The Sixteenth Finance Commission, A Cautious Mandate That Sidesteps Structural Reform in Fiscal Federalism
The recommendations of the Sixteenth Finance Commission (FC-16), tabled in Parliament and constituting a foundational fiscal pact for the five-year period from 2026 to 2031, have arrived amidst fervent anticipation and profound anxiety from India’s states. Tasked with the constitutional mandate of defining the principles governing the distribution of net tax proceeds between the Union and the States, the Commission’s report is more than an accounting exercise; it is a barometer of the health of India’s federal compact. After extensive deliberation, the FC-16 has delivered a verdict of continuity over change, and caution over bold reform. By recommending the retention of the vertical devolution ratio at 41%—rejecting the states’ collective demand for 50%—and making only incremental tweaks to horizontal distribution, the Commission has prioritized short-term stability. However, in doing so, it has arguably deferred the urgent, structural changes required to address the deepening fiscal asymmetries and restore a genuine balance in India’s fiscal federalism, leaving the fundamental tension between a powerful Centre and revenue-starved states unresolved.
The Vertical Stalemate: Retaining the 41% Ceiling and Its Implications
The most contentious and significant recommendation of the FC-16 is its decision to maintain the states’ share in the divisible pool of central taxes at 41%. This figure, first established by the Fourteenth Finance Commission and retained by the Fifteenth, has become a symbolic battleground. States, across political spectrums, have united in demanding an increase to 50%, arguing that their expenditure responsibilities—especially in social sectors like health, education, and agriculture—have ballooned while their own revenue-raising capacities have been constrained, particularly under the Goods and Services Tax (GST) regime.
The FC-16’s rationale for holding the line at 41% likely stems from a concern for the Union government’s own fiscal space, especially given its commitments to high levels of capital expenditure on national infrastructure and defense, and the need for fiscal consolidation post-pandemic. However, this decision flies in the face of the Commission’s own diagnosis. The report acknowledges the “tightening fiscal space States face under the GST framework” and notes that the growing mismatch between their responsibilities and assured revenues has left them with “recourse to market borrowings” as the principal adjustment mechanism. This is a damning admission: states are being pushed into debt because the system does not provide them with adequate, predictable revenues to fulfill their constitutionally mandated functions.
By not increasing the vertical devolution, the FC-16 has effectively endorsed this status quo. It has ignored a potential middle path—such as a staggered increase to 45% by 2031—that could have expanded states’ discretionary fiscal space (money they can spend according to their own priorities) while maintaining overall macroeconomic stability. The retention of the 41% share reinforces a centralizing tendency, ensuring that states remain financially dependent on the Centre’s whims, both through tax devolution and, more controllably, through grants.
The Shrinking Divisible Pool: The Unaddressed Elephant in the Room
Compounding the problem of a static share is the continued shrinkage of the pool itself. The FC-16 flags the issue of cesses and surcharges—levies imposed by the Centre that are not shared with states—but stops short of recommending their inclusion in the divisible pool. This is a critical omission. Over the years, the Union government has increasingly relied on these instruments to raise revenue. While legally permissible, this practice ethically and strategically undermines the spirit of fiscal federalism. It allows the Centre to raise funds for its priorities without having to share them with states, effectively reducing the actual pie from which the 41% is calculated.
For states, this is a double whammy: not only is their share frozen, but the cake from which it is cut is being deliberately reduced. The Commission had a historic opportunity to correct this distortion and strengthen the integrity of the devolution system by recommending that a portion of these levies be shared. Its failure to do so represents a missed chance for structural correction and leaves states justifiably feeling short-changed.
Horizontal Devolution: Modest Tweaks Towards Performance, But No Radical Redistribution
On the formula for distributing the states’ share among themselves (horizontal devolution), the FC-16 has introduced a modest but meaningful change. It has reworked the earlier “tax effort” criterion into a broader “contribution to GDP” measure and sharply increased its weight from a negligible 2.5% under FC-15 to 10%. This is intended to reward productive, industrialized states that contribute disproportionately to the national economy. States like Tamil Nadu, Maharashtra, Karnataka, and Gujarat, which have long argued that their economic efficiency is penalized by a distribution formula overly focused on need and equity, will see this as a positive, if limited, step.
Simultaneously, the Commission has reduced the weight for demographic performance (which penalized states with higher population growth) and modestly increased the weight for population size. This reflects a pragmatic view that penalizing population growth is less appropriate as India nears the peak of its demographic dividend, and a recognition that providing basic services to a large population remains a costly and legitimate basis for claiming resources.
However, the Commission’s approach here is characterized by extreme caution. It explicitly states that any restructuring must be undertaken “gradually” to avoid abrupt redistributive shocks to poorer, recipient states like Bihar, Uttar Pradesh, and Madhya Pradesh, which are heavily dependent on central transfers. Consequently, the net gains for industrialized states are “deliberately restrained” and incremental. While this prevents instability, it also “underscores the limits of the Commission’s ambition.” It avoids making a stronger statement that would significantly reward fiscal efficiency and economic contribution, potentially missing a chance to incentivize better state-level economic governance more powerfully.
The Rise of Conditional Transfers: Reinforcing a “Implementer” Model for States
Perhaps the most telling indicator of the shifting balance of fiscal federalism is not in the tax devolution numbers alone, but in the composition of total transfers. The FC-16 notes that total transfers to states are budgeted to rise by 12.2% between 2025-26 and 2026-27. However, a staggering ₹1.2 lakh crore—about 42% of this increase—comes from revenue transfers under Centrally Sponsored Schemes (CSS).
This is a crucial distinction. Tax devolution (the 41% share) is untied money; states can spend it as they see fit, according to their local needs and political mandates. Funds from CSS, however, are highly conditional. They come with strict guidelines, implementation frameworks, and often require state co-financing. They represent priorities “set in New Delhi,” turning state governments into implementers of a national agenda.
The increasing reliance on CSS transfers, even as the tax devolution share remains static, reinforces a top-down governance model. It erodes the autonomy and accountability of state governments. They have less freedom to innovate or tailor solutions to local problems, and their electoral accountability is blurred when schemes are branded as central initiatives. The FC-16’s recommendations, by not expanding the untied fiscal space of states, implicitly accept and reinforce this centralized model of development administration.
The Road Not Taken: What Structural Change Would Entail
The FC-16’s report is competent and cautious, but it does not catalyze the “structural change” needed. Such change would involve a more courageous reimagining of fiscal responsibilities and resources. It could have included:
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A Time-Bound Increase in Vertical Devolution: A roadmap to elevate the states’ share to 45% or higher by the end of the award period, signaling a commitment to rebalancing.
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Incorporating Cesses and Surcharges: Recommending that a significant portion of these levies be added to the divisible pool, or alternatively, justifying their existence with greater transparency and linking them more directly to specific, time-bound national projects.
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A Bolder Horizontal Formula: While protecting vulnerable states through a stabilization fund, a more significant weight could have been assigned to “contribution to GDP” or “fiscal efficiency” to send a powerful incentive signal.
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Reviewing the Seventh Schedule: While beyond the FC’s strict mandate, highlighting the need for a review of the Union and State Lists (Seventh Schedule of the Constitution) to better align responsibilities with revenue capacities in the 21st century would have been a visionary push.
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Strengthening State Borrowing Frameworks: Providing a clearer, rules-based framework for state market borrowings that complements devolved revenues, rather than treating debt as a default option.
Conclusion: A Holding Pattern in Federal Relations
The Sixteenth Finance Commission has navigated complex political and economic currents to produce a report that ensures stability for the next five years. It has avoided rocking the boat. However, in an era where states are demanded to be laboratories of democracy and engines of regional growth, the Commission’s recommendations may prove insufficient.
By retaining the 41% vertical devolution, ignoring the cess and surcharge problem, and allowing conditional transfers to constitute a growing part of the flow, the FC-16 has maintained a fiscal architecture that centralizes power and decision-making. It has diagnosed the patient’s illness—states pushed into debt due to a mismatch between resources and responsibilities—but prescribed only palliative care, not curative surgery.
The recommendations recognize the stresses but do not push for the structural change needed to restore balance. As a result, the fundamental tensions of Indian fiscal federalism—between equity and efficiency, between autonomy and unity, between devolution and delegation—will continue to simmer. The states’ recourse to market borrowings and their political discontent are likely to intensify, setting the stage for a more contentious debate when the Seventeenth Finance Commission convenes. For now, the balance remains tilted, awaiting a more daring future intervention to set it right.
Q&A on the Sixteenth Finance Commission (FC-16) Recommendations
Q1: What is the single most significant and contentious recommendation of the FC-16, and why have states opposed it?
A1: The most significant recommendation is the retention of the vertical devolution ratio at 41%, meaning states collectively will receive 41% of the divisible pool of central taxes. States, who had unitedly demanded an increase to 50%, oppose this because they argue their expenditure responsibilities (health, education, social welfare) have expanded dramatically. Their own revenue-raising power has been curtailed by the GST, creating a growing mismatch between what they must spend and what they earn. The FC-16 itself acknowledges this has forced states to rely heavily on market borrowings. By denying an increase, the Commission is seen as ignoring states’ genuine fiscal distress and reinforcing their financial dependency on the Centre.
Q2: How has the FC-16 tweaked the formula for distributing funds among states (horizontal devolution), and what is the intended goal?
A2: The FC-16 made a key change by replacing the old “tax effort” criterion with a broader “contribution to GDP” measure and raising its weight sharply from 2.5% to 10%. The intended goal is to reward productive and efficient states—those that contribute more to the national economy—by linking fiscal transfers to economic governance outcomes. Additionally, it reduced the weight for demographic performance (penalizing population growth) and slightly increased the weight for population size, reflecting a view that penalizing growth is less appropriate as India nears its demographic peak.
Q3: Despite acknowledging the problem, what key structural issue did the FC-16 fail to correct, and why does it matter?
A3: The FC-16 flagged the issue of cesses and surcharges shrinking the effective divisible pool of taxes but stopped short of recommending their inclusion in the pool. This matters profoundly because cesses and surcharges are levied by the Centre but not shared with states. Their increasing use means the actual pool from which the 41% is calculated is artificially reduced. This is a double blow for states: a frozen share percentage applied to a shrinking base. Correcting this would have been a major structural reform to ensure the spirit of tax-sharing is upheld.
Q4: The analysis suggests that the increasing reliance on Centrally Sponsored Schemes (CSS) is changing the nature of fiscal federalism. How?
A4: While total transfers to states are rising, a large portion (42% of the increase) comes from revenue transfers under Centrally Sponsored Schemes (CSS). Unlike tax devolution (untied funds), CSS money is highly conditional and tied to priorities and guidelines set by the central government. This reinforces a governance model where states act primarily as “implementers” of New Delhi’s agenda. It erodes state fiscal autonomy (less freedom to spend as they choose) and dilutes their political accountability, as schemes are often branded as central initiatives. This trend centralizes power despite the facade of federal fund transfers.
Q5: Why does the article describe the FC-16’s approach as one of “caution” that avoids “structural change,” and what alternative path could have been considered?
A5: The FC-16’s approach is cautious because it prioritizes stability and avoids redistributive shocks. It retains the 41% devolution, makes only gradual tweaks to horizontal shares, and sidesteps the cess/surcharge issue. It acknowledges problems but does not push for transformative fixes. An alternative, more structural path could have included: 1) A staggered increase in vertical devolution (e.g., to 45% by 2031); 2) Inclusion of some cesses/surcharges in the divisible pool; 3) A bolder weighting for performance in the horizontal formula to incentivize efficiency more strongly. Such measures would have expanded states’ discretionary fiscal space and moved towards rebalancing the fiscal relationship, rather than just managing its current imbalances.
