Source: TH
Subject: Polity/ Economics
Context: The Sixteenth Finance Commission (16th FC), chaired by Dr. Arvind Panagariya, submitted its final report for the period 2026–31.
- The recommendations have sparked a nationwide debate, with former RBI Governor C. Rangarajan and several state governments expressing concerns over the discontinuation of traditional grants.
About Sixteenth Finance Commission — Misses and Concerns:
What it is?
- The Finance Commission is a constitutional body established under Article 280 to define the financial relations between the Union and the States.
- The 16th FC’s mandate was to recommend the vertical share of taxes for states and the horizontal formula to distribute those funds among them for the five-year award period starting April 1, 2026.
Recommendations of the 16th FC:
- Vertical Devolution (41%): The Commission recommended retaining the states’ share in the divisible pool of central taxes at 41%, maintaining the status quo from the 15th FC.
- Horizontal Devolution Formula: A new formula was introduced with a 10% weightage for Contribution to GDP (measured by the square root of GSDP), replacing the previous Tax Effort criterion.
- Local Body Grants (₹7.9 Lakh Crore): Substantial funds were allocated for rural and urban local bodies, with 80% as basic grants and 20% as performance-linked grants.
- Disaster Management: A corpus of ₹2.04 Lakh Crore was recommended for State Disaster Relief and Mitigation Funds, with a 75:25 cost-sharing ratio (90:10 for Himalayan/NE states).
- Urbanisation Premium: A unique ₹10,000 Crore grant was proposed to incentivise the merger of peri-urban villages into larger urban local bodies.
- Fiscal Deficit Targets: The Commission recommended that the Centre reduce its deficit to 3.5% of GDP by 2030-31, while States must strictly adhere to a 3% GSDP cap.
Concerns Associated with the Recommendations:
- Cesses and Surcharges: The Commission failed to cap non-shareable cesses and surcharges, which now account for nearly 20% of the Centre’s gross tax revenue, effectively reducing the actual money available for states.
- End of Revenue Deficit Grants: For the first time, the FC discontinued Article 275 revenue deficit grants, leaving states with high debt (like Himachal Pradesh and Punjab) in a precarious fiscal debt spiral.
- Overestimation of Growth: Critics argue the projected 32.7% effective transfer ratio for 2026-27 is based on an optimistic 11% nominal GDP growth, which may not materialize.
- GST Reform Impact: The 16th FC did not factor in the revenue-reducing effects of the September 2025 GST rate cuts (which moved most 12% and 28% items into 5% and 18% slabs).
- Horizontal Inequity: The use of GSDP Contribution (10%) favors industrially advanced richer states, while the reduction in weight for Income Distance may hurt poorer states like Bihar and Uttar Pradesh.
Way Ahead:
- Constitutional Amendment on Cesses: There is a growing demand to amend Article 270 to include cesses and surcharges in the divisible pool to protect the spirit of cooperative federalism.
- Equalisation Grants: The Centre should consider Need-based equalisation grants under Article 275 to support states struggling with the delivery of essential services like health and education.
- Off-Budget Borrowing Transparency: States must move all off-budget liabilities onto their main budgets as recommended, to ensure long-term debt sustainability.
- Performance Tracking: A robust, independent mechanism is needed to monitor the Performance Component of local body grants to ensure money leads to actual urban/rural infrastructure improvement.
- GST Compensation Review: Given the 2025 reforms, the GST Council and the Centre may need to revisit the compensation mechanism if state revenues fall significantly below the 14% growth benchmark.
Conclusion:
The 16th Finance Commission marks a philosophical shift toward a compliance-driven, performance-oriented fiscal model that prioritizes economic contribution over traditional gap-filling. While it offers predictability by maintaining the 41% share, the withdrawal of safety nets like revenue deficit grants puts the onus of fiscal survival squarely on the states.
