Recalibrating Fiscal Federalism: The 16th Finance Commission Report

On 1 February 2026 , alongside the Union Budget 2026–27 , the 16th Finance Commission Report was tabled in both Houses of Parliament. Its presentation comes at a time when debates around fiscal federalism have intensified especially after GST, rising welfare commitments, and increasing dependence of states on central transfers. The report reflects an attempt to maintain stability while recalibrating the fiscal framework for the coming decade. However, the manner and timing of its tabling also highlight the political and economic importance of resource-sharing between the Union and the states.

Composition and Mandate of the Commission

The 16th Finance Commission was chaired by Dr. Arvind Panagariya and was tasked with recommendations for the award period 2026–27 to 2030–31 .

Its Terms of Reference (TOR) required it to recommend principles for distribution of taxes between Centre and states, provide grants-in-aid, and suggest measures for fiscal stability and sustainable growth.

Vertical and Horizontal Devolution - Continuity with Tweaks

The Commission retained vertical devolution at 41% of the divisible pool, the same as the 15th Finance Commission , despite repeated demands by several states to raise it closer to 50% due to rising expenditure responsibilities, unfunded mandates, and the shrinking fiscal space after GST. States also flagged that the growing use of cesses and surcharges by the Union reduces the effective divisible pool, meaning the real share of states in central taxes is often lower than the stated percentage.

On horizontal devolution , the report continued using parameters such as income distance, population (2011), area, forest and ecology cover, and demographic performance , but introduced a major shift by assigning 10% weightage to states’ contribution to GDP . While this is projected to reward efficiency and economic productivity, critics argue that it may disproportionately benefit high-income states and deepen regional imbalances by reducing the redistributive character of the Finance Commission framework. Compared to the 15th Finance Commission, the 16th Commission is seen as moving from a need-based equity approach toward a more performance-based distribution model.

Other provisions include the recommendation of nearly ₹9.47 lakh crore in grants over five years, with significant allocations for local bodies , disaster risk management , and institutional strengthening. The report also emphasized fiscal discipline by reaffirming the 3% of GSDP fiscal deficit limit for states, while linking additional borrowing flexibility to reforms and prudent financial management. It further underlined the need for a sustainable debt trajectory, signalling tighter scrutiny of state finances in the coming award period.

The Missing Question of Finance Buoyancy

Several concerns were raised about the report, especially regarding fiscal buoyancy and the ability of a state’s revenue to grow faster than its expenditure needs as the economy expands. States argued that retaining vertical devolution at 41% does not address the widening mismatch between responsibilities and resources, particularly when the Union increasingly mobilises revenue through cesses and surcharges , which remain outside the divisible pool. This reduces the effective share of states in central taxes, weakening their natural revenue growth potential.

The real issue is that devolution alone cannot ensure sustainability unless states have buoyant revenue streams . For example, a relatively high-growth state like Karnataka , with a strong services sector and GST base, may generate rising GST collections, but its expenditure burden urban infrastructure, migration-linked welfare, and capital investment needs also rises sharply. Without greater flexibility in tax policy or predictable transfers, even a high-performing economy can face fiscal stress. On the other hand, a smaller state like Mizoram or Manipur , with limited industrial activity and a narrower tax base, has weak revenue buoyancy by default and remains structurally dependent on transfers. In such cases, rewarding “GDP contribution” in horizontal devolution may further tilt the balance toward richer states, while poorer states struggle to break out of low-growth traps.

Horizontally, while giving weightage to states’ contribution to GDP may encourage competitiveness, it risks penalising less-developed states that require stronger equalisation support to fund health, education and basic infrastructure. More importantly, the report missed an opportunity to recommend measures that directly enhance state-level buoyancy such as expanding the divisible pool by reducing cesses, ensuring a stronger GST compensation-like safety net, or incentivising reforms that improve tax administration. Instead, the framework largely remains a distribution exercise , without addressing how states can sustainably grow their revenues in proportion to their developmental responsibilities.

Who Gains, What Was Missed

The report may benefit many states through grants for local governance and disaster preparedness, improving last-mile service delivery. It also reinforces fiscal discipline by setting deficit ceilings, which can help states maintain creditworthiness and avoid long-term debt traps.

However, the report missed an opportunity by removing or reducing revenue deficit grants and state-specific support , which had earlier helped structurally weaker states manage basic expenditure needs. This creates fear that poorer states may struggle to maintain welfare delivery without adequate compensatory mechanisms.

A Balanced Federal Future Needs Reform

Going forward, fiscal federalism must evolve beyond a fixed devolution share. The divisible pool should be expanded by bringing more cesses and surcharges under shareable taxation. States must also be empowered with greater fiscal autonomy, improved GST architecture, and mechanisms that encourage revenue growth rather than dependence.

A stronger framework is needed that balances performance incentives with equity-based support. Only then can India ensure that economic growth is not concentrated but shared, and that cooperative federalism becomes a reality rather than a slogan.