16th Finance Commission Holds Firm on 41% Devolution Amid Federal Tensions
The 16th Finance Commission, chaired by economist Arvind Panagariya, has submitted its crucial report to Parliament, maintaining the vertical devolution rate at 41% of the divisible tax pool. This decision comes at a time when federal relations between the Centre and several states are strained over resource allocation mechanisms.
Historical Context of Fiscal Devolution
India's federal structure relies on systematic resource transfer from the central government to states, as mandated by Article 280 of the Constitution. The Finance Commission, appointed every five years, determines both vertical devolution (states' overall share) and horizontal devolution (distribution among states).
From the first Finance Commission in 1951 recommending 16% gross tax revenue sharing to the current 41%, the journey reflects evolving fiscal priorities. The 15th Finance Commission had set the 41% benchmark, though actual transfers have often fallen short of recommendations.
State Concerns and Demands
Despite increasing transfers over decades, many states express significant dissatisfaction:
- Progressive southern states feel penalized for development achievements and population control
- States argue that cess and surcharges, which aren't shared, deprive them of legitimate revenue
- Eighteen of twenty-eight states requested increasing devolution to 50%
- Demands included incorporating cess/surcharges into the divisible pool or capping them
The Centre countered these demands, citing constitutional rights to levy cess/surcharges and emphasizing defense and macroeconomic management needs.
Commission's Balanced Approach
The 16th Finance Commission navigated these competing interests with several key decisions:
- Maintained 41% vertical devolution, rejecting both states' demands for increases and Centre's suggestions for reductions
- Introduced GDP contribution as a new horizontal devolution criterion with 10% weightage
- Continued using 2011 census population data despite state objections
- Declared cess/surcharge inclusion in divisible pool unconstitutional
- Proposed folding cess revenues into regular taxes as a compromise solution
Significant Policy Changes
The Commission implemented several structural reforms:
Revenue Deficit Grants Eliminated: The Commission discontinued revenue deficit grants to states, arguing they created perverse incentives for maintaining deficits rather than encouraging fiscal discipline.
Urban Local Body Funding Boosted: Allocation to urban local bodies increased by 45% to ₹3.56 trillion, potentially transforming municipal governance and infrastructure development.
Fiscal Discipline Framework: The report recommends capping states' fiscal deficits at 3% and reducing the Centre's deficit to 3.5% of GDP by 2030-31.
Mixed State Reactions
State responses varied significantly:
- Kerala welcomed increased share from 1.9% to 2.4%
- Tamil Nadu's Chief Minister expressed disappointment over unchanged 4.1% allocation
- Himachal Pradesh projected ₹40,000 crore shortfall from revenue grant elimination
- Karnataka highlighted mismatch between economic contribution (8.7% of GDP) and allocation
Economic Context and Recommendations
The Commission noted India's return to growth trajectory, crediting restrained pandemic stimulus for avoiding inflationary pressures. Between 2011-12 and 2023-24:
- GDP grew at average 11% annually
- Revenue increased 11.4%, expenditure rose 10.9%
- Fiscal deficit peaked at 9.2% during pandemic, now reduced to 4.4%
- Central capital expenditure doubled from 1.6% to 3.2% of GDP
The Commission expressed moderate concern about state finances, noting rising fiscal deficits from 1.9% to 2.9% over the review period, with recommendations for power sector reforms, subsidy efficiency, and public enterprise restructuring.
This balancing act between rewarding economic performance and ensuring equitable distribution continues to define India's fiscal federalism evolution.
