By Annie George Mathew and Soumya Kanti Ghosh
Every five years, finance commissions in India play a crucial role in determining the financial framework for all levels of government—the Centre, states, and municipalities. Their recommendations directly impact the fiscal health and operational capabilities of these entities.
Vertical Devolution: Maintaining Stability at 41%
The 16th Finance Commission's recommendations cover the period from 2026 to 2031, focusing on both vertical devolution (distribution between Centre and states) and horizontal devolution (distribution among states). Projections indicate that proceeds from Union taxes will increase significantly from Rs 138 lakh crore during the 15th Finance Commission period to Rs 254 lakh crore under the 16th Finance Commission.
Despite this growth, the commission has decided to keep the share of vertical devolution unchanged at 41%, which translates to Rs 104 lakh crore. This decision is supported by three key factors.
Reasons for Unchanged Vertical Devolution
First, India has already achieved substantial fiscal decentralisation at the vertical level. The post-transfer revenue balance has shifted dramatically from 43:57 in favour of the Centre during the 5th Finance Commission to 33:67 in favour of states by the 15th Finance Commission.
Second, there has been no significant decline in states' own tax revenues following the implementation of GST. The six-year average of own tax revenue for states was 6.2% in 2016-17 and remained stable at 6.3% in 2023-24.
Third, total transfers to states—including tax devolution, Finance Commission grants, and non-Finance Commission grants—accounted for 57% of gross tax revenue in 2023-24. However, the size of the divisible pool has decreased from 89.1% of gross tax revenue in FY15 to a range of 74-80% during the first four years of the 15th Finance Commission period. This reduction leaves no room to decrease the states' share from the current 41% of the Centre's tax kitty.
Horizontal Devolution: Balancing Equity and Efficiency
Once vertical distribution is established, the next challenge is horizontal devolution, which allocates shares among states themselves. This process ideally balances equity and efficiency considerations.
The 16th Finance Commission has introduced a significant innovation by incorporating states' Gross State Domestic Product (GSDP) as a horizontal criterion to measure efficiency. This marks the first time such a metric has been used in this context.
Additionally, the commission has replaced the inverse total fertility rate—introduced by the 15th Finance Commission following the shift from the 1971 to 2011 Census—with the inverse of population growth between 1971 and 2011. This change reflects the understanding that fertility rate-based devolution may gradually become less relevant as the connection between demography, tax collections, and debt remains tenuous.
The forest and ecology criterion has been refined to include open forest areas and increases in forest cover. Furthermore, the inclusion of contribution to GDP as a criterion serves as an indirect proxy for efficiency-oriented attributes such as tax effort, fiscal discipline, and growth-enhancing policy choices. This approach partially compensates states that demonstrate superior fiscal and administrative performance, thereby reinforcing the efficiency-equity complementarity within the horizontal devolution framework.
Grants: Reforms and Increased Allocations
Revenue deficit grants under Article 275(1) were originally designed as gap-filling transfers to bridge post-devolution revenue and assessed expenditure needs. However, over the past three decades, there has been a significant deviation between normatively assessed revenue deficits and the actual revenue deficits of states (excluding these grants).
In this context, the 16th Finance Commission's assessment of untapped revenue potential and expenditure rationalisation strengthens the argument for discontinuing revenue deficit grants in their current form.
Regarding grants to local bodies, the commission has recommended a total allocation of Rs 7.9 lakh crore, with a particular focus on urban infrastructure. Combined grants for rural and urban local bodies under the 16th Finance Commission are 2.2 times higher than those recommended by the 15th Finance Commission.
The 16th Finance Commission has also separated grants into basic and performance categories, ensuring that local bodies have more untied components to spend—60% compared to 40% previously. Access to performance grants is now linked to the existence of duly constituted local bodies, public disclosure of information, and the constitution of a State Finance Commission.
Fiscal Roadmap and Cooperative Federalism
As part of its fiscal roadmap, the commission has recommended reducing the fiscal deficit of the Centre to 3.5% of GDP by the end of the award period, with state governments targeting 3%. Within the Union's fiscal deficit, approximately 0.5% of GDP would be earmarked for onward lending to states under the Scheme for Special Assistance to States for Capital Investment.
This deficit target is considered both pragmatic and aspirational. Overall, the 16th Finance Commission's recommendations reflect a deepening of cooperative federalism, combining sustained fiscal decentralisation with incentive-compatible transfers oriented toward macro-fiscal stability and long-term growth.
Ghosh is a member of the 16th Finance Commission and PMEAC, and Group Chief Economic Advisor at SBI. Mathew is a member of the 16th Finance Commission and former special secretary of expenditure in the finance ministry.
