Finance Commission Maintains Tax Devolution at 41%, Addresses Southern States' Concerns
As the 16th Finance Commission commenced its crucial work, southern states expressed significant apprehension regarding potential reductions in their share of tax transfers from the central government. These states, having made substantial investments in population control and human development initiatives over several decades, were concerned about being penalized for outperforming many northern states on these critical parameters.
Revised Allocation Formula Recognizes State Contributions
The Commission, under the leadership of economist Arvind Panagariya, has effectively addressed these concerns by incorporating states' contributions to the combined national GDP into the resource allocation framework. This innovative criterion captures various forms of efficiency, including prudent fiscal management and effective expenditure patterns, according to the Commission's detailed report.
Furthermore, the Commission has redefined demographic performance as the inverse of population growth between 1971 and 2011, while simultaneously revising the forest and ecology criteria to ensure more equitable distribution.
Winners and Losers in the New Allocation
The outcome of these revisions reveals that, with the exception of Tamil Nadu, the four southern states have secured improved positions, receiving a larger portion of the devolved funds. The overall tax devolution percentage remains unchanged at 41% of the central government's tax collections.
Similarly, economically significant states like Maharashtra and Gujarat emerge as beneficiaries under the new allocation formula. Conversely, states including Madhya Pradesh, Uttar Pradesh, West Bengal, Bihar, and Rajasthan experience marginal declines in their allocated shares, though they will collectively receive over 48% of total transfers.
Balancing Competing Demands
The Finance Commission faced considerable challenges in striking this delicate balance, particularly given that its award period extends from April 2026 through March 2031. Eighteen out of twenty-eight states advocated for a 50% share of the divisible pool, emphasizing their growing requirements for funding essential sectors such as healthcare, education, agriculture, drinking water, sanitation, welfare programs, and law enforcement.
The central government, while not specifying exact figures, argued for moderation in tax devolution, citing increased defense expenditures and broader macroeconomic management needs as justification for retaining a larger portion of tax revenues.
Addressing State Concerns Over Cesses and Surcharges
Numerous states, including those advocating for transfers below 50%, raised concerns about the central government's increasing reliance on cesses and surcharges, which are not shared with state governments. The five-member Commission panel rejected this argument, maintaining that these levies serve specific purposes and including them in the divisible pool would undermine their intended objectives.
The Commission acknowledged improvements in central subsidy targeting and delivery mechanisms, while praising ongoing tax reforms in both direct taxation and the Goods and Services Tax system. However, the report noted that significant opportunities remain for further enhancements in tax policy and administrative efficiency to boost revenue collections.
Warning Signs in State Finances
At the state level, the Commission identified concerning trends where tax collections are growing at a slower rate than overall economic expansion. This disparity has made states increasingly dependent on central transfers for funding their operations and development projects.
Northeastern states, along with Uttar Pradesh, Bihar, West Bengal, and Jharkhand, demonstrate the highest reliance on tax devolution. In contrast, Telangana, Haryana, Karnataka, and Maharashtra exhibit the lowest dependence on central transfers, according to the Commission's comprehensive analysis.
Rising Subsidies and Cash Transfers Raise Alarms
The Commission issued strong cautions regarding escalating subsidy expenditures and off-budget borrowings by state governments. The report highlighted persistent financial stress in power distribution companies, recommending privatization as a potential solution to this ongoing challenge. Power subsidies represent the largest financial burden on state finances, accounting for approximately 27% of total subsidies and transfers.
However, the Commission expressed particular concern about the rapid proliferation of unconditional cash transfer schemes across various states. These programs are projected to account for nearly one-fifth of all subsidies and transfers this fiscal year, a dramatic increase from just 3% in 2018-19. The total value of these unconditional transfers is expected to approach Rs 2 lakh crore.
The report specifically identified Maharashtra's Majhi Ladki Bahin Yojana, Karnataka's Gruha Lakshmi, and West Bengal's Lakshmir Bhandar as the largest unconditional transfer schemes according to 2025-26 budget estimates. This substantial growth in cash transfer programs represents a significant shift in state expenditure patterns that warrants careful monitoring and evaluation.
