The Sixteenth Finance Commission (FC16) plays a crucial role in shaping India's fiscal federal architecture by recommending how financial resources should be distributed between the Union and the States. One of its most significant recommendations was to retain the States’ share in the divisible pool of central taxes at 41%. This continues the arrangement introduced after the reorganisation of Jammu and Kashmir and signals continuity in vertical devolution between the Centre and States.

In addition to maintaining the 41% share, FC16 also accepted the existing horizontal devolution formula used to distribute resources among States, though with certain modifications. The Commission recommended a new criterion—contribution to national GDP—with a weight of 10% in the formula. This replaced the earlier tax and fiscal effort criterion, which had rewarded States that demonstrated stronger tax mobilisation relative to their economic capacity. The Commission also recommended substantial transfers for local body grants and disaster management funds, recognising the importance of strengthening grassroots governance and disaster preparedness.

However, FC16 discontinued certain targeted fiscal support mechanisms such as revenue deficit grants, sector-specific grants, and state-specific grants. While the Commission projected that general government debt could decline gradually—from about 77.3% of GDP in 2026–27 to around 73.1% by 2030–31—the broader debate revolves around whether these changes adequately address structural fiscal imbalances between the Centre and the States.

Although the States’ share of 41% in the divisible pool of taxes appears to represent a significant commitment to fiscal federalism, the actual fiscal reality is more complex. The key issue lies in the distinction between gross tax revenues and the divisible pool. Only certain taxes collected by the Union are included in the divisible pool that is shared with States, while revenues collected through cesses and surcharges are excluded and retained entirely by the Centre.

Over the years, the share of cesses and surcharges in the Union government’s total tax collection has increased substantially. As a result, the divisible pool as a proportion of gross tax revenue has gradually declined. According to Finance Commission data, it fell from about 89.2% during the Thirteenth Finance Commission period to 82.1% during the Fourteenth and further to approximately 78.3% during the Fifteenth. Consequently, even though the States receive 41% of the divisible pool, the base from which that percentage is calculated has shrunk.

This trend raises concerns about the spirit of cooperative federalism. Several States have argued that excessive reliance on cesses and surcharges reduces the predictability and adequacy of their fiscal resources. The issue has therefore become a central debate in India’s fiscal federal framework, with calls for reforms to ensure that tax-sharing arrangements genuinely reflect the constitutional principle of equitable distribution.

The horizontal devolution formula determines how the share of tax revenues allocated to States is distributed among them. Under earlier Finance Commissions, the formula incorporated criteria such as population, income distance, demographic performance, and tax effort. The tax and fiscal effort criterion, with a weight of about 2.5% under the Fifteenth Finance Commission, rewarded States that demonstrated better tax mobilisation relative to their economic capacity.

The Sixteenth Finance Commission replaced this criterion with a new factor: contribution to national GDP, which has been assigned a significantly larger weight of 10%. This criterion allocates resources partly based on each State’s economic contribution to the national economy. Consequently, economically stronger States with larger GSDP—such as Maharashtra, Gujarat, and Karnataka—are likely to benefit structurally from the revised formula.

However, this shift has sparked debate about the underlying philosophy of fiscal equalisation. Traditionally, Finance Commissions aimed to reduce regional disparities by allocating greater resources to poorer States with higher development needs. Critics argue that emphasising economic contribution may tilt the balance away from the principle of need-based equalisation, potentially disadvantaging States like Bihar, Jharkhand, and Uttar Pradesh that have lower per capita incomes but greater developmental requirements.

The Sixteenth Finance Commission identified several structural challenges affecting the fiscal sustainability of States, yet many of these issues were not immediately addressed in policy implementation. One major concern is the prevalence of off-budget borrowings. Many States borrow through government-owned entities or special purpose vehicles and later service these liabilities through the state budget. This practice allows liabilities to remain outside official deficit figures, reducing transparency in fiscal accounting.

Another significant challenge relates to the Fiscal Responsibility Legislation (FRL) frameworks followed by States. These laws were designed to maintain fiscal discipline by setting limits on deficits and debt levels. However, the Commission observed that these rules are often weakly enforced, allowing States to accumulate large debts. For example, Punjab’s debt-to-GSDP ratio was estimated at around 42.9%, while Rajasthan and West Bengal also carry liabilities exceeding 37% of GSDP.

Additionally, the end of the GST compensation regime in 2022 created a new fiscal challenge. States had earlier been guaranteed 14% annual growth in GST revenues. Without this protection, some States have experienced significant revenue shortfalls. Despite recognising these structural issues, reforms such as tightening borrowing controls and amending fiscal rules were largely deferred for future consideration.

The recommendations of the Sixteenth Finance Commission have significant implications for India’s fiscal federal structure. On one hand, the continuation of the 41% tax devolution ensures a degree of stability and predictability in Centre-State financial relations. The large allocation for local body grants and disaster management funds also reflects an effort to strengthen decentralised governance and improve disaster resilience.

However, several concerns have emerged regarding the broader trajectory of fiscal federalism. The growing reliance on cesses and surcharges by the Union government effectively reduces the size of the divisible pool, thereby limiting the real financial autonomy of States. Similarly, replacing the tax-effort criterion with the contribution-to-GDP criterion shifts the focus away from equalisation toward rewarding economic weight. Critics argue that this may widen regional disparities by favouring already developed States.

Another concern is the deferral of key structural reforms. Issues such as power sector losses, off-budget borrowing, and fiscal rule enforcement remain unresolved. Without addressing these underlying structural challenges, the fiscal stress faced by several States may persist. Therefore, while FC16 provides a framework for fiscal transfers, its long-term impact on cooperative federalism will depend on whether deeper institutional reforms follow.

While aggregate fiscal indicators for the general government may appear stable, the fiscal health of individual States varies widely. For instance, Punjab has one of the highest debt burdens among Indian States, with a debt-to-GSDP ratio of approximately 42.9%. A large portion of its borrowing is used to meet revenue expenditure such as salaries, pensions, and debt servicing rather than capital investment, which raises concerns about long-term fiscal sustainability.

Similarly, Rajasthan and West Bengal have outstanding liabilities close to or exceeding 38% of their GSDP. Persistent revenue deficits in these States limit their capacity to invest in infrastructure and development. In contrast, economically stronger States such as Maharashtra and Gujarat possess stronger revenue bases and greater fiscal flexibility due to higher economic output and tax collection capacity.

These examples highlight the uneven fiscal landscape across India. While the national fiscal trajectory may appear manageable, several States face structural constraints such as limited revenue capacity, high debt burdens, and rising subsidy commitments. This uneven distribution of fiscal stress underscores the importance of designing Finance Commission transfers in a manner that balances both economic efficiency and regional equity.

Strengthening fiscal federalism in India requires a combination of institutional reforms, greater transparency, and cooperative policymaking between the Centre and the States. One important reform would be to rationalise the growing use of cesses and surcharges. Bringing a greater portion of these revenues into the divisible pool would ensure that States receive a fairer share of national tax collections and improve predictability in fiscal transfers.

Second, reforms are needed to strengthen fiscal responsibility frameworks. Both the Union and State governments should adopt transparent and enforceable fiscal rules that limit excessive borrowing and off-budget liabilities. Strengthening the oversight role of institutions such as the Comptroller and Auditor General (CAG) and improving public financial management systems can enhance fiscal accountability.

Finally, a more balanced horizontal devolution formula could combine criteria reflecting both economic contribution and developmental need. Encouraging States to improve tax administration while also supporting poorer regions would preserve the equalisation principle embedded in India’s federal design. Such reforms would not only improve fiscal sustainability but also reinforce cooperative federalism and reduce tensions between different tiers of government.