Mentor’s Comment

The Finance Commission is the institutional backbone of India’s fiscal federalism. The article examines whether the 16th Finance Commission (16th FC), despite formal continuity in States’ share, has substantively weakened State fiscal autonomy by expanding the Centre’s reliance on cesses and surcharges. The analysis is critical for understanding vertical devolution, fiscal centralisation, and cooperative federalism, recurring themes in GS-II and GS-III.

Why in the News?

The article gains salience as the 16th Finance Commission retained the States’ share at 41%, yet expanded the divisible pool only marginally while allowing a sharp rise in cesses and surcharges, which lie outside the pool. For the first time, States across political lines showed rare consensus that their effective share of central revenues is shrinking, even as headline devolution figures remain unchanged. The issue marks a structural shift from shared taxation to unilateral central levies, raising concerns over the erosion of fiscal federalism and States’ fiscal capacity.

Has the divisible pool expanded meaningfully under the 16th Finance Commission?

1. Marginal Expansion: Divisible pool revenues rose from 1.1% of GDP (2013-14) to 2.2% of GDP (2023-24), indicating limited expansion despite economic growth.
2. Static Devolution Rate: States’ share remained at 41%, unchanged from the 15th FC, masking underlying revenue shifts.
3. Exclusion Mechanism: Cesses and surcharges remain outside the divisible pool, structurally limiting States’ access to rising revenues.

Why are cesses and surcharges central to the controversy?

1. Revenue Composition Shift: Cesses and surcharges increased from ₹44,688 crore (FY15) to ₹4,15,022 crore (FY22).
2. Rising Share: For every ₹100 collected by the Centre, cesses and surcharges rose from ₹7 (2012-13) to ₹13.5 (2021-22).
3. Budget Estimate 2025-26: Centre expects ₹8.89 lakh crore through cesses and surcharges, excluding GST compensation cess.
4. Structural Impact: These levies bypass constitutional sharing, reducing States’ fiscal predictability.

Has the States’ effective share in central revenues declined?

1. Consistent Decline: Between FY13 and FY18, States’ share exceeded 93% of the divisible pool revenues.
2. Post-2019 Reversal: Following GST implementation, States’ share fell as cesses surged.
3. 2021-22 Data Point: Out of every ₹100 collected, ₹86.5 entered the divisible pool, down from ₹93.5 in 2012-13.
4. Fiscal Asymmetry: Vertical devolution appears intact only in form, not in substance.

Does the Finance Commission acknowledge this imbalance?

1. Institutional Admission: The 16th FC recognises that long-term reliance on cesses is “undesirable.”
2. Contradictory Position: Despite acknowledging distortion, the Commission refrains from imposing limits on such levies.
3. Deference to Centre: FC cites defence and security spending as justification for higher cesses.
4. Policy Gap: No binding mechanism introduced to curb revenue centralisation.

What are the implications for State finances and governance?

1. Reduced Fiscal Autonomy: States face constrained revenue capacity despite increased expenditure responsibilities.
2. Infrastructure Stress: High-performing States bear the raw end of fiscal imbalance due to limited untied funds.
3. Governance Asymmetry: Centralisation weakens States’ ability to tailor welfare and development spending.
4. Political Neutrality Questioned: Uniform State dissatisfaction indicates systemic, not partisan, concern.

Conclusion

The article concludes that the 16th Finance Commission preserves the appearance of fiscal federalism while weakening its substance. By allowing unchecked expansion of cesses and surcharges, the Centre has effectively reduced States’ fiscal space without altering formal devolution ratios. The issue raises fundamental questions about the constitutional balance of power, revenue sovereignty, and cooperative federalism.

PYQ Relevance

[UPSC 2020] Explain the rationale behind the Goods and Services Tax (Compensation to States) Act of 2017. How has COVID-19 impacted the GST compensation fund and created new federal tensions?

Linkage: This PYQ tests GST design, compensation to States, and fiscal federalism under GS-III, especially Centre-State revenue sharing during economic shocks. COVID-19 exposed GST revenue fragility, leading to delayed compensation and greater reliance on cesses and surcharges, echoing the article’s concern over shrinking effective State fiscal space.

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