Context:

Recently, the Government of India accepted the recommendations of the Sixteenth Finance Commission (16th FC) for the period 2026–31, raising serious concerns about the future of fiscal federalism and the financial balance between the Centre and the states.

About the Sixteenth Finance Commission:

The 16th Finance Commission is a constitutional body constituted by the Government of India in November 2023, chaired by Dr. Arvind Panagariya, under Article 280 of the Constitution. The Commission recommends the distribution of financial resources between the Centre and the states for the five-year period from 1 April 2026 to 31 March 2031.

Key Recommendations of the 16th FC and Impact on Fiscal Federalism

Vertical Devolution

The share of states in central taxes has been maintained at 41%.
This ensures financial stability, although several states had demanded an increase to 50% due to rising responsibilities.

Changes in Horizontal Distribution Criteria

The 16th FC has revised the horizontal distribution formula by introducing GDP contribution (10%) and removing the “tax effort” criterion.
This shift moves allocation from equity-based redistribution toward efficiency and performance-based allocation. While income distance remains dominant, the new framework benefits economically stronger states, potentially reducing redistributive justice.

Discontinuation of Statutory Grants

A major change is the discontinuation of revenue deficit grants and sector-specific grants.
This reduces predictable fiscal support to weaker states and increases their dependence on conditional or discretionary grants, over which the Centre has greater control.

Shrinking Divisible Pool

Although states’ share remains 41%, the effective divisible pool is shrinking due to the increasing use of cesses and surcharges, which are excluded from sharing with states.
This results in lower actual transfers, weakening the spirit of fiscal federalism.

Increasing Influence of Discretionary Transfers:

With a reduction in untied transfers and an increase in conditional grants, the Centre gains greater leverage in influencing state policies. This marks a shift from rule-based fiscal federalism toward discretion-driven control.

Challenges to Fiscal Federalism:

• • Regional Imbalances: Performance-based criteria may benefit economically advanced southern states while widening the fiscal gap for poorer states.
  • Declining Financial Autonomy: Strict borrowing limits and conditional grants reduce states’ access to untied funds for welfare schemes.
  • Strain on Cooperative Federalism: The growing use of cesses and enhanced budgetary control is creating tension in Centre-state fiscal relations.

About the Finance Commission

The Finance Commission (FC) is a key constitutional body under Article 280, tasked with ensuring equitable and balanced distribution of financial resources between the Centre and the states. It is constituted by the President of India every five years or as needed.

Its main functions include:

• • Determining states’ share in central taxes (Vertical Devolution)
  • Allocating resources among states (Horizontal Devolution)
  • Recommending grants-in-aid to states
    It also provides recommendations for financial support to panchayats and municipalities, promoting local-level development.

Conclusion:

The Finance Commission acts as the “balancing wheel” of fiscal federalism, ensuring fairness between the Centre and the states. With GST implementation and emerging fiscal challenges, its role is becoming increasingly complex, performance-oriented, and data-driven.