Shrinking Fiscal Space of Indian States:16th Finance Commission’s Recommendations That Fail State Demands

A diverse country like India is home to states that differ sharply in income levels, population pressures, geography, and administrative capacity, giving rise to vast and uneven fiscal pressures that can't be fulfilled with a one-size-fits-all system.

Illustration by The Geostrata

Fiscal Federalism is at the heart of the Indian Economy, sustaining strong Centre-State relations and upholding political legitimacy. In this backdrop, the constitution provides a balance between the centre and state fiscal relationship through the Finance Commission, a silent mechanism renewed every five years and entrusted with the essential task of deciding how the nation's fiscal resources will be shared. 

THE 16TH FINANCE COMMISSION

The President of India constituted the 16th Finance Commission on 31st December 2023 under the chairmanship of Dr Arvind Panagariya, the former vice-chairman of NITI Aayog. The commission, under his leadership along with Ajay Narayan Jha, Annie George Mathew, Niranjan Rajadhyaksha, & Dr. Soumya Kanti Ghosh has made recommendations which will be implemented from 1st April 2026 and will be in effect till 31st March 2031, shaping India's intergovernmental fiscal architecture at a time marked by post-GST constraints, rising fiscal responsibilities of states, & intensifying debates on equity, efficiency, & cooperative federalism.

CHARTING THE FISCAL ROADMAP: KEY RECOMMENDATIONS

Article 280 of the Indian Constitution mandates the Finance Commission to make recommendations on the distribution of the Union government’s tax revenues between the Centre and the States, and also lays down the principles governing fiscal transfers between them.

The 16th Finance Commission made notable recommendations by keeping the vertical devolution unchanged, retaining the state's share at 41% of the divisible pool of central taxes, the same as the 15th Finance Commission. 

Whereas the commission has significantly modified the horizontal distribution method, which determines how the funds will be shared among states. The method continues to prioritise income disparity among states, supporting relatively weaker states, but also introduced a new parameter- contribution to Gross Domestic Product. This recommendation represents a shift towards rewarding and recognising economic productivity and growth performance.

Other areas of focus include strengthening local governance institutions by substantially allocating funds to both urban and rural local bodies with a combination of basic grants and performance-based grants. While the commission laid down the fiscal roadmap for the next five years, several states have expressed dissatisfaction with its recommendations. At the heart of the discontent among several states lies not merely the arithmetic of transfers, but the philosophy that appears to guide them.

FAULTLINES IN THE FISCAL FRAMEWORK

The major bone of contention lies over the vertical devolution formula. The states expected a rise from 41%, as recommended by the 15th Finance Commission, to 50% by the 16th Finance Commission. But while the papers signal continuity and states receive 41% of the divisible pool of central taxes, the key phrase is “divisible pool,” and not all Union tax revenues are a part of it.

Under Article 270, the constitution specifies that some central taxes are shareable with the states, and Article 271 excludes cesses and surcharges from the pool, which means that states get 41% of only what remains after excluding them. Over the years, the centre has increasingly relied on cess and surcharges to raise revenue, which has reduced the overall divisible pool.

States are dissatisfied with the increasing reliance on non-shareable taxes, and if the divisible pool keeps shrinking due to expanding cess and surcharges, states may receive a smaller share in real terms, and this will weaken the fiscal autonomy, undermining predictable revenue flows, and centralising financial authority.

Similarly, the horizontal devolution method, which determines how funds are distributed among states, still uses 2011 population data, which is outdated. Southern and Western states, which have been successful in controlling population, argue that demographic efficiency is inadequately rewarded. Although the method includes demographic performance as a criterion, it balances unfavourably against them.

Simultaneously, economically weaker and less industrialised states express their concerns over emphasis on performance-based grants, including contribution to GDP as a distribution parameter. While the move is fundamentally redistributive, it also risks benefiting already developed states and hence widening regional disparities.

Thus, dissatisfaction surrounding the 16th Finance Commission reflects a deeper structural tension between the centre and states with respect to equity and efficiency, autonomy and accountability, redistribution and reward. 

From the perspective of Indian states, these recommendations embody a paradox- while they strengthen macroeconomic discipline and incentivise performance, they also leave unresolved core concerns of vertical fiscal imbalance. From the Centre’s view, while retaining the 41% vertical devolution ensures predictability without overburdening the Union’s fiscal position, increasing it could compromise the national fiscal consolidation.

The Commission has introduced the GDP contribution criterion, encouraging competitiveness and efficiency across states, which is a significantly crucial move towards better governance. The performance-linked grants for local bodies also ensure that funds are used judiciously, reducing leakages and improving economic outcomes.

States, on the other hand, reflect the paradox in these recommendations from the 41% question, the unchecked use of cess and surcharge leads to reduced effective tax devolution, centralisation of financial power, and reduced fiscal autonomy of states, to the fear of dilution of redistributive justice for weaker states. 

THE FUTURE OF INDIA'S FISCAL TRAJECTORY

The successful implementation of the recommendations depends upon the contribution of cess and surcharges in the divisible pool, the balance between efficiency and redistribution with respect to GDP-based incentives, and the struggle of weaker states to catch up, and most importantly, the political realities of different states.

In a nation based on political and economic diversity, a single method or formula cannot satisfy all stakeholders. Yet, the debate is a testament to the vibrancy of India's fiscal democracy. At its core, fiscal federalism in India is not just an accounting exercise but a continuous negotiation between unity and diversity.

As economic aspirations widen and regional disparity gaps are bridged, the challenge is no longer about dividing revenue but inculcating trust and calibrating balance that rewards efficiency, protects equity, and preserves state autonomy. The growth of fiscal federalism in India will depend upon a continued partnership of shared prosperity, where both centre and state rise together and not at each other's cost.

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BY VASUDHA

TEAM GEOSTRATA

info@thegeostrata.com