Sixteenth Finance Commission

Constitutional Basis

🔹 Constitution of India

Article 280 → Establishes Finance Commission
Article 270 → Distribution of taxes between Union and States
Article 275 → Grants-in-aid to States

🔹 What is the Finance Commission?

A constitutional body appointed every 5 years to recommend:

Vertical tax devolution (Centre vs States)
Horizontal distribution (among States)
Grants-in-aid

1️⃣ Vertical Devolution (Centre vs States)

Background Trend

Finance Commission	States’ Share in Divisible Pool
11th–13th FC	~27–28% effective transfer
14th FC	42% (major jump)
15th FC	41%
16th FC	41% (retained)

Key Issue:

The 14th FC increased States’ share from 32% to 42%.

The Centre responded by:

Increasing cesses & surcharges (non-shareable)
Reducing share in Centrally Sponsored Schemes (CSS)
Not fully accepting sector/state-specific grants

⚖️ Sixteenth FC Approach

Retained 41% share → gives semi-permanence
Did NOT recommend curbing cesses & surcharges
Proposed a “grand bargain”:
- Merge cesses into divisible pool
- States accept slightly lower share of a larger pool

🔎 Criticism:

Did not strongly uphold constitutional spirit
Dropped revenue deficit grants
No sector/state-specific grants
Effective transfers reduced to ~32.7% (2026–27 BE)

📌 Core Issue: Shrinking fiscal space of States

2️⃣ Cesses and Surcharges – Federal Tension

Why controversial?

Not shareable with States
Increasing proportion of Union revenue
Often not time-bound

📌 UPSC Link:

Cooperative vs Competitive Federalism
Off-budget fiscal practices
Transparency in taxation

3️⃣ Horizontal Devolution (Among States)

New “Contribution” Criterion

Earlier:

Income distance (poorer States get more)

Now:

Share of State’s GSDP in all-State GSDP
Used square root of GSDP to moderate impact

⚖️ Conceptual Problem

Two opposing logics used:

Lower per capita GSDP → More share (equity)
Higher GSDP → More share (contribution)

This creates tension between:

Equalisation principle
Efficiency principle

Dropped Criterion

❌ Tax effort / Fiscal discipline criterion removed

👉 Weakens incentive for fiscal responsibility

4️⃣ States That Lost

Major losers:

Uttar Pradesh
Bihar
Madhya Pradesh
West Bengal
Odisha
Rajasthan
Chhattisgarh

Other affected:

North-East States
Small States like Goa

Gains:

Some richer States (uneven)

📌 Political Economy Implication:

Redistributive tension between:

High population, low-income States
High-income, high-contribution States

5️⃣ Article 275 – Missed Opportunity

🔹 Article 275

Allows:

State-specific grants
Equalisation transfers
Addressing cost disabilities

The 16th FC discontinued revenue gap grants.

👉 Criticism:

Devolution alone cannot capture:

Cost differentials
Service delivery gaps
Special needs

6️⃣ Major Themes for Mains

A. Fiscal Federalism

Vertical imbalance (tax powers with Centre)
Horizontal imbalance (uneven development)

B. Equalisation vs Incentivisation

Should richer States be rewarded?
Or poorer States be equalised?

C. Constitutional Morality

Spirit of Articles 270 & 280
Rise of non-shareable revenue

D. GST Impact

Major GST reforms (Sept 2025) not factored in

Nominal GDP assumption optimistic (11%)

📚 UPSC Syllabus Mapping

GS Paper II

Centre-State relations
Constitutional bodies
Federalism

GS Paper III

Government budgeting
Public finance
Fiscal consolidation

🎯 5 Practice PYQs (UPSC Pattern) with Explanation

Q1. Consider the following statements regarding cesses and surcharges:

They form part of the divisible pool of central taxes.
They are not required to be shared with States.
They are meant to be levied permanently.

Which of the above is/are correct?

A) 1 only

B) 2 only

C) 2 and 3 only

D) 1, 2 and 3

✅ Answer: B

Explanation:

Not shareable
Ideally time-bound, not permanent

Q2. Article 280 of the Constitution relates to:

A) GST Council

B) Inter-State Council

C) Finance Commission

D) NITI Aayog

✅ Answer: C

Q3. The concept of “income distance” in Finance Commission formula is primarily aimed at:

A) Encouraging rich States

B) Equalisation across States

C) Increasing Central revenue

D) Promoting exports

✅ Answer: B

Q4. Which of the following best explains vertical fiscal imbalance?

A) Unequal development among States

B) Higher revenue powers with Centre compared to expenditure responsibilities of States

C) Revenue deficit in Union Budget

D) GST compensation

✅ Answer: B

Q5. Which principle justifies grants under Article 275?

A) Market competition

B) Equalisation of public services

C) Defence expenditure

D) Corporate taxation

✅ Answer: B

🖋️ Possible Mains Question

“The Sixteenth Finance Commission reflects the evolving tensions between equity and efficiency in India’s fiscal federalism.” Critically examine.

“Increasing reliance on cesses and surcharges undermines the spirit of cooperative federalism.” Discuss.

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Monday, March 2, 2026