Sixteenth Finance Commission (SFC)

Why in News? The Sixteenth Finance Commission (SFC), set to recommend financial devolution formulas effective from April 1, 2026, is under scrutiny due to States’ demands for an increased share in the divisible pool of central taxes. With 22 out of 28 States advocating for their share to rise from 41% to 50%, concerns about the Centre’s increasing reliance on non-shareable cesses and surcharges have sparked debates on cooperative federalism and fiscal balance

Relevance : UPSC Pre &  Mains

Prelims : SFC

Mains :   GS 3/ Economy

Key Points

States’ Demand for Increased Share:

• Current Share: States receive 41% of the divisible pool of tax collections.
• Demand: Many States, including those governed by the BJP, are asking for an increase to 50%.
• Rationale:

• • Centre’s rising non-shareable revenue through cesses and surcharges (12.8% in 2015-20 to 18.5% in 2020-24).
  • Declining effective share of States in the Centre’s gross tax revenue (from 35% pre-pandemic to 31% post-pandemic).
  • Limited avenues for States to raise revenue due to the Goods and Services Tax (GST).

 Issues with Horizontal Devolution Formula

• Weightage: Current formula prioritizes population and income distance.
• Impact:

• • Economically progressive States (e.g., Southern States) feel penalized for better governance and performance.
  • Calls for a more balanced approach that considers performance and specific State needs.

Challenges in Increasing Vertical Devolution:

• Centre’s Stance:

• • Rising expenditures on defense and capital projects make the Centre reluctant to reduce its share.
  • A sudden 9% jump to 50% could disrupt fiscal stability.

• Need for Compromise: A modest increase in devolution may balance States’ demands and fiscal prudence.

Recommendations for the Finance Commission:

• Capping Cesses and Surcharges: Introduce a fixed percentage cap on non-shareable cesses and surcharges.
• Inclusion in Divisible Pool: Surplus collections from cesses and surcharges should be included in the divisible pool.
• Revising Horizontal Devolution Formula: Balance States’ needs, area, and performance in the distribution formula.
• Strengthening Cooperative Federalism: Foster trust between the Centre and States through a more equitable fiscal compact.

Key Mandates

• Vertical Devolution: Decide the percentage of tax revenues shared with States.
• Horizontal Devolution: Frame a formula for distributing the States’ share based on parameters like population, income distance, and area.
• Special Grants: Recommend grants for specific purposes or addressing fiscal imbalances.