Fiscal Federalism and the Debate Over the 41% Tax Devolution

March 11, 2026

Why in the News?

The Union government’s acceptance of the 16^th Finance Commission’s recommendation to retain 41% tax devolution to States has sparked debate about the changing nature of fiscal federalism in India.

What’s in Today’s Article?

Fiscal Federalism (Introduction, Divisible Pool, 16^th Commission Recommendations, Structural Issues, Local Body Grants, Implications, etc.)

Fiscal Federalism in India

Fiscal federalism refers to the distribution of financial powers and responsibilities between different levels of government in a federal system.
In India, fiscal federalism determines how tax revenues are shared between the Union government and the States.
The Constitution provides a framework for fiscal relations through several provisions:

Articles 268-281: These articles govern taxation powers and revenue sharing between the Centre and the States.
Article 280: Provides for the establishment of the Finance Commission to recommend tax devolution and grants to States.
7^th Schedule: Divides taxation powers between the Union List and the State List.

Since the Union government collects a large portion of taxes, a mechanism is needed to distribute revenue fairly among States. The Finance Commission performs this role by recommending how the divisible pool of central taxes should be shared.
Over the years, tax devolution to States has increased. The 14^th Finance Commission raised the States’ share to 42%, which was slightly reduced to 41% by the 15^th Finance Commission after the reorganisation of Jammu and Kashmir.
The 16^th Finance Commission has now recommended continuing the 41% share of the divisible pool for States.

Understanding the Divisible Pool

The divisible pool refers to the portion of central tax revenues that is shared with States.
However, not all tax revenues are included in this pool. Certain components, such as cesses and surcharges, are excluded from sharing with States.
These taxes are levied by the Union government for specific purposes and are retained entirely by the Centre.
According to Finance Commission data, the share of the divisible pool in gross tax revenues has gradually declined:

During the 13^th Finance Commission period, the divisible pool averaged 89.2% of gross tax revenues.
During the 14^th Finance Commission period, it fell to 82.1%.
During the 15^th Finance Commission period, it further declined to 78.3%.

This trend suggests that although the States’ share is officially 41%, the actual amount transferred may be lower because the base itself has been shrinking.

Recommendations of the 16^th Finance Commission

The 16^th Finance Commission examined the fiscal position of both the Union and State governments and proposed several recommendations regarding tax sharing and fiscal discipline.
The Union government accepted several key recommendations, including:

However, several structural reforms proposed by the Commission were deferred. These include:

The Union government indicated that these issues would be examined separately at a later stage.

Structural Issues in State Finances

The Finance Commission’s analysis highlights growing fiscal stress in several States.
For instance:

Punjab’s debt-to-GSDP ratio reached 42.9% in 2023-24, along with a revenue deficit of 3.7% of GSDP.
Rajasthan’s liabilities stood at 37.9% of GSDP.
West Bengal recorded liabilities of 38.3% of GSDP.
Andhra Pradesh had liabilities of about 34.6% of GSDP.

In some cases, borrowing is used primarily to meet revenue expenditure, such as salaries and interest payments, rather than to create productive capital assets.
Another concern is off-budget borrowing, where States borrow through government-controlled entities and repay the loans using public funds. This practice keeps liabilities outside official fiscal deficit figures.
The Finance Commission recommended tighter regulation of such borrowing practices, but implementation has been deferred.

Changes in the Horizontal Devolution Formula

The Finance Commission also revised the formula used to distribute funds among States.
Previously, a portion of transfers depended on tax and fiscal effort, which rewarded States that improved their tax collection efficiency relative to their economic capacity.
Under the new formula, this criterion has been replaced by a “contribution to GDP” indicator, which carries a weight of 10% in the allocation formula.
This shift benefits economically stronger States such as Maharashtra, Gujarat, and Karnataka.
These States contribute significantly to the national GDP and already have relatively strong fiscal capacity.
On the other hand, poorer States such as Bihar, Jharkhand, and Uttar Pradesh, which rely more heavily on central transfers, may benefit less from this criterion.
Critics argue that this change weakens the principle of fiscal equalisation, which traditionally aimed to help less developed States.

Local Body Grants and Conditionalities

Another major component of Finance Commission transfers involves grants to local governments.
The Sixteenth Finance Commission recommended 7,91,493 crore in grants for rural and urban local bodies.
These grants are divided into two categories:
- Basic grants - Provided to support essential services and administrative functions of local governments.
- Performance grants - Provided only if certain conditions are met, such as:
  - Timely constitution of State Finance Commissions
  - Maintenance of audited accounts
  - Compliance with central data reporting systems
While these conditions aim to improve governance, some analysts argue that they may disproportionately affect States with weaker administrative capacity.
During the previous Finance Commission period, only about 62.6% of recommended urban local body grants were actually released, indicating implementation challenges.

Implications for India’s Fiscal Federalism

The recent developments reflect broader trends in India’s fiscal federal system.
Three key implications emerge:
- Growing Centre-State asymmetry: Increasing reliance on cesses and surcharges allows the Union government to retain a larger share of tax revenues.
- Shift in allocation principles: Greater weight to GDP contribution may favour richer States over poorer ones.
- Delayed structural reforms: Important issues such as fiscal discipline rules and power sector reforms remain unresolved.
Together, these trends may gradually reshape fiscal relations between the Union and the States.