Sixteenth Finance Commission and the Erosion of Fiscal Federalism

Context

The Indian Express editorial critiques the Sixteenth Finance Commission (16th FC) recommendations as a structural shift from equity-based statutory transfers toward discretionary central control. The editorial argues that effective state devolution is being reduced and need-based grants are being discontinued — weakening cooperative federalism and the constitutional guarantees of state fiscal autonomy under Article 280.

The Editorial Argument

1. Statutory devolution remains constant but effective devolution falls — while the headline tax devolution share remains around 41%, the actual money reaching states is reduced through cesses and surcharges (not part of the divisible pool)
2. Discretionary transfers grow at the cost of formula-based ones — Centrally Sponsored Schemes (CSS) are growing in importance, giving the Centre control over how states spend
3. Need-based grants discontinued — earlier Finance Commissions provided grants to states with specific revenue gaps; the 16th FC has reduced these dramatically
4. Constitutional federalism vs cooperative federalism — the editorial distinguishes between constitutional rights (states are entitled to a share) and cooperative arrangements (Centre offers to share)
5. Northern vs Southern states — fiscally responsible Southern states feel the squeeze as devolution formulas favour population-heavy Northern states

What is the Finance Commission?

The Finance Commission is a constitutional body established under Article 280 to recommend the distribution of tax revenues between the Centre and States, and among States.

History of Finance Commissions

The 14th Finance Commission under Y.V. Reddy made the historic recommendation to raise states’ share from 32% to 42% — a transformation in cooperative federalism. The 16th FC under Arvind Panagariya is expected to submit its report by October 2025.

Tax Devolution — The Headline Number vs Reality

Headline: 41% (15th FC)

The divisible pool consists of net proceeds of all taxes referred to in Chapter I, Part XII of the Constitution — Union taxes minus surcharges, cesses, and the cost of collection.

Reality: Cesses and Surcharges

The Centre has increasingly used cesses (Health and Education Cess, GST Compensation Cess, Krishi Kalyan Cess, Swachh Bharat Cess) and surcharges (Income Tax Surcharge for high earners) — which are not shared with states because they fall outside the divisible pool.

Result: Cesses and surcharges grew from ~6% of gross tax revenue in 2009-10 to ~16% in 2022-23. Effective state share has fallen below 35% even though headline statutory share is 41%.

Centrally Sponsored Schemes (CSS) — A Different Channel

CSS allows the Centre to direct state spending on its priorities — even though the constitutional principle is that states have autonomy over List II subjects. Examples include:

• PM-KISAN (income support for farmers)
• PMAY (housing for all)
• PMGSY (rural roads)
• Swachh Bharat Mission
• Jal Jeevan Mission

States must contribute matching grants (typically 25-40%) to access CSS funds — which forces them to align spending with central priorities.

North vs South Devolution Debate

The North-South divide in fiscal federalism stems from the devolution formula, which uses:

• Population (current criterion using 2011 Census) — favours northern states
• Income distance (gap from highest per capita state) — favours poorer states
• Forest cover, demographic performance, tax effort — secondary criteria

Southern states’ grievance: Tamil Nadu, Karnataka, and Kerala argue they:

• Have lower fertility (population control success) → “punished” with smaller share
• Generate higher per capita tax revenue → “subsidising” northern states
• Have made structural development progress → no longer entitled to backwardness grants

Northern states’ counter: Higher population means higher needs for services, infrastructure, and welfare.

Cesses and Surcharges Issue

This rise has been criticised by all major opposition parties and several state governments. The 15th Finance Commission recommended that the Centre limit cesses and surcharges to strict minimum — but the recommendation has not been implemented.

UPSC Relevance

GS Paper 2 — Polity & Governance

• Article 280 — Finance Commission
• Centre-State financial relations
• Cooperative federalism vs constitutional federalism
• Centrally Sponsored Schemes
• North-South divide in devolution

GS Paper 3 — Indian Economy

• Tax devolution and fiscal federalism
• Cesses and surcharges
• Divisible pool composition
• Public finance and state budgets

Mains Probable Questions:

• “Critically examine the role of the Finance Commission in maintaining fiscal federalism in India. How has the use of cesses and surcharges by the Centre affected effective devolution?” (250 words)
• “The North-South divide in tax devolution reflects deeper questions about equity, efficiency, and federal principles. Discuss.” (250 words)

Facts Corner

• The Finance Commission was first established in 1951 under Chairman K.C. Neogy — the first FC report was submitted in 1952.
• K.C. Neogy was the only person to chair the Finance Commission and also serve as a member of the Union Cabinet — a unique position in Indian constitutional history.
• The 16th FC’s terms of reference, set by the President in November 2023, include considering the impact of GST (since 2017), the need for revenue stability for states, and population data based on the 2011 Census (since the 2021 Census remains uncompleted).
• Article 270 specifies which taxes are shareable; Article 271 allows the Centre to impose a surcharge for its own purposes that is NOT shareable — this is the constitutional basis for the Centre’s growing reliance on surcharges.
• The Goods and Services Tax (GST) is a critical part of fiscal federalism — through the GST Council, where states have a 2/3 weighted vote — but GST has constrained states’ tax-raising autonomy on most goods and services.
• Arvind Panagariya was the first Vice Chairman of NITI Aayog (2015-2017) before being appointed Chairman of the 16th Finance Commission.