The 16th Finance Commission (2026–31): Rewriting India’s Fiscal Federalism

Why the Finance Commission Matters for UPSC

The Finance Commission lies at the heart of India’s federal architecture. It determines how financial resources are shared between the Centre and the States, balancing equity, efficiency, and fiscal discipline. The 16th Finance Commission (FC), chaired by Dr. Arvind Panagariya, marks an important shift in how India views growth, governance, and fiscal responsibility for the period 2026–27 to 2030–31.

Vertical Devolution: Continuity with Stability

The Commission has recommended that 41% of the divisible pool of central taxes be devolved to states.
This maintains continuity with the 15th Finance Commission, signaling fiscal predictability and respect for cooperative federalism.

Divisible pool here excludes cesses, surcharges, and cost of collection, a critical conceptual point often tested in Prelims.

Horizontal Devolution: What Changed and Why It Matters

The real innovation of the 16th FC lies in how states are differentiated.

Income Distance: Equity Still Dominates

The largest weight (42.5%) is given to Per Capita GSDP Distance.
States with lower income levels receive higher transfers, ensuring redistribution toward poorer states.

Notably, income distance is calculated using the average GSDP from 2018–19 to 2023–24, excluding the pandemic year, improving accuracy.

Population and Demography: A Subtle Rebalancing

• Population (2011 Census) weight has increased to 17.5%.
• Demographic Performance is redefined:
  Instead of Total Fertility Rate, the focus is now on population growth between 1971 and 2011.

This change avoids penalising states for recent demographic transitions and rewards long-term population control.

Forests: Conservation Meets Incentives

Forest weight remains 10%, but the methodology has expanded:

• Includes open forests (earlier excluded)
• Rewards both existing forest cover and increase in forest area (2015–2023)

This aligns fiscal transfers with environmental sustainability, a recurring GS-III theme.

Contribution to GDP: Growth Gets a Seat at the Table

A major conceptual shift is the introduction of Contribution to National GDP (10%).

Instead of rewarding tax effort, the Commission now recognises:

• The economic engine role of high-growth states
• GSDP is measured in nominal terms, averaged over five years

This reflects a mature federal approach: redistribution without disincentivising growth.

Grants-in-Aid: Fewer but Sharper Instruments

Total grants recommended amount to ₹9.47 lakh crore.

What Was Discontinued

The Commission discontinued:

1. Revenue deficit grants
2. Sector-specific grants
3. State-specific grants

This indicates a move away from ad-hoc fiscal support toward rule-based transfers.

Local Body Grants: Strengthening the Third Tier

Nearly ₹7.9 lakh crore is allocated to rural and urban local bodies, divided into:

• Basic grants (80%)
• Performance-based grants (20%)

Entry conditions include:

• Constitutional functioning of local bodies
• Public disclosure of audited accounts
• Timely State Finance Commissions

This links money to institutional accountability, a governance reform often asked in Mains.

Urban Focus: Managing India’s Inevitable Urbanisation

Two innovative grants stand out:

• Special Infrastructure Grant for wastewater systems in cities with 10–40 lakh population
• Urbanisation Premium Grant to support peri-urban mergers and rural-to-urban transition policies

This reflects recognition of urban stress, not just urban growth.

Disaster Management: Predictability in Crisis Financing

A disaster corpus of over ₹2 lakh crore is recommended.

Cost-sharing:

• 90:10 for Himalayan and North-Eastern states
• 75:25 for others

This reinforces climate vulnerability sensitivity, relevant for GS-III and Essay.

Fiscal Roadmap: Discipline without Shock Therapy

The Commission charts a clear fiscal path:

• Centre’s fiscal deficit to fall to 3.5% of GDP by 2030–31
• States’ deficit capped at 3% of GSDP

A critical recommendation is the strict prohibition of off-budget borrowings, demanding transparency in fiscal accounting.

Combined Centre-State debt is projected to fall from 77.3% to 73.1% of GDP, signalling medium-term sustainability.

Structural Reforms Beyond Transfers

Power Sector: Privatisation with Safeguards

States are encouraged to privatise DISCOMs, with:

• Debt parked in a Special Purpose Vehicle
• Central capital assistance linked to completion of privatisation

This tackles chronic power sector inefficiencies without overburdening private investors.

Subsidy Rationalisation: Targeting over Populism

The Commission flags:

• Poor targeting of unconditional cash transfers
• Lack of standard definitions and accounting of subsidies

It recommends:

• Clear exclusion criteria
• Uniform disclosure standards
• Ending off-budget financing of subsidies

Highly relevant for questions on fiscal populism vs fiscal prudence.

Public Sector Enterprises: Exit Where Necessary

The Commission identifies 308 inactive State PSEs for closure.

Loss-making enterprises for 3 out of 4 years must face cabinet-level review for:

• Closure
• Privatisation
• Strategic continuation

This embeds accountability in state capitalism.

Why the 16th Finance Commission Is UPSC-Relevant

This report connects:

1. Federalism with growth
2. Environment with finance
3. Urbanisation with governance
4. Discipline with development

Comparison of Horizontal Devolution Criteria: 15th vs 16th Finance Commission

FAQs on the 16th Finance Commission (2026–31)

1. What is the Finance Commission and why is it important?

The Finance Commission is a constitutional body under Article 280 that recommends how financial resources are shared between the Centre and States. It is crucial for ensuring fiscal federalism, equity among states, and macro-economic stability.

2. Who chaired the 16th Finance Commission and for which period was it constituted?

The 16th Finance Commission was chaired by Dr. Arvind Panagariya and covers the five-year period from 2026–27 to 2030–31

3. What is the share of states in central taxes as recommended by the 16th FC?

The Commission recommended 41% share of states in the divisible pool of central taxes, the same as the 15th Finance Commission.

4. What is meant by “divisible pool of central taxes”?

The divisible pool refers to gross central tax revenue minus:

1. ·      Cost of tax collection
2. ·      Cesses and surcharges
3. ·      Only this net amount is shared with states.

5. What are the major criteria used for horizontal devolution among states?

The 16th FC used the following criteria:

1. ·      Income Distance
2. ·      Population (2011 Census)
3. ·      Demographic Performance
4. ·      Area
5. ·      Forest cover and increase in forest area
6. ·      Contribution to national GDP

Each criterion has a specific weight to balance equity and efficiency.

6. How is “Income Distance” defined by the 16th Finance Commission?

Income distance is defined as the difference between a state’s per capita GSDP and the average per capita GSDP of the top three richest large states.
Lower-income states receive a higher share under this criterion.

7. Why was the pandemic year excluded while calculating income distance?

The year 2020–21 was excluded to avoid data distortion caused by COVID-19, ensuring a more realistic assessment of state incomes

8. How has the concept of demographic performance been changed?

Instead of using Total Fertility Rate (TFR), the 16th FC measures demographic performance using population growth between 1971 and 2011.
States with lower long-term population growth are rewarded.

9. How has the forest criterion been modified?

The Commission:

·      Included open forests along with dense forests

·      Considered both existing forest area and increase in forest cover (2015–2023)

·      This links fiscal transfers with environmental conservation efforts.

10. What major change was made regarding grants-in-aid?

The 16th FC discontinued:

·      Revenue deficit grants

·      Sector-specific grants

·      State-specific grants

This reflects a shift towards rule-based and performance-linked transfers.

11. What is the total amount of grants recommended by the Commission?

The Commission recommended grants worth ₹9.47 lakh crore for the five-year period.

12. How are grants for local bodies structured?

Local body grants are divided into:

·      Basic grants (80%)

·      Performance-based grants (20%)

These apply to both rural and urban local bodies.

13. How has disaster management financing been structured?

 A disaster management corpus of over ₹2 lakh crore has been recommended, with:

·      90:10 Centre-State sharing for Himalayan and North-Eastern states

·      75:25 sharing for other states

   This reflects differential vulnerability.

14. What fiscal targets has the 16th FC recommended?

Centre’s fiscal deficit to be reduced to 3.5% of GDP by 2030–31

States’ fiscal deficit capped at 3% of GSDP

15. What reforms were suggested for the power sector?

  States are encouraged to privatise DISCOMs, with legacy debt parked in a Special Purpose Vehicle,       reducing investor risk and improving efficiency.

 16. Why did the Commission emphasise subsidy rationalisation?

   It observed that many subsidies:

·      Are poorly targeted

·      Are financed through off-budget routes

   It recommended clear exclusion criteria, uniform accounting, and better disclosure.