A cautious nudge: On the 16th Finance Commission’s recommendations

In its much-awaited recommendations, which were also tabled on Sunday, the Sixteenth Finance Commission (FC-16), as anticipated, has recommended that the vertical devolution ratio — the States’ share in the divisible pool of Central taxes — be retained at 41% for the period 2026-31. States want this to be 50%. This is despite the Commission acknowledging the tightening fiscal space States face under the GST framework, and that the growing mismatch between expenditure responsibilities and assured revenues has increasingly left them with “recourse to market borrowings” as the principal adjustment mechanism. Predictably, several States have criticised the projected devolutions for the coming fiscal but have also cautiously welcomed a tweak in the horizontal devolution formula. The FC-16 has reworked the earlier “tax effort” criterion into a broader “contribution to GDP” measure and raised its weight sharply — from 2.5% under the FC-15 to 10%. This change is intended to reward productive and efficient States and represents a modest but meaningful attempt to link governance outcomes with fiscal transfers.

However, the resulting gains are deliberately restrained. The FC-16 makes it clear that any restructuring of horizontal devolution must be undertaken “gradually”, to avoid abrupt redistributive shocks to States that are more dependent on transfers. Accordingly, the weight accorded to demographic performance has been reduced, reflecting the view that penalising population growth is no longer appropriate at a time when India is close to the peak of its demographic dividend. Conversely, the weight for population size has been modestly increased. The net effect is that industrialised States such as Tamil Nadu and Maharashtra see only incremental improvements in their inter-State shares. This caution is understandable but also underscores the limits of the Commission’s ambition. A stronger signal could have been sent through a staggered increase in vertical devolution, for instance by committing to raise the States’ share to 45% by 2031, expanding discretionary fiscal space while preserving stability. The FC-16 flags the shrinking of the effective divisible pool due to cesses and surcharges but stops short of correcting this by recommending their inclusion in the pool. To be sure, total transfers to States are budgeted to rise by 12.2% between 2025-26 (RE) and 2026-27 (BE). But ₹1.2 lakh crore — or about 42% of this increase — is from revenue transfers under Centrally Sponsored Schemes, reinforcing a governance model in which States act as implementers of priorities set in New Delhi. The FC-16’s recommendations recognise the stresses in State finances but do not push for the structural change needed to restore the balance in fiscal federalism.