The 16th Finance Commission has finalized the framework for distributing central tax revenues among India's 28 states for the next five years, from FY27 to FY31. This pivotal decision, which shapes the fiscal landscape of the nation, comes after extensive consultations with states, revealing both alignment and stark differences in their recommendations.
Balancing Competing Objectives
The Commission faced the complex task of reconciling two primary goals: rewarding states that have achieved higher income levels and controlled population growth, while simultaneously supporting those with lower per capita incomes and higher fertility rates. This challenge is set against the broader backdrop of India's aging population, which risks diminishing the demographic dividend that has fueled economic growth in recent decades.
Criteria Overhaul: What Changed?
In its methodology, the 16th Finance Commission introduced significant modifications to the criteria determining individual state shares. A new efficiency criterion—contribution to India's GDP—has been added, reflecting states' economic output. Additionally, the weight assigned to population has been increased, acknowledging demographic realities.
Conversely, the weights for three existing criteria have been reduced: per capita income gap, area, and demographic performance. Notably, tax and fiscal efforts have been entirely removed from the calculation. The Commission also implemented definitional tweaks to certain criteria, subtly shifting emphasis toward the quality of state efforts and long-term planning initiatives.
State Submissions: Convergence and Divergence
States largely endorsed the Commission's approach, with five of the six adopted criteria being suggested by 23 to 28 states. The new GDP contribution criterion was proposed by 9 states. Beyond these, states put forward 13 additional criteria, including poverty levels, vulnerability, international border overlap, and infrastructure quality, though these were not incorporated into the final formula.
However, where states diverged sharply was in the preferred weightage for each criterion. For instance, the per capita income distance criterion, which carries the highest weight at 42.5% in the Commission's framework, saw state preferences ranging from 15% (Haryana) to 55% (Manipur). On average, states suggested a weight of 38.6%, with economically poorer states advocating for higher weights and better-off states preferring lower ones.
This pattern of self-interest was evident across other criteria as well. For example, forest cover weightage proposals varied widely: four states suggested 20% (Andhra Pradesh, Sikkim, Tripura, and Uttarakhand), while two states recommended just 5% (Haryana and Uttar Pradesh).
The Devolution Mechanism Explained
India's fiscal system relies heavily on the centre-state compact, where the central government collects the majority of taxes—including income tax, corporation tax, and since 2017, GST—while states handle bulk expenditures like education, healthcare, and law enforcement. To address this mismatch, tax revenues are devolved through two mechanisms.
Vertical devolution, which determines the overall share of tax revenues allocated to states, has been retained at 41% by the 16th Finance Commission. Horizontal devolution then distributes this 41% among individual states based on the revised criteria.
Winners and Losers in the New Formula
The inclusion of GDP contribution as a criterion has partially alleviated concerns among richer, better-performing states—particularly in the south, along with Maharashtra and Gujarat—who feared being penalized for their economic success. This change has boosted their shares of divisible revenues.
Conversely, some poorer states have experienced marginal declines in their shares. For instance, Uttar Pradesh's share has dipped from 17.9% to 17.6%, and Bihar's from 10.1% to 9.9%. Despite this, these states will still see an increase in absolute terms due to expected growth in central tax revenues over the next five years.
A New Blow for Poorer States
In a significant departure from previous commissions, the 16th Finance Commission has recommended eliminating grants meant to bridge revenue deficits for states. The rationale is that states have the capacity to levy additional taxes and that covering deficits may encourage fiscal inefficiencies. As a result, states are projected to receive at least 0.5 percentage points less as a share of GDP by 2030-31 compared to the current distribution.
Overall, the 16th Finance Commission's award reflects a nuanced attempt to balance equity and efficiency, setting the stage for India's fiscal federalism in the coming half-decade. The changes underscore the ongoing evolution of the centre-state fiscal compact, with long-term implications for regional development and economic cohesion.
