Sixteenth Finance Commission (2026–31): Tax Devolution And Fiscal Federalism In India

Policy Update
Sandra Menon

Background

The Finance Commission is the statutory body established by the President, according to Article 280 of the Constitution, which determines the formula of distribution of tax revenues of the Union between the Union and the States every five years. The amount of shareable resources is the gross revenue of the Union from taxes less cess, surcharge, and costs of collection, this share is called a divisible pool. During the awards, the share of States from this pool has been increasing; it was 29.5% in the Eleventh Commission, 30.5% in the Twelfth, 32% in the Thirteenth and 42% in the Fourteenth one.

The Fifteenth Commission has allocated a share of 41% from the divisible pool for the 28 States, however, this change happened because of the restructuring of Jammu and Kashmir in two Union Territories, which had the share of 1% from the pool, not as a reduction of the States’ share. In total, the transfers of the Finance Commission have increased from 23.1% of the gross revenue from the taxes of the Union during the first four awards to 38.5% during the last two awards.

The Sixteenth Finance Commission (FC-16) was set up on 31 December 2023, chaired by Dr. Arvind Panagariya, having the award period of 1 April 2026 to 31 March 2031. FC-16’s terms of reference remained close to the constitutional provisions without further directions that were included in the terms of references of some other finance commissions, and it was asked to examine the disaster financing mechanism provided in the Disaster Management Act, 2005. FC-16 took the opinion of all 28 States between June 2024 to June 2025, and the Commission submitted its report in November 2025.

The report was laid in Parliament along with the Union Budget and the Action Taken Report on 1 February 2026, and the Union Government agreed with the Commission’s recommendation regarding retention of 41 per cent share of the divisible pool to be provided to the States, although 18 States wanted 50 per cent and a few others 45 to 48 per cent.

Functioning

FC-16 uses double-tier distribution of taxes. In the first tier, 41 per cent of the divisible pool goes to the States together, while the balance stays with the Union. The second tier divides the States’ share amongst the 28 States using a weighted formula. Income Distance, which means difference between the per capita GSDP of a state and the average of the three top per capita GSDP among the big states, gets the highest weight of 42.5 per cent.

While the 2011 population receives a weight of 17.5 per cent, demographic performance 10 per cent, area 10 per cent, forest cover 10 per cent, and finally a new element, contribution to the GDP of the country, also 10 per cent. Tax and fiscal effort criteria of the Fifteenth Finance Commission has been abandoned, having had only 2.5 per cent share earlier. Income and GSDP have been averaged from 2018-19 to 2023-24, excluding 2020-21 due to pandemics.

There have been changes in several of the criteria. First, demographic performance will favor a slower rate of population increase during the period of 1971-2011 as compared to the inverse total fertility rate adopted by the Fifteenth Commission. Second, the forest criterion will take into account not only the moderately dense and very dense forests but also the open forests, and a minor bonus will be given due to the increase in the weighted area of forests, while the minimum area allocated to every State has been reduced to 1.5 per cent from 2 per cent.

Grants totalling ₹9.47 lakh crore for the period 2026-31 were suggested besides devolving taxes, which includes ₹4.35 lakh crore for grants to rural local bodies, ₹3.56 lakh crore for grants to urban local bodies and ₹1.56 lakh crore as Union’s contribution towards disaster fund. Grants towards revenue deficit, sectoral grants and State grants, as recommended by the Fifteenth Commission, have ceased to exist.

The grants to local bodies shall consist of 80 per cent of basic grants and 20 per cent of performance grants and shall be paid only if the State establishes its local bodies as required under the Constitution, publishes its provisional and audited accounts and establishes its State Finance Commission at the appropriate time. The Commission also has drawn up a fiscal blueprint in which the fiscal deficit of the Union should be reduced to 3.5 per cent of GDP by 2030-31, that of the States to 3 per cent of GSDP and off-budget borrowings should be placed on budget.

Performance

The award started functioning only on 1 April 2026, so the most clear proof comes from the manner in which the redistribution of shares is done and in which the funds have been flowing in the first few months. In terms of the former, there is no significant change except that fourteen States will gain shares and fourteen others will lose them as shown in Table 1 below.

The biggest gainers in terms of shares are Karnataka, which rises from 3.65 per cent to 4.13 per cent, followed by Kerala and Gujarat, while the biggest losers in terms of shares are Madhya Pradesh, Arunachal Pradesh and Uttar Pradesh. As for the latter, Uttar Pradesh continues to be the biggest beneficiary at 17.62 per cent, followed by Bihar at 9.95 per cent.

Source: Report of the 16th Finance Commission, as summarised by PRS Legislative Research (2026a); changes computed from published shares rounded to two decimals. Selected States shown; shares are out of 100 of the amount devolved.

There is continuity in aggregate flows along with some volatility. For Union Budget 2026-27, there is the estimation of tax devolution to be ₹15,26,255 crore which is 9.6 percent more than the revised estimate for 2025-26 and the amount of total transfer to states, which includes grants and loans, is ₹26,20,769 crore. In case of previous year, it serves as an example of the extent to which the devolution will be dependent upon union government’s income: the revised estimate for 2025-26, which is ₹13,92,971 crore, is 2 percent less than budgeted ₹14,22,444 crore. In August 2026, an additional instalment of ₹1,09,019 crore has been paid by the Centre.

This side of the story reflects a definite shift in the paradigm. Urban local bodies will be getting ₹3.56 lakh crore, which makes up nearly 45 percent of local bodies’ grants as opposed to 36 percent as recommended by the Fifteenth Commission. Additionally, there will be an exclusive infrastructure block of ₹56,100 crore allocated to 22 selected cities with a population of 10 to 40 lakh in relation to sewage and drainage system and an initial allocation of ₹10,000 crore urbanisation premium.

Impact

Predictability becomes an obvious outcome here. The Commission did not reduce the States’ allocation by reducing it to below the feared level of 41 per cent, and kept the significant untied transfer on which the state budgeting depends; taking into account the allocations through the Finance Commission and other sources, States now own 68 to 69 per cent of revenue receipts from the combined Union and State levels without considering the capital receipts. The benefit is marginal for better economic States.

ICRA reveals that the share increase of several States with good fiscal management happens even without an increase in the vertical ratio. Moreover, Karnataka experiences the largest increase out of the 28. On the other hand, there is less progressiveness in the process of transfer. As R. Mohan, who served in the Indian Revenue Service, reveals, the correlation coefficient between per capita income and tax share was -0.42 and significant at Fifteenth Commission, while -0.36 under Sixteenth.

The burden is borne by yet another set of States. Fourteen States, such as Uttar Pradesh, Bihar, Madhya Pradesh, Rajasthan, West Bengal, and most of the North-Eastern States, are getting smaller shares, since the revenue deficit grants have not been renewed and general purpose grants under Article 275 have not been proposed, and thus there are no buffers for them in this award. The rationale offered by the Commission for revenue deficit grants is that these grants were generating some adverse incentives, because practically the same bunch of States kept coming back for them round after round. In respect of urban India, this means urban local body grants and urban infrastructural grants related to drainage facilities.

Emerging Issues

The first problem is the decreasing divisible pool. According to the report of the Commission itself, the cess and surcharge reduced the divisible pool from 89.1 per cent of the total tax revenue of the Union in 2014-15 to 74 to 80 per cent in the first four years of the Fifteenth award period. This can be calculated as follows: 42 per cent of 89.1 per cent amounts to about 37 per cent of the gross tax revenue, but 41 per cent of 74 to 80 per cent only accounts for 30 to 33 per cent.

From this, the Commission came to the conclusion that there was no possibility of reducing the states’ share and made a grand proposal wherein the Union would incorporate most of its cess and surcharge revenues in its tax revenues and the states would settle for a smaller share of the bigger divisible pool. It has not approved any proposal for putting a cap on cesses and surcharges, apparently arguing that capping them is both impermissible and undesirable within the existing constitutional framework. According to ICRA, cesses are projected to come down to 14% of the tax revenue of the Union by 2026-27 from 22% in 2021-22 due to the expiration of the GST compensation cess.

The second problem is analytical in nature. According to Mohan, the Commission failed to make an estimate of the fiscal imbalance vertically, the difference between the revenue sources of the States and their expenditure, despite the presence of three factors affecting it; the equal sharing of GST between the Center and States reducing the State’s effective rate of taxes on many items as compared with the VAT; the increase in the States’ share of expenditure incurred under centrally sponsored schemes from 25 per cent to 40 per cent; and the increase in cesses and surcharges.

Thus, the basis of 41 per cent is continuity and constraint of the Union, rather than the needs of the States. The same criticism can be applied to the formula. The contribution to GDP requirement was designed as an incentive for efficiency according to the Commission. However, according to Mohan, it is a reward for history and location advantages.

Thirdly, there is a tilt towards conditions. Grants by local bodies have been based on three basic prerequisites, out of which Mohan highlights two restrictions: block panchayat grants are not made if fewer than 75% of the gram panchayats in its jurisdiction satisfy their own revenue targets, while local body grants may be held up if the State does not fulfill the fund transfer condition, thus punishing a local body for the fault of the State. He even doubts if a roadmap of finances, which also includes the recommendation of abolishing off-budget borrowing, comes under terms of reference that do not include sound finance of Article 280.

In conclusion, there still exist two design issues. According to the Commission itself, the inverse population growth test should be phased out eventually because India faces a danger of getting old before getting rich, thus states that have been rewarded for maintaining demographic balance will receive less reward in the next round of awards. Concerning the financing of disasters, the Commission found that the utilization of funds allocated for mitigation purposes under the Fifteenth Award Scheme was too late to measure its effect, but it decided to maintain the system. It is an important observation with regard to urban flood risk mitigation projects, funded by the National Disaster Mitigation Fund.

Way Forward

Each of these gaps does not merit a rewrite of the constitution’s provisions; most of them can be remedied through data, design and negotiations. First, one must find out what the award fails to take account of. The Union and any future Commission should provide a report of the vertical fiscal imbalance by way of a standard method such that the next fight about the share of the States is based on data rather than the competing claims of 41 and 50 percent. Similarly, cess and surcharge should be made equally transparent.

While there are suggestions in the literature that these cess and surcharges should be capped to say 10 percent of gross tax revenue, the fact remains that the Commission was not supportive of a cap; hence the grand bargain can be negotiated either in the Inter-State Council or in the GST Council where the schedule of conversion of temporary taxes into shareable taxes can be published along with the revised share of the States.

Secondly, an incentive that is more soundly based is required by the formula. The inclusion of tax effort or something of a like nature along with GDP contributions to the formula will tie the process of devolution to how the States utilize their tax base. An incentive to bring balance where the share of states falls, which will be a time-bound and tapering incentive as suggested by Mohan, will ensure smooth devolution without reverting to revenue deficit grants. The suggestion made by the Commission itself of phasing out the inverse population growth criteria must be followed once new population figures become available.

Thirdly, there must be performance monitoring of the body itself. Body Grants for an effectively performing body or block must not be held back because another body or the State itself is underperforming, and the criteria for eligibility, i.e. public audit and a timely State Finance Commission, must be tracked publicly so that 20 percent of performance is duly credited for. Lastly, mitigations and city-finance grants should also be tracked on the basis of outcomes, i.e. utilization and reduction in losses, so that the next Commission does not find itself in the same position as this one.

References

1. Drishti IAS. (2026, February 4). 16th Finance Commission report. https://www.drishtiias.com/daily-updates/daily-news-analysis/16th-finance-commission-report

2. ICRA. (2026, February). State government finances: 16th FC – Several economically stronger states to benefit from change in their inter-se share, despite retention of tax devolution at 41% [Special comment]. https://www.icra.in/Rating/DownloadResearchSpecialCommentReport?id=6763

3. Ministry of Finance, Government of India. (2026). Receipt budget 2026-2027. https://www.indiabudget.gov.in/doc/rec/allrec.pdf

4. Mohan, R. (2026, April 6). Continuity and change in the 16th Finance Commission. The India Forum. https://www.theindiaforum.in/economy/continuity-and-change-16th-finance-commission

5. PRS Legislative Research. (2026a, February 1). Report of the 16th Finance Commission for 2026-31 [Report summary]. https://prsindia.org/policy/report-summaries/report-of-the-16th-finance-commission-for-2026-31

6. PRS Legislative Research. (2026b, February). Union Budget 2026-27 analysis. https://prsindia.org/files/budget/budget_parliament/2026/Union_Budget_Analysis-2026-27.pdf

7. Shankar IAS Parliament. (n.d.). Sixteenth Finance Commission – The gain to the states and their demands. https://www.shankariasparliament.com/current-affairs/sixteenth-finance-commission-the-gain-to-the-states-and-their-demands

8. Sixteenth Finance Commission. (2025). Report for 2026–31: Volume I – Main report. Government of India. https://fincomindia.nic.in/asset/doc/commission-reports/16th-FC/reports/Vol1-Main-Report.pdf

9. The Tribune. (2026, August 1). Centre releases additional tax devolution of Rs 1.09 lakh crore to state governments. The Tribune. https://www.tribuneindia.com/news/business/centre-releases-additional-tax-devolution-of-rs-1-09-lakh-crore-to-state-governments/

10. Vision IAS. (2026, March 31). Recommendations of 16th Finance Commission. https://dce.visionias.in/monthly-magazine/2026-03-31/polity-and-governance/recommendations-of-16th-finance-commission

About the Contributor

Sandra Menon, is a Research and Editorial Intern at IMPRI and an MA Public Policy student at M.O.P. Vaishnav College for Women, Chennai.

Acknowledgement

The author extends sincere thanks to the IMPRI team for their guidance. This article was reviewed by Anushree Khare & Arjya Shree Pande.

Disclaimer

The views and opinions expressed in this article are those of the author and do not necessarily reflect the official policy or position of IMPRI (Impact and Policy Research Institute).

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