It’s sad that India’s 16th Finance Commission award has given up a tradition of tax-sharing impartiality

Though FCs are not widely known, their awards have far reaching implications for fiscal federalism and macroeconomic fiscal outcomes. Successive finance commissions (FCs) have established a sound tradition of impartial awards.

Slight shifts in one direction or another notwithstanding, most earlier FCs have tried to navigate a balanced course between interests of the central government and those of states and between considerations of equity and efficiency.

The 16th Finance Commission (16th FC) report has changed this course. It reveals a distinct re-orientation in favour of the central government vis-à-vis the states and shows little concern for equity.

Also, unlike past FCs, it has expressed opinions without always presenting data in their support. Hence, it is not possible to judge whether some of these opinions are based on robust evidence.

Renowned domain experts have therefore been quite critical of the 16th FC awards (Rangarajan & Srivastava in The Hindu, 2 March; Govinda Rao in Business Standard, 12 March). This column illustrates how a once-balanced approach has been changed in both vertical transfers between the Centre and states and the horizontal devolution among states.

In its tax devolution formula, the 16th FC has maintained the share of states at 41% of the shareable pool, like the 15th FC, giving the appearance of continuity. However, the shareable pool itself has been progressively squeezed, with the Centre increasingly resorting to resource mobilization through cesses and surcharges, which are Constitutionally excluded from the shareable pool.

Further, the 16th FC has eschewed most grants, especially the revenue deficit grant (RDG), though grants constitute the second channel of non-discretionary FC transfers to states. In principle, the RDG should be computed normatively as the difference between the resource needs of a state—to provide a level of public services comparable with all other states—and the sum of its own revenue raising capacity and tax devolution.

Typically, RDGs have never fully offset the fiscal disability of states, but they have helped to reduce the gap. By ignoring the impact of GST and doing away with the RDG altogether, the 16th FC award has led to a sharp reduction in the share of central gross revenue transferred to states. That share rose from around 27% in the 11th FC award to a peak of 35.6% in the 14th FC award, moderating marginally to 34.4% in the 15th FC award. Based on 2026-27 budget allocations, Rangarajan and Srivastava estimate that the share is now down to 32.7% under the 16th FC award.

FC transfers to states, both devolution and grants, are transparent and non-discretionary. With a reduction in the share of such FC transfers, the share of discretionary Centrally Sponsored Schemes (CSS) has risen to around 50% of total transfers to states. Since generally 40% of the cost of these schemes have to be financed by states, CSS spending entails a significant diversion of states’ resources to priorities of the Centre from those of states.

Moreover, these schemes relate to sectors that are often state subjects as per the Seventh Schedule of the Constitution. As such, the increasing share of CSS transfers constitutes a major distortion of the federal architecture envisaged in the Constitution. The 16th FC awards have significantly exacerbated this distortion.

Finally, the 16th FC has appropriately been very critical of the increasing provision of budgetary transfers and non-merit subsidies by states to power distribution companies and populist schemes for vote banks, or ‘freebies’ as they are often called. However, the 16th FC makes no adverse comment about bailouts of central public undertakings or the proliferation of central ‘freebie’ schemes, which is further evidence of its centrist bias.

Turning to the horizontal transfers among states, the 16th FC has introduced a new component in its devolution formula, ‘contribution to GDP,’ with a weight of 10%. This has apparently been done to represent fiscal efficiency while the FC has dropped standard measures of states’ fiscal performance used by earlier FCs.

What the new component actually reflects is not the fiscal efficiency of a state, but its economic strength, the size of its gross state domestic product (GSDP), demographic size, capital stock, etc, which have little to do with fiscal performance. This component biases the devolution in favour of larger, more developed states, undermining equity.

With every FC award, there are some states that gain share while some lose when allocation formulas and weights change. This is because the total of all state shares must add up to 100%. The difference this time is that most of the states that have lost share are India’s smaller and poorer states: Bihar, Chhattisgarh, Uttar Pradesh, Madhya Pradesh, Rajasthan, Odisha, West Bengal and all the northeastern hilly states that are totally dependent on central transfers.

In navigating a path between the Centre and states and between equity and efficiency in its award, the 16th FC has unfortunately turned the clock back. We have to live with this award for the next five years. Hopefully the 17th FC will take us back to the well-established balanced path.