The Shrinking Pie, How the 16th Finance Commission’s Status Quo Undermines Fiscal Federalism

The Shrinking Pie, How the 16th Finance Commission’s Status Quo Undermines Fiscal Federalism

The recommendations of the 16th Finance Commission (FC-XVI) for the period 2026-31 have landed with a thud in the state capitals of India, confirming the worst fears of chief ministers and finance ministers across the political spectrum. Despite a rare and overwhelming consensus among States demanding an enhanced share of central revenues, the Commission has chosen the path of least resistance and greatest centralization. By retaining the vertical devolution rate at 41%—the states’ share of the divisible pool of taxes—the FC-XVI has delivered a verdict that prioritizes the fiscal priorities of the Union government over the acute and escalating financial realities of the States. However, this superficial continuity masks a deeper, more insidious dynamic: the deliberate and structural shrinkage of the divisible pool itself through the Union’s excessive reliance on cesses and surcharges. The Commission’s report, while acknowledging this fiscal sleight of hand, has failed to correct it, effectively siding with the Centre and raising profound questions about the future balance of India’s fiscal federalism.

The Illusion of 41%: The Vanishing Divisible Pool

The headline figure of 41% vertical devolution is a masterclass in political misdirection. It creates an impression of stability and fairness, a continuation of the award made by the 14th and 15th Finance Commissions. But this percentage is applied to a denominator—the divisible pool—that is not fixed. The divisible pool consists only of taxes and duties that are mandated by the Constitution to be shared with the States. It explicitly excludes cesses and surcharges, which are levies imposed by the Centre for specific purposes and retained entirely by it.

This loophole has been weaponized. As the data in the analysis starkly reveals, the Union government has systematically shifted its revenue collection from shareable taxes to non-shareable cesses and surcharges. Chart 1 illustrates this dramatic transformation:

• Pre-2019: For every ₹100 collected by the Centre, ₹93-₹95 came from taxes and duties forming the divisible pool; only ₹5-₹7 came from cesses and surcharges.

• 2021-22: The share of the divisible pool shrank to ₹86.5, while cesses and surcharges ballooned to ₹13.5.

• 2025-26 (Budget Estimate): A slight improvement is projected, but the pool remains shrunken at ₹89, with cesses/surcharges at ₹11.

In absolute terms, the rise is staggering (Charts 2A & 2B). Cess collections (excluding GST compensation) skyrocketed from ₹44,688 crore in FY15 to ₹3,52,650 crore in FY22. Surcharges jumped from ₹15,702 crore to ₹40,758 crore in the same period. Consequently, as Chart 3 shows, the share of the divisible pool in the Centre’s Gross Tax Revenue has remained below 90% for six consecutive years, a sharp fall from the consistent 93%+ levels seen between FY13 and FY18.

The FC-XVI’s own report confirms this: the non-shareable portion of revenues expanded from 1.1% of GDP in 2011-12 to 2.2% in 2023-24, while the divisible pool grew only marginally from 9.1% to 9.4%. The Commission acknowledges the problem but refuses to solve it. This is the central paradox: a static devolution rate applied to a deliberately shrinking pool. States are, in effect, fighting over a smaller slice of a pie that the Centre is quietly eating from the other side.

The States’ Consensus vs. The Centre’s “Moderation”

Against this backdrop of fiscal erosion, the demands of the States were not unreasonable but a cry for survival. A formidable coalition of 18 States—including Odisha, Haryana, Gujarat, Kerala, and Tamil Nadu—demanded an increase in the vertical devolution to 50%. Most other States advocated for a rise to 45% or 48%. This cross-party, cross-region consensus underscored a universal truth: States are on the frontline of delivering constitutionally mandated services like health, education, agriculture, and law and order, but their revenue-raising capacities, especially after the GST subsumed key state taxes, have been severely constrained.

In stark opposition, the Centre called for a “moderation in tax devolution.” The FC-XVI, in its wisdom, chose to “balance” these demands by siding with the party seeking moderation against the unanimous voice of those seeking enhancement. Its reasoning, as parsed in the analysis, reveals a Commission that has internalized the Centre’s narrative.

Deconstructing the Commission’s Reasoning: A Pro-Centre Bias

The FC-XVI’s justification for inaction is a series of logical contortions that privilege Union power:

1. The Constitution and the Cess Conundrum: The Commission notes the Constitution does not permit a cap on cesses and surcharges. It then argues the Centre needs these funds for emergencies (war, famine, pandemics), concluding a cap would be “imprudent.” This is a profound abdication of its mediating role. By refusing to recommend even a normative limit or a framework for their use, the FC has given the Centre a blank check. It admits long-term reliance is “undesirable” but offers no mechanism to prevent it, effectively telling States their fate depends on the Centre’s voluntary restraint—a naive proposition in a competitive fiscal environment.

2. The Security and Infrastructure Justification: The report points to “recent shifts in the external security and defence environment” to justify higher central spending. It also lavishes praise on the Centre’s “high degree of effectiveness” in infrastructure building. These arguments are deeply problematic. First, they prioritize Union subjects (defence, national infrastructure) over State subjects (social infrastructure, human development), implicitly devaluing the latter. Second, they ignore that many “high-performing” states contribute disproportionately to national GDP and tax collection but are now being told to make do with less to fund projects that may not align with their immediate developmental needs.

3. The “Sufficient Resources” Fallacy: Most gallingly, the FC maintains that the current distribution “gives States sufficient resources to discharge their constitutional responsibilities.” This claim is directly contradicted by the unanimous demand from States for more resources. If resources were truly sufficient, why would financially prudent states like Gujarat and Haryana join others in this demand? The statement reveals a top-down, Delhi-centric view of state finances, ignoring the reality of rising expenditure on salaries, pensions, social welfare schemes, and the capital investments needed to spur growth.

4. Passing the Buck: The Commission’s ultimate solution is a masterpiece of buck-passing. It suggests the resolution lies in a “mutual agreement” where the Centre voluntarily moves revenue collection from cesses back into the divisible pool. After documenting the Centre’s aggressive use of these instruments to sidestep sharing, expecting it to voluntarily reverse course is an exercise in wishful thinking that absolves the FC of its duty to propose an enforceable solution.

The Consequences: A Weakened Federal Compact

The FC-XVI’s recommendations will have several deleterious effects:

• Increased State Indebtedness: With assured revenues stagnating and responsibilities growing, States will have no choice but to ramp up market borrowings, pushing many towards unsustainable debt levels. The Commission itself notes that states’ recourse to borrowing is a primary adjustment mechanism—a problem it has now exacerbated.

• Erosion of State Autonomy: Greater reliance on central transfers tied to specific schemes (Centrally Sponsored Schemes) will increase, turning States into mere implementing agencies of New Delhi’s priorities, stifling local innovation and accountability.

• Stifling Competitive Federalism: States that perform well economically are penalized under this model. Their higher contributions to the national exchequer do not translate into proportionally higher devolved funds, dampening incentives for progressive fiscal and economic policies at the state level.

• Undermining the Finance Commission’s Role: By failing to check the Centre’s fiscal manipulation and ignoring a historic consensus among States, the FC-XVI risks being seen as a rubber stamp rather than an independent arbitrator. This erodes the credibility of a key constitutional body designed to manage Centre-State fiscal tensions.

Conclusion: A Commission That Chose Caution Over Courage

The 16th Finance Commission had a historic opportunity. Faced with a unified plea from States and clear evidence of a shrinking divisible pool, it could have championed the cause of cooperative federalism. It could have recommended a meaningful increase in the devolution rate or, more boldly, proposed a constitutional or legal mechanism to include a portion of cesses and surcharges in the divisible pool, or at least cap their growth.

Instead, it chose caution over courage, alignment over arbitration. It acknowledged the disease—the cancerous growth of non-shareable levies—but prescribed no medicine. By maintaining the 41% status quo, it has not preserved balance but sanctioned an imbalance. The report’s conclusion that States have “sufficient resources” rings hollow in the corridors of state legislatures grappling with budgetary shortfalls. The Commission has, in effect, answered the question in its title: yes, it has sidelined the States. In doing so, it has not resolved the underlying tension of Indian fiscal federalism but has merely postponed a more contentious reckoning, one that will inevitably play out in the political arena and the courts, as States are pushed to the brink of fiscal distress. The fragile balance of the Indian federation now tilts more perilously towards a unitary centre.

Q&A on the 16th Finance Commission’s Recommendations

Q1: The 16th Finance Commission retained the vertical devolution rate at 41%. Why is this decision considered a blow to states despite the rate remaining unchanged?
A1: The decision is a blow because the 41% rate is applied to a shrinking “divisible pool” of central taxes. The Union government has increasingly collected revenue through cesses and surcharges, which are not shared with states. While the percentage share remains the same, the actual pool of money it is calculated from has been systematically reduced. Data shows the share of the divisible pool in central revenue has fallen from over 93% (pre-2019) to consistently below 90% in recent years. Thus, states are fighting for a static share of a pie that the Centre is eating away from the edges.

Q2: What does the data reveal about the Centre’s use of cesses and surcharges, and how has this impacted the divisible pool?
A2: The data reveals a dramatic and strategic shift:

• Proportion: For every ₹100 collected, the share of cesses & surcharges has nearly doubled from ₹5-7 (pre-2019) to ₹11-13.5 (2021-22).

• Absolute Collections: Cess collections (ex-GST compensation) exploded from ₹44,688 crore (FY15) to ₹3,52,650 crore (FY22). Surcharges rose from ₹15,702 crore to ₹40,758 crore in the same period.

• Impact on Pool: This has caused the share of the divisible pool in Gross Tax Revenue to drop below 90% for six straight years, down from over 93% between FY13-FY18. The FC’s own report notes the non-shareable portion of revenue grew from 1.1% to 2.2% of GDP between 2011-12 and 2023-24.

Q3: How did the demands of the States and the Centre differ before the Commission, and what does the final decision reveal about the FC’s alignment?
A3: The demands were diametrically opposed:

• States: A strong, cross-party coalition of 18 states demanded an increase to 50% devolution. Most others asked for 45-48%. This was a rare consensus highlighting universal fiscal stress.

• Centre: It argued for “moderation in tax devolution,” effectively seeking to retain a larger share for itself.
  The FC’s decision to retain the 41% status quo, despite the states’ united front and evidence of a shrinking pool, demonstrates a clear alignment with the Centre’s priorities. It chose to “balance” demands by siding with the party advocating for less sharing.

Q4: What were the key justifications the FC provided for its conservative stance, and why are they considered problematic?
A4: The FC’s justifications, seen as pro-Centre, include:

1. No Cap on Cesses: It said capping cesses/surcharges is “imprudent” as the Centre needs them for emergencies, despite admitting their long-term use is “undesirable.” This abdicates its role to check fiscal manipulation.

2. Security & Infrastructure Needs: It cited external security threats and the Centre’s “effectiveness” in infrastructure to justify central spending needs, prioritizing Union subjects over State responsibilities.

3. “Sufficient Resources” Claim: It asserted states have “sufficient resources,” directly contradicting the unanimous demand from states of all political stripes, which signals a disconnect from ground fiscal realities.

4. Passing the Buck: It suggested a “mutual agreement” for the Centre to voluntarily reduce cesses—a naive solution after documenting the Centre’s aggressive use of them.

Q5: What are the likely long-term consequences of the 16th FC’s recommendations for India’s fiscal federalism?
A5: The long-term consequences are damaging to federal balance:

• Increased State Debt: States will be forced to borrow more, risking unsustainable debt burdens.

• Erosion of Autonomy: Greater dependence on tied central grants (CSS) will turn states into implementers, not innovators, eroding their policy autonomy.

• Penalizing Performing States: States that contribute more to GDP will not see proportional returns, stifling competitive federalism.

• Weakened Institution: The FC risks being seen as a rubber stamp, undermining its constitutional role as an independent arbiter in Centre-State finance. It postpones but does not resolve the fundamental tension, setting the stage for greater political and legal conflict over fiscal space.