The States and the 16th Finance Commission
Content
Introduction
Constituted every five years, the Fifteenth Finance Commission’s term ended in 2026, and the Sixteenth Finance Commission (16th FC) took charge for the period 2026-27 to 2030-31 with Dr Arvind Panagariya as its Chairman.
The Finance Commission is a constitutional body established under Article 280 of the Indian Constitution to recommend the distribution of financial resources between the Government of India and the State Governments of India. It plays a pivotal role in fiscal federalism, balancing revenue powers with expenditure responsibilities and ensuring equitable development across regions.
Background and Mandate
- The Finance Commission is a constitutional mechanism designed to maintain fiscal balance within India’s federal structure. Under Article 280 of the Constitution, the President constitutes a Finance Commission every five years or earlier if required.
- The body addresses a structural imbalance inherent in Indian federalism while the Union government controls major taxation powers, states bear a large share of expenditure responsibilities such as health, education, agriculture, and law and order.
- This mismatch creates vertical and horizontal fiscal imbalances that necessitate periodic, rule-based resource transfers.
- Since the First Finance Commission in 1951, successive commissions have played a critical role in evolving India’s fiscal federal framework. Over time, their mandate has expanded beyond simple tax sharing to include fiscal consolidation, performance incentives, disaster management financing, and strengthening of local governments.
- The recommendations of the Fifteenth Finance Commission (2021-26) were shaped by challenges such as the GST regime transition, pandemic-induced fiscal stress, and rising public debt levels.
- As its award period concluded, the Sixteenth Finance Commission was constituted to reassess intergovernmental fiscal relations in light of changing economic realities, demographic shifts, climate vulnerabilities, and the growing demand for cooperative yet accountable federalism.
The Sixteenth Finance Commission operates in a context marked by increasing expenditure needs of states, rising expectations of local governance institutions, concerns over fiscal sustainability, and debates over equitable versus performance-based devolution. Thus, its mandate is not merely distributive but also reform-oriented aimed at strengthening fiscal responsibility, enhancing efficiency in public expenditure, and ensuring balanced regional development across the Union.
Key Recommendations of the 16th Finance Commission
1. Tax Devolution: Maintaining 41% Share
The Commission retained the states’ share in the divisible pool of central taxes at 41% for the five-year period. This continuity offers stability but drew criticism from some states that had sought a higher share to match rising fiscal responsibilities.
- The divisible pool excludes cesses and surcharges, which remain with the Centre, reducing the actual share available for devolution.
2. Revisions in Horizontal Distribution Criteria
The Commission revised the horizontal devolution formula to better balance need and performance:
- Income distance, population (2011 Census), area, and forest & ecology remain components, but a new methodology emphasises economic performance by considering a state’s share in national GDP.
- This shift from purely need-based criteria aims to incentivise states that contribute more effectively to economic growth.
3. Grants and Local Body Financing
- The Commission recommended robust grants to strengthen Panchayats and Urban Local Bodies, aligning with the spirit of 73rd and 74th Constitutional Amendments.
- Disaster management funding was also bolstered with dedicated grants for State Disaster Relief and Management Funds under differentiated sharing ratios.
4. Fiscal Roadmap and Debt Sustainability
To ensure medium-term fiscal discipline, the 16th FC laid out a fiscal consolidation path:
- The Government of India is advised to target a fiscal deficit of 3.5% of GDP by 2030-31.
- State Governments of India should aim for a fiscal deficit limit of 3% of Gross State Domestic Product (GSDP).
- The commission also strongly recommended ending off-budget borrowings, ensuring all liabilities are reflected in the budget, enhancing fiscal transparency.
- Combined Centre-State debt is projected to decline over the commission period, signalling improved sustainability.
5. Subsidy Rationalisation and Structural Reforms
- A key recommendation was to rationalise subsidies especially those that are non-merit by introducing sunset clauses and clearer targeting to avoid fiscal populism.
- The Commission also suggested reforms in key sectors such as power distribution (including privatisation options and legacy debt management) and public sector enterprises, with criteria for review or closure of loss-making SPSEs.
Significance of the 16th Finance Commission
Fiscal Federalism
The 16th FC reinforces fiscal federalism by maintaining a significant devolved share while introducing performance incentives and refined horizontal criteria that reward economic contribution and efficiency. This approach strives to balance equity with incentives for reform and growth.
Sustainable Fiscal Management
The emphasis on fiscal consolidation both at the Centre and states, helps anchor macroeconomic stability amid large expenditure commitments and rising public debt.
Local Governance and Disaster Resilience
Enhanced financing for local bodies and disaster funds directly supports implementation of public services at grassroots levels and strengthens resilience against climate and other shocks, aligning fiscal transfers with emerging governance needs.
Contemporary Political and Policy Relevance
The 16th FC’s recommendations were reflected in the Union Budget 2026-27, including maintenance of the 41% tax share, and were the subject of debates around state autonomy, resource allocation, and the balance between equity and performance. Support for sunset clauses for centrally sponsored schemes also aligns with the commission’s push for fiscal discipline and targeted expenditure.
