Context:
The Sixteenth Finance Commission (FC-16) has recommended retaining the vertical devolution of central taxes to states at 41% for the period 2026–31, while making adjustments to the horizontal distribution formula among states.
Key Highlights:
Vertical Devolution
- The Commission recommended maintaining the 41% share of Union taxes for states.
- This continues the formula adopted by the Fifteenth Finance Commission.
Horizontal Devolution Formula Changes
- The “tax effort” criterion has been modified into a broader “contribution to GDP” indicator.
- The new approach aims to reward economically productive and efficient states.
- Weightage for demographic performance has been reduced.
- Weight for population size has been slightly increased.
Fiscal Pressures on States
- The Commission acknowledged shrinking fiscal autonomy of states under the GST framework.
- States face limited independent taxation powers due to GST centralization.
Concerns Regarding Divisible Pool
- The Commission noted the shrinking effective divisible pool of taxes.
- This is due to increasing reliance by the Centre on cesses and surcharges, which are not shareable with states.
Transfers through Centrally Sponsored Schemes (CSS)
- A major share of additional transfers to states occurs through Centrally Sponsored Schemes.
- CSS programs are designed by the Union but implemented by states.
Relevant Prelims Points:
- Finance Commission
- A constitutional body under Article 280 of the Constitution.
- Constituted every five years by the President of India.
- Recommends:
- Distribution of tax revenues between Centre and States.
- Allocation of funds among states.
- Grants-in-aid to states.
- Vertical Devolution
- Sharing of Union tax revenues between the Centre and states.
- Horizontal Devolution
- Distribution of the states’ share of taxes among different states.
- Divisible Pool of Taxes
- Total tax revenues of the Union that are shareable with states.
- Excludes cesses and surcharges.
- Centrally Sponsored Schemes (CSS)
- Schemes funded jointly by Centre and states but designed by the Union government.
- Examples include:
- PM Poshan
- MGNREGA
- PMGSY
Relevant Mains Points:
Importance of Fiscal Federalism
- Ensures financial autonomy for states.
- Promotes balanced regional development.
- Supports cooperative federalism in policy implementation.
Positive Aspects of FC-16 Recommendations
- Maintains stability in fiscal transfers by retaining 41% devolution.
- Introduces economic productivity indicators in resource allocation.
- Recognizes fiscal stress faced by states under GST.
Limitations and Concerns
- No structural reform in Centre–state fiscal balance.
- Cesses and surcharges reduce the divisible pool, limiting state resources.
- States remain dependent on centrally designed schemes.
- Lack of significant increase in unconditional fiscal space for states.
Way Forward
- Gradually increase the vertical devolution share to enhance state autonomy.
- Bring cesses and surcharges into the divisible pool.
- Strengthen state fiscal capacity and tax administration.
- Reform Centrally Sponsored Schemes to give states greater flexibility.
- Promote transparent and predictable fiscal transfers.
UPSC Relevance:
- GS 2: Polity – Finance Commission and fiscal federalism
- GS 3: Economy – Centre–State financial relations and GST framework