Budget 2026 Outllook: The 16th Finance Commission and fiscal consolidation

An examination of Finance Commission awards from the 11th to the 15th shows that transfers to states have not materially strained the Centre's finances, even during periods of higher devolution

One of the striking expenditure items in the Union Budget will be the allocation Finance Minister Nirmala Sitharaman makes for the award of the 16th Finance Commission. Will this push out the timetable for the further compression of the fiscal deficit from the 4.4 per cent of GDP expected for FY26?

 

This is unlikely, as a study of the impact of the awards of past Finance Commissions shows. None of the Commissions, going as far back as the 11th to the 15th, accounted for more than 3.5 to 4 per cent of GDP off the Centre’s plate. The balance is one of the key reasons why the finance ministry has been able to convince foreign investors that India’s macro balances are not only stable but would improve despite global uncertainties. Barclays Bank has forecast that another upgrade to India’s sovereign rating is expected in 2026 itself. In 2025, S&P had upgraded India papers to BBB in August 2025.

 

“The Finance Commission awards always make room within the constraints of the Union finances,” Pinaki Chakraborty, who served as the chief economic adviser to the 14th Finance Commission, told Business Standard. So making space for what the 16th Finance Commission asks her to set aside will not disturb her budget arithmetic, going by past trends.

 

The Finance Commissions are set up every five years by the President of India as per the mandate of the Constitution. The Commissions decide what percentage of the Centre’s tax revenues should be transferred to state governments and then how the sum should be allocated among the states. The 16th Finance Commission, under former deputy chairman of Niti Aayog Arvind Panagariya, submitted its report to President Droupadi Murmu in November 2025. The Union finance ministry has therefore had enough time to build the impact of the recommendations into the Budget numbers.

 

As the accompanying data sheet shows, between FY05 and FY23, total transfers to states as a percentage of the gross revenue receipts of the Union government remained largely unchanged during the period. So did the share of central government schemes, at about 3 per cent of GDP, making the aggregate transfer to states about 6.5 per cent. This has recently tipped above 7 per cent, with capital expenditure support being handed out by the Centre. 

 

The trend applied even for the 14th Finance Commission, under YV Reddy. The award of the Commission offered a substantial jump in the share of the states to 42 per cent from 32 per cent. Even though the Commission had recommended that tax devolution should remain the primary source of transfer of funds to states — the rationale being that this would increase the flow of unconditional transfers and give states more flexibility in their spending — in practice, this too was achieved by clubbing the non-plan allocation with plan funds. “The tax devolution recommended by the Commission subsumed some of the Plan transfers to States and covered both Plan and non-Plan revenue expenditure,” YV Reddy, chairman of the 14th Finance Commission, noted in the book Indian Fiscal Federalism, which he co-authored with GR Reddy and Chakraborty.

 

The distinction between plan and non-plan has been done away with by the current government, but the percentage allocation — at roughly 42 per cent — for the states has remained even under the 15th Finance Commission award. This reflects near stability in the shares of the Centre and the states in the combined revenue receipts, both before and after transfers.

 

However, as a PRS India note states, the quality of the transfers has improved over the past ten years. So even as the share of central revenues shared with states has been split almost in half, “during the 14th and 15th Finance Commission periods, the Centre shared relatively more of its revenue through tax devolution than grants and other transfers”. This has happened despite the supposed clawback by the 15th Finance Commission, which saw plain vanilla transfers of revenues to states that had reached 68 per cent slip back to 64 per cent. 

 

Director of the Madras School of Economics NR Bhanumurthy also agreed with the assessment that the finance minister will not need to be perturbed by the scale of the transfers recommended by the 16th Finance Commission. “It is quite possible that the award will not disturb the fiscal balance at the Centre,” he said.