The Sixteenth Finance Commission (16th FC) has sought to balance continuity with reform in India’s fiscal federal architecture by retaining states’ share at 41% of the divisible pool of central taxes, ensuring predictability in intergovernmental transfers over its five-year award period from FY27 to FY31. The report has been accepted by the government.
The real innovation of the 16th FC, however, lies in its horizontal devolution formula. Under its Chairman Arvind Panagariya, the commission has attempted to blend equity with efficiency by introducing “contribution to GDP” as a new criterion, assigning it a calibrated weight of 10% to avoid sharp redistribution shocks.
“This is a new criterion we are introducing in recognition of India’s growth ambition,” the commission said.
Fifteenth Commission Comparison
A comparison with the Fifteenth Finance Commission (15th FC) underscores the shift. The earlier formula was heavily need-based: income distance carried the highest weight at 45%, followed by population (2011) at 15%, area at 15%, forest and ecology at 10%, and demographic performance at 12.5%. Efficiency featured only marginally, through tax effort at 2.5%.
The 16th FC has retained income distance as the dominant factor, but trimmed its weight to 42.5%. Population’s share has been raised to 17.5%, area reduced to 10%, forest and ecology retained at 10%, and demographic performance lowered to 10%. The most significant conceptual change is the replacement of tax effort with GDP contribution at 10%, marking a clear move towards performance-linked federalism.
On Union finances, the Commission noted that its principal lever remains the divisible tax pool. The growing reliance on cesses and surcharges — which are not shareable with states — has steadily eroded the effective size of this pool, from 89.1% of gross tax revenue in 2014–15 to around 74–80% in recent years.
With limited room to reduce states’ share further, the 16th FC proposed a “grand bargain”. Under this approach, the Union would fold a larger share of cess and surcharge revenues into regular taxes, expanding the divisible pool, while states could accept a lower percentage of a larger pool without suffering revenue losses. To improve transparency, the Commission also recommended annual disclosure of net tax proceeds, certified by the Comptroller and Auditor General under Article 279.
Fiscal Deficit Targets
On fiscal discipline, the Commission reiterated the need to cap states’ fiscal deficits at 3% of GSDP, phase out off-budget borrowings and align Fiscal Responsibility legislation with its consolidation roadmap. For the Union, it recommended bringing the fiscal deficit down to 3.5% of GDP by the end of the award period in FY31.
The 16th FC also called for a rationalisation of Centrally Sponsored Schemes through a high-powered review, aimed at pruning poorly performing programmes and linking spending to measurable, real-time outcomes to address duplication and inefficiency.
For states, the commission stressed subsidy rationalisation, stronger tax administration and stricter fiscal discipline, alongside reforms or closure of loss-making state public sector enterprises. It warned that off-budget liabilities and persistent losses in the power sector pose growing risks to macro-fiscal stability.
Finally, the commission even suggested a constitutional amendment to delink Finance Commission recommendations for local bodies from the mandatory reliance on State Finance Commission (SFC) reports, citing the weak functioning of many SFCs. It also proposed that NITI Aayog document and disseminate best practices to strengthen state-level fiscal institutions.