In India’s federal set up, devolution of funds ensures proper transfer of resources, from the central government to the states, and further down to local bodies. Article 280 of the Indian constitution mandates that the President of India appoint a Finance Commission every five years to make recommendations on how to divide the net tax proceeds of the Union (divisible pool) with the states. The commission recommends both vertical devolution (what states as a whole get from Centre) and horizontal devolution (how states’ share is distributed among each state). It also, among other things, allocates grants and resources for local governments.
The 16th Finance Commission, headed by economist Arvind Panagariya, recently submitted its report, now tabled in the Parliament. The report comes at a time when relationships between the Centre and many states are frayed over how devolution is done. Progressive states, especially in the south of the country, feel punished for pursuing development and reducing population. They are also upset that the Centre is depriving them of legitimate revenue by imposing cess and surcharges which are not shared with them. Fiscal federalism, they argue, has collapsed. The Centre has refuted such claims.
Mint looks at the recommendations of the 16th Finance Commission and whether it has addressed the concerns the states have.
Past trends
The first Finance Commission was set up in 1951 and was mandated to recommend devolution for the period 1952 to 1957. It recommended that 16% of the gross tax revenue (GTR) be shared with the states. It further allocated 4.5% of GTR as grants, taking the total transfer from Centre to states to 20.5%. From the first Finance Commission to the sixth, the actual transfer varied significantly (see chart). From then on, it has been on a rising trend. Between the first and the 15th Finance Commission, the devolution, excluding grants, doubled from 16% to 32.1% of GTR. The overall vertical transfer recommended by the 15th Finance Commission was 41%. However, the report states that if Finance Commission and non-Finance Commission transfers are taken into account, the states currently get 69% share of the total revenue receipts (excluding capital receipts).
Angry states
Despite the higher transfers, many states are upset. They have two major grouses. One, states are not receiving their full share of the divisible pool as recommended by the Finance Commission. Two, the Centre was offsetting the states share of the divisible pool by levying higher cess and surcharge (which are not shareable) and reducing grants and transfers. As against 41% recommended by the 15th Finance Commission, average transfer has been lower at 37.7%. In the 14th Finance Commission period, it was 39.4% as against the recommended 42%. In discussions with the 16th Finance Commission, the states (18 of the 28) sought an increase in devolution to 50%. They wanted inclusion of cess and surcharges in the divisible pool. These levies, they argued, reduced their divisible pool (see chart). Some states sought a cap on cess and surcharges. Others wanted some non-tax revenues to be added to the divisible pool. The Centre, for its part, sought moderation in tax devolution. It claimed that it needed more revenue for defence spending and macro-economic management. It argued that cess/surcharges were its constitutional right and states too benefitted from them. Roads were being built in the states using the road cess, it said. The centre also pointed out that the share of cess—if GST compensation cess (which any way went to the states) was excluded—declined in recent years.
Good bargain
The 16th Finance Commission has maintained the vertical devolution at 41%. It has denied states’ claim that the Centre was not sharing the Commission’s recommendation fully. It looked at the data for the last five years and stated that there was no deviation. It has also argued that the states’ demand for including cess and surcharge into the divisible pool, or adding non-tax revenue to it, were unconstitutional. It refused to cap the quantum of cess/surcharge on the grounds that the constitution provided for cess/surcharge for the state to raise resources during emergencies. It did not want to cap it. On the other hand, the Commission did not agree to the Centre’s demand for reducing the quantum of devolution. It insisted that reliance on cess as a source of revenue receipts is undesirable except for short term specific needs and suggested a good bargain—fold revenues from cess/surcharge into regular taxes and states can agree to a lower devolution with no loss of revenue.
Trends in horizontal devolution
Till the 6th Finance Commission period (1974 to 1979), 80% of the states’ divisible pool was shared among each state based on population. Equity based criteria such as tax revenue and distance of the state’s per capita income from the benchmark per capita income (greater the distance, higher the devolution) accounted for the balance 20%. From the seventh Finance Commission period, the weightage for the equity criteria increased. The 10th Finance Commission introduced tax effort and area of the state. In subsequent years, other elements— such as fiscal discipline, forest cover and total fertility rate—found their way into the formula.
Unhappy states
Despite these refinements, many states were unhappy about the way the states’ share of devolution was handled. Progressive states, especially those in the south, were upset that they were not getting a higher share despite contributing a lot more to the exchequer. They argued that poorer states like Uttar Pradesh and Bihar, in spite of getting a higher share of resources over many decades, were yet to develop. Higher devolution, they further argued, acted as a disincentive. They also feared that they could be punished for pursuing population control effectively. As population number was a critical criteria in determining the devolution, they were against using the 2011 population figures.
Some tweaks
The Commission, to address the concerns of the progressive states, tweaked the criteria it uses to share the funds with various states. It introduced a new norm—‘contribution to the GDP’—which looks at a state’s contribution to the nation’s GDP growth and gave it a weightage of 10%. At the same time, it used the 2011 census figures. It also tweaked other weightages such as demographic performance and per capita distance. The net result? There isn’t much difference in the devolution between the 15th and 16th Commissions (see chart).
Revenue deficit grant shelved
The 16th Finance Commission has ended the revenue deficit grant given to select states to help them eliminate revenue deficit (excess of revenue expenditure over revenue receipts). Experts have welcomed this move as this grant has not led to adoption of policies towards reduction and ultimately, elimination of revenue deficit. The Commission, in its report, argued that the grant created incentives for persistence of revenue deficit.
Urban local grants
In a bid to accelerate the development of the government’s third tier—local bodies—the 16th Finance Commission has announced a 45% jump in allocation to urban local bodies to ₹3.56 trillion. “The Finance Commission has ushered in a revolution in funding of urban local bodies. Its allocation equals the outlay of centrally sponsored schemes during a 13-year period from 2014-15 to 2026-27,” said Srikanth Viswanathan, chief executive officer, Janaagraha, a Bengaluru-based non-profit working to improve the quality of life in Indian cities and towns. “This could be a pivotal transition towards substantive improvement in first mile infrastructure and services for citizens,” he added.
The states now need to build capabilities urgently at the local level to tender out and execute high quality projects.
Mixed reaction
C. Rangarajan, former Reserve Bank of India governor and chairman of the 12th Finance Commission, said the 16th Finance Commission has made very little change to the way devolution is made. The new GDP contribution criteria, for horizontal devolution, did not help the progressive states significantly. Tamil Nadu’s share remained at 4.1%.
States, meanwhile, have given mixed reactions to the proposals. Kerala has welcomed it—its share has risen from 1.9% to 2.4%. Tamil Nadu’s chief minister M.K. Stalin expressed his disappointment that the vertical devolution has not been increased to 50%. Also, Tamil Nadu has the lowest share among the developed states, he rued. Himachal Pradesh’s chief minister Sukhvinder Singh Sukhu estimated that withdrawing the revenue deficit grant would result in a ₹40,000 crore shortfall for the state. Karnataka chief minister Siddaramaiah said that despite the state contributing 8.7% to India’s GDP, and the state being the highest per-capita tax collector, it continues to get low allocations.
Back to the growth path
The Indian economy has reverted to the growth path, the Commission stated while reviewing the nation’s economic performance. This, it added, was possible as the government refrained from offering strong stimulus during the pandemic. Countries which gave such sops were today battling inflation. Analyzing the performance of the central government for the period between 2011-12 and 2023-24, it said the nation’s GDP grew on an average by 11%. The revenue grew by 11.4% and expenditure by 10.9%. The fiscal deficit, which had declined to 3.4% of GDP in 2018-19, shot up to 9.2% due to the pandemic and has since dropped to 4.4% in 2025-26. The Centre’s capex doubled from 1.6% of GDP in 2018-19 to 3.2% in 2023-24.
No alarm but some concerns
Reviewing the state finances, the Commission has said the financial position of the states is not alarming but they do raise some concerns. High debt in some states limits their fiscal resources for development, which, in turn, undermines growth. Between 2011-12 and 2023-24, the states’ fiscal deficit grew from 1.9% to 2.9%. Twice during this period, the combined fiscal deficit of the states exceeded the 3% limit set by the Centre—once in 2016-17 (due to implementation of power sector turnaround and revival package) and in 2020-21 (due to the pandemic).
The remedy
The Commission, in its report, has laid the path for macro and fiscal stability. It has said that states’ fiscal deficit should be capped at 3% and the Centre should reduce its fiscal deficit to 3.5% of GDP by 2030-31. To improve their fiscal situation, the Commission has advised states to pursue power sector reforms, contain and make subsidies efficient and take up public sector enterprises reform.