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The 16th Finance Commission: Transfer Design and Its Impacts

Examining the implications of the 16th Finance Commission's transfer framework on equity and fiscal equalization for Indian states
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Surya
••6 mins read
16th Finance Commission reshapes tax devolution, impacting fiscal transfers to states
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1. Vertical Dimension of Fiscal Transfers and Tax Devolution

Fiscal transfers in India operate along vertical and horizontal dimensions, with vertical transfers addressing the imbalance between the Centre’s revenue-raising powers and the expenditure responsibilities of states. The share of states in the sharable pool of central taxes constitutes the core vertical determinant.

This share witnessed a major shift with the Fourteenth Finance Commission (FC14), which raised it sharply from 32% (FC13) to 42%. This increase was unexpected for the Centre and marked a decisive move towards greater fiscal decentralisation.

Subsequent Finance Commissions have largely treated this share as a rigid parameter. Except for a 1 percentage point reduction by FC15 following the reorganisation of Jammu & Kashmir, the states’ share has remained at 41% from 2015–16 onwards, and is set to continue at least up to 2030–31.

The persistence of this ratio, without periodic reassessment, limits flexibility in adapting the vertical transfer framework to evolving fiscal realities. If ignored, this rigidity can constrain the Centre’s fiscal space and distort overall intergovernmental balance.

Vertical devolution shapes the basic fiscal relationship between the Centre and states. Treating the share as immutable reduces the Finance Commission’s ability to respond to changing expenditure needs and macro-fiscal conditions.

Key statistics:

  • States’ share raised from 32% to 42% by FC14
  • Operative share: 41% from 2015–16 onwards
  • Valid at least till 2030–31

“The increase in tax devolution marks a decisive step towards cooperative federalism.” — Fourteenth Finance Commission Report

2. Shift Away from Grant-Based Transfers under Article 275

While tax devolution has remained dominant, the Centre has altered the composition of transfers by reducing reliance on grants under Article 275. Historically, these grants addressed revenue needs, sector-specific requirements, and state-specific concerns.

With the recommendations of the Sixteenth Finance Commission (FC16), three major grant channels have been discontinued: revenue-need grants under Article 275, sector-specific grants, and state-specific grants. This represents a significant change in the architecture of fiscal transfers.

As a result, tax devolution has become the overwhelmingly dominant transfer mechanism. This narrows the instruments available to address differentiated state needs that cannot be captured through formula-based devolution alone.

If this shift persists without compensatory mechanisms, states with unique structural disadvantages may face fiscal stress, potentially affecting service delivery and sub-national equity.

Grant-based transfers provide flexibility to address specific fiscal gaps. Their elimination concentrates adjustment pressures within tax devolution, reducing the system’s capacity for targeted equalisation.

3. Narrowing Information Base of Horizontal Devolution

The inter se distribution of tax devolution among states relies on formulae that use a limited set of indicators. With the discontinuation of grants, this information base has become even narrower.

Tax devolution formulae are necessarily broad-based and cannot capture detailed variations in state-specific needs, costs, and fiscal conditions. This is significant in India, where states differ widely in size, geography, development levels, and administrative costs.

A key limitation arises from reliance on dated data. Population, a core criterion, continues to be based on Census 2011, which will be nearly 21 years old by the end of FC16’s award period in 2030–31.

Similarly, fiscal capacity is measured using nominal per capita GSDP data from 2018–19 to 2023–24, centred around 2021–22, which will be nine years old by the terminal year. Outdated data weakens the responsiveness and equity of transfers.

When fiscal transfers rely on stale and limited information, they risk misaligning resources with needs. Ignoring this undermines the equalising role of the Finance Commission framework.

4. Revenue Deficit Grants and Their Discontinuation

Revenue-deficit grants under Article 275 were designed to address post-devolution revenue imbalances of individual states. FC16 chose not to assess or provide such grants, citing that the aggregate revenue deficit of states is only 0.3% of GDP.

However, aggregate figures mask significant inter-state variation. Revenue surpluses in some states do not offset deficits in others, as fiscal stress is experienced at the individual state level.

When considered appropriately, the combined revenue deficit of deficit states amounted to 0.8% of GDP in 2023–24, which is substantial compared to other grants recommended by FC16. In contrast, local body and natural calamity grants together amount to only 0.4% of GDP.

By not undertaking a post-devolution needs assessment, FC16 departed from earlier practice. This raises concerns about whether fiscal equalisation objectives are being adequately met.

Revenue deficits are state-specific phenomena. Ignoring them on aggregate grounds weakens the Finance Commission’s mandate to address individual fiscal imbalances.

Key figures:

  • Aggregate state revenue deficit: 0.3% of GDP
  • Deficit states’ combined deficit: 0.8% of GDP
  • Local body + calamity grants: 0.4% of GDP

5. Changes in Devolution Formula and Distributional Outcomes

FC16 introduced a new criterion in tax devolution: a 10% weight for a state’s share in all-India GSDP. This was accommodated by reducing the weights of existing criteria.

Specifically, the income distance criterion, which has an equalising role, was reduced by 2.5 percentage points, while the area criterion, reflecting cost disabilities, was reduced by 5 percentage points. The tax effort criterion (2.5%) was entirely dropped.

This redesign has produced clear winners and losers. States that lost under FC16 compared to FC15 include Madhya Pradesh, Uttar Pradesh, Bihar, Odisha, Rajasthan, Chhattisgarh, and several smaller or low fiscal-capacity states.

A post-devolution needs assessment could have mitigated some adverse impacts while preserving gains for others. The absence of such an exercise raises concerns about the long-term equity implications of the revised framework.

Formula changes alter fiscal incentives and outcomes. Without complementary need-based corrections, devolution risks reinforcing disparities rather than reducing them.

Distributional impacts:

  • New GSDP share criterion: 10%
  • Income distance weight reduced by 2.5%
  • Area weight reduced by 5%
  • Tax effort criterion (2.5%) removed
  • Losses concentrated among low-capacity and smaller states

Conclusion

The evolving design of fiscal transfers under FC16 reflects a decisive tilt towards formula-based tax devolution and away from discretionary and need-based grants. While this enhances predictability, it also narrows the system’s capacity to address differentiated state needs using updated information. Over the long term, sustaining cooperative federalism will require periodic reassessment of vertical shares, richer data inputs, and complementary mechanisms to preserve fiscal equalisation across states.

Quick Q&A

Everything you need to know

The 16th Finance Commission (FC16) introduced several structural changes in fiscal transfers, both in tax devolution and grants allocation.

  • Tax devolution: The FC16 retained the overall share of states in the sharable pool of central taxes at 41%, but introduced a new criterion of a state's share in all-state GSDP with a 10% weight, replacing part of the equalising components like income distance (reduced by 2.5%) and area criterion (reduced by 5%). The tax effort criterion (2.5%) was dropped entirely.
  • Grant-based transfers: FC16 eliminated three grant channels: revenue-deficit grants under Article 275, sector-specific grants, and state-specific grants. This represents a shift from compensatory grant mechanisms to a more formula-based devolution framework.
  • Post-devolution revenue assessment: FC16 decided not to assess post-devolution revenue deficits for individual states, arguing that the aggregate revenue deficit of states is low (0.3% of GDP). This marks a departure from earlier frameworks where revenue-deficit grants aimed to equalize fiscal capacities of deficit states.
Implications: These changes emphasize formula-driven fiscal transfers and aim to simplify the devolution process, but they also risk disadvantaging certain low-capacity or small states that previously benefited from targeted grants.

The shift toward tax devolution and away from grants under FC16 reflects both fiscal and administrative considerations.

  • Fiscal transparency: Direct tax devolution allows for predictable, formula-based transfers, reducing discretionary allocations and simplifying budget planning for both the Centre and states.
  • Efficiency in allocation: Formula-based devolution ensures that states receive a share of centrally collected taxes proportional to their fiscal capacity, population, and contribution to the economy, minimizing distortions associated with ad hoc grants.
  • Reduction of administrative burden: Grants require detailed assessments of state-specific needs, sectoral priorities, and monitoring mechanisms. By eliminating revenue-deficit, sector-specific, and state-specific grants, FC16 simplifies the fiscal transfer architecture and reduces compliance overhead.
However: This approach has limitations, such as not accounting for the fiscal position of individual deficit states, potentially exacerbating inequalities. For example, states like Madhya Pradesh and Bihar face revenue deficits that may not be fully addressed through formulaic devolution alone.

The reliance on dated information, particularly the 2011 Census, introduces limitations in accurately targeting fiscal transfers under FC16.

  • Population-based formulae: Population is a core factor in calculating tax devolution shares. By 2030-31, the 2011 Census data will be nearly 21 years old, potentially misrepresenting demographic changes, migration trends, and population growth rates in different states.
  • GSDP-based fiscal capacity: FC16 uses nominal per capita GSDP data from 2018-19 to 2023-24 to estimate state capacities, centered around 2021-22. By the end of the FC16 period, these estimates may no longer reflect the true fiscal capacities of states, especially in rapidly growing or lagging regions.
  • Implications for equity: States with fast population growth or economic expansion may receive less than their fair share, while states with declining populations may benefit disproportionately. This undermines the objective of fiscal equalization and can exacerbate regional disparities over time.
Example: A state like Uttar Pradesh, with substantial demographic changes since 2011, may experience mismatched transfers under current formulae, while smaller states with slower population growth may maintain or increase relative shares despite weaker fiscal needs.

FC16 decided to discontinue revenue-deficit grants, citing aggregate fiscal outcomes and formula-based devolution as sufficient mechanisms.

  • Rationale: The Commission observed that the aggregate revenue deficit across all states is only 0.3% of GDP, implying minimal need for additional compensatory grants. It also argued that post-devolution revenue deficits would naturally adjust under the new formula, especially with the inclusion of GSDP shares.
  • Consequences for deficit states: Aggregating revenue balances masks the challenges of individual deficit states. States like Madhya Pradesh, Bihar, and Chhattisgarh, which face structural fiscal deficits, may find that formula-driven devolution does not fully compensate for their gaps, potentially constraining developmental spending.
  • Equity concerns: Without targeted revenue-deficit grants, poorer or high-need states may be disadvantaged, while high-GSDP states with surpluses benefit disproportionately. This could undermine the objective of horizontal fiscal equalization, a key principle in Indian federalism.
Illustration: In 2023-24, the cumulative deficits of all deficit states amounted to 0.8% of GDP, significantly higher than the combined local body and disaster grants (0.4% of GDP). This gap highlights the risks of relying solely on aggregate measures.

The introduction of the GSDP share criterion, weighted at 10% in FC16, represents a significant shift in the philosophy of tax devolution.

  • Rationale: Incorporating GSDP shares rewards states that contribute more to the national economy, potentially incentivizing revenue growth and economic performance.
  • Impact on fiscal equalization: This adjustment comes at the cost of reducing the equalizing influence of the income distance criterion and area-based weights. Consequently, low-GSDP states with high fiscal needs may receive lower transfers, exacerbating inequalities.
  • Winners and losers: States such as Uttar Pradesh, Madhya Pradesh, and Bihar, which have lower fiscal capacity, experienced relative losses, while wealthier states gained. Without complementary needs-based grants, these losses may affect public service delivery and development outcomes.
Conclusion: While the GSDP criterion encourages efficiency and growth orientation, it raises concerns about maintaining vertical and horizontal equity. A careful post-devolution assessment is needed to mitigate adverse effects on fiscally weaker states.

FC16 tax devolution resulted in both winners and losers among Indian states due to the new weighting criteria.

  • States that lost: Madhya Pradesh, Arunachal Pradesh, Uttar Pradesh, West Bengal, Meghalaya, Bihar, Odisha, Chhattisgarh, Rajasthan, Manipur, Nagaland, Tripura, Sikkim, and Goa generally lost relative shares. These are either low-fiscal-capacity states or smaller states, negatively affected by the reduction in equalizing criteria and the introduction of the GSDP weight.
  • States that gained: Wealthier or high-GSDP states benefited from the new formula, as the 10% GSDP criterion increased their relative share of central tax devolution. States with stronger revenue bases or higher nominal GSDP, such as Maharashtra or Karnataka, gained despite smaller population or area-based weights.
  • Reasons: The shift from income distance and area-based weighting toward GSDP favors economically stronger states. Additionally, the removal of tax effort and reduction in equalizing weights further accentuated gains for wealthier states while limiting compensatory support for deficit states.
Implication: This illustrates the trade-off between incentivizing economic growth and maintaining horizontal fiscal equity, highlighting the need for complementary grant mechanisms to support vulnerable states.

States with high revenue deficits face significant challenges under the FC16 framework due to reduced grant support and formulaic devolution adjustments.

  • Reduced revenue-deficit grants: Without Article 275 revenue-deficit grants, deficit states must rely solely on tax devolution. If the state has low GSDP, it receives a smaller share relative to wealthier states, which may constrain its ability to fund public services and infrastructure projects.
  • Fiscal planning implications: The state must optimize resource allocation, prioritize essential services, and improve revenue mobilization to avoid widening deficits. Development projects may be delayed or scaled down, affecting economic growth and social outcomes.
  • Potential strategies: The state can focus on enhancing own-tax revenues, leveraging public-private partnerships, and improving efficiency in expenditure. For instance, targeted reforms in sectors like GST compliance, property taxation, and state-level user charges may partially offset lower devolution.
Example: A state like Bihar or Madhya Pradesh, historically revenue-deficit heavy, may need to reassess its budget priorities under FC16, balancing between immediate welfare obligations and long-term investment in infrastructure. This underscores the importance of complementary state-level fiscal reforms to maximize the benefits of formula-driven devolution.

Attribution

Original content sources and authors

DK
D K Srivastava
BS
Business Standard
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