The 16th Finance Commission (FC) faces a difficult task as states strive for greater financial autonomy and a larger share of the divisible tax pool

Regarding the 16th Finance Commission

The 16th Finance Commission (FC) was established pursuant to Article 280 in December 2023, led by Arvind Panagariya, to advise on tax devolution and fiscal federalism changes for 2026-31.

Present Framework of Decentralization:

States’ Share: Set at 41% by the 15th FC (decreased from 42% after J&K’s reorganization).

De Facto Share: States obtain merely around 32% of the Centre's total tax revenues because of the increase in cesses and surcharges (which are non-shareable).

Main Challenges Prior to the 16th Finance Commission:

Diminishing Divisible Pool and Increasing Cesses: Cesses and surcharges have decreased the divisible pool size from 88.6% (2011–12) to 78.9% (2021–22) of the Centre's gross tax revenue (RBI data).

States advocate for reinstating equity by limiting these taxes and raising their portion to 50%.

Financial Limitations of the Central Government:

Significant Pressure on Centre’s Budget: Increasing overall transfers might lead to fiscal strain.

Borrowing for Transfers: The Centre is securing funds through borrowing for grants, prompting inquiries about spending priorities.

Tied vs. Untied Transfers – Requirement for Rebalancing:

Present Situation: Overdependence on centrally-sponsored schemes (CSS) restricts states to expenditures dictated by the Centre.

Proposal: Raise untied transfers to give states greater flexibility within the current transfer framework.

Challenge: Necessitates the trimming of CSS, which entails political and developmental sensitivities.

Consequences of Rising Unrestricted Transfers:

Quality of Government Expenditure:

Increasing Revenue Deficits: Numerous states, such as Karnataka and Punjab, are experiencing deteriorating revenue situations.

Danger of Misappropriation: Unallocated funds could be redirected to operational costs or non-merit subsidies (e.g., complimentary electricity, water), instead of being used for capital investments.

Increase in Cash Transfer Programs:

Quasi-Universal Transfers: 14 states initiated income assistance programs, amounting to 0.6% of GDP (Axis Bank report).

Concern: Additional unallocated funds might be directed towards electoral populism rather than systemic enhancements.

Fairness in Public Service Provision:

Inter-State Disparities: States with low income, such as Bihar, invest considerably less per person on public services.

Question: Will an increase in untied funds result in a convergence of service delivery standards among states?

Delegation to Local Authorities:

Overlooked Third Tier: Panchayats and municipalities get a significantly lesser portion of overall public expenditure compared to nations such as China and South Africa.

Hope: Increased flexibility in funds might motivate states to allocate more resources to local governments.

Path Ahead:

Reform Transfers Framework: Think about limiting cesses, streamlining CSS, and boosting untied transfers while ensuring accountability measures.

Enhance Institutional Capability: Establish monitoring frameworks to guarantee that unrestricted funds are utilized for fruitful and fair results.

Encourage Local Devolution: FC may suggest performance-driven grants to states that enhance third-tier empowerment.

Embrace Diverse Strategies: Customize devolution processes to align with state capabilities, developmental requirements, and fiscal well-being.

Conclusion:

The 16th Finance Commission needs to balance increasing fiscal independence for states while ensuring the stability of national finances. A restructured transfer system—designed to guarantee fair, responsible, and aligned public service provision—will be essential for enhancing India’s cooperative federalism.