16th Finance Commission and the Future of Indian Federalism

Introduction

• India’s federal system is built on a delicate balance between national economic priorities and State-level autonomy. At the heart of this relationship lies fiscal federalism-the constitutional and institutional framework through which taxation powers, expenditure responsibilities, borrowing powers and financial transfers are distributed among different levels of government.
• The 16th Finance Commission (FC-16), chaired by Dr. Arvind Panagariya, has introduced important changes for the award period 2026–31. While retaining the States’ share in the divisible pool at 41%, it has significantly altered the approach to horizontal devolution by introducing a 10% weight for contribution to GDP, discontinuing Post-Devolution Revenue Deficit Grants, and substantially increasing transfers to local governments.

These recommendations raise a fundamental question for Indian federalism:

Should fiscal transfers primarily equalise the fiscal capacity of States, or should they increasingly reward economic performance, fiscal discipline and contribution to national growth?

The answer will shape the future of cooperative federalism, competitive federalism and fiscal autonomy in India.

What is Fiscal Federalism?

• Fiscal federalism refers to the distribution of taxation powers, expenditure responsibilities, borrowing powers and intergovernmental transfers among different levels of government.

India’s fiscal federalism attempts to address three major forms of imbalance:

For instance, a State such as Bihar cannot necessarily provide the same level of public services as a high-income State simply by imposing similar tax rates because its revenue-raising capacity and expenditure requirements are different.

Constitutional Framework of Fiscal Federalism in India

The Constitution provides the institutional foundation for Centre-State fiscal relations.

The Finance Commission, constituted by the President every five years or earlier under Article 280, recommends both vertical devolution between the Union and States and horizontal distribution among individual States. It also recommends principles governing grants-in-aid and measures to augment State Consolidated Funds for Panchayats and Municipalities.

Key Recommendations of the 16th Finance Commission

1. States’ Share Retained at 41%

• The 16th Finance Commission has retained the States’ share in the divisible pool at 41%, the same level recommended by the 15th Finance Commission.
• This provides continuity and predictability in Centre-State fiscal transfers.
• However, the decision has also generated debate because several States had demanded a higher share, with 18 States seeking an increase to 50% while some others sought a share in the range of 45–48%.

2. Major Change in Horizontal Devolution Formula

• One of the most significant changes is the revision of the criteria used to distribute the States’ share among individual States.

The new formula represents an important philosophical shift-from a primarily redistributive approach towards a combination of equity and economic performance.

3. 10% Weight for Contribution to GDP

• The introduction of a 10% weight for States’ contribution to GDP is perhaps the most debated feature of FC-16.
• The criterion uses the square root of State GSDP to moderate the advantage that could otherwise accrue disproportionately to the largest State economies.    

4. Discontinuation of Revenue Deficit Grants

The 16th Finance Commission has discontinued Post-Devolution Revenue Deficit Grants (RDGs). 

It has also discontinued:

• Sector-Specific Grants

• State-Specific Grants

The underlying concern is that persistent deficit-filling transfers could create moral hazard, reducing incentives for States to mobilise revenues, rationalise subsidies and control revenue expenditure

5. Greater Focus on Local Governments

• FC-16 has significantly increased the recommended allocation for rural and urban local governments.
• It recommends ₹7.91 lakh crore for 2026–31, compared with approximately ₹4.36 lakh crore recommended by FC-15.
• Basic and performance grants are generally structured in an 80:20 ratio.
• The recommendations also include:

• ₹56,100 crore as Special Infrastructure Grants for wastewater management in selected cities.
• ₹10,000 crore Urbanisation Premium for transitioning peri-urban areas into urban local bodies.

This strengthens the financial foundation of the third tier of government, although the effectiveness of such transfers will also depend on stronger State Finance Commissions and local institutional capacity.

6. Strengthening Disaster-Management Financing

FC-16 recommends an overall corpus of ₹2,04,401 crore for State Disaster Response and Mitigation Funds.

The estimated Union contribution is ₹1,55,916 crore.

The recommended Centre-State sharing ratio is:

This recognises the higher disaster vulnerability and geographical challenges faced by several States.

7. Stronger Fiscal Responsibility Framework

FC-16 has placed greater emphasis on fiscal sustainability.

Key recommendations include:

• States should maintain fiscal deficits within 3% of GSDP.

• The Union should progressively reduce its fiscal deficit to 3.5% of GDP by 2030–31.

• Off-budget borrowing should be discontinued and transparently brought onto government budgets.

• Poorly targeted subsidies should be rationalised.

• Inactive and persistently loss-making State public enterprises should be reviewed.

The Commission projects combined Centre-State debt to decline from 77.3% of GDP in 2026–27 to 73.1% in 2030–31.

Major Concerns for the Future of Indian Fiscal Federalism

1. Persistent Vertical Fiscal Imbalance

• The Union continues to control many buoyant tax instruments, while States remain responsible for several expenditure-intensive public services.
• This creates a structural mismatch between revenue capacity and expenditure responsibility.
• The debate over increasing States’ share to 50% therefore remains central to India’s fiscal federalism.

2. Cesses and Surcharges and the Shrinking Divisible Pool

A major concern is the increasing role of cesses and surcharges, which are excluded from the divisible pool.

The share of the divisible pool in Gross Tax Revenue declined from 89.1% in 2014–15 to roughly 74–80% during 2020–24.

The issue is not simply whether cesses and surcharges are constitutional. The deeper concern relates to their:

• Scale

• Duration

• Transparency

• Impact on the shareable tax base

A shrinking divisible pool can reduce the effective resources available to States even when the nominal devolution percentage remains unchanged.

3. Equity vs Efficiency

• The introduction of GDP contribution creates a new debate:
• Should States be rewarded for producing more, or should transfers primarily help States that have less fiscal capacity?
• A purely equity-oriented system may frustrate economically productive States.
• On the other hand, an excessive focus on economic output could create a cumulative advantage for already prosperous States.
• Therefore, India's fiscal architecture must find a balance between:

                                      Equalisation → Efficiency → Accountability → Growth

4. Reduced Space for State-Specific Needs

• India's States face very different development challenges.
• For example:

• A uniform formula cannot fully capture such diverse expenditure needs.
• The discontinuation of State-specific and sector-specific grants therefore raises concerns about the ability of the transfer system to respond to asymmetrical State-level requirements.

5. Weak State Finance Commissions

India's third-tier governments cannot achieve genuine fiscal autonomy merely through larger transfers from the Union Finance Commission.

State Finance Commissions often face:

• Delayed constitution

• Delayed reports

• Weak implementation

• Limited administrative capacity

Consequently, increasing Union-level grants without strengthening the State Finance Commission mechanism could produce top-down decentralisation rather than genuine local fiscal autonomy.

6. GST and State Fiscal Autonomy

• The introduction of GST created a common national indirect-tax market and reduced tax cascading.
• However, it also pooled important taxation powers of the Union and States within the GST Council under Article 279A.
• States therefore have less unilateral flexibility over major consumption taxes than they had before GST.
• At the same time, the Supreme Court's decision in Union of India v. Mohit Minerals (2022) emphasised that GST Council recommendations have persuasive rather than binding value, highlighting the cooperative as well as contested nature of Indian federalism.

What Can India Learn from Global Fiscal Federalism?

• International experience shows that equalisation and incentives do not have to be mutually exclusive.

• Australia's Commonwealth Grants Commission explicitly seeks to enable States to provide broadly comparable public services by accounting for differences in revenue capacity and expenditure needs. Canada's Equalization Program similarly provides unconditional transfers to provinces with weaker revenue-raising capacity.
• For India, the key lesson is that fiscal equalisation can coexist with State autonomy and performance incentives.

How Can India Strengthen Fiscal Federalism?

1. Preserve an Explicit Equalisation Mechanism

• India should retain a clearly identifiable equalisation component in intergovernmental transfers.
• If traditional Revenue Deficit Grants are considered distortionary, they could be replaced with a transparent equalisation grant based on measurable fiscal capacity and expenditure needs.

2. Rationalise Cesses and Surcharges

Long-running cesses and surcharges should be periodically reviewed.

A stronger fiscal bargain between the Union and States could involve:

• Greater transparency

• Periodic review

• Disclosure of collections

• Disclosure of utilisation

• Disclosure of unspent balances

• Clear timelines for major cesses

Where their original purpose has effectively become permanent, they could progressively be incorporated into ordinary shareable taxes.

3. Reward Performance Without Sacrificing Equity

Economic contribution can legitimately form part of horizontal devolution, but it should remain supplementary to equalisation.

Future formulas could also reward:

• Fiscal effort

• Improvement in tax capacity

• Human-development outcomes

• Environmental services

• Governance and institutional performance

This would create incentives without disproportionately favouring States that already possess larger economic bases.

4. Strengthen State Finance Commissions

State Finance Commissions should be constituted within constitutional timelines.

Their recommendations should be:

• Tabled before State Legislatures

• Publicly disclosed

• Followed by action-taken reports

• Supported with adequate technical capacity

This is essential for transforming decentralisation into genuine local fiscal autonomy.

5. Reduce Excessive Dependence on Centrally Sponsored Schemes

• Centrally Sponsored Schemes serve important national objectives, but excessive earmarking can reduce States' flexibility.
• The Union should periodically rationalise overlapping schemes and provide States with greater flexibility in programme design while retaining national priorities where necessary.

6. Improve Fiscal Transparency

Both the Union and States should comprehensively disclose:

• Off-budget liabilities

• Government guarantees

• Public-sector enterprise liabilities

• Major subsidy commitments

A common fiscal-accounting framework can improve transparency and prevent governments from shifting liabilities outside headline deficit figures.

7. Account for Climate and Geographical Vulnerability

Future Finance Commissions should develop better measures of:

• Disaster exposure

• Mountainous terrain

• Coastal vulnerability

• Ecological services

• Climate-adaptation costs

Environmental protection and climate resilience often generate benefits for the entire country. Therefore, the fiscal burden should not fall disproportionately on States that provide these national public goods.

8. Institutionalise Continuous Centre-State Dialogue

Fiscal federalism should not be treated as a negotiation that happens only once every five years.

Regular dialogue should be strengthened through institutions such as:

• GST Council

• Inter-State Council

• NITI Aayog Governing Council

• State Finance Ministers' forums

A continuous fiscal dialogue can help India manage emerging challenges in taxation, debt, climate change, urbanisation and public expenditure.

The Future of Indian Federalism: From Devolution to a Fiscal Compact

• The 16th Finance Commission marks an important evolution in India's fiscal federal architecture.
• Its approach attempts to move beyond a simple "Centre gives, States receive" framework towards a system that places greater emphasis on:

                      Economic Contribution + Fiscal Discipline + Performance + Local Governments

• However, the success of this approach will depend on whether India can preserve the principle of fiscal equalisation.
• The fundamental challenge is to ensure that a State's ability to provide essential public services does not depend overwhelmingly on its existing economic strength.

Conclusion

• The 16th Finance Commission represents a significant shift in the philosophy of India's fiscal federalism. By retaining 41% vertical devolution, introducing a 10% GDP contribution criterion, discontinuing Revenue Deficit Grants and expanding local government transfers, it attempts to combine equity, efficiency and fiscal discipline.
• Yet, the future of Indian federalism cannot be determined by the size of transfers alone. The deeper question is whether India's fiscal system can simultaneously encourage economic growth in successful States and protect the fiscal capacity of States facing structural disadvantages.
• The way forward is therefore not a choice between competitive federalism and cooperative federalism, or between equity and efficiency.
• India needs a durable fiscal compact that rewards performance while preserving equalisation, strengthens State autonomy while ensuring fiscal responsibility, and empowers local governments while maintaining national priorities.
• In the long run, the strength of Indian federalism will depend not merely on how much money is devolved, but on how fairly, transparently and effectively public resources are distributed across the Union, States and local governments.