16th Finance Commission: Recalibrating Fiscal Federalism for Economic Growth

Source: The Hindu 

Introduction 

On February 1, 2026, Finance Minister Nirmala Sitharaman presented the 16th Finance Commission report alongside the Union Budget, marking a pivotal moment in India's fiscal federalism framework. The government's acceptance of the Commission's recommendation to maintain the states' share at 41% of divisible central taxes for 2026-31 ensures continuity, while significant recalibration of distribution criteria signals a strategic shift toward rewarding economic performance and sustainable development. 

What are the Key Changes in Devolution Criteria? 

Introduction of GDP Contribution Parameter: 

• The most significant innovation is the introduction of a 10% weightage for "Contribution to GDP," calculated using the square root of state GSDP.  
• This rewards states for their economic output, creating incentives for growth-oriented policies while ensuring proportionality favors smaller economies. 

Recalibrated Weights: 

• Income Distance weight reduced from 45% to 42.5%, maintaining focus on equity while accommodating new parameters.  
• Population weight increased from 15% to 17.5%, reflecting demographic realities. Area weightage halved from 15% to 10%, reducing emphasis on geographical size.  
• Tax Effort eliminated entirely, removing the previous 2.5% allocation. 

Enhanced Forest & Ecology Criteria: 

• The 10% weightage now includes open forests and rewards forest cover growth between 2015-23, promoting environmental conservation alongside economic development. 

What are the Major Recommendations Beyond Devolution? 

Comprehensive Grants Framework: 

• Total grants-in-aid of Rs. 9.47 lakh crore include Rs. 7.91 lakh crore for local bodies and Rs. 1.56 lakh crore for disaster management.  
• Urban local bodies receive special infrastructure grants (Rs. 56,100 crore) for wastewater management and urbanisation premium (Rs. 10,000 crore) for peri-urban integration. 

Fiscal Discipline Roadmap: 

• Centre's fiscal deficit target set at 3.5% of GDP by 2030-31, states capped at 3% of GSDP. Combined debt projected to decline from 77.3% to 73.1% of GDP, ensuring macroeconomic stability. 

Structural Reforms: 

• Power sector reforms mandate DISCOM privatisation with debt warehousing through SPVs.  
• Public sector enterprise reforms require closure of 308 inactive state PSEs. 
• Subsidy rationalisation demands transparent accounting and targeted delivery mechanisms. 

What are the Legal Provisions in Reference to the Finance Commission? 

About: 

• Article 280 of the Constitution of India, 1950 (COI) provides for a Finance Commission which is a quasi-judicial body. It is constituted by the President of India.  
• Article 280(1) states that the President shall, within two years from the commencement of this Constitution and thereafter at the expiration of every fifth year or at such earlier time as the President considers necessary, by order constitute a Finance Commission which shall consist of a Chairman and four other members to be appointed by the President.  

Composition: 

• Article 280(2) states that the Parliament may by law determine the qualifications which shall be requisite for appointment as members of the Commission and the manner in which they shall be selected. 
• The Finance Commission consists of a chairman and four other members to be appointed by the President.  
• They hold office for such period as specified by the president in his order. They are eligible for reappointment. 
• The chairman should be a person having experience in public affairs and the four other members should be selected from amongst the following: 
  • A judge of the high court or one qualified to be appointed as one. 
  • A person who has specialized knowledge of finance and accounts of the government. 
  • A person who has wide experience in financial matters and in administration. 
  • A person who has special knowledge of economics. 

Functions:  

• Article 280(3) states that it shall be the duty of the Commission to make recommendations to the President as to—  
• (a) The distribution between the Union and the States of the net proceeds of taxes which are to be, or may be, divided between them and the allocation between the States of the respective shares of such proceeds. 
• (b) The principles which should govern the grants-in-aid of the revenues of the States out of the Consolidated Fund of India. 
• (bb) The measures needed to augment the Consolidated Fund of a State to supplement the resources of the Panchayats in the State on the basis of the recommendations made by the Finance Commission of the State. 
• (c) The measures needed to augment the Consolidated Fund of a State to supplement the resources of the Municipalities in the State on the basis of the recommendations made by the Finance Commission of the State.  
• (d) Any other matter referred to the Commission by the President in the interests of sound finance.  

Conclusion 

The 16th Finance Commission balances continuity with innovation, maintaining vertical devolution while introducing performance-based horizontal criteria. The emphasis on GDP contribution, environmental sustainability, and structural reforms reflects a forward-looking approach to fiscal federalism. However, implementation challenges remain—particularly in DISCOM privatisation and subsidy reforms—requiring sustained political commitment and administrative capacity across states.