
Horizontal Devolution and a Narrowing Information Base
As grants recede, the entire informational burden of inter-State distribution is now borne by the tax devolution formula. This has narrowed the data base used for fiscal equalisation. Tax devolution criteria are necessarily broad-brush and struggle to capture the wide diversity of States in terms of size, fiscal capacity, expenditure needs and cost disabilities.
A key limitation is the dated nature of the data. Population, a core criterion, must be drawn from the latest Census — currently 2011. By the final year of FC-16’s award period, this data will be over two decades old. Similarly, fiscal capacity is measured using nominal per capita Gross State Domestic Product (GSDP) data from 2018-19 to 2023-24 (excluding the pandemic year), centred around 2021-22. This too will be nearly nine years out of date by 2030-31.
Revenue Deficit Grants: A Significant Departure
A notable decision of FC-16 is its refusal to assess post-devolution revenue deficits of individual States or to provide revenue-deficit grants. The Commission justifies this by pointing out that the aggregate revenue deficit of States is only 0.3% of GDP.
This reasoning is contestable. Aggregates mask inter-State disparities. The Constitution mandates the Commission to examine the fiscal position of individual States. In 2023-24, the combined revenue deficits of deficit States alone amounted to about 0.8% of GDP — a sum that dwarfs the combined allocations for local body grants and disaster management grants (together about 0.4% of GDP).
More importantly, revenue deficits are endogenous to the devolution framework itself. Changes in the tax devolution formula alter post-devolution revenue balances. FC-16’s introduction of a new criterion — States’ share in all-India GSDP — could systematically raise surpluses for already surplus States while deepening deficits for fiscally weaker ones. Without a State-wise post-devolution assessment, the equalisation impact of the overall transfer scheme remains unclear.
Winners and Losers Under the FC-16 Formula
FC-16 assigned a 10% weight to the new GSDP-share criterion. This was accommodated by reducing:
- the income-distance criterion (the main equalising component) by 2.5%, and
- the area criterion (reflecting cost disabilities) by 5%.
The tax effort criterion (2.5%) was dropped entirely. As a result, several States — largely those with lower fiscal capacity or smaller size — have seen reduced shares compared to the FC-15 formula. These include Madhya Pradesh, Uttar Pradesh, Bihar, Odisha, Rajasthan, Chhattisgarh, West Bengal, and several North-Eastern and hill States.
A post-devolution needs assessment could have partially offset these losses through targeted grants, without undoing the gains accruing to higher-capacity States. The absence of such an exercise represents a clear departure from earlier Finance Commission practices.
Implications for Fiscal Equalisation
By freezing the vertical share, narrowing the information base, and eliminating revenue-deficit grants, FC-16 has shifted India’s transfer system towards a more formula-driven but less responsive framework. While predictability has increased, flexibility and sensitivity to State-specific fiscal stress have diminished.
This design choice raises a broader question for India’s fiscal federalism: whether tax devolution alone can carry the burden of equalisation in a country marked by deep regional disparities. The FC-16 framework, unless reviewed carefully, risks setting a precedent where horizontal imbalances persist even as overall transfers grow.
What to Note for Prelims?
- Vertical vs horizontal devolution.
- 42% (later 41%) States’ share since FC-14.
- Role of Article 275 grants.
- Key criteria used in Finance Commission tax devolution.
What to Note for Mains?
- Impact of freezing vertical devolution on Centre–State relations.
- Limits of formula-based tax devolution for fiscal equalisation.
- Debate on revenue-deficit grants and State-specific needs.
- Changing balance between predictability and flexibility in fiscal federalism.
FC-16’s approach underscores a gradual but significant recalibration of India’s transfer system — one that prioritises stability and formulaic clarity, but raises enduring questions about equity and the future role of Finance Commissions in correcting regional imbalances.
Last Modified: February 4, 2026