Sixteenth Finance Commission

The Sixteenth Finance Commission is facing growing demands from States to increase their share in the divisible tax pool from 41% to 50%, amid declining actual transfers due to the Centre’s rising use of cesses and surcharges. This has reignited debates on fiscal federalism, vertical and horizontal devolution, and equitable revenue-sharing.

Vertical Devolution Challenges

• Shrinkage of Effective State Share: The share of cesses and surcharges in the Centre’s gross tax revenues rose from 12.8% (2015–2020) to 18.5% (2020–2024), reducing the States’ effective share from ~35% to ~31%, despite the de jure 41% recommendation.
• Demand for Increased Devolution: 22 out of 28 States, across political lines, have demanded an increase in vertical devolution to 50%, citing rising responsibilities, revenue constraints under GST, and limited fiscal autonomy.
• Centre’s Reluctance Due to Expenditure Pressures: The Union government cites increasing defence and capital expenditure as reasons to resist higher devolution, with the Commission's leadership hinting against major upward revisions due to fiscal balancing concerns.

Horizontal Devolution Inequities

• Population and Income Distance Bias: The current horizontal devolution formula gives high weightage to population and income distance, which penalises demographically stable and economically advanced States — particularly in southern India.
• Disincentive for Performance: Progressive States perceive the current formula as discouraging good fiscal management and developmental outcomes, thereby undermining the principles of efficiency and accountability.
• Need for Balanced Formula Revision: A reworked formula that incorporates fiscal effort, area, ecological sensitivity, and social indicators—alongside need-based transfers—can achieve equity without penalising governance performance.

Institutional and Policy Imperatives

• Regulating Cesses and Surcharges: The Finance Commission must consider recommending a cap on cesses and surcharges as a percentage of gross tax revenue, and suggest including surplus collections in the divisible pool to ensure transparency.
• Towards a Federal Compact: A modest increase in vertical devolution — for instance, from 41% to ~45% — would reflect cooperative federalism and address States' fiscal stress without compromising national priorities.
• Strengthening Fiscal Prudence and Equity: The Commission should aim to strike a balance between macroeconomic stability and equity by ensuring its recommendations incentivise revenue generation, efficiency, and inter-state equity.

Practice Question:

Q. "The Finance Commission plays a critical role in balancing the fiscal powers between the Union and the States. In the context of increasing reliance on non-divisible revenues by the Centre, critically analyse the challenges and suggest a roadmap for strengthening fiscal federalism in India."