GS II: Issues and challenges pertaining to the federal structure.
Context: Recently, the 16th Finance Commission (FC-16) submitted its report for 2026–31, retaining the States’ share in the divisible pool at 41% but significantly restructuring grants-in-aid. The report has reignited the debate over balancing fiscal efficiency with equity and cooperative federalism.
Background- Finance Commission
- Constitutional Body: Established under Article 280 to recommend the distribution of taxes between the Union and the States and recommend grants-in-aid.
- Objective: To strengthen fiscal federalism by addressing both vertical imbalance (Centre–State fiscal relations) and horizontal imbalance (inter-State disparities).
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Key Recommendations of FC-16
- Vertical Tax Devolution: Retains the States’ share in the divisible pool at 41%, despite several States demanding an increase to 50%.
- Grants-in-Aid Restructured: Recommends ₹9.47 lakh crore in grants, lower than ₹10.1 lakh crore under the 15th Finance Commission.
- Revenue Deficit Grants (RDGs) Discontinued: Eliminates Revenue Deficit Grants, Sector-Specific Grants, and State-Specific Grants, retaining primarily grants for Local Bodies and Disaster Management.
- Greater Emphasis on Performance: Increases reliance on performance-based and tied grants, particularly for local governments.
- Devolution Formula Modified: Reduces the weight assigned to Income Distance from 45% to 42.5% while introducing a 10% weight for Contribution to GDP.
Concerns with FC-16 Recommendations
- Weakening the Equalisation Role: Removal of Revenue Deficit Grants may weaken the Finance Commission’s constitutional role of supporting fiscally weaker States.
- Reduced Fiscal Support: Several States may face a decline in both tax devolution and grants-in-aid, increasing regional disparities.
- Efficiency over Equity: Greater emphasis on performance-based transfers may disadvantage States with structural constraints despite genuine fiscal needs.
- Continued Fiscal Dominance of the Centre: The Commission does not recommend a binding reduction in cesses and surcharges, which remain outside the divisible pool, thereby limiting States’ revenue share.
- Reduced Fiscal Autonomy: Conditional grants linked to performance indicators may restrict the spending flexibility of States and local governments.
Arguments in Favour of FC-16 Approach
- Promotes Fiscal Discipline: Discontinuing Revenue Deficit Grants discourages persistent fiscal dependence and encourages better revenue mobilisation.
- Encourages Better Governance: Performance-linked grants incentivise improvements in financial management, accountability and service delivery.
- Strengthens Local Governments: Higher allocation for Panchayats and Urban Local Bodies can improve grassroots governance and local development.
- Focus on Economic Contribution: Inclusion of GDP contribution rewards economically productive States and promotes efficiency.
Concerns from the Perspective of Fiscal Federalism
- Persistent Horizontal Imbalances: States differ significantly in fiscal capacity, geography, demographic pressures and development levels, requiring targeted equalisation.
- Structural Disadvantages: Hill States, North-Eastern States, border States and socially committed States face higher expenditure needs that cannot be addressed solely through formula-based devolution.
- Asymmetry in Fiscal Reforms: While States are expected to maintain strict fiscal discipline, the continued use of cesses and surcharges allows the Centre to retain greater fiscal flexibility.
- Impact on Cooperative Federalism: Reduced untied transfers may weaken the fiscal autonomy of States and affect the federal balance envisaged by the Constitution.
Constitutional & Institutional Provisions
- Article 280: Establishes the Finance Commission.
- Article 275: Provides for Grants-in-Aid to States requiring financial assistance.
- Article 270: Governs the distribution of taxes between the Union and the States.
- Article 282: Enables discretionary grants by the Union and States for public purposes.
Way Forward
- Preserve the Equalisation Principle: Fiscal transfers should continue to address structural inequalities alongside rewarding efficiency.
- Revisit Grants Framework: Retain targeted Revenue Deficit or State-Specific Grants for States with genuine fiscal disabilities.
- Rationalise Cesses and Surcharges: Gradually merge non-shareable levies into the divisible pool to strengthen fiscal federalism.
- Balance Incentives with Equity: Performance-based transfers should complement, rather than replace, need-based equalisation.
- Strengthen Cooperative Federalism: Fiscal reforms should emerge through greater consultation between the Union, States and the Finance Commission.
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Conclusion
Fiscal federalism must balance efficiency with equity. While fiscal discipline is essential, the Finance Commission should continue to uphold cooperative federalism by ensuring fair, need-based and equitable resource distribution that promotes balanced regional development.
6 Aug 2026
