Sixteenth Finance Commission — Misses and Concerns

Background: Finance Commission in India

🔹 Constitutional Basis

• Article 280 – Provides for the constitution of a Finance Commission (FC) every five years.

• Article 270 – Deals with distribution of taxes between the Centre and States.

• Article 275 – Provides for grants-in-aid to States in need of assistance.

🔹 Composition

• Appointed by the President.

• One Chairman + four members.

🔹 Core Functions

1. Recommend vertical devolution (Centre vs States share).

2. Recommend horizontal devolution (distribution among States).

3. Suggest grants-in-aid under Article 275.

4. Strengthen fiscal federalism.

 Key Concepts

Evolution of States’ Share in Divisible Pool

Vertical Dimension: Issues & Concerns

A. Retention of 41% Share

• 14th FC increased share from 32% → 42%.

• Justification: Discontinuation of Plan grants (~3%).

• 15th FC reduced to 41% (J&K reorganisation).

• 16th FC retained 41% → gives semi-permanent character.

🔎 Concern:

• Centre argued fiscal space was shrinking.

• But effective transfers were already historically high (34–35%).

B. Rising Use of Cesses and Surcharges

Problem:

• These are non-shareable taxes.

• Centre increased them after 42% devolution.

Constitutional Concern:

• Should be:

  • For specific purpose

  • Limited period

  • Not merged with general revenue

16th FC Stand:

• Suggested a “Grand Bargain”:

  • Centre merges cesses into divisible pool

  • States accept smaller share

  • No revenue loss to either side

Criticism:

• FC did not strongly object to excessive cesses.

• Did not fully uphold spirit of Article 270.

C. Discontinuation of Revenue Deficit Grants

• 16th FC discontinued:

  • Revenue deficit grants

  • State/sector-specific grants

Impact:

• Indirect reduction in States’ effective share.

• Compared to 15th FC period, transfer ratio declined to 32.7% (2026-27).

D. Overestimation Issues

• Assumed nominal GDP growth: 11%

• Budget estimate: 10%

• Did not account for revenue loss due to GST reforms (Sept 2025).

Horizontal Dimension: Changes & Issues

A. Introduction of “Contribution” Criterion

What it Means:

• States contributing more to national GDP get higher share.

• Measured by share in all-State GSDP.

Conceptual Issue:

Need to differentiate:

1. Production efficiency

2. Fiscal efficiency

Production concentration:

• Capital & skilled labour move to developed States.

• Market forces → richer States grow faster.

Rewarding this may:

• Undermine equalisation principle.

B. Dual Use of GSDP

To soften impact:

• Used square root of GSDP, not full GSDP.

C. Dropping Tax Effort Criterion

Earlier FCs used:

• Tax effort

• Fiscal discipline

16th FC dropped it.

🔎 Criticism:

• If efficiency is goal, fiscal effort should matter more than production size.

Losses and Gains Among States

Major Losing States

• Madhya Pradesh

• Uttar Pradesh

• West Bengal

• Bihar

• Odisha

• Chhattisgarh

• Rajasthan

Other Losing States

• Arunachal Pradesh

• Meghalaya

• Manipur

• Nagaland

• Tripura

• Sikkim

• Goa

Observation:

• Richer States gained, but not uniformly.

Role of Article 275: Missed Opportunity

Article 275 Grants:

• For State-specific needs.

• Can equalise standards of:

  • Health

  • Education

  • Infrastructure

Difference:

• Revenue deficit ≠ Needs-based grants

Needs-based grants:

• Normatively determined.

• Promote equalisation.

🔎 Argument:
Even if devolution formula changes,
→ Losses could be neutralised through revenue gap grants.

Sample UPSC Mains Question

Q. Discuss the challenges in balancing equity and efficiency in tax devolution as reflected in the Sixteenth Finance Commission’s recommendations.

Answer Structure:

1. Constitutional framework

2. Vertical balance issues

3. Horizontal formula shifts

4. Equalisation vs performance

5. Way forward

 Way Forward 

• Rationalise cesses and merge into divisible pool.

• Reintroduce fiscal discipline parameter.

• Use Article 275 equalisation grants.

• Improve transparency in formula weights.

• Strengthen GST revenue stabilisation.

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