Sixteenth Finance Commission: Misses and Concerns

Why in News?

The Sixteenth Finance Commission marks an important phase in India’s fiscal federal framework, But several concerns arise regarding its approach and outcomes.

What about the vertical devolution?

• Background of increasing state share – The Fourteenth Finance Commission had significantly raised the States’ share in the divisible pool of central taxes from 32% to 42%.
• This was justified by the discontinuation of State Plan grants, which constituted around 3% of the divisible pool at that time.
• Subsequently, the Fifteenth Finance Commission reduced the share marginally to 41%, primarily due to the reorganisation of Jammu and Kashmir.
• The Sixteenth Finance Commission retained this 41% share, thereby imparting a degree of semi-permanence to the arrangement.
• Issue of cesses and surcharges – Following the Fourteenth Finance Commission’s award, the Centre responded to the enhanced State share by:
  • Increasing non-shareable cesses and surcharges
  • Reducing its contribution to Centrally Sponsored Schemes
  • Not fully accepting sector- or State-specific grants recommended by the Fifteenth Commission

Cesses and surcharges, by constitutional design (Articles 270 and 280), are not shareable with States.

• Their growing use effectively reduces the divisible pool.
• Instead of firmly addressing this issue, the Sixteenth Commission proposed a “grand bargain,” whereby:
  • States would accept a smaller share of a larger divisible pool
  • The Centre would merge a significant portion of cesses and surcharges into regular taxes
• However, this approach raises concerns:
  • It appears to dilute the Commission’s constitutional responsibility to objectively determine States’ share.
  • It does not explicitly critique the steep increase in cesses and surcharges, which arguably undermines fiscal federalism.
• Declining effective transfers – Effective transfers (tax devolution plus Finance Commission grants) as a percentage of the Centre’s pre-transfer gross revenue receipts show the following trend:
  • 11th–13th FC periods: 27–28%
  • 14th FC period: 35.6% (sharp increase)
  • 15th FC period: 34.4%
  • 2026–27 (first year of 16th FC award): 32.7% (Budget Estimate)
• Thus, although the statutory devolution share remains at 41%, the effective transfer ratio shows a declining trend.
• The Commission assumed nominal GDP growth of 11% for 2026–27, higher than the Budget estimate of 10%.
• It did not account for the revenue-reducing effects of major GST reforms undertaken in September 2025.
• These factors may result in overestimation of the divisible pool and actual transfers.
• Discontinuation of revenue deficit and sector-specific grants – The Commission discontinued revenue deficit grants and did not recommend State- or sector-specific grants.
• The Implications are:
  • Reduces fiscal space for vulnerable States
  • Lowers effective transfer share compared to the Fifteenth Commission
  • Limits scope for need-based equalisation

What about the horizontal devolution?

• Introduction of “contribution” criterion – The Commission introduced a new efficiency-based criterion called “contribution,” measured through a State’s share in aggregate Gross State Domestic Product (GSDP).
• The concerns are:
  • GSDP reflects production efficiency, not fiscal efficiency.
  • Inter-State GSDP differences are influenced by capital mobility, labour migration, and market forces.
  • Concentration of capital in developed States skews outcomes.
• Thus, production-based indicators may not accurately measure fiscal performance.
• Conceptual contradiction in use of gsdp – The Commission used GSDP in two opposite ways:
  • Income distance criterion – Lower per capita GSDP → Higher share
  • Contribution criterion – Higher per capita GSDP → Higher share
• To moderate the distortion, the Commission used the square root of GSDP rather than the absolute value.
• This was intended to reduce excessive benefits to richer States.
• Nevertheless, this adjustment appears largely judgement-based rather than normatively grounded.
• Dropping fiscal discipline criterion – The Commission removed the tax effort/fiscal discipline criterion—an established fiscal efficiency indicator.
• This appears inconsistent with its stated emphasis on efficiency, as fiscal responsibility and revenue effort directly reflect governance quality.

What are the Losses and Gains?

• Major losing states – Compared to the Fifteenth Commission, the main losing States include:
  • Madhya Pradesh
  • Uttar Pradesh
  • West Bengal
  • Bihar
  • Odisha
  • Chhattisgarh
  • Rajasthan
• Additionally, several north-eastern and small States—Arunachal Pradesh, Meghalaya, Manipur, Nagaland, Tripura, Sikkim, and Goa—also witnessed relative losses.
• Uneven gains – Richer States gained, but not uniformly.
• The redistribution pattern reflects the altered weights and criteria in the new devolution formula.
• The missing equalisation framework – Devolution alone cannot address India’s wide cost and need differentials.
• Article 275 provides for grants-in-aid to meet State-specific needs. These need not be confused with revenue deficits.
• They can be normatively designed to:
  • Equalise standards of essential services like health and education
  • Address structural disadvantages
  • Neutralise losses arising from formula changes
• While ad hoc grants are undesirable, well-designed equalisation grants remain crucial in a heterogeneous federation like India.
• By discontinuing revenue gap grants entirely, the Sixteenth Commission arguably adopted an expedient route rather than undertaking the complex normative assessment required for balanced equalisation.

What lies ahead?

• The Sixteenth Finance Commission sought to balance fiscal prudence, efficiency, and federal equity. While it retained the 41% devolution share, concerns persist regarding:
  • The unchecked expansion of cesses and surcharges
  • The decline in effective transfers
  • The conceptual inconsistency in the horizontal formula
  • The abandonment of revenue gap and equalisation grants
• In a deeply diverse and asymmetrical federation like India, fiscal federalism must reconcile efficiency with equity.
• The Sixteenth Commission’s approach tilts toward formulaic redistribution while weakening the equalisation function—raising important questions about the evolving nature of India’s cooperative federalism.

Reference

The Hindu| 16^th FC Misses and Concerns