Mentor’s Comment

The Sixteenth Finance Commission (SFC) has retained the States’ share in the divisible pool at 41% but introduced significant changes in methodology, particularly in horizontal devolution and treatment of cesses, surcharges, and grants. The article evaluates whether the Commission has strengthened fiscal federalism or diluted equalisation principles. The issue is critical as Finance Commission transfers constitute the largest source of untied fiscal transfers to States and directly affect Centre-State fiscal balance.

Why in the News?

The SFC is in the news for redesigning the transfer framework without increasing support to States. It discontinues revenue deficit grants and adds a GSDP-based parameter while removing the tax effort criterion. Several States see reduced shares compared to the Fifteenth Finance Commission. The changes affect the largest channel of formula-based fiscal transfers and have revived debate on Centre-State financial balance.

Has vertical devolution been strengthened or diluted?

1. Retention of 41% Share: Maintains States’ share at 41% of the divisible pool, continuing the post-Fourteenth Finance Commission structure.
2. Decline from 42%: Reduces from the 42% recommended earlier after accounting for the reorganisation of Jammu & Kashmir.
3. Rise of Cesses and Surcharges: Expands non-shareable revenue instruments, reducing the effective divisible pool.
4. Absence of Reform Recommendation: Does not mandate merger of cesses and surcharges into the divisible pool.
5. Grand Bargain Proposal: Suggests States accept smaller share if cesses are merged into regular taxes; lacks constitutional enforcement mechanism.

Does the redesign of horizontal devolution alter equalisation principles?

1. GSDP Contribution Criterion: Introduces efficiency-linked parameter through share in aggregate GSDP.
2. Income Distance Formula Modification: Uses square root of GSDP to moderate excessive impact.
3. Removal of Tax Effort/Fiscal Discipline Criterion: Eliminates performance-based fiscal efficiency parameter.
4. Judgmental Weight Changes: Adjusts weights of criteria without transparent normative reasoning.
5. Distributional Impact: Madhya Pradesh, Uttar Pradesh, West Bengal, Bihar, Odisha, Chhattisgarh, and Rajasthan lose share; small North-Eastern States also record losses.

What is the impact of discontinuing revenue deficit and sector-specific grants?

1. Revenue Deficit Grants Dropped: Discontinues gap-filling support despite inter-State fiscal disparities.
2. Sector-Specific Grants Eliminated: Removes targeted interventions in priority areas.
3. Shift from Normative to Formula-Based Transfers: Reduces flexibility to address cost disabilities.
4. Article 275 Mechanism Underused: Limits equalisation through need-based grants despite constitutional provision.
5. Ad Hoc Grants Risk: Encourages discretionary transfers outside formula-based system.

Are projections and fiscal assumptions realistic?

1. High Nominal GDP Assumption: Assumes 11% nominal GDP growth from 2026-27 onwards.
2. Budget Estimate Contrast: Exceeds Budget’s 10% projection.
3. Overestimation Risk: Inflates projected transfer envelope.
4. GST Reform Impact Ignored: Does not factor revenue effects of September 2025 GST reforms.
5. Stability Concerns: Potential fiscal stress if growth assumptions underperform.

Does the Commission address structural federal concerns?

1. Central Fiscal Space Concern: Notes Centre’s shrinking fiscal space.
2. Cesses and Surcharges Expansion: Recognises distortion but avoids structural correction.
3. Uneven State Capacity: Does not fully compensate for cost disabilities and migration-driven GSDP concentration.
4. Market-Driven Capital Concentration: Ignores structural advantage of developed States in attracting capital and labour.
5. Equalisation Objective Weakened: Reduces redistributive thrust compared to earlier Commissions.

Conclusion

The Sixteenth Finance Commission preserves the formal 41% vertical devolution but recalibrates the structure of transfers. The removal of revenue deficit grants and introduction of a GSDP-based contribution parameter shift the framework from strong equalisation toward efficiency-linked allocation. The expansion of cesses and surcharges continues to constrain the divisible pool. The long-term impact on fiscal federalism will depend on whether future reforms strengthen constitutional equity under Articles 270 and 280 or deepen inter-State disparities.

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