16th Finance Commission’s Tax Sharing Formula: Why States Finally Win

The 16th Finance Commission (FC) must be applauded for breaking the mould of prior FCs in what is possibly the most contentious area of fiscal federalism: ‘horizontal devolution’ or how each state’s part of India’s divisible pool of taxes is worked out.

Understanding the Scope of the 16th Finance Commission

In addition to the two primary components of horizontal and vertical devolution—the latter of which refers to the binary division of taxes between the Union and states taken together—the 16th FC’s report covers four major areas: revenue-deficit grants, local-body grants, disaster-management funds, and public finances.

There are five questions in the report. First, how should the 28 states divide the state share between 2026–2027 and 2030–2031? Second, how much should be awarded and what guidelines should guide grants-in-aid to augment state revenues? 3. How might states augment their resources for third-tier governance? Four, what should be done to finance disaster-relief initiatives? And fifth, how can we provide a solid foundation for public finances?

Balancing Continuity With Directional Change

To its credit, the 16th FC has made an effort to blend “directed change” with gradualism. It has modified the horizontal formula by rewarding states that have made greater contributions to economic growth while maintaining the vertical devolution to states at 41% of the tax pool to ensure continuity.

This resolves a major complaint of comparatively wealthy states, which is that they receive insufficient compensation for their contributions to economic growth and tax revenue. Additionally, it sends a message to less wealthy states that they need to improve.

Shifting From Population to Performance

For a long time, this categorization of states has been based on a set of criteria, each of which has a weight. Population had a crucial weight, which provided more populated states a resource edge over those with stronger records on social indices. The 16th FC properly argues that given India’s growth imperative, we should bend the criterion somewhat towards efficiency.

Thus, the percentage of a state’s gross state domestic product (GSDP) in GDP is part of its formula. The reasoning behind this is that it incorporates the impact of several efficiencies, such as prudent financial management and efficient spending.

Rethinking Grants and Fiscal Discipline

The 16th FC adopts a similar strategy for grants-in-aids, but it departs from previous practices by completely eliminating revenue-deficit grants. Previous FCs often supported “gap-filling,” which involved estimating and plugging the difference between the amount of money a state could raise on its own and what it required to provide public services.

The 16th FC notes that such grants have not led to policies that alleviate revenue shortfalls, but have instead generated perverse incentives. States perceive no need to address the reasons behind their revenue deficiency, and the expectation of such grants has led to continuous deficits resulting from profligacy.

Urbanization, Disaster Funding, and Public Finances

The 16th FC has attempted to encourage faster urbanization through local-body funding on the grounds that this serves as a stimulus for quicker economic growth. On catastrophe management, it has not broken new ground, opting instead to continue forward the work of the 15th FC on the logic that we need more time to observe how these arrangements are working.

In terms of public finances, the report would have the nation strengthen its overall fiscal management, guarantee the long-term stability of electricity distribution corporations, rationalize subsidies, limit the growth of subsidy regimes, and increase the efficiency and competitiveness of public-sector businesses. It is difficult to dispute any of it. The report’s directional shift on horizontal devolution, however, is what sets it apart.

Frequently Asked Questions

1. What does the Finance Commission’s report mean by “horizontal devolution”?

Horizontal devolution refers to how the entire proportion of taxes granted to states is split across specific states. It selects which states get how much from the divisible pool depending on selected criteria and their assigned weights.

2. What significant adjustment to horizontal devolution has the 16th Finance Commission made?

The 16th Finance Commission changed the methodology to include a state’s GDP share (GSDP) in order to reward states that make greater contributions to economic growth. This signifies a change away from primarily depending on population and toward efficiency and performance-based allocation.

3. Why were revenue-deficit grants eliminated by the 16th Finance Commission?

The Commission discovered that by fostering expectations of ongoing assistance, revenue-deficit grants promoted fiscal irresponsibility. States frequently relied on these grants rather than addressing fundamental problems, which resulted in ongoing deficits and inadequate fiscal reforms.

4. How does the report hope to affect budgetary behavior at the state level?

By connecting tax sharing and grants to efficiency, economic contribution, and fiscal prudence, the report incentivizes states to strengthen governance, manage expenditure better, and pursue growth-oriented policies rather than depend on transfers.

5. What is the approach of the 16th Finance Commission on local bodies and public finances?

The Commission favors rapid urbanization through local-body grants, considers it as a growth driver, and emphasizes overall budgetary discipline—calling for subsidy rationalization, power-sector reforms, and increased efficiency of public-sector companies.

Conclusion

The 16th Finance Commission deserves credit for commencing a fundamental transition in India’s fiscal federal framework. By keeping continuity in vertical devolution while recalibrating horizontal devolution toward efficiency and growth contribution, it finds a compromise between equity and performance.

Its decision to terminate revenue-deficit grants and encourage fiscal responsibility sends a strong signal that long-term sustainability must replace dependency-driven fiscal practices.

While not innovative in every area, the Commission’s emphasis on incentives, accountability, and good public finances represents a major directional change—one that could stimulate healthy competition among states and strengthen India’s entire economic base.

Disclaimer: This article is for informational purposes only and reflects analysis based on publicly available policy documents and reports.