Relevance: GS II (Polity – Centre-State Relations) & GS III (Economy) | Source: FC-16 Report (Feb 1, 2026)

1. Vertical Devolution: Status Quo

The 16th Finance Commission, chaired by Dr. Arvind Panagariya, has decided to retain the States’ share in the divisible pool of taxes at 41%.

  • The Logic: Despite states demanding a hike to 50%, the Commission prioritized stability in the Union’s finances.
  • The Divisible Pool: It comprises all central taxes excluding cesses and surcharges. The Commission flagged that the excessive use of these non-shareable “cesses” by the Centre has shrunk the actual pool available for states.

2. Horizontal Devolution: Rewarding Performance

This determines how the 41% is distributed among the states. The formula sees a major shift to reward economic efficiency.

  • New Criteria: A new parameter, “Contribution to GDP” (10%), has been introduced. This rewards states that grow their economies and contribute more to the national pie.
  • Weights Revised:
    • Income Distance (Equity): Reduced to 42.5%.
    • Population (2011 Census): Increased to 17.5%.
    • Forest & Ecology: Expanded to include “open forests,” rewarding green cover.
  • Demographic Performance: Now calculated based on inverse population growth (1971–2011), continuing to reward states that controlled population early.

3. Grants & Local Bodies

  • Total Grants: Recommended ₹9.47 lakh crore.
  • Local Focus: A huge chunk is for Rural and Urban Local Bodies (60:40 split). Grants are tied to basic services like Water and Sanitation.
  • Major Exclusions: The Commission has discontinued Revenue Deficit Grants (RDGs) and sector-specific grants, pushing states to manage their own deficits.

UPSC Value Box

Concept / Article Relevance for Prelims
Article 280 Mandates the President to constitute a Finance Commission every 5 years to recommend the distribution of tax proceeds between Centre and States (Vertical) and among States (Horizontal).
Divisible Pool The gross tax revenue of the Centre minus cost of collection, minus cesses and surcharges (Article 270/271). This is the “net proceeds” shared with states.
Income Distance The distance of a state’s per capita income from the state with the highest per capita income (usually Haryana/Goa). It ensures equity by giving more funds to poorer states.

Q. With reference to the recommendations of the 16th Finance Commission, consider the following statements:

  1. It has increased the vertical devolution share of states from 41% to 42% to address GST concerns.
  2. A new criterion titled “Contribution to GDP” has been introduced in the horizontal devolution formula.
  3. The Commission has recommended the discontinuation of Revenue Deficit Grants (RDGs) for states.

Which of the statements given above is/are correct?

(a) 1 only

(b) 2 and 3 only

(c) 3 only

(d) 1, 2 and 3

Correct Answer: (b)

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