16th Finance Commission Redraws Tax Devolution Map: Who Gains, Who Loses | Explained

The Centre accepted the recommendations of the 16th Finance Commission, Union Finance Minister Nirmala Sitharaman stated during her Union Budget speech on Sunday. The Commission has recommended retaining a 41% share of tax devolution to the states. “The Government has accepted the recommendation of the Commission to retain the vertical share of devolution at 41%,” Sitharaman said. “As recommended by the Commission, I have provided ₹1.4 lakh crore to the states for FY 2026–27 as Finance Commission grants. These include rural and urban local body and disaster management grants.”

In their submissions, eighteen out of twenty-eight states urged that their share in central taxes be raised from 41% to 50%. Retaining the states’ tax devolution share has sparked criticism from opposition leaders as well as from several states that sought a higher 50% share. Besides retaining the states’ share in the divisible pool of taxes, the Finance Commission also suggested outcome-based spending, greater transparency in tax devolution data, and better fiscal discipline for states.

The panel stated that there is a need to improve efficiency in public spending and strengthen fiscal accountability frameworks across states. This comes amid rising concerns regarding several states’ fiscal positions, which have seen a sharp rise in deficits owing to higher committed expenditure and the increasing use of ‘freebies’ in electoral politics.

The 16th Finance Commission was set up on December 31, 2023, for the period FY26–FY31 and was chaired by Dr. Arvind Panagariya. In its report, the panel said “there is a need to rationalise their structure by linking implementation with measurable, real-time output indicators for efficient use of resources.” The panel recommended that the Centre appoint a high-powered committee to reassess such schemes and recommend the closure of those not spending resources productively.

Devolution Formula

The 16th Finance Commission brought in a major change with the inclusion of a state’s contribution to national GDP as a new factor in the horizontal devolution formula. This parameter has been given a 10% weight. Tax devolution can be divided into two components—vertical devolution is the share of central taxes given to all states collectively, while horizontal devolution determines how that total share is divided among individual states based on certain criteria.

Besides adding GDP contribution, the Commission also removed the 2.5% weight given to states’ tax efforts, increased population weight by 2.5 percentage points, and reduced the weight given to area, demographic performance, and per capita GSDP distance. Per capita GSDP distance measures how far a state’s income falls below a benchmark, set as the average of the top three richest states, to help poorer states receive more funds.

Key Recommendations

1. Discontinuing Revenue Deficit Grants
In line with the recommendations of the 15th Finance Commission, which reduced revenue deficit grants to near zero by FY26, the 16th Finance Commission said it does not recommend revenue deficit grants during its award period. The Commission said state revenue deficits were driven by committed and discretionary expenditure, adding that states have scope to increase revenues and rationalise spending. The report cautioned that “the anticipation of revenue deficit grants by states weakens the incentive to undertake difficult but necessary fiscal reforms such as rationalising subsidies, improving tax administration, or curbing revenue expenditure.”

2. Stricter Borrowing Discipline
The Commission recommended that states’ fiscal deficits remain at 3% of gross state domestic product (GSDP), while the Centre should bring its fiscal deficit down to 3.5% of GDP by FY31. The panel also called on states to completely discontinue the practice of incurring off-budget borrowings.

3. Subsidy Rationalisation and PSU Reform
The Commission cautioned that borrowing for expenditure on subsidy and transfer schemes is not sound fiscal policy and urged states to rationalise schemes and introduce sunset clauses. The report suggested performance evaluations and said inactive public sector units (PSUs) should be considered for immediate closure to reduce fiscal strain.

4. Performance-linked Local Body Funding
The Commission recommended ₹7,91,493 crore in grants for rural and urban local bodies for the period FY27–FY31. It also suggested classifying the grants into basic and performance-linked components and stressed that states need to improve local revenue systems.

5. Disaster Funding and Real-Time Data Monitoring
For disaster management, the panel recommended ₹2,04,401 crore for states over the next five years. The report also suggested strengthening digital monitoring by converting the National Disaster Management Information System into a real-time, transaction-level disaster data platform. It further recommended adding heatwaves and lightning to the list of notified national disasters.

Who Are the Gainers and Losers?

Southern states, along with Gujarat and Haryana, are among the biggest gainers, each expected to see an increase of a few thousand crore rupees. Andhra Pradesh’s share rose to 4.2% from 4.05%, while Karnataka is set to receive ₹11,173 crore more.

However, Karnataka Chief Minister Siddaramaiah said on Sunday that the state could lose nearly ₹10,000 crore–₹15,000 crore annually, as the Commission fixed Karnataka’s share of divisible taxes at 4.13%. Siddaramaiah highlighted that while the share is higher than the 15th Finance Commission’s recommendation, it remains lower than the 14th Finance Commission’s allocation of 4.71%.

Leaders from Kerala also said that apart from inclusion in the Dedicated Rare Earth Corridor scheme, the state’s key demands were not addressed, including a request for a ₹21,000 crore special fiscal correction package to address current-year borrowing stress. However, Kerala’s share rose by 0.45 percentage points to 2.38% in FY27 from 1.92% a year earlier. This translates into tax devolution of ₹36,355.39 crore, up from ₹26,814.70 crore previously.

Gujarat’s share climbed to 3.75% from 3.47%, while Haryana’s share rose by 0.26 percentage points to 1.09%. In contrast, states such as Uttar Pradesh, Bihar, Rajasthan, and Madhya Pradesh saw a dip in their share of tax devolution.