India’s 16th Finance Commission and Fiscal Federalism Reform

India’s 16th Finance Commission (FC) begins its work amid a very important shift in the country’s fiscal landscape. The economy is valued around $4 trillion, with states now responsible for over 55% of public expenditure. This marks change from less than five years ago. The Union government continues to set macroeconomic strategy, but states are the main drivers of growth and service delivery. The Commission’s task is to balance equity with efficiency and growth with justice. It must design a fiscal framework suitable for a $10-trillion economy by 2030.

Changing Fiscal Structure in India

States’ share in public spending has risen to about 55%, while the Union’s share has dropped to 45%. States lead in infrastructure, health, and welfare spending. Between 2021 and 2026, gross tax collections surged 26% above projections. Devolution to states also increased by 24%. This reflects a resilient economy and a broader tax base. However, resource-sharing formulas have not kept pace with these changes.

Challenges in Horizontal Devolution

High-performing states like Maharashtra, Karnataka, Gujarat, and Tamil Nadu feel under-recognised in the horizontal devolution formula. Their economic contributions exceed the transfers they receive. Southern states oppose the continued use of outdated population data from 1971 and 2011. This penalises states that have successfully controlled population growth. The current formula does not reward fiscal discipline, efficiency, or innovation. The rise of cesses and surcharges reduces the divisible tax pool, limiting states’ fiscal space.

Modernising the Fiscal Design

The 16th FC must modernise India’s fiscal federalism to reflect a more complex and globalised economy. It should base allocations on data rather than perceptions. Although southern states’ shares have declined, populous northern states like Uttar Pradesh and Bihar have also seen reductions. Smaller northeastern states have gained disproportionately. The Commission proposes keeping 41% vertical devolution for stability but updating horizontal allocation. New variables include sustainable development goals, fiscal effort, and ecological resilience. This aligns state incentives with national goals of sustainability, competitiveness, and inclusion.

Innovations in Grants and Fiscal Autonomy

The new model suggests compensatory grants to prevent any state from receiving less than before. Local government grants will support rural development and urban governance. Untied grants will give states freedom to address local priorities without central conditions. Urban India, expected to be 38% of the population by 2031, will receive focused financing. Devolution should shift from compensatory to enabling, helping states generate growth independently. The Centre and states must co-create fiscal strategies.

Key Reforms for Fiscal Federalism

Three reforms are crucial – 1. Protect the divisible pool by capping cesses and surcharges at 10% of gross tax revenue. 2. Make the devolution formula performance-sensitive, rewarding fiscal health and digital infrastructure improvements. 3. Internalise climate and demographic differences, recognising ageing southern states’ health costs and northern states’ need for education and jobs.

Risks and Future Outlook

Risks include over-reliance on non-shareable revenues and political tensions from population-based criteria. Underfunded local bodies may weaken service delivery. The 16th FC must combine technical skill with political insight. It aims to establish a new federal contract to support India’s $10-trillion economy goal. The challenge is to sustain equity while rewarding efficiency and to transform fiscal federalism into a growth enabler.

Questions for UPSC:

1. Critically discuss the role of the Finance Commission in India’s fiscal federalism and its impact on Centre-State relations.
2. Analyse the challenges and opportunities in implementing a performance-sensitive fiscal devolution formula in India.
3. Examine the implications of demographic changes on fiscal policy and resource allocation in state of Indias.
4. Estimate the effects of cesses and surcharges on cooperative federalism and suggest measures to improve fiscal transparency.

Answer Hints:

1. Critically discuss the role of the Finance Commission in India’s fiscal federalism and its impact on Centre-State relations.

1. The Finance Commission (FC) constitutionally allocates financial resources between Centre and states, ensuring fiscal balance.
2. It balances equity and efficiency, growth and justice, shaping fiscal federalism dynamics.
3. FC’s recommendations influence Centre-State power sharing and fiscal autonomy of states.
4. Recent FCs reflect shifting fiscal structure – states now account for over 55% of public expenditure.
5. FC impacts Centre-State relations by determining devolution formula and grants, affecting states’ fiscal space.
6. Its evolving role includes promoting cooperative federalism and enabling states to drive growth independently.

2. Analyse the challenges and opportunities in implementing a performance-sensitive fiscal devolution formula in India.

1. Challenges include measuring fiscal performance objectively across diverse states.
2. Resistance from states fearing loss of guaranteed share or penalisation for underperformance.
3. Opportunities lie in incentivising fiscal discipline, administrative efficiency, and innovation.
4. Performance-sensitivity can align state incentives with national goals like sustainability and competitiveness.
5. Requires robust data systems and transparency to ensure fairness and acceptance.
6. Can modernise fiscal federalism from compensatory to enabling, encouraging growth and resilience.

3. Examine the implications of demographic changes on fiscal policy and resource allocation in states of India.

1. Population control success penalises some states under outdated population-based devolution formulas.
2. Ageing southern states face rising health and pension costs, increasing fiscal burden.
3. Younger northern states require more investment in education, jobs, and infrastructure.
4. Demographic asymmetries necessitate differentiated fiscal support and policy responses.
5. Ignoring demographic changes risks fiscal inequity and inefficient resource distribution.
6. Fiscal policy must internalise demographic trends for sustainable and equitable development.

4. Estimate the effects of cesses and surcharges on cooperative federalism and suggest measures to improve fiscal transparency.

1. Cesses and surcharges reduce the divisible tax pool, limiting states’ fiscal space despite growing responsibilities.
2. Excessive use (averaging 15%) erodes cooperative federalism by undermining resource sharing balance.
3. Lack of transparency in their imposition creates mistrust between Centre and states.
4. Measures include capping cesses and surcharges at 10% of gross tax revenue.
5. Introducing transparency and accountability in levy and utilization of these levies.
6. Restoring divisible pool protects states’ fiscal autonomy and strengthens Centre-State cooperation.