16th Finance Commission

Why in news: 16th FC recommended that Centre retain 41% share of tax devolution to States as in force since 2021.

• ₹1.4 lakh crore States Grant include Rural and Urban Local Body and Disaster Management Grants.
• It tweaked formula that decides the division of the share among the States. 5 southern States assigned a collectively higher share under the distribution scheme of the 16th FC than in the past.
• Kerala’s degree of rise is only next to Haryana’s 24.52%, while the third slot goes to Karnataka.

Changes in Devolution Formula

• FC-16 has reworked the earlier “tax effort” criterion into a broader “contribution to GDP” measure. Weight raised from 2.5% (FC-15) to 10%. This is intended to reward productive and efficient States.
• Weight accorded to demographic performance has been reduced. Reflects the view that penalising population growth is not appropriate when India is close to the peak of its demographic dividend.
• Weight for population size has been increased.
• FC-16 flags shrinking of the effective divisible pool due to cesses and surcharges but stops short of correcting this.

Horizontal Devolution Formula (16th FC vs 15th FC)

• Income Distance: 42.5% (Reduced from 45%). Population (2011): 17.5% (Increased from 15%).
• Area: 10% (Reduced from 15%). Forest & Ecology: 10% (Retained).
• Demographic Performance: 10% (Reduced from 12.5%). Contribution to GDP: 10% (Replaces Tax-Fiscal Effort)
• Maharashtra, Gujarat, Karnataka benefit structurally. Bihar, Jharkhand, Uttar Pradesh do not benefit.

Finance Commission and urban local governments

• FM tabled the 16th Finance Commission report in the Lok Sabha.
• Recommended allocation of ₹3.5 lakh crore to urban local governments for the next 5 years.
• Funds are devolved to ULGs through transfers by the Central and State governments in the form of grants.
• Allocation of ₹10,000 crore to the urbanisation premium grant could incentivise rural-urban transition.
• Commission allocated 45% of local government grants to ULGs, increased from 36%.
• More than 60% of grants to ULGs were basic grants.
• Tied grants can be used for basic services such as sanitation and water supply.
• Untied grants can be used for location-specific needs excluding salary and establishment expenses.

Divisible pool concerns

• Divisible pool excludes cesses, surcharges, and collection costs. Between 2013–2019, for every ₹100, about ₹93–95 formed the divisible pool. Remaining ₹5–7 collected as cesses and surcharges.
• In 2021-22, for every ₹100, ₹86.5 formed taxes and duties while ₹13.5 was cesses and surcharges.
• Share of divisible pool in Gross Tax Revenue to remain below 90% (81%) for the sixth consecutive year.
• Underlying divisible pool shrinking due to increasing reliance on cesses and surcharges.
• Constitution does not permit a cap on cesses and surcharges.
• FC argues Centre requires these funds for war, famine, and pandemics.

Constitutional provisions and Finance Commission framework

• 16th Finance Commission under the chairmanship of Dr. Arvind Panagariya submitted report for 2026-31.
• Central government accepted its recommendations.
• Article 270 provides for distribution of net tax proceeds between Centre and States.
• Shared taxes include corporation tax, personal income tax, Central GST, and Centre’s share of IGST.
• Distribution based on recommendations of the Finance Commission constituted under Article 280.

Trends in vertical and horizontal devolution

• Till the 13th Finance Commission (2010-15), vertical devolution fixed at 32%.
• Since the 14th Finance Commission (2015-20), vertical devolution increased to 42%.
• Revised to 41% in the 15th Finance Commission (2020-26) due to reorganisation of Jammu and Kashmir.
• Horizontal devolution since 13th FC gave higher weight to equity and needs compared to efficiency.
• Share of southern and western States marginally increased & big north and central States decreased.