Context:
The Sixteenth Finance Commission (16th FC) has recommended retaining the States’ share at 41% of the divisible pool of central taxes, similar to the Fifteenth Finance Commission. However, its recommendations have raised concerns about fiscal federalism, reduction in grants, and the growing role of cesses and surcharges, which affect the actual transfers to States.
Key Highlights:
Tax Devolution Recommendation
- The Commission retained 41% share of States in the divisible pool of central taxes.
- This follows the Fifteenth Finance Commission recommendation, after the share was reduced from 42% (14th FC) to 41% due to the reorganization of Jammu & Kashmir.
New Criterion Introduced
- A new “contribution criterion” based on the share of a State’s Gross State Domestic Product (GSDP) has been introduced.
- To reduce extreme effects, the Commission used the square root of GSDP values.
States Likely to Lose
- Some states expected to receive relatively lower allocations include:
- Madhya Pradesh
- Uttar Pradesh
- West Bengal
- Bihar
- Odisha
- Chhattisgarh
- Rajasthan
Grants and Fiscal Transfers
- The Commission discontinued revenue deficit grants.
- It also did not recommend State-specific or sector-specific grants.
Grand Bargain Proposal
- Suggested a “grand bargain”:
- States accept a smaller share of taxes,
- In return, the Centre merges cesses and surcharges into shareable taxes, expanding the divisible pool.
Concerns Raised
- The Commission did not adequately account for the rising share of cesses and surcharges, which are not part of the divisible pool.
- It projected nominal GDP growth at 11%, higher than the Budget estimate of 10% for 2026–27.
- It did not incorporate the fiscal effects of GST reforms introduced in September 2025.
- Dropping the tax effort/fiscal discipline criterion contradicts the Commission’s own emphasis on fiscal responsibility.
Significance
- Raises important questions about fiscal federalism and resource sharing between the Centre and States.
- Highlights the growing imbalance caused by non-shareable taxes like cesses and surcharges.
Relevant Prelims Points:
- Finance Commission
- A constitutional body under Article 280.
- Constituted every five years by the President of India.
- Functions include:
- Recommending distribution of tax revenues between Centre and States.
- Determining principles governing grants-in-aid to States.
- Divisible Pool of Taxes
- Portion of central taxes shared with States.
- Includes taxes such as income tax and GST compensation share.
- Cesses and surcharges are excluded.
- Gross State Domestic Product (GSDP)
- Total value of goods and services produced within a state’s economy.
- Indicator of state-level economic performance.
- Cesses and Surcharges
- Additional taxes levied by the Union Government for specific purposes.
- Not shareable with States.
- Article 275
- Provides for grants-in-aid from the Union to States, especially for special needs and equalization of services.
Relevant Mains Points:
Issues in Fiscal Federalism
- Rising share of cesses and surcharges reduces the effective share of States.
- Limited flexibility for States to manage fiscal responsibilities.
- Reduction of revenue deficit grants may affect fiscally weaker states.
Impact on State Finances
- Some states may face reduced fiscal space for social sector spending.
- Increased dependence on borrowing or state taxes.
Importance of Balanced Fiscal Transfers
- Fiscal transfers help reduce regional inequalities.
- Ensure uniform standards in public services such as health and education.
Way Forward
- Integrate cesses and surcharges into the divisible pool to strengthen cooperative federalism.
- Restore performance-based criteria like tax effort and fiscal discipline.
- Use revenue gap grants to support fiscally weaker states.
- Strengthen Centre–State fiscal dialogue through institutions like the GST Council.
UPSC Relevance:
- Prelims: Finance Commission, divisible pool, cesses and surcharges, Article 280, Article 275.
- Mains: Fiscal federalism in India, Centre–State financial relations, challenges in tax devolution.