11. 16th Finance Commission (2026-31): Redefining Fiscal Federalism

The 16th Finance Commission (FC), chaired by Dr. Arvind Panagariya, has submitted its report for the period 2026-31. The Union Government has accepted the recommendations, which navigate the complex demands of states while maintaining fiscal stability at the Centre. The report signals a shift towards rewarding economic efficiency and growth, marking a significant departure from purely equity-based historical models. Core Summary of the Development • Vertical Devolution Maintained: The Commission has recommended retaining the States\' share in the divisible pool of central taxes at 41%, rejecting the demand of 18 states to increase it to 50%. • Divisible Pool Constraints: Cess and surcharges remain outside the divisible pool, which currently constitutes only about 81% of the Centre’s gross tax revenue. The FC opined that capping these is not currently desirable due to Union exigencies. • New Horizontal Criterion: A major structural change is the introduction of \'State\'s Contribution to GDP\' as a criterion with a 10% weight, replacing the previous \'Tax and Fiscal Effort\' parameter. • Equity vs. Efficiency: While Income Distance remains the dominant factor, its weightage has been reduced to 42.5% (from 45%). Weights for Area and Demographic Performance were also lowered to accommodate the efficiency-linked GDP parameter. • Consolidation of Grants: The FC has recommended total grants of ₹9.47 lakh crore, but has significantly discontinued Revenue Deficit Grants, Sector-specific, and State-specific grants, focusing instead on Local Bodies and Disaster Management. • Fiscal Discipline Roadmap: The report sets a target for the Centre to reduce its fiscal deficit to 3.5% of GDP by 2030-31, while states are mandated to cap theirs at 3% of GSDP, with a strict end to off-budget borrowings. Key Definitions • Divisible Pool: The portion of Gross Tax Revenue (GTR) that is distributed between the Centre and States. It excludes the cost of tax collection, cess, and surcharges. • Vertical Devolution: The percentage of the divisible pool of taxes that is transferred from the Union to all States collectively. • Horizontal Devolution: The formula-based distribution of the States\' collective share among individual States based on specific criteria like population, area, and income. • Income Distance: The difference between a state\'s per capita GSDP and the average of the top three high-income states (Telangana, Karnataka, and Haryana for this award period).Constitutional and Legal Context • Article 280: Mandates the President to constitute a Finance Commission every five years to recommend the distribution of tax proceeds. • Article 270: Governs the distribution of \'net proceeds\' of taxes between the Union and the States. • Article 275: Provides for \'Grants-in-aid\' to the revenues of states which Parliament may determine to be in need of assistance. • Article 271: Allows the Union to levy surcharges on taxes for its own purposes, which do not form part of the divisible pool—a major point of contention for states. Horizontal Devolution Criteria: 15th FC vs. 16th FC

Additional Key Points • Incentivizing Reforms: Local body grants (₹8 lakh crore) are now tied to entry-level conditions: proper constitution of bodies, public disclosure of audited accounts, and timely State Finance Commission (SFC) reports. • Power Sector Focus: States are encouraged to privatize DISCOMs, with the Commission suggesting the creation of a Special Purpose Vehicle (SPV) to warehouse legacy power sector debt. • Urbanisation Premium: A one-time grant of ₹10,000 crore has been proposed to support the transition of rural areas into urban local bodies (ULBs). • Southern States Gain: Due to the 10% weightage for GDP contribution, industrialized states like Karnataka, Kerala, and Tamil Nadu have seen a marginal increase in their share compared to the previous commission. Conclusion The 16th Finance Commission marks a \'directional change\' in Indian fiscal federalism. By maintaining the 41% vertical split, it ensures fiscal continuity for the Centre’s defense and infrastructure needs. However, the pivot toward \'Contribution to GDP\' in horizontal devolution addresses long-standing grievances of highperforming states. While it promotes efficiency, the discontinuation of Revenue Deficit Grants may pose a challenge for fiscally stressed and geographically disadvantaged states, requiring them to move toward stricter self-reliance. UPSC Relevance • GS Paper II: Indian Constitution—historical underpinnings, evolution, features, and significant provisions (Articles 280, 270, 275); Statutory, regulatory, and various quasi-judicial bodies. • GS Paper III: Issues relating to planning, mobilization of resources, growth, development, and employment; Inclusive growth and issues arising from it (Fiscal Federalism).• Mains Perspective: \'Analyze the shift from equity to efficiency in the 16th Finance Commission\'s recommendations. To what extent does the inclusion of \'Contribution to GDP\' resolve the \'demographic punishment\' debate in India?\'