Sixteenth Finance Commission: Centre-State Fiscal Relations upsc

The Sixteenth Finance Commission (FC-16) has recommended retaining the States' share at 41% of the divisible pool of Union taxes for the period 2026-31. Chaired by Dr. Arvind Panagariya, the Commission has also recommended changes in the formula for distributing taxes among States, grants for local bodies and fiscal deficit targets. Its recommendations seek to balance fiscal needs, economic performance and the financial responsibilities of the Union and States.

Why in the News?

• The Sixteenth Finance Commission's award period began on April 1, 2026, and will continue until March 31, 2031.
• The Union Government accepted the recommendation to retain the States' share at 41% of the divisible pool.
• The Commission recommended ₹9.47 lakh crore in grants for rural and urban local bodies and disaster management during 2026–31.
• Its recommendations have raised concerns over the distribution of tax revenues, the shrinking divisible pool and the conditions attached to grants.

Background of Constitutional Provisions

The Finance Commission is a constitutional body established by the President under Article 280 of the Constitution. The divisible pool refers to the share of Union tax revenues available for distribution between the Union and the States after excluding cesses, surcharges, and the cost of collection. Its major functions include:

• Recommending the distribution of shareable Union tax revenues between the Union and the States.
• Determining the allocation of the States' collective share among individual States.
• Recommending grants-in-aid to States.
• Examining matters related to the financial arrangements specified in its terms of reference, including disaster financing.

Evolution of States' Share

The share of States in the divisible pool has changed across successive Finance Commissions. The Fifteenth Finance Commission recommended 41% for the 28 States after the reorganisation of Jammu and Kashmir into two Union Territories. The change from 42% to 41% was associated with the altered administrative arrangement, rather than a reduction in the States' overall share in the manner originally feared.

Sixteenth Finance Commission

The Commission consulted all 28 States between June 2024 and June 2025. Its terms of reference also required it to examine the disaster financing mechanism under the Disaster Management Act, 2005.

• Constituted: December 31, 2023
• Chairperson: Dr. Arvind Panagariya
• Award period: April 1, 2026, to March 31, 2031
• Report submitted: November 2025
• Report laid in Parliament: February 1, 2026, alongside the Union Budget and the Action Taken Report

Functioning of the Sixteenth Finance Commission

The Commission follows a two-tier system of tax devolution.

Vertical Devolution

Vertical devolution determines how the divisible pool is shared between the Union and all States collectively.

• 41% of the divisible pool goes to the States.
• The remaining share stays with the Union.

Horizontal Devolution

Horizontal devolution determines how the States' collective share is distributed among individual States using weighted criteria. Income distance measures the gap between a State's per capita income and the average per capita income of the three highest-income large States. It receives the highest weight to support States with lower income levels.

Major Changes in the Devolution Formula

For income and GSDP calculations, the Commission used averages for 2018–19 to 202324, excluding 2020-21 because of the pandemic.

• Demographic Performance: The formula rewards States for slower population growth between 1971 and 2011, replacing the inverse total fertility rate criterion used by the Fifteenth Commission.
• Forest Cover: The criterion includes open forests in addition to moderately dense and very dense forests. A small bonus is provided for an increase in weighted forest area.
• Minimum State Share: The minimum allocation for each State has been reduced from 2% to 1.5%.
• GDP Contribution: A new criterion gives 10% weight to a State's contribution to India's GDP.
• Tax and Fiscal Effort: The earlier criterion, which carried a 2.5% weight under the Fifteenth Commission, has been removed.

Grants and Fiscal Roadmap

The Commission recommended a total of ₹9.47 lakh crore in grants for 2026–31. The Commission discontinued the revenue deficit grants, sectoral grants and State-specific grants recommended by the Fifteenth Finance Commission.

Conditions for Local Body Grants

Local body grants are divided into:

• Basic grants: 80%
• Performance grants: 20%

Their release is linked to conditions such as:

• Establishment of local bodies in accordance with constitutional requirements.
• Publication of provisional and audited accounts.
• Timely establishment of the State Finance Commission.

Fiscal Deficit Targets

The Commission proposed a fiscal roadmap with the following targets:

• Union Government: Fiscal deficit of 3.5% of GDP by 2030–31.
• State Governments: Fiscal deficit of 3% of GSDP.
• Off-budget borrowings: These should be brought onto the budget to improve transparency.

Performance and Distribution of Tax Shares

The new award began operating on April 1, 2026. Its early impact can be assessed through changes in States' shares and the flow of funds. The Commission's formula results in 14 States gaining shares and 14 States losing shares compared with the Fifteenth Finance Commission.

Major Gainers and Losers

Karnataka records the largest increase among the selected States, while Madhya Pradesh records the largest decrease. Despite a reduction in its share, Uttar Pradesh remains the largest beneficiary, receiving 17.62% of the States' share, followed by Bihar at 9.95%

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Tax Devolution and Transfers

These figures highlight that actual transfers also depend on the Union Government's tax collections.

• The Union Budget for 2026–27 estimated tax devolution at ₹15,26,255 crore, 9.6% higher than the revised estimate for 2025–26.
• Total transfers to States, including grants and loans, were estimated at ₹26,20,769 crore.
• The revised tax devolution estimate for 2025–26 was ₹13,92,971 crore, below the budget estimate of ₹14,22,444 crore.
• In August 2026, the Centre released an additional instalment of ₹1,09,019 crore to States.

Urban Local Bodies and Infrastructure

The Commission increased the emphasis on urban local bodies.

• Urban local bodies receive ₹3.56 lakh crore, accounting for nearly 45% of grants to local bodies, compared with 36% under the Fifteenth Commission's recommendations.
• An exclusive infrastructure allocation of ₹56,100 crore has been proposed for 22 selected cities with populations between 10 lakh and 40 lakh.
• These funds are linked to urban infrastructure, particularly sewage and drainage systems.
• An initial allocation of ₹10,000 crore has been proposed as an urbanisation premium.

Impact on Fiscal Federalism

Fiscal federalism in India, the system of financial relations and resource distribution between the Union and state governments, has shifted heavily toward centralization, straining state fiscal autonomy. Let's Look at the Impact on Fiscal Federalism:-

Continuity in States' Share

Retaining the States' share at 41% provides continuity and predictability in fiscal transfers. States depend on these transfers to finance public services and development expenditure.

Considering Finance Commission transfers and other sources, States account for an estimated 68–69% of combined Union and State revenue receipts, excluding capital receipts.

Unequal Distributional Outcomes

The formula produces different outcomes for different States. The Commission argued that repeated revenue deficit grants could create adverse incentives because many of the same States continued to receive them across successive Finance Commissions

• Karnataka, Kerala and Gujarat gain from the revised distribution formula.
• Uttar Pradesh, Bihar, Madhya Pradesh, Rajasthan, West Bengal and several North-Eastern States face reductions in their shares.
• The removal of revenue deficit grants reduces an additional source of financial support for some States..

Reduced Progressivity

The distribution formula continues to give substantial weight to income distance, but the inclusion of GDP contribution has raised concerns about its redistributive impact.

According to an analysis cited in the debate, the correlation between per capita income and tax share changed from -0.42 under the Fifteenth Commission to -0.36 under the 16th Finance Commission. A less negative relationship indicates a weaker association between lower per capita income and a higher share of tax transfers.

Shrinking Divisible Pool

The growing use of cesses and surcharges reduces the proportion of Union tax revenue available for sharing with States.

• The divisible pool reportedly declined from 89.1% of gross Union tax revenue in 2014-15 to around 74-80% during the first four years of the Fifteenth Commission's award period.
• A 41% share of a smaller divisible pool may result in a lower effective share of gross Union tax revenue for States.
• The Commission did not recommend a cap on cesses and surcharges, citing constitutional and practical concerns.
• The end of the GST compensation cess was expected to reduce the share of cesses in Union tax revenue.

The Commission proposed a broader arrangement under which more cess and surcharge revenue could be incorporated into the divisible pool, alongside a revised States' share.

Vertical Fiscal Imbalance

Vertical fiscal imbalance refers to the gap between the revenue-raising capacity of a level of government and its expenditure responsibilities. Concerns have been raised that the Commission did not adequately estimate this imbalance, despite several factors affecting State finances:

• The equal sharing of GST between the Centre and States has affected the States' effective tax rates on several items compared with the earlier VAT system.
• The States' share of expenditure under centrally sponsored schemes has reportedly increased from 25% to 40%.
• Greater reliance on cesses and surcharges has reduced the share of Union tax revenue available for devolution.

These issues raise questions about whether the 41% share adequately reflects the expenditure responsibilities of States.

Conditional Grants

The increasing use of conditions for grants may affect the financial autonomy of local bodies. The Commission's recommendations on fiscal discipline and off-budget borrowing have also raised questions about the scope of its mandate under Article 280.

• Block panchayat grants may be withheld if fewer than 75% of gram panchayats in their jurisdiction meet their own-revenue targets.
• Local body grants may also be delayed if a State fails to meet fund-transfer conditions.
• Such arrangements may penalise a local body for shortcomings at the State level.

Demographic and Disaster Financing Concerns

• The Commission acknowledged that the demographic performance criterion may eventually need to be phased out as India faces the challenge of population ageing before achieving high income levels.
• States previously rewarded for slower population growth may receive less benefit in future awards.
• The Commission retained the existing disaster financing framework even though the effects of mitigation funding under the Fifteenth Commission's award period were considered difficult to assess.
• This is relevant for urban flood mitigation projects funded through the National Disaster Mitigation Fund.

Way Forward

Improve Fiscal Transparency

• The Union Government and future Finance Commissions should adopt a standard method for estimating vertical fiscal imbalance.
• Greater transparency is needed in the use of cesses and surcharges.
• The Union and States could negotiate a framework through the Inter-State Council or GST Council to bring temporary taxes into the divisible pool where appropriate.

Strengthen the Devolution Formula

• Reintroducing tax effort or a similar criterion, alongside GDP contribution, could link transfers more closely to States' efforts to mobilise revenue.
• A time-bound and gradually declining incentive could support States whose shares fall, without permanently relying on revenue deficit grants.
• The demographic performance criterion should be reviewed when new population data become available.

Improve Grant Administration

• Grants for a performing local body should not be withheld solely because another local body or the State government has failed to meet its obligations.
• Eligibility conditions, public audits and the timely constitution of State Finance Commissions should be monitored transparently.
• Performance grants should be released against clearly measurable criteria.

Focus on Outcomes

• Urban infrastructure and disaster mitigation grants should be assessed through measurable outcomes, including fund utilisation and reductions in losses.
• Monitoring should establish whether investments in drainage, sewage systems and disaster preparedness have improved local resilience.

Conclusion

The Sixteenth Finance Commission has maintained the States' collective share of the divisible pool at 41%, while revising the horizontal distribution formula and placing greater emphasis on local body grants and fiscal discipline. However, the shrinking divisible pool, unequal distributional outcomes, and conditions attached to grants remain important challenges. Greater fiscal transparency, a more balanced devolution formula and outcome-based monitoring can strengthen cooperative fiscal federalism in India.