16th Finance Commission and Centre-State Fiscal Relations

Finance Commission Latest News

• The 16th Finance Commission has submitted its report for 2026-31, and the Union government has accepted its recommendations on tax devolution to States. 

Constitutional Framework of Fiscal Federalism

• India’s fiscal federal structure is anchored in Article 270 and Article 280 of the Constitution. 
  • Article 270 provides for the distribution of net tax proceeds between the Centre and the States. 
  • Article 280 mandates the constitution of a Finance Commission every five years to recommend how this distribution should take place.
• The taxes shared between the Centre and States include:
  • Corporation Tax
  • Personal Income Tax
  • Central Goods and Services Tax (CGST)
  • Centre’s share of Integrated GST (IGST)
• However, cess and surcharge levied by the Centre are excluded from the divisible pool. 
• The divisible pool forms about 81% of the Centre’s gross tax revenue for 2025-26 after excluding cess and surcharge. 
• This distinction has been central to debates on fiscal equity and resource adequacy for States.

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Evolution of Vertical Devolution

• Vertical devolution refers to the share of States in the divisible pool of central taxes.
  • Till the 13th Finance Commission (2010-15): States received 32% of the divisible pool, along with conditional transfers under Centrally Sponsored Schemes (CSS).
  • 14th Finance Commission (2015-20): Vertical devolution was significantly increased to 42%, and many tied CSS transfers were rationalised.
  • 15th Finance Commission (2020-26): The share was reduced to 41% after the reorganisation of Jammu and Kashmir into two Union Territories. 
• This marked a structural shift toward greater untied fiscal autonomy for States.

Horizontal Devolution Criteria

• Horizontal devolution refers to how the States’ share is distributed among individual States.
• Since the 13th Finance Commission, the criteria have broadly emphasised:
  • Equity (Income Distance)
  • Population and Area (Needs-based factors)
  • Efficiency factors such as forest cover, demographic performance, and tax effort
• This has led to persistent debates between economically advanced and less-developed States.

States’ Key Demands Before the 16th Finance Commission

• Demands on Vertical Devolution – Many States sought an increase in vertical devolution:
  • 18 States demanded raising the share from 41% to 50%.
  • Some others sought 45-48%.
• Several States demanded inclusion of cess and surcharge in the divisible pool and a cap on their imposition. 
• Demands on Horizontal Devolution:
  • Many States wanted equity parameters to retain dominance.
  • Some recommend reducing the weight of “income distance”.
• Industrialised States such as Maharashtra, Gujarat, Tamil Nadu, Karnataka, and Telangana demanded inclusion of States’ contribution to GDP as a criterion. 
• These demands reflected the tension between redistribution and reward for performance.

Recommendations of the 16th Finance Commission

• On Vertical Devolution
  • The Commission rejected the proposal to cap or include cess and surcharge in the divisible pool, stating that under the present constitutional scheme, it is neither permissible nor desirable. These instruments may be required for exigencies. 
  • It retained the States’ share at 41%, citing three reasons:
    • States already receive a substantial share of total tax revenues.
    • Much of Union spending under CSS is routed to the States.
    • The Union requires higher resources for defence and infrastructure. 
  • Thus, there is no major change in vertical devolution.
• On Horizontal Devolution
  • The Commission adopted two guiding principles:
    • Changes in States’ shares should be gradual.
    • Efficiency and growth contributions should receive due recognition.
    • Accordingly, a new criterion of States’ contribution to GDP has been introduced. The weight assigned ensures a directional shift without drastic redistribution. 
  • As a result:
    • Southern and western States have seen a marginal increase in their share.
    • Large northern and central States have seen a marginal decrease. 
  • Overall, the outcome represents a calibrated shift toward efficiency while maintaining redistributive balance.

Broader Fiscal Observations

• The Commission made several important observations:
  • The Centre should progressively reduce reliance on cess and surcharge.
  • States should make subsidies more efficient and targeted.
  • Power sector reforms must be actively pursued.
  • States need to control fiscal deficits and debt levels.
  • Both the Centre and States should undertake public sector enterprise reforms. 
• These recommendations reflect concerns over fiscal sustainability and cooperative federalism.

Source: TH