11. 16th Finance Commission: Vertical Devolution and the \'Cess-Surcharge\' Crisis

The 16th Finance Commission (FC) has maintained the status quo on vertical devolution at 41%, triggering a debate on the shrinking divisible pool and the perceived sidelining of States\' fiscal autonomy in favor of Central priorities.Core Summary for UPSC • Stagnant Devolution Rate: Despite a rare consensus among 18 States (including Odisha, Tamil Nadu, and Gujarat) demanding an increase to 50%, the 16th FC kept vertical devolution at 41%, aligning with the Centre’s plea for \'moderation.\' • The Shrinking Divisible Pool: While the percentage remains 41%, the actual shareable revenue is decreasing. The non-shareable portion (cesses and surcharges) rose from 1.1% of GDP in 2011-12 to 2.2% in 2023-24, effectively bypassing the States. • Cess and Surcharge Proliferation: Between FY13 and FY18, the share of the divisible pool in the Centre’s Gross Tax Revenue (GTR) was above 93%. Due to the unbridled rise in cesses, this share is expected to remain below 90% for the sixth consecutive year in FY26. • Defense and Infrastructure Justification: The Commission justified prioritizing Central funds by citing shifts in the \'external security environment\' and the Centre’s \'high effectiveness\' in large-scale infrastructure building. • Constitutional Gap: The 16th FC noted that the Constitution does not permit a cap on cesses and surcharges. While acknowledging that long-term reliance on them is \'undesirable,\' it labeled imposing a legal limit as \'imprudent.\' • Fiscal Mediocrity vs. Efficiency: Critics argue that the Commission’s stance ignores the fiscal pressures on high-performing States, assuming they have \'sufficient resources\' despite unanimous demands for more. Key Definitions • Vertical Devolution: The percentage of the divisible pool of taxes that the Union government must share with the State governments. • Divisible Pool: The portion of Central taxes that can be shared with States, excluding collection costs and cesses/surcharges. • Cess: A \'tax on tax\' levied for a specific purpose (e.g., Education Cess). It is not shared with States and must be used for the designated objective. • Surcharge: An additional tax levied on the existing tax liability, primarily used to increase Union revenue without sharing it with States. Constitutional & Legal Provisions • Article 280: Mandates the President to constitute a Finance Commission every five years to recommend the distribution of net tax proceeds between the Centre and States. • Article 270: Specifies that all taxes and duties referred to in the Union List shall be distributed between the Union and States, except cesses and surcharges referred to in Article 271.• Article 271: Empowers Parliament to increase any of the duties or taxes by a surcharge for the purposes of the Union, and the entire proceeds of such surcharge form part of the Consolidated Fund of India (non-shareable). • Article 282: Provisions for \'Miscellaneous Financial Provisions\' often used for discretionary grants, which States argue are used to bypass the formula-based devolution. UPSC Relevance • GS Paper II: Federal structure and challenges; Functions and responsibilities of the Union and the States; Appointment to various Constitutional posts, powers, functions and responsibilities of various Constitutional Bodies. • GS Paper III: Indian Economy and issues relating to planning, mobilization of resources, and Government Budgeting. • Prelims Focus: Article 270 vs. Article 271, components of the \'Divisible Pool,\' and the evolution of devolution rates from the 14th to 16th FC. Conclusion The 16th Finance Commission’s recommendations reflect a \'conservative\' fiscal approach that prioritizes national security and central infrastructure over the granular fiscal needs of the States. By refusing to mediate the \'cess and surcharge\' loophole, the Commission has left the expansion of the divisible pool to the \'mutual agreement\' or voluntary restraint of the Centre. This risks deepening the vertical fiscal imbalance, as States are increasingly burdened with social sector spending while their share of the total tax pie remains structurally constrained.