The 16th finance commission under the chairmanship of Dr Arvind Panagariya has submitted its report for the period of 2026-31 to the president. It is likely to be tabled in the budget session of the parliament in February 2026.
Basis for allocation
The share of states in the divisible pool of Central taxes (vertical devolution) stands at 41 per cent as per the recommendations of the 15th FC. The distribution of this share among individual States (horizontal devolution) is based on multiple criteria, including income distance, population, area, forest and ecology, demographic performance, and tax effort. While political differences between the centre and opposition-ruled states often amplify tensions, there are genuine issues that need to be considered.
First, cesses and surcharges levied by the centre, which are excluded from the divisible pool, have expanded significantly. For 2024–25, such levies are estimated to account for about 23 per cent of the centre’s gross tax receipts. Against a total central tax revenue of Rs 38.8 lakh crore (Budget Estimates) for 2024–25, the states’ share is Rs 12.2 lakh crore. This is only about 32 per cent of total tax receipts, substantially lower than the 41 per cent share mandated by the 15th FC. Some cesses, such as the GST compensation cess are used to repay loans raised to compensate states for revenue shortfalls during the GST transition period (2017–22) or to fund centrally sponsored schemes. States exercise little control over these resources.
Second, there is a sharp inter-state variation in returns from central taxes. Industrialised states receive far less. For every one rupee, contributed, Tamil Nadu receives 29 paise, while Maharashtra, Karnataka and Gujarat receive 8, 15 and 28 paise, respectively. In contrast, states such as Bihar, Uttar Pradesh and Madhya Pradesh receive multiple times their contribution like Rs 2.42, Rs 2.73 and Rs 7.06 respectively. This is partly due to the fact that many corporations are headquartered in the industrialised states where they would remit their direct taxes. However, this variation can also be attributed to the difference in GST collection amongst various states.
Third, southern states have witnessed a steady decline in their share of the divisible pool over successive FCs. Tamil Nadu’s share, for instance, has fallen from over 6.5 per cent under the 10th FC to about 4 per cent under the 15th FC, largely due to greater weightage for equity and need-based criteria over efficiency-based parameters. Finally, grants-in-aid covering revenue deficits, sector-specific needs, state-specific requirements and local bodies, vary widely across states, adding another layer of complexity to fiscal federal relations.
Balance between equity and efficiency
States generate nearly 40 per cent of revenue while bearing close to 60 per cent of expenditure. FCs recommendations are meant to assess this imbalance and propose a fair sharing mechanism. Equitable development is a collective national responsibility. Growth of industrialised states has been supported by labour migration and consumption from less-developed States. However, three important reforms may be considered for maintaining the balance between equity and federalism while sharing the revenue.
First, the divisible pool should be expanded by including a portion of cesses and surcharges, while gradually rationalising and reducing their proliferation. Second, greater weightage should be accorded to efficiency-based criteria in horizontal devolution. As GST is a destination-based tax shared equally between the centre and states, relative GST contribution, including IGST settlement, can serve as an objective indicator of economic activity and compliance. Some states have also argued for recognising their contribution to national GDP as a criterion. Finally, on the lines of the GST Council, a more formal mechanism for state participation in the constitution and functioning of the FC should be considered to strengthen cooperative federalism.
The author is a former IAS officer. He currently trains civil-service aspirants.