Union Budget FY27: Centre to retain states' share of central taxes at 41% for FY27-31

NEW DELHI: The central government has decided to retain states’ share in the central government’s divisible pool of taxes at 41% for the five-year period starting FY27, in line with the recommendations of the Sixteenth Finance Commission (SFC) chaired by economist Arvind Panagariya.

In her speech for the Union Budget 2026-27, presented on 1 February, finance minister Nirmala Sitharaman told Parliament that the commission submitted its report to President Droupadi Murmu on 17 November 2025 and that the government has accepted its recommendation to keep the vertical devolution ratio unchanged.

Mint had reported on 14 June 2025 that the government was inclined to retain the 41% share. With the economy projected to grow at about 7% annually over the medium term, states’ share in absolute terms is expected to rise as central revenues expand.

“As recommended by the commission, I have proposed ₹1.4 lakh crore (trillion) to the states for year 2026-27 as finance commission grants. These include rural and urban body and disaster management grants,” minister Sitharaman said.

SFC, a constitutional body, is mandated to recommend the distribution of tax revenues collected by the Centre between the Centre and states for the period 1 April 2026 to 31 March 2031. The horizontal sharing of the 41% pool, excluding cesses and surcharges, is based on five factors such as population, demographic performance, area, forest cover and level of economic backwardness, and a new criteria introduced—state’s contribution to gross domestic product (GDP).

“With the SFC largely retaining vertical devolution at 41% for the next the five years (fiscal years 2027-2031) and Finance Commission grants remaining broadly unchanged for fiscal 2027, incremental fiscal support from the central government to states will be limited next fiscal. As a result, capital outlay growth for states could see a moderation given their modest growth in own tax revenues and sticky committed and welfare expenditures,” said Aditya Jhaver, director, Crisil Ratings on States.

The new criterion is aimed at incentivizing states’ economic reform performance and appeal to investors, a key theme that has dominated multiple meetings of the NITI Aayog governing council led by Prime Minister Narendra Modi.

Backwardness of a state, which has the highest weightage in apportioning tax revenue among states, is measured by per capita GSDP distance, which measures how far a state is from the richest state.

As per SFC recommendations, the most populous state Uttar Pradesh walks away with 17.6% of Centre’s divisible pool of tax revenues, followed by Bihar with 9.9%, Madhya Pradesh with 7.3% and West Bengal with 7.2%. North Eastern states with low population levels have much less share, several of them getting less than 1%.

The top six beneficiaries as per the Fifteenth Finance Commission (FFC) award period of FY21 to FY26—UP, Bihar, Madhya Pradesh, West Bengal, Maharashtra and Rajasthan—retain the same position in the SFC award period starting 1 April, too, although their respective shares have undergone marginal changes.

The share of Goa, Himachal Pradesh as well as those of North Eastern states barring Arunachal Pradesh and Assam, which remained below 1% during the FFC award period remains the same in the five year period starting April as well.

State’s contribution to GDP is defined as the ratio of square root of its GSDP to the square root of all states’ GSDP.

Finance commission recommendations usually spark controversy because some states, especially in southern Indian, which have successfully implemented population stabilization, claim the population criteria adversely affect their interests.

SFC said that although the central government has made no explicit submission regarding a shift in the share of the divisible pool in its favour, it has emphasized the need for a larger share of the nation’s revenues.

“There is no doubt that the recent shifts in the external security and defence environment call for increased capital expenditures on defence. The Union has also shown a high degree of effectiveness in building the nation’s infrastructure, an effort that must be supported with more financial resources,” the commission had said in its report.

However, given that cesses and surcharges have reduced the size of the divisible pool over the years, there is no room to cut states’ share.

The SFC has also suggested that if an efficient and broad-based system of taxation is to be put in place, a grand bargain would have to be struck between the Centre and the states in which the former should agree to fold a large part of the revenue from cesses and surcharges into regular taxes and states would agree to a smaller share in the resulting larger divisible pool, with no loss of revenues to either side.

The commission has also proposed doing away with the Centre’s revenue deficit grants to states, which the commission said offered a perverse incentive for not observing fiscal discipline.

“When states anticipate that shortfalls in their revenue account will be compensated through revenue deficit grants, the incentive to undertake difficult but necessary fiscal reforms such as rationalizing subsidies, improving tax administration, or curbing revenue expenditures weakens,” the SFC said. For FY27, Centre has not allocated any revenue deficit grants.

The new criterion, seeks to give due recognition to states’ contributions to growth, SFC said. “Taking cognizance of the principle of gradualism, however, we decided that the weight assigned to the criterion, 10, should be such that it spells only a directional change without the Sixteenth Finance Commission causing a drastic shift in the states’ shares,” the commission said.