Every five years, a Finance Commission is constituted to recommend how the Union’s tax revenues and certain grants should be shared with states so they can discharge responsibilities listed in the Seventh Schedule. The 16th Finance Commission’s award for 2026–31 largely preserves the headline architecture, but shifts in the horizontal formula and a tighter grants design will change incentives and, at the margin, outcomes.
The Finance Commission is the Constitution’s built-in corrective for fiscal federalism. Article 280 avoided hard-coding a permanent state share in the constitutional text and instead created a periodic expert mechanism to reflect shifting demographics, widening income differences across states, and changing fiscal pressures. That flexibility has mattered as the delivery role of state governments has expanded with urbanisation and rising demands for social and infrastructure spending.
READ | Fiscal federalism: Karnataka demands a fairer deal from the 16th Finance Commission
Vertical devolution and the fault lines
On vertical devolution, the Commission has retained the states’ share in the divisible pool at 41%.
This is where the politics sits. Many states argued for a higher share, pointing to the growing use of cesses and surcharges that lie outside the divisible pool. The Commission does not offer a “fix” to this dispute. Its view is constitutional and blunt: the Constitution does not permit capping cesses and surcharges or bringing them into the divisible pool; and the present division of tax revenues, combined with other transfers, gives states sufficient resources to discharge their responsibilities.
That stance effectively closes the door on an immediate compensatory rise in vertical devolution as an antidote to non-shareable levies, even as the political grievance remains.
Horizontal devolution formula and the weights
The sharper change is horizontal distribution: how the states’ share is split among states. The Commission introduces a new “Contribution to GDP” criterion with a 10% weight, calculated using the square root of each state’s GSDP share to moderate extremes.
READ | 16th Finance Commission’s imperative: Sustainable livelihoods for inclusive growth
But the distribution story is not “GDP replaces redistribution”. The full formula makes clear what dominates:
So the efficiency signal is real, but bounded. The centre of gravity remains the per-capita income-distance criterion, which is where equalisation largely happens.
The inter-se shares table also clarifies the likely fault lines. Uttar Pradesh remains the single largest beneficiary by share (17.619%), followed by Bihar (9.948%), Madhya Pradesh (7.347%) and West Bengal (7.215%). Among richer states, Maharashtra’s share is 6.441%; Tamil Nadu’s 4.097%; Karnataka’s 4.131%; Gujarat’s 3.755%; Kerala’s 2.382%.
This is the practical meaning of the Commission’s attempted balance: keep the equalisation core, but insert a small reward for contribution to national output.
Revenue-deficit grants and the grant menu
The Commission has not recommended revenue-deficit grants. It has also not recommended sector-specific or state-specific grants.
That is a substantive tightening. Whatever the methodological objections to “normative deficits”, the removal matters because it reduces explicit shock-absorbers for states that struggle to fund routine service delivery.
What remains are essentially two grant heads: local body grants and disaster management grants. PRS summarises total grants at ₹9.47 lakh crore over the award period, limited to these categories.
Local body and disaster grants are conditional
Local body grants are sizeable: the government’s action-taken memorandum records ₹7,91,493 crore for rural and urban local bodies for 2026–27 to 2030–31. It also specifies how these are structured: basic and performance components (80:20) for both rural and urban, with additional components for urban bodies including special infrastructure and an urbanisation premium.
READ | The 16th Finance Commission must address fiscal equity concerns
These grants are not a free cheque. Eligibility is tied to three entry conditions: duly constituted local bodies, public disclosure of provisional and audited accounts, and timely constitution of State Finance Commissions with action taken reports laid in the legislature.
On disaster management, the recommended corpus is ₹2,04,401 crore for SDRF and SDMF, with a cost-sharing pattern of 90:10 for north-eastern and Himalayan states and 75:25 for others.
FRBM constraints and off-budget debt
The timing matters because fiscal space is tight. The PRS summary records the Commission’s recommendation that states’ annual fiscal deficit limit remain 3% of GSDP, and that off-budget borrowings be strictly discontinued with definitions expanded to include such borrowings uniformly.
For poorer states with weak revenue bases, this is where the design becomes consequential. If borrowing headroom is capped and revenue-deficit grants are discontinued, the question is not whether states prefer “untied transfers”. It is whether the remaining transfer design—dominated by income-distance equalisation but now carrying a GDP-contribution nudge—can prevent infrastructure and service-delivery gaps from hardening into persistence.
Whether it does will show up less in the theory of the formula than in the lived constraint: which states can still fund health, education, and basic infrastructure while staying inside a tighter fiscal envelope.