The 16th Finance Commission has retained States’ share in the divisible tax pool at 41 per cent for the five years 2026-27 to 2030-31, while introducing major tweaks in the grants to States and factoring their contribution to the country’s GDP into the horizontal devolution formula that decides which State gets how much of the tax pool. The constitutional panel also sought urgent fiscal reforms, including ending the practice of off-budget borrowings by states.
In their submissions to the Commission, as many as 18 of the 28 States had “overwhelmingly” pitched for an increase in the states’ share of the divisible tax pool from 41 per cent to 50 per cent. However, the Commission noted that “states already account for more than two-thirds of the nation’s total non-debt revenues” and any further increase would unduly constrain the Union government’s fiscal space and its ability to meet national obligations.
Under the revised horizontal devolution framework, the Commission has introduced a State’s GDP contribution as a new parameter, with a weightage of 10 per cent to recognise efficiency and state contribution. “Taking cognisance of the principle of gradualism, however, we decided that the weight assigned to the criterion should be such that it spells only a directional change without the Sixteenth Finance Commission causing a drastic shift in the States’ shares,” according to the Arvind Panagariya-led Commission’s report tabled in Parliament on Sunday.
The Commission also tweaked the horizontal devolution formula by removing the 2.5 per cent weight given for States’ tax efforts, increasing the share of population by 2.5 percentage points and decreasing the weight of area, demographic performance and per capita Gross State Domestic Product (GSDP) distance. Per capita GSDP distance describes how far a state’s average per-capita income falls short of the benchmark — set as the average of the top three highest per capita GSDP States, hence devolving more to States with lower per capita GSDP.
M Govinda Rao, member of the 14th Finance Commission, said he considers the addition of GDP contribution as a deliberate “hedge” by the Commission against the heavy weight assigned to per capita income distance so the large states don’t lose on this equity leg.
“In the long run, I think it's a good idea to try and start bringing in greater weightage to the states who are giving you faster GDP growth. But at the same time, overall, you do need to look at the balance of equity issues also,” noted Arvind Mehta, who served as a member secretary to the 15th Finance Commission.
The recalibration of horizontal devolution has led to visible shifts in the inter se share of states with industrialised states such as Gujarat, Maharashtra, Karnataka, Tamil Nadu and Andhra Pradesh seeing an increase in their share of tax devolution.
Karnataka recorded the largest increase in its share, followed by Kerala, Gujarat and Haryana, with gains of 0.48 percentage points, 0.45 percentage points, 0.28 percentage points and 0.27 percentage points, respectively. In contrast, more populous states such as Uttar Pradesh, Bihar, Rajasthan and Madhya Pradesh have witnessed a relative decline in their shares.
In a major departure from earlier Finance Commissions, the panel has recommended no revenue deficit grants (RDGs), arguing that states have significant scope to increase revenues and rationalise expenditure.
“When States anticipate that shortfalls in their revenue account will be compensated through RDGs, the incentive to undertake difficult but necessary fiscal reforms such as rationalising subsidies, improving tax administration, or curbing revenue expenditures weakens,” the Commission noted, stressing that grants soften fiscal discipline and embed dependency rather than resilience.
In addition, the Commission does not recommend any sector-specific or State-specific grants but has earmarked Rs. 7.91 trillion for rural and urban local bodies over 2026-31, with a 60:40 rural-urban split, and a strong emphasis on water, sanitation, and urban infrastructure.
It also recommended Rs. 2.04 trillion for State disaster response and mitigation funds plus about Rs. 79,000 crore for national funds, allocated using a revamped disaster risk index.
Mehta described the move as “a very major departure from all earlier finance commissions,” adding that a closer analysis would be needed to assess whether the assumption is realistic or not.
The Commission has recommended capping states’ fiscal deficits at 3 per cent of GSDP (excluding loans under SASCI) and lowering the Union government’s fiscal deficit to 3.5 per cent of GDP by the end of the award period.
It has also called for the complete discontinuation of off-budget borrowings by states, with all such liabilities brought onto budget, and for state fiscal responsibility laws to be amended to ensure uniformity and alignment with the Commission’s consolidation roadmap.
The government said it has accepted the recommended net borrowing ceilings for states in-principle, while other proposals — including those on off-budget borrowings and the Union government’s fiscal deficit — would be examined separately.
To enhance transparency in tax devolution each year, the Commission further recommended the Union Government disclose the data pertaining to net proceeds, as certified by the Comptroller and Auditor General under Article 279—a proposal the government has accepted. The move, Rao reckoned, stems from the fact that proceeds to each state are provided on the basis of “estimated” gross tax revenues, leading some states to feel they are not receiving their full share. The corresponding adjustment, he said, is intended to address this data concern, adding that “in the atmosphere of Union-State relations, there is always a trust factor.”
 "16th Finance Commission retains 41% devolution, introduces GDP criterion")
