Sixteenth Finance Commission: Concerns & Impact

Context

• The Sixteenth Finance Commission had significant flexibility in determining its approach and methodology as its terms of reference followed directly from constitutional provisions, unlike earlier commissions that operated under detailed central directives.
• Like previous commissions, it addressed two key dimensions of fiscal transfers:  vertical (Centre-State share) and horizontal (inter-State distribution).

Vertical Dimension (Centre-State Tax Devolution)

• The States’ Share Decision
  • The Fourteenth Finance Commission had increased States’ share in the divisible pool from 32% to 42%, later reduced to 41% due to the change in status of Jammu and Kashmir.
  • Despite the Centre’s concerns about reduced fiscal space, the Sixteenth Finance Commission retained the States’ share at 41%, giving it a kind of semi-permanence.
• Centre’s Response to Increased State Share (Historical Context)
  • Increased non-shareable cesses and surcharges to protect its fiscal space.
  • Reduced its share in financing Centrally Sponsored Schemes.
  • Did not accept sector-specific and State-specific grants recommended by the Fifteenth Finance Commission.
• Trend in Effective Transfers

Finance Commission Period	Effective Transfers as % of Centre’s Gross Revenue Receipts
11th, 12th, 13th FC	27.0%, 27.2%, 28.3%
14th FC	35.6% (sharp increase)
15th FC (2020-25)	34.4%
16th FC (2026-27, Budget Estimate)	32.7%

Horizontal Dimension (Inter-State Distribution Formula)

• The Sixteenth Finance Commission introduced a new criterion of “contribution” to reflect efficiency, which is measured through a State’s share of Gross State Domestic Product (GSDP) in all-State GSDP.
• However, GSDP was used in two opposite ways, thus creating an internal contradiction:
  • In the income distance formula, a lower per-capita GSDP means a higher share.
  • In the contribution criterion, a higher per-capita GSDP means higher share.
• To reduce the excessive effects, the Commission used the square root of GSDP rather than GSDP itself.
• The tax effort and fiscal discipline criterion,  a fiscal efficiency measure, was dropped, which is inconsistent with the Commission’s own narrative on efficiency.
• Changes in weights of other criteria were purely judgmental.

Limitations and Concerns

• On Cesses and Surcharges
  • The Commission made no recommendations regarding non-shareable cesses and surcharges, despite their constitutional significance under Articles 270 and 280.
  • Cesses and surcharges by their nature should be limited, levied for finite periods, and earmarked for specific purposes, thus not merged with the Centre’s general funds.
  • The Commission did not point out to the Centre that the steep increase in cesses and surcharges was not in the spirit of the Constitution.
  • Instead, it recommended a “grand bargain”, i.e. States would agree to a smaller share in a larger divisible pool if the Centre merged cesses and surcharges into regular taxes, thus leaving the constitutional concern unresolved.
• On Grants
  • The Commission chose to discontinue revenue deficit grants and did not recommend any State-specific or sector-specific grants.
  • This effectively became a route to lower the overall share of States in Centre’s revenue receipts compared to the Fifteenth Finance Commission.
• On GDP Growth Assumptions
  • The Commission’s projections for later years may prove to be overestimates since the assumed nominal GDP growth of 11% for 2026-27 is higher than the Budget estimate of 10%.
  • The Commission also did not factor in the revenue-reducing effect of major GST reforms undertaken in September 2025, while the Commission was still in session.
• States That Have Lost Under the New Formula
  • Major losing States compared to the 15th FC: Madhya Pradesh, Uttar Pradesh, West Bengal, Bihar, Odisha, Chhattisgarh, and Rajasthan.
  • Smaller losing States: Arunachal Pradesh, Meghalaya, Manipur, Nagaland, Tripura, Sikkim, and Goa.
  • Gains by richer States have not been uniform.

Way Forward

• Losses of States due to changed devolution formulae could have been mitigated through normatively determined revenue gap grants rather than dropping them altogether.
• Tax devolution alone is insufficient to capture the finer details of cost and need differentials across India’s highly differentiated States.
• Article 275 provides an important constitutional mode of fiscal transfers for State-specific needs, but it should not be confused with revenue deficits and must be used to equalise standards of critical services like health and education.
• When a Finance Commission changes devolution formulae, consequential losses of some States could be neutralised through revenue gap grants rather than leaving them unaddressed.
• While ad hoc State-specific grants are not appropriate, equalisation grants that objectively assess State needs still have a legitimate constitutional place.
• The Centre must be reminded that the steep increase in cesses and surcharges is not warranted and not in the spirit of the constitutional framework governing fiscal federalism.