Rebalancing India’s Fiscal Federalism: Key Takeaways from the 16th Finance Commission

Why in 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, shaping Centre–State fiscal relations for the next five years.

Background and Context

India’s federal system rests on a delicate balance between:

• The Centre’s responsibility for national priorities such as defence, macroeconomic stability, and major infrastructure, and
• The States’ responsibility for delivering core public services such as health, education, agriculture, and local development.

The Finance Commission, constituted every five years under Article 280, is the constitutional mechanism to manage this balance by recommending how central tax revenues should be shared between the Centre and the States and among States themselves.

Over the past decade, this balance has come under strain due to:

• Rising use of cess and surcharge by the Centre (outside the divisible pool)
• Increasing fiscal stress on States
• Greater expenditure responsibilities devolved to States, particularly after the 14th Finance Commission

Against this backdrop, the 16th Finance Commission’s recommendations carry major implications for fiscal autonomy, equity, and efficiency in India’s federal structure.

Constitutional Framework of Fiscal Federalism

India’s fiscal federalism is anchored in:

• 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.

Taxes Shared Between the Centre and States

• Corporation Tax
• Personal Income Tax
• Central Goods and Services Tax (CGST)
• Centre’s share of Integrated GST (IGST)

Cess and surcharge, however, are excluded from the divisible pool.

For 2025–26, the divisible pool constitutes about 81% of the Centre’s gross tax revenue, after excluding cess and surcharge. This exclusion has been central to debates on fiscal equity and resource adequacy for States.

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%, alongside conditional transfers under Centrally Sponsored Schemes (CSS).
• 14th Finance Commission (2015–20): Share increased to 42%, and many tied CSS transfers were rationalised, significantly enhancing States’ untied fiscal space.
• 15th Finance Commission (2020–26): Share reduced to 41% after the reorganisation of Jammu and Kashmir into two Union Territories.

This marked a structural shift toward greater fiscal autonomy for States, though concerns remained over the Centre’s growing use of non-shareable cesses.

Horizontal Devolution Criteria

Horizontal devolution refers to how the States’ share is distributed among individual States.

Since the 13th Finance Commission, criteria have broadly emphasised:

• Equity: Income distance
• Need-based factors: Population and area
• Efficiency factors: Forest cover, demographic performance, tax effort

This framework has generated persistent debates between:

• Economically advanced States seeking recognition for growth and contribution, and
• Less-developed States seeking redistribution to ensure minimum standards of public services.

States’ Key Demands Before the 16th Finance Commission

Demands on Vertical Devolution

• 18 States demanded an increase in the States’ share from 41% to 50%.
• Others sought 45–48%.
• Several States demanded:
  • Inclusion of cess and surcharge in the divisible pool, or
  • A cap on their imposition.

Demands on Horizontal Devolution

• Many States wanted equity parameters (income distance) to retain dominance.
• Some recommended 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 a fundamental tension between:

• Redistribution, and
• Rewarding performance and growth contribution.

Recommendations of the 16th Finance Commission

On Vertical Devolution

• The Commission rejected the proposal to include or cap cess and surcharge in the divisible pool, stating that under the present constitutional scheme, this is neither permissible nor desirable, as these instruments may be required for exigencies.
• It retained the States’ share at 41%, citing:
  • 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, infrastructure, and national priorities.

 Result: No major change in vertical devolution.

On Horizontal Devolution

The Commission adopted two guiding principles:

1. Changes should be gradual, avoiding fiscal shocks.
2. Efficiency and growth contributions should receive due recognition.

Accordingly:

• A new criterion of States’ contribution to GDP has been introduced.
• The assigned weight ensures a directional shift without drastic redistribution.

Outcome:

• Southern and western States witness a marginal increase in their share.
• Large northern and central States see 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 Centre and States should undertake public sector enterprise reforms.

These recommendations reflect concerns over fiscal sustainability, macroeconomic stability, and cooperative federalism.

Significance for India

1. Strengthening Cooperative Federalism

By maintaining stability in vertical devolution while refining horizontal criteria, the Commission reinforces trust between the Centre and States.

2. Balancing Equity and Efficiency

The introduction of GDP contribution as a criterion reflects a shift toward recognising performance, without abandoning redistribution.

3. Preserving Fiscal Stability

Retaining the 41% share avoids sudden fiscal shocks and helps the Union meet national expenditure priorities.

4. Encouraging Responsible State Finances

Emphasis on subsidy rationalisation, debt control, and power sector reforms pushes States toward fiscal discipline and long-term sustainability.

5. Shaping the Next Phase of Federal Governance

The report sets the tone for Centre–State fiscal relations in an era of:

• Expanding welfare commitments
• Infrastructure push
• Increasing subnational responsibilities

Challenges and Way Forward

Challenges

• Persistent State concerns over rising cess and surcharge
• Balancing redistribution with incentives for growth
• Managing fiscal stress in poorer States
• Ensuring implementation of recommended reforms

Way Forward

• Gradual reduction of cess and surcharge to enhance States’ fiscal space.
• Transparent consultation mechanisms between Centre and States on fiscal policy.
• Strengthening State revenue capacity through tax administration reforms and economic diversification.
• Monitoring and incentivising fiscal discipline through outcome-based transfers.
• Aligning Centre–State priorities under a shared vision of cooperative federalism.