Sixteenth Finance Commission — misses and concerns

The Sixteenth Finance Commission had significant flexibility in determining its approach and methodology, as its terms of reference followed directly from constitutional provisions, unlike earlier commissions that operated under detailed central directives. This Commission, as before, addressed the two key dimensions of fiscal transfers — namely the vertical and the horizontal.

The vertical dimension

The Commission took note of the increase in the share of States in the divisible pool of central taxes from 32% to 42% by the Fourteenth Finance Commission. The Fourteenth Finance Commission had justified it on account of a discontinuation of State plan grants, amounting to only 3% of the divisible pool of central taxes at the time of transition. The subsequent reduction to 41% was due to the change in the status of Jammu and Kashmir. The Sixteenth Finance Commission noted the Centre’s concern about the reduction in its fiscal space. The Centre had responded to this substantial increase in the share of states by the Fourteenth Finance Commission by, first, increasing the non-shareable cesses and surcharges, second, reducing its share in the financing of centrally sponsored schemes and third, not accepting sector-specific/State-specific grants recommended by the Fifteenth Finance Commission. In the end, however, the Sixteenth Finance Commission retained the States’ share at 41%, imparting to it a kind of semi-permanence.

The Sixteenth Finance Commission makes no recommendations regarding the non-shareable cesses and surcharges which, by their very nature, should be limited and levied for finite periods. These should be earmarked for specific purposes and not merged with the Centre’s general funds. Instead, the Sixteenth Finance Commission recommended a ‘grand bargain’ (paragraph 7.67) between the Centre and States saying that ‘States would agree to a smaller share in the resulting larger divisible pool, with no loss of revenues to either side’ provided the Centre agreed to merge a large part of the cesses and surcharges in the regular taxes.

The Commission did not take into account its constitutional duty as enumerated in Articles 270 and 280 for objectively determining the share of States in the shareable pool of central taxes while making its observations on the cesses and surcharges. It would have been better had the Commission at least pointed out to the Centre that the steep increase in cesses and surcharges was not warranted and not in the spirit of the Constitution. Further, the Commission chose to discontinue the revenue deficit grants and did not recommend any State and sector specific grants. This became a route to lower the share of States in the Centre’s revenue receipts as compared to the Fifteenth Finance Commission.

The average effective transfers covering tax devolution and Finance Commission grants to the States as a percentage of the Centre’s pre-transfer gross revenue receipts were 27.0%, 27.2% and 28.3%, respectively during the Finance Commission periods (11, 12, 13). This share increased sharply to 35.6% during the Fourteenth Finance Commission period. In the Fifteenth Finance Commission period, covering the years 2020-21 to 2024-25, this share came down marginally to 34.4%, still considerably higher than those of the Eleventh and Thirteenth Finance Commission periods. This steep increase in resources transferred as a proportion of gross revenue receipts of the Centre should not be overlooked.

Looking at the first year of the Sixteenth Finance Commission’s award period, 2026-27, this ratio is 32.7% as per the Centre’s budget estimates. The Sixteenth Finance Commission’s projections for later years may prove to be overestimates since the 2026-27 nominal GDP growth, assumed at 11%, is higher than the Budget estimate of 10%. The Commission also did not factor in the revenue reducing effect of the major Goods and Services Tax (GST) reforms undertaken in September 2025, while the Commission was still in session.

Horizontal dimension

The Sixteenth Finance Commission introduced a new criterion of contribution to reflect an efficiency consideration. But it measured it through the share of a State’s Gross State Domestic Product (GSDP) in an all-State GSDP.

There is a need, however, to differentiate the efficiency of the production system from that of the fiscal system. In the production system, the inter-State distribution of GSDP depends on many factors which includes the inter-State movement of financial and human resources. It largely depends on market forces which tend to lead to a concentration of productive capital stock in a limited number of States. Human resources also move from less developed to the more developed States.

This change involved using GSDP in two opposite ways. In the income distance formula, the lower the per-capita GSDP of a State, the higher the per-capita share of that State. In the contribution criterion, the higher the per-capita GSDP of a State, the higher is its share. However, the Commission did not finally use the GSDP. Instead, it used its square root. This was meant to reduce the excessive effects of using GSDP to reflect contribution on some States.

In the devolution formula, the weights of some of the other criteria have also been changed. These are purely judgemental. Dropping the tax effort/fiscal discipline criterion, which was a fiscal efficiency criterion is not consistent with the Commission’s own narrative.

Losses and gains

Consequently, the main States that have lost on account of the Sixteenth Finance Commission devolution scheme as compared to the Fifteenth Finance Commission are Madhya Pradesh, Uttar Pradesh, West Bengal, Bihar, Odisha, Chhattisgarh and Rajasthan. The other group of losing States are Arunachal Pradesh, Meghalaya, Manipur, Nagaland, Tripura, Sikkim, and Goa (the north-east or extremely small States). The gain by other richer States has not been uniform.

Ideally, the losses of some States could have been mitigated through normatively determined revenue gap grants. Devolution is not enough to capture the finer details of cost and need differentials of India’s highly differentiated States. Further, if a Finance Commission changes the tax devolution formulae, then the consequential loss of some of the States could be neutralised by the revenue gap grants.

In fact, Article 275 provides an important mode of fiscal transfers for the consideration of State-specific ‘needs’. It should not be confused with revenue deficits. Needs can be estimated in order to equalise standards of critical services such as health and education.

This would have facilitated accommodating the performance argument of the richer States while still promoting the equalisation objective. Even if there are difficulties in estimating revenue gap grants since it involves normative assessment of States’ needs and resources, the Sixteenth Finance Commission need not have taken the shortcut of dropping these altogether. While ad hoc State-specific grants are not appropriate, equalisation grants still have a place.

C. Rangarajan is a former Governor of the Reserve Bank of India and Chairman of the Twelfth Finance Commission. D.K. Srivastava is Chief Policy Adviser, EY India, a former Director of the Madras School of Economics and Member, Twelfth Finance Commission. The views expressed are personal

Published – March 02, 2026 12:16 am IST