Context

• The Sixteenth Finance Commission (SFC) operated with considerable autonomy, drawing its mandate directly from constitutional provisions.
• It examined the two core pillars of India’s fiscal federalism: vertical devolution (distribution between Centre and States) and horizontal devolution (distribution among States).
• While it preserved certain structural features of earlier commissions, it introduced important shifts affecting fiscal balance, constitutional responsibility, and the principle of equalisation.

Vertical Devolution: Fiscal Space and Constitutional Mandate

• Background: The 42% Shift and Its Aftermath
  • A major restructuring occurred under the Fourteenth Finance Commission, which raised the States’ share in the divisible pool from 32% to 42%, citing the discontinuation of plan grants.
  • This was later revised to 41% after the reorganisation of Jammu and Kashmir and retained by the Fifteenth Finance Commission.
  • The Sixteenth Commission maintained the 41% benchmark, granting it semi-permanence.
  • However, the Centre expressed concerns about shrinking fiscal space, prompting adjustments outside the divisible pool framework.
• The Issue of Cesses and Surcharges
  • The Centre increasingly relied on non-shareable cesses and surcharges, reduced funding for centrally sponsored schemes, and declined certain grants recommended earlier.
  • Since cesses and surcharges are excluded from the divisible pool, their expansion effectively narrows the States’ share of total central revenue.
  • Instead of firmly addressing this under its constitutional mandate, the Commission proposed a grand bargain: States would accept a smaller share of a larger pool if cesses were merged into regular taxes.
  • Although pragmatic, this approach did not fully reinforce the spirit of Articles 270 and 280.
• Trends in Effective Transfers
  • Effective transfers (tax devolution plus grants) averaged about 27–28% of the Centre’s pre-transfer gross revenue during the Eleventh to Thirteenth Commissions.
  • This rose sharply to 35.6% under the Fourteenth Commission and moderated to 34.4% under the Fifteenth.
  • For 2026–27, the first year of the Sixteenth Commission’s award, the ratio stands at 32.7%.
  • The projections assume 11% nominal GDP growth, higher than budget estimates, and do not fully account for revenue-reducing GST reforms of September 2025.
  • These assumptions may affect the credibility of long-term fiscal projections and signal a relative contraction in States’ fiscal capacity.
• Discontinuation of Revenue Deficit and Sector-Specific Grants
  • The discontinuation of revenue deficit grants and the absence of sector-specific grants mark a major departure.
  • Such grants traditionally addressed revenue gaps and structural cost disabilities.
  • Their removal limits scope for calibrated adjustments and weakens redistributive flexibility within the system.

Horizontal Devolution: Efficiency Versus Equalisation

• Introduction of the Contribution Criterion
  • A new contribution criterion was introduced, measured through a state’s share in aggregate
  • While intended to reward efficiency, GSDP reflects market-driven concentration of capital and migration patterns rather than fiscal prudence.
  • High-income States benefit from structural advantages, not necessarily superior fiscal management.
• Dual Use of GSDP and Conceptual Tensions
  • GSDP was used in opposite ways: the income distance criterion favours lower per capita GSDP States, whereas the contribution criterion rewards higher GSDP States.
  • To moderate extremes, the square root of GSDP was applied.
  • Even so, the same indicator simultaneously advances equity and performance, creating conceptual inconsistency between efficiency and equity objectives.
• Dropping the Fiscal Discipline Criterion
  • The removal of the fiscal discipline or tax effort criterion contradicts the emphasis on performance.
  • This criterion directly measured fiscal responsibility and revenue mobilization.
  • Its exclusion reduces incentives for prudent financial management and shifts emphasis toward output-based indicators rather than governance quality.

Distributional Impact: Gains and Losses

• States Experiencing Losses
  • Compared to the Fifteenth Commission, significant States such as Madhya Pradesh, Uttar Pradesh, West Bengal, Bihar, Odisha, Chhattisgarh, and Rajasthan faced reductions.
  • Several smaller and north-eastern States, including Arunachal Pradesh, Meghalaya, Manipur, Nagaland, Tripura, Sikkim, and Goa also experienced losses. Gains among richer States were uneven.
• The Case for Equalisation Grants
  • Article 275 provides for grants-in-aid addressing State-specific needs, particularly in health and education.
  • Well-designed equalisation grants can offset disparities arising from formula changes.
  • The complete withdrawal of such mechanisms limits corrective capacity and risks widening inter-State disparities.

Conclusion

• The Sixteenth Finance Commission preserved the 41% devolution benchmark but avoided assertive intervention on expanding cesses and surcharges.
• The reduction in effective transfers, optimistic growth assumptions, and discontinuation of revenue gap grants signal a cautious recalibration of fiscal federalism.
• In horizontal distribution, the adoption of a GSDP-based contribution measure introduces tension between performance incentives and the constitutional goal of balanced development.
• The long-term impact on cooperative federalism, regional equity, and sustainable public finance will unfold over time.