OPINION | 16th Finance Commission: A shift in approach to grants and tax devolution

Many of the larger and lower fiscal capacity states stand to lose.

The report of the 16th Finance Commission was tabled in parliament along with the Union Budget 2026-27. The approach of the Commission and some of its recommendations are tangibly different from the previous finance commissions.

Discontinuation of Revenue need grants under Article 275

Departing from the practice and principles set by the preceding 15 finance commissions that the 16th edition of the constitutionally mandated finance commission, chose to discontinue grants-in-aid for revenue needs of states. The phrase used by Article 275 (1) of the Constitution is “… Parliament may by law provide…grants-in-aid of the revenues of such states as Parliament may determine to be in need of assistance.”. This exercise of determining needs of states is to be conducted by the finance commission on behalf of the Parliament.

No details of any such assessment of state finances in the projection period of the commission are available from the report. Even if the assessment is that no state is in any need of assistance, such a recommendation should have been based on a detailed examination and assessment of state finances.

The FC16 has argued that it has discontinued this grant since the aggregate revenue deficit of states was only 0.3% of GDP in the post-Covid years that is 2022-23 and 2023-24 (paragraph 9.48 of the Report of FC16). This argument presumes that such aggregation is meaningful. In fact, Article 275 is about individual states and it is not meaningful to argue that the revenue deficits of some states can be offset by revenue surplus of other states since surplus states do not transfer revenues to deficit states.

The commission has also not recommended any state-specific or sector-specific grants. All these three grants have been historically meant for catering to the individual needs of states and their cost differentials which cannot be properly captured by a broad-based scheme of tax devolution.

Changes in inter-se shares of tax devolution

The commission continued with most of the historically used devolution criteria. It however, introduced one additional criterion whereby contribution of a state nominal GSDP to nominal GDP was given a weight of 10%. This is an incentive criterion meant to encourage states to show higher nominal growth.

Not all states are equally placed in attracting capital

This implies that GDP growth in a state takes place due to the growth effort of a state. In fact, it largely depends on the inter-state movement of capital and availability of capital stock. Many states have natural advantages including location of ports which leads to increased economic and trade activities. Many landlocked states have natural disadvantages including hilly terrain and historically disadvantaged segments of population.

Available data on inter-state allocation of capital stock which includes private and government capital stock shows considerable concentration in a narrow geographical belt covering already developed western and southern states with some exceptions. Market drivers where the free movement of financial savings in a common market in our federal setup provides this comparative advantage to already developed states. With a higher per-capita GSDP, they get a built-in reward in terms of per-capita own tax revenues even if the tax effort is the same.

Performing fiscal surgery through blunt instruments

The underlying assumption of relying on tax devolution as the core transfer channel is that a limited set of criteria can provide the fine targeting that is needed to cater to the needs and cost conditions of India’s highly differentiated states in terms of population, geographical and other features. The sole reliance on a limited set of broad-based criteria amounts to performing a fiscal surgery by using extremely blunt instruments. It is doubtful that the scheme of the Commission can deliver adequate fiscal equalization which is the guiding principle of most established federations such as Australia and Canada.

In fact, the earlier Indian finance Commissions had a similar scheme of devolution but a considerably detailed assessment process. In Australia and Canada also, it is the assessment of the needs of the states on a normative basis which is undertaken first in relation to its tax effort. Such an assessment ensures that no state is rewarded for deficiency in tax effort whereas any deficiency in fiscal capacity is made up. In fact, they assess the gap first and then either give it as grants or convert those into shares. The tax devolution exercise of the kind that is undertaken in India remains incomplete without a framework of overall assessment of needs and unit costs of providing public services by the states.

States with lower fiscal capacity stand to lose

It is no surprise therefore, that many of the larger and lower fiscal capacity states stand to lose sometimes by relatively tangible margins in the scheme of transfers recommended by the FC16 as compared to FC15. Some of these states are Madhya Pradesh, Arunachal Pradesh, Uttar Pradesh, West Bengal, Odisha, Meghalaya, Chhattisgarh, Rajasthan, Bihar, Nagaland and Manipur.

- With inputs from Tarrung Kapur, Senior Manager, Tax and Economic Policy Group, EY India.

(DK Srivastava is Chief Policy Advisor, EY India.) 

Views expressed are personal and do not represent the stand of this publication.