UPSC Mains
GS Paper II & III
Polity & Economy
Fiscal Federalism: 16th Finance Commission
The FC-16 report retains vertical devolution at 41% but completely eliminates Revenue Deficit Grants, raising concerns about equity among structurally weaker states.
Vertical Devolution
Retained at 41%
Grants-in-Aid Share
Halved (19.4% → 8.3%)
Local Govt Allocation
₹7.2 Lakh Crore
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News & Background
- The 16th Finance Commission (FC-16), chaired by Arvind Panagariya, submitted its report covering the period of 2026-31.
- The commission retained the vertical devolution at 41%, ignoring demands from 18 states to raise it to 50%.
- The share of Grants-in-aid in total transfers has more than halved from 19.4% to 8.3%.
- The commission completely eliminates Revenue Deficit Grants (RDGs), sector-specific grants, and state-specific grants.
- What is Fiscal Federalism? It refers to the constitutional division of financial powers and responsibilities between the Centre and States.
- Under Article 280, the Finance Commission distributes central taxes, and under Article 275, it recommends grants-in-aid acting as a corrective institution mediating asymmetry.
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Advantages of Fiscal Federalism
- Targeted Support: Enables crucial financial support for states with special needs beyond simple formula-based tax devolution.
- Recognising Heterogeneity: Revenue Deficit Grants historically recognised heterogeneity across states, preventing a rigid “one-size-fits-all” treatment.
- National Contributions: Proper federalism rewards systemic contributions—such as Kerala’s human capital investment (contributing 23% of India’s remittances) and Punjab’s contribution to national food security.
- Geographical Realities: Hill states and North-Eastern states face structurally high administrative costs that only targeted grants can address.
- Local Accountability: Performance-based grants to local bodies (₹7.2 lakh crore) promote accountability and transparency at the critical third tier of governance.
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Challenges in Fiscal Federalism
Equity Deficit
Removal of RDGs imposes sudden fiscal stringency on states while preserving absolute fiscal flexibility for the Union.
Cesses and Surcharges
Non-shareable Union levies are consistently increasing, effectively reducing the actual divisible tax pool available to states.
Double Burden on Poor States
Lower tax devolution combined with the removal of RDGs creates a compounding financial disadvantage for weaker states.
Income Distance Reduction
The weight assigned to “income distance” was reduced from 45% to 42.5%, directly hurting the poorer states.
GDP Contribution Bias
The new 10% weight for GDP contribution disadvantages industrially weaker states that lack the infrastructure to compete.
North-South Divide
Southern states generating more GST and revenue fear long-term penalisation for their better fiscal performance and demographic management.
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Way Forward
Restore RDGs
Revenue Deficit Grants must be reinstated to support structurally disadvantaged states facing genuine fiscal stress.
Cess Reform
Non-shareable cesses and surcharges must be merged into the divisible pool to reduce vertical fiscal imbalance.
Raise Devolution Share
Seriously consider raising the states’ share in the divisible pool from 41% to 50% as demanded by 18 states.
Income Distance Weight
Restore a higher weight to the income distance criterion to protect and uplift poorer and historically backward states.
Flexible Conditionalities
Conditionalities attached to local body grants must be realistic and capacity-sensitive, not uniformly rigid across all regions.
Special Category Status
Revive meaningful special category financial treatment for hill, north-eastern, and coastal states facing geographic disadvantages.
Conclusion: Fiscal federalism in India cannot be sustained on performance metrics alone—it must be anchored in fairness. The Finance Commission must reward high-performing states while simultaneously supporting structurally disadvantaged ones. For a country as diverse as India, pursuing efficiency without equity risks deepening regional disparities permanently.
