Why in the news?

The 16th Finance Commission (FC) submitted its report for 2026-31, reopening debates on fiscal federalism. The 14th FC had raised vertical devolution from 32% to 42%, marking a structural shift. The 15th FC reduced it to 41% due to the reorganisation of Jammu and Kashmir into two Union Territories. Industrialised States demanded an increase to 50%, while several States sought restoration to 45-48%. The divisible pool has shrunk due to rising cesses and surcharges, which formed around 19% of gross tax revenue in 2015-16, leaving only 81% for distribution. The issue highlights tensions between equity-based redistribution and efficiency-based reward mechanisms.

Introduction

The 16th Finance Commission  chaired by Dr. Arvind Panagariya, submitted its final report to the President of India on November 17, 2025. Its recommendations, which cover the five-year period from April 1, 2026, to March 31, 2031, were accepted by the Union Government and tabled in Parliament on February 1, 2026

What is the constitutional and institutional framework governing tax devolution?

1. Article 270: Provides for distribution of net tax proceeds between Centre and States.
2. Article 280: Mandates constitution of Finance Commission to recommend devolution formula.
3. Divisible Pool: Includes corporation tax, personal income tax, Central Goods and Services Tax (CGST), and Centre’s share of Integrated GST.
4. Exclusion of Cesses and Surcharges: These are not part of the divisible pool. In 2015-16, divisible pool constituted about 81% of gross tax revenue due to this exclusion.

How has vertical devolution evolved over time?

1. 13th FC (2010-15): Provided 32% share to States. Maintained specific transfers for Centrally Sponsored Schemes (CSS) with conditionalities.
2. 14th FC (2015-20): Increased States’ share to 42%. Discontinued specific CSS transfers. Marked significant fiscal decentralisation.
3. 15th FC (2020-26): Reduced share to 41% due to reorganisation of Jammu and Kashmir into Union Territories.
4. 16th FC (2026-31): Retained 41% vertical devolution.

What criteria guide horizontal devolution among States?

13th FC Criteria:

1. Income Distance (47.5%): Favoured poorer States to reduce fiscal disparities.
2. Population (1971) (25%): Reflected demographic basis.
3. Area (10%): Addressed administrative cost variations.
4. Fiscal Discipline (17.5%): Incentivised prudent financial management.

14th FC Criteria:

1. Income Distance (50%): Increased equity emphasis.
2. Population (1971) (17.5%) & Population (2011) (10%): Incorporated updated demographic data.
3. Area (15%): Continued geographic consideration.
4. Forest Cover (7.5%): Recognised ecological services.

15th FC Criteria:

1. Income Distance (45%): Slight reduction in redistributive weight.
2. Population (2011) (15%): Sole population criterion.
3. Area (15%) & Forest (10%): Maintained ecological compensation.
4. Demographic Performance (12.5%): Incentivised population control.
5. Tax Effort (2.5%): Rewarded revenue mobilisation.
6. State’s Contribution to GDP (10%): Recognised growth contribution.

What were the demands of States before the 16th FC

1. Higher Vertical Share: Industrialised States such as Maharashtra, Gujarat, Tamil Nadu, Karnataka, and Telangana demanded an increase from 41% to 50%.
2. Restoration Demand: Several States sought to increase to 45-48%.
3. Inclusion of Cesses and Surcharges: States demanded their inclusion in the divisible pool.
4. Cap on Cesses: Sought ceiling on Centre’s ability to levy cesses and surcharges.
5. GDP Contribution Criterion: Industrialised States advocated inclusion of States’ contribution to GDP in horizontal devolution formula.

What did the 16th FC recommend?

1. Vertical Devolution: The share of states in the divisible pool of central taxes has been retained at 41%, the same level as the 15th Finance Commission
2. Horizontal Devolution Formula: A new formula was introduced to determine how the 41% is divided among individual states. Horizontal Devolution Approach: is guided by two principles: Equity Consideration: Recognises need to address inter-State income disparities. And Efficiency Recognition: Gives due weight to States’ contributions to growth and fiscal performance. Notable changes include:
   1. Contribution to GDP: A new criterion with a 10% weight to reward states’ economic performance
   2. Income Distance: Weight reduced to 42.5% (from 45%).
   3. Population: Based on the 2011 Census, with a weight of 17.5%
   4. Forest & Ecology: Weight maintained at 10%, but now includes “open forests” and rewards increases in forest cover.
3. Grants-in-Aid: Recommended total grants of ₹9.47 lakh crore over five years.
   1. Discontinued Grants: The Commission has stopped Revenue Deficit Grants (RDG), sector-specific grants, and state-specific grants
   2. Local Body Grants: ₹8 lakh crore allocated, split 60:40 between rural (₹4.4 lakh crore) and urban (₹3.6 lakh crore) bodies.
4. Fiscal Roadmap:
   1. Centre’s Fiscal Deficit: Target to reduce to 3.5% of GDP by 2030-31.
   2. States’ Fiscal Deficit: Capped at 3% of GSDP.
   3. Off-Budget Borrowings: Recommended a strict end to off-budget borrowings for both Centre and States. 

What are the broader fiscal implications?

1. Redistribution vs Incentives: Higher income distance weight benefits poorer States; GDP contribution and tax effort reward growth-oriented States.
2. Shrinking Divisible Pool: Rising cesses reduce effective devolution.
3. Union Fiscal Needs: Increased defence and infrastructure expenditure cited as constraints.
4. State-Level Reforms: Recommends subsidy targeting, power sector reforms, and fiscal deficit control.

Conclusion

The 16th Finance Commission retains the 41% vertical devolution, maintaining continuity with the 15th FC despite demands for expansion. It upholds constitutional limits on cesses and surcharges while balancing equity through income distance and efficiency through recognition of States’ GDP contribution and fiscal performance. The recommendations reflect calibrated fiscal federalism, where redistribution, growth incentives, and Union fiscal requirements coexist within constitutional boundaries.

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: The question directly connects to the debate on shrinking divisible pool, rising cesses and surcharges, and the resulting Centre-State fiscal tensions that frame the discussion on vertical devolution and fiscal federalism.

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