1. Vertical Devolution: Retaining 41% and the States’ Fiscal Space
The Sixteenth Finance Commission (FC-16) has retained the 41% vertical devolution of the divisible tax pool to States for 2026–31, despite States demanding 50%. This continuity signals stability but also reflects the Centre's apprehension about its own fiscal headroom. The decision comes even as FC-16 acknowledges that States’ fiscal space has tightened post-GST, limiting their ability to raise independent revenue.
States increasingly rely on market borrowings to meet expenditure responsibilities that outpace assured revenues. The absence of increased vertical devolution thus risks deepening their fiscal stress. While total transfers are projected to rise, much of the increase stems from scheme-based transfers, reinforcing vertical dependence.
A gradual increase in vertical devolution, such as a commitment toward 45% by 2031, could have enhanced States’ autonomy without destabilising federal finances. The Commission flags the shrinking of the effective divisible pool due to cesses and surcharges, but refrains from recommending their inclusion — a major missed opportunity for structural reform.
Ignoring the structural imbalance between responsibilities and revenue autonomy reinforces centralisation, compels States toward unsustainable borrowings, and weakens cooperative federalism.
Key figures:
- Vertical devolution retained: 41%
- States’ demand: 50%
- Rise in total transfers (2025–26 RE → 2026–27 BE): 12.2%
- Increase from CSS revenue transfers: ₹1.2 lakh crore (≈42%)
2. Horizontal Devolution: A Shift Toward Productivity and Efficiency
FC-16 introduces a significant shift by replacing the older “tax effort” criterion with a broader “contribution to GDP” indicator and raising its weight from 2.5% to 10%. This signals an attempt to reward productive and efficient States, linking fiscal transfers more closely to governance outcomes and economic dynamism.
The approach remains cautious: the gains for industrialised States such as Tamil Nadu and Maharashtra are incremental. FC-16 emphasises avoiding abrupt redistributive shocks, especially for States reliant on inter-State transfers. This constrained design reflects the Commission’s intent to maintain federal balance while still nudging performance-based federalism.
Demographic parameters have been reoriented — the weight for demographic performance has been reduced, while population size receives a marginal increase. This aligns with the view that penalising population growth is no longer appropriate as India approaches its demographic peak.
If performance incentives remain marginal, States may lack motivation to pursue efficiency-enhancing reforms, limiting the transformative potential of fiscal devolution.
Key modifications:
- “Contribution to GDP” weight: 10% (up from 2.5%)
- Reduced weight for demographic performance
- Slight increase in weight for population size
- Industrial States see only incremental improvements
3. Structural Constraints: Cesses, Surcharges, and Shrinking Fiscal Federalism
The FC-16 explicitly notes the continued shrinking of the effective divisible pool due to rising cesses and surcharges that are not shareable with States. However, it stops short of recommending their inclusion. This reflects an enduring structural bottleneck that disproportionately affects State finances.
While headline transfers are rising, a large share comes through Centrally Sponsored Schemes (CSS). This reinforces a model where States act as implementers of Central priorities, limiting fiscal autonomy and policy innovation. Such scheme-driven transfers also reduce States’ flexibility in allocating resources according to regional needs.
Consequently, even as FC-16 acknowledges fiscal stress, its recommendations fall short of enabling deeper rebalancing. The mismatch between rising expenditure mandates (health, education, urbanisation) and constrained revenue autonomy remains unresolved.
Without structural correction of the divisible pool dilution, incremental tweaks cannot restore fiscal federalism, leading to prolonged strain on State-level governance and service delivery.
Key concerns:
- Cesses and surcharges continue to remain outside divisible pool
- 42% of transfer increase driven by CSS
- States’ role shifts toward implementation rather than policy-setting
4. Federal Balance: Limits of Ambition and the Need for a Calibrated Reform Path
FC-16 adopts a cautious, stability-focused stance rather than pushing a transformative redesign of fiscal federalism. It recognises States’ rising stress but opts for continuity in vertical devolution and moderation in horizontal redesign. The insistence on gradual change reflects sensitivity to redistributive impacts but also signals restricted ambition.
A stronger reform trajectory — such as progressive vertical devolution increases, rationalisation of cesses, or rebalancing scheme architecture — could have provided greater fiscal autonomy. Without such steps, States remain constrained in responding to development priorities independently and efficiently.
This calibrated but limited approach underscores the evolving tension between cooperative federalism principles and central resource control. As fiscal pressures mount in the medium term, the absence of structural correction may intensify Centre–State frictions.
If the current imbalance persists, States’ developmental capacities may weaken further, affecting long-term outcomes in social sectors and economic competitiveness.
Reform gaps highlighted:
- No roadmap for phased increase to 45% or 50%
- No recommendation to include cesses/surcharges
- Continued reliance on CSS for fiscal transfers
5. Conclusion
FC-16’s recommendations maintain stability but do not fundamentally address the structural imbalance in India’s fiscal federal architecture. Incremental improvements in horizontal devolution are outweighed by constraints in vertical devolution and an unreformed divisible pool. A long-term reform pathway is essential to strengthen States’ fiscal autonomy, enhance cooperative federalism, and improve the overall quality of governance and development outcomes.