The 16th Finance Commission (FC), chaired by Dr. Arvind Panagariya, has submitted its recommendations for the award period 2026–31, and the Union government has accepted its proposals on tax devolution. At first glance, the report appears to maintain status quo in Centre–State fiscal relations. Yet, beneath this continuity lies a calibrated shift — especially in recognising States’ contributions to growth while preserving equity considerations.
Constitutional Framework of Fiscal Devolution
India’s fiscal federal structure is rooted in Articles 270 and 280 of the Constitution.
- Article 270 provides for the distribution of net tax proceeds between the Union and the States.
- Article 280 mandates the constitution of a Finance Commission every five years to recommend this distribution.
Taxes that form part of the divisible pool include corporation tax, personal income tax, Central GST, and the Centre’s share of IGST. However, cess and surcharge levied by the Centre are excluded from this pool.
For 2025–26, the divisible pool is estimated to constitute around 81% of the Centre’s gross tax revenue after excluding cess and surcharge. The growing reliance on these non-shareable components has been a persistent point of friction in Centre–State fiscal relations.
Evolution of Vertical Devolution: From 32% to 41%
Vertical devolution refers to the share of States in the divisible pool.
- Up to the 13th FC (2010–15): States’ share was fixed at 32%, with substantial conditional transfers under Centrally Sponsored Schemes (CSS).
- 14th FC (2015–20): Increased vertical devolution to 42% and reduced tied transfers, strengthening fiscal autonomy of States.
- 15th FC (2020–26): Revised it slightly downward to 41% following the reorganisation of Jammu and Kashmir.
The shift initiated by the 14th FC marked a significant move towards cooperative federalism by enhancing untied funds to States.
States’ Demands Before the 16th Finance Commission
Ahead of the 16th FC recommendations, States articulated two major demands:
On Vertical Devolution
- 18 States demanded an increase in their share from 41% to 50%.
- Others proposed a rise to 45–48%.
- Several States sought inclusion of cess and surcharge in the divisible pool and a cap on their imposition.
On Horizontal Devolution
Horizontal devolution concerns distribution among States. Key demands included:
- Retention of equity-based parameters such as income distance.
- Reduction in the weight assigned to income distance.
- Inclusion of States’ contribution to GDP as a criterion, particularly demanded by industrialised States like Maharashtra, Gujarat, Tamil Nadu, Karnataka, and Telangana.
This reflected a long-standing debate between equity (supporting poorer States) and efficiency (rewarding better-performing States).
16th FC on Vertical Devolution: Status Quo with Caution
The Commission retained the States’ share at 41%, rejecting demands for enhancement.
It offered three broad justifications:
- States already receive a significant share of total tax revenues.
- Much of the Union’s spending under CSS ultimately flows to States.
- The Union requires fiscal space for national priorities such as defence and infrastructure.
On cess and surcharge, the Commission stated that under the current constitutional framework, neither inclusion in the divisible pool nor a statutory cap is permissible or desirable. However, it advised the Centre to progressively reduce excessive reliance on these instruments.
Thus, while maintaining the existing structure, the Commission implicitly acknowledged concerns over shrinking shareable revenues.
Horizontal Devolution: A Directional Shift Toward Efficiency
The 16th FC introduced a nuanced change in horizontal devolution.
Two guiding principles shaped its approach:
- Changes in States’ shares should be gradual to avoid fiscal shocks.
- Efficiency and contribution to growth should receive due recognition.
Accordingly, a new criterion — States’ contribution to GDP — has been introduced. The weight assigned is calibrated so as to signal a policy shift without drastically altering State shares.
The outcome:
- Marginal increase in shares of southern and western States.
- Marginal decrease for large northern and central States.
This represents a careful balancing act between redistributive justice and performance-based incentives.
Equity vs Efficiency: The Core Federal Debate
Since the 13th FC, horizontal devolution has heavily weighted equity parameters such as:
- Income distance (gap from the highest per capita income State).
- Population.
- Area.
Efficiency indicators like forest cover, demographic performance, and tax effort have had relatively lower weightage.
By adding GDP contribution as a criterion, the 16th FC has acknowledged that sustained contributors to national growth seek fiscal recognition. This may moderate tensions between “donor” and “recipient” States, without undermining redistributive goals.
Fiscal Responsibility and Reform Imperatives
Beyond devolution percentages, the Commission has emphasised structural reforms:
- The Centre should gradually reduce dependence on cess and surcharge.
- States should rationalise subsidies and improve targeting.
- Power sector reforms must be accelerated.
- Both Centre and States should rein in fiscal deficits and public debt.
- Public sector enterprise reforms are necessary for fiscal sustainability.
These recommendations highlight that fiscal federalism is not merely about resource sharing but about improving quality of expenditure and governance.
What to Note for Prelims?
- Articles 270 and 280 – Constitutional basis of Finance Commission.
- Divisible pool excludes cess and surcharge.
- Vertical devolution retained at 41% for 2026–31.
- New horizontal criterion: States’ contribution to GDP.
- Distinction between vertical and horizontal devolution.
What to Note for Mains?
- Debate between equity and efficiency in fiscal federalism.
- Implications of excluding cess and surcharge from divisible pool.
- Impact of stable vs enhanced vertical devolution on cooperative federalism.
- Recognition of growth contribution in horizontal transfers.
- Need for fiscal discipline and power sector reforms in States.