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The debate on fiscal federalism in India has intensified following the Union government’s acceptance of the 41% tax devolution recommended by the Sixteenth Finance Commission. While the recommendation appears to maintain the existing share of tax revenues for States, critics argue that structural changes in the fiscal framework may gradually reshape the balance of financial power between the Centre and the States.

Fiscal Federalism in India

Fiscal federalism refers to the division of financial powers, taxation authority, and expenditure responsibilities between different levels of government in a federal system. In India, the Constitution establishes a structured framework for fiscal relations between the Union and the States.

Key constitutional provisions include:

• Articles 268–281: These articles govern the distribution of taxation powers and revenue sharing between the Union and the States.
• Article 280: Provides for the establishment of the Finance Commission, which recommends the sharing of central taxes and grants to States.
• Seventh Schedule: Divides taxation powers between the Union List and the State List.

Since the Union government collects a major share of taxes, the Finance Commission periodically recommends how the divisible pool of central taxes should be distributed among States.

Evolution of Tax Devolution

The share of States in the divisible pool has increased over time:

• 14th Finance Commission: Increased States’ share to 42%.
• 15th Finance Commission: Reduced it slightly to 41% after the reorganisation of Jammu and Kashmir.
• 16th Finance Commission: Recommended retaining the 41% share.

Although the percentage has remained unchanged, analysts argue that the effective transfer of resources to States may be declining.

The Divisible Pool and the Issue of Cesses and Surcharges

The divisible pool represents the portion of central tax revenues that is shared with States. However, certain revenues such as cesses and surcharges are excluded from this pool and are retained entirely by the Union government.

Over time, the share of the divisible pool in gross tax revenue has declined:

• 13th Finance Commission period: 89.2%
• 14th Finance Commission period: 82.1%
• 15th Finance Commission period: 78.3%

This trend implies that even though the States’ share is fixed at 41%, the base from which this percentage is calculated has shrunk, reducing the overall transfer to States.

Key Recommendations of the Sixteenth Finance Commission

The Union government accepted several major recommendations of the Commission, including:

• Retaining 41% tax devolution to States
• Acceptance of the horizontal distribution formula among States
• Approval of grants to local bodies
• Continuation of the disaster management funding framework

However, several structural reforms proposed by the Commission were deferred. These include:

• Reform of Fiscal Responsibility Legislation (FRL) frameworks
• Regulation of off-budget borrowings by States
• Reforms in the power sector distribution companies (DISCOMs)
• Rationalisation of subsidies

Fiscal Stress in States

The Commission also highlighted rising fiscal stress in several States. For example:

• Punjab: Debt–GSDP ratio of 42.9% and revenue deficit of 3.7% of GSDP (2023–24).
• Rajasthan: Liabilities at 37.9% of GSDP.
• West Bengal: Liabilities at 38.3% of GSDP.
• Andhra Pradesh: Liabilities around 34.6% of GSDP.

In some cases, borrowing is used primarily to finance revenue expenditure such as salaries and interest payments, rather than capital investment. Another concern is off-budget borrowing, where loans are raised through government-controlled entities and serviced using public funds.

Changes in Horizontal Devolution

The Finance Commission also revised the horizontal distribution formula among States. Earlier, a criterion known as tax and fiscal effort rewarded States that improved their tax collection efficiency. This has now been replaced with a “contribution to GDP” indicator with a weight of 10%.

This shift may benefit economically stronger States such as Maharashtra, Gujarat, and Karnataka, which contribute significantly to national GDP. However, poorer States such as Bihar, Jharkhand, and Uttar Pradesh, which depend heavily on central transfers, may gain relatively less, raising concerns about weakening the principle of fiscal equalisation.

Local Body Grants

The Sixteenth Finance Commission also recommended ?7,91,493 crore in grants for rural and urban local bodies. These grants are divided into:

• Basic grants for essential services and administration.
• Performance grants linked to conditions such as timely constitution of State Finance Commissions, audited accounts, and compliance with data reporting systems.

However, implementation challenges persist, as only 62.6% of recommended urban local body grants were released during the previous Finance Commission period.

Conclusion

The retention of 41% tax devolution appears to preserve the formal structure of fiscal federalism. However, the increasing use of cesses and surcharges, changes in allocation criteria, and delays in structural reforms indicate evolving Centre–State fiscal dynamics. These developments may gradually reshape India’s fiscal federal landscape, raising important questions about resource distribution, fiscal autonomy, and cooperative federalism.