16th Finance Commission redraws distribution; states share remains at 41%

Nirmala Sitharaman's budget speech said that there was no change in states’ share in central taxes from the 15th FC and it would continue to be 41%.

The biggest story of the day may well be the 16th Finance Commission’s recommendations that have been accepted by the government and which, while keeping the share of states the same as in the 15th Finance Commission, has sought to do its bit to address challenges to the country’s fiscal federalism framework -- mostly arising from high-performing states feeling short-changed. It has done so by primarily, introducing the size of a state’s economy as a variable, and altering both the

Before she began her budget speech, finance minister Nirmala Sitharaman told the Lok Sabha that the government had accepted the 16th FC’s recommendations. (Bloomberg)

How shares in divisible pool of taxes will change

The GSDP variable

Contribution to India’s GDP enters as a criterion for a share in central taxes for the first time with a weight of 10%. This has been a big complaint of high-growth high-income southern states who have been threatening to rebel against the principle of equity – taking resources from richer states via central taxes and giving it to poorer ones via higher share in devolutions – in India’s fiscal federalism framework. To be sure, the 16th FC has relied on a mathematical workaround – it will take ratio of square roots of state-wise GSDP than just GSDP – to mute some of the potentially inequality enhancing impact of this change. The impact is that Madhya Pradesh and Uttar Pradesh are among the biggest losers (in terms of share of revenue); and Karnataka and Kerala, the biggest gainers.

Measure of demographic performance

The 16th FC also makes a big pivot in how it looks at the link between demography and resource sharing to states. Instead of using changes in total fertility rate (TFR) – the number of children a woman is expected to have over the course of her reproductive life -- as the indicator for demographic performance, the population growth figures between 1971 and 2011 census will be used. In fact, demographic performance itself will be assigned a lower weightage. The logic is to pre-empt a situation where India faces the “risk of aging before it becomes rich”. This should put a rest to those still invested in doomsday theories of population explosion.

The impact

These are not the only changes in the FC’s methodology to decide resource allocation among states. But they are by far the most important. There are also changes such as dropping of criterion of tax and fiscal effort and change in weights of all other criteria except forest cover in a state, and how they are defined. But how does all this translate into actual share of states compared to what they had under the 15th FC awards?

The share of seven major states in the divisible pool -- Rajasthan, Madhya Pradesh, Chhattisgarh, Uttar Pradesh, Bihar, West Bengal, and Odisha -- will come down. All other big states now have a higher share in the divisible pool, including southern states. The five biggest losers among big states are Madhya Pradesh, Uttar Pradesh, West Bengal, Bihar, and Odisha; whose shares have decreased by 50, 32, 31, 11, and 11 basis points – one basis point is one hundredth of a percentage point -- respectively. The five biggest gainers are Karnataka, Kerala, Gujarat, Haryana, and Punjab, whose shares have increased by 48, 46, 28, 27, and 19 basis points. The share of Tamil Nadu, one of the states most vocal about its share in the divisible pool, has increased by only 1.8 basis points, the smallest gain among those whose share has increased. These changes are already reflected in the distribution of central taxes among states in the budget for 2026-27.

To be sure, not all these changes are necessarily because of a change in the formula. Some of these changes could also be because of an update in the underlying data, the 16th FC argued in its report before detailing the changes it made.

“As a preliminary point, it is important to note that the states’ shares are impacted not only due to shifts in the devolution criteria applied, but also because of the changes in the values of underlying parameters. For instance, the per capita income distance of a State under the FC15 was not the same as under the FC14 because the per capita incomes of the states in the base years relevant to the former were different from those for the latter. In fact, analysis done by this commission shows that, even if we were to retain the exact same criteria and associated weights as the FC15, the States’ shares shift significantly due to the updation of underlying data,” the 16th FC report said.

To be sure, while tax devolution comprises around 90% of all finance commission transfers, the 16th FC has also changed grants, which comprise the remaining 10% and are awarded in absolute terms. These grants were awarded earlier for revenue deficit, local bodies, disaster management, and particular sectors and states. The 16th FC has removed revenue deficit, sector-specific, and state-specific grants. The 16th FC’s claim of continuity along with change notwithstanding, its recommendations might usher in a new chapter in India’s fiscal federalism framework where aspirations of states try to balance India’s larger growth story.