Relevance: GS Paper II (Federalism) & GS Paper III (Government Budgeting)

Source: The Hindu / PIB (Analysis by C. Rangarajan)

Context: The Constitutional Referee

The 16th Finance Commission (FC), chaired by Dr. Arvind Panagariya, has submitted its recommendations for 2026-31.

Acting under Article 280, the FC determines how the nation’s tax revenue is shared between the Centre and States. This report attempts to navigate the tricky “North-South” divide by balancing the needs of the poor with the performance of the rich.

1. Vertical Devolution: The 41% Status Quo

Vertical Devolution decides the States’ aggregate share in the central tax pool.

• Recommendation: The Commission has retained the share at 41%, rejecting the demand from several states for 50%.
• The Logic: The Centre cited its heavy financial obligations towards National Defence, Infrastructure, and external debt as reasons for not increasing the share.
• The “Hidden” Cut: A major friction point remains the Cess and Surcharges. Since these are excluded from the divisible pool, the effective share states receive is often much lower (approx. 30-32%) than the headline 41%.

2. Horizontal Devolution: Rewarding Growth

Horizontal Devolution determines how the 41% is distributed among the 28 states. The 16th FC has introduced a paradigm shift by rewarding Economic Efficiency.

The New Formula:

A new criterion, “Contribution to GDP,” has been introduced. This directly rewards industrialized states.

3. The North-South Balancing Act

• The Grievance: Southern and Western states (the “Growth Engines”) have long argued they are penalized for their success in population control and development.
• The Fix: By introducing the 10% GDP Contribution weight, the FC explicitly acknowledges that “performers” need incentives.
• The Balance: While poorer states (North/East) still get the bulk of funds due to Income Distance, the marginal shift favors the industrialized South/West, attempting to soothe federal tensions.

UPSC Value Box

Key Term: “Divisible Pool”

The portion of Gross Tax Revenue (GTR) that is shared with states. It excludes Cesses and Surcharges (Article 270).

Analytical Insight:

• Paradigm Shift: The 16th FC moves India from “Need-Based Federalism” to “Performance-Based Federalism.”
• The Challenge: While rewarding efficiency is good, the Centre must address the “Cess Issue”. If the size of the pie (Divisible Pool) keeps shrinking relative to total revenue, the percentage share (41%) becomes meaningless.

Summary

The 16th Finance Commission has chosen stability over disruption. By maintaining the 41% vertical share, it protects the Centre’s fiscal space. However, the introduction of the “GDP Contribution” criterion is a landmark shift, signaling that in New India, states will be rewarded not just for their needs, but for their contribution to the national economy.

One Line Wrap: Efficiency is now a partner to Equity in India’s fiscal architecture.

Q. “The 16th Finance Commission aims to balance ‘Equity’ for poorer states with ‘Efficiency’ for industrialized states.” Analyze the changes in the horizontal devolution criteria in this context. (10 Marks, 150 Words)

Model Hints

• Introduction: Mention Article 280 and the 16th FC’s role.
• Body:
  • Equity: Explain that Income Distance (42.5%) still helps backward states.
  • Efficiency: Highlight the New Criterion (GDP Contribution – 10%) rewarding growth engines (South/West).
  • The Shift: Mention the trade-off (reduced weight for Income Distance/Area) to accommodate performance.
• Conclusion: Conclude that this “Performance-Based Federalism” is crucial to prevent fatigue in the more developed states.