The balance of money between the Centre and the States has entered a new phase. The 16th Finance Commission, whose recommendations will apply from 2026-27 to 2030-31, has decided to retain the States’ share at 41% of the divisible tax pool but has significantly altered how that share is distributed. By introducing GDP contribution as a new criterion and ending revenue deficit grants, the Commission has signalled a shift towards efficiency, growth and fiscal discipline, making this a high-importance topic for competitive exams.
41% Tax Devolution Retained: What It Means
- Despite demands from 18 states to raise their share to 50%, the Commission retained the 41% devolution rate.
- It argued that states already account for over two-thirds of total non-debt public revenues, and increasing their share further would constrain the Union government’s ability to meet national obligations.
- This decision reflects continuity with the 15th Finance Commission, while signalling that fiscal federalism will now focus more on quality of spending rather than only higher transfers.
GDP Contribution Added
- A major innovation is the introduction of State GDP contribution as a new parameter in the horizontal devolution formula, with a 10% weight.
- This criterion recognizes states that contribute more to national economic growth.
- The Commission clarified that this is a directional change, not a radical shift, to balance efficiency with equity.
Changes in Horizontal Devolution Formula
- Along with GDP contribution, the Commission made several adjustments.
- It removed the 2.5% weight for tax effort, increased the population weight by 2.5 percentage points, and reduced the weights for area, demographic performance, and per capita GSDP distance.
- As a result, industrialized and faster-growing states like Karnataka, Kerala, Gujarat and Maharashtra gained higher shares, while more populous and poorer states such as Uttar Pradesh and Bihar saw relative declines.
- This redistribution has major political and economic implications.
No Revenue Deficit Grants
- For the first time, the Commission recommended zero Revenue Deficit Grants (RDGs).
- It argued that RDGs weaken incentives for fiscal reform by encouraging dependency.
- States, it said, have sufficient scope to increase revenues and rationalise expenditure.
- This is a major departure from earlier Finance Commissions and reflects a strong push towards self-reliance and fiscal responsibility at the state level.
Local Bodies and Disaster Management Funding
- While cutting RDGs, the Commission earmarked ₹7.91 trillion for rural and urban local bodies over five years, with a 60:40 rural–urban split, focusing on water, sanitation and urban infrastructure.
- It also recommended ₹2.04 trillion for State Disaster Response and Mitigation Funds and ₹79,000 crore for national disaster funds, using a revamped disaster risk index.
- This shows a preference for functional, purpose-linked grants rather than general fiscal support.
Question
Q. What percentage of the divisible tax pool has been retained for states by the 16th Finance Commission?
A. 42%
B. 45%
C. 41%
D. 50%