Finance Minister Nirmala Sitharaman | Photo Credit: MOORTHY RV

Finance Minister Nirmala Sitharaman announced on Sunday that the Centre has accepted the 16th Finance Commission’s recommendation to maintain the vertical devolution at 41 per cent. This tax-sharing formula will span five years from April 1, 2026, to March 31, 2031, preserving the fiscal continuity established during the previous five-year cycle

“As recommended by the Commission, I have provided ₹1.4 lakh crore to the States for the FY 2026-27 as Finance Commission Grants. These include Rural and Urban Local Body and Disaster Management Grants,” Sitharaman said in her budget speech. The Commission submitted its report last November, and its recommendations on devolution are binding on the government.

Grand bargain

In its report, the Commission noted that the evolving global security landscape necessitates a significant increase in defence capital expenditure. Furthermore, it acknowledged the Union’s success in infrastructure development, a priority that requires sustained financial backing. Given these pressures, the Commission recognised that its primary lever for bolstering the Union’s fiscal capacity is through the calibration of the divisible pool share

“With cesses and surcharges having cut the size of the divisible pool from 89.1 per cent of GTR in 2014‑15 to a 74‑80 per cent range during the first four years of the FC‑15 award period for which actuals are available, there is no room for cutting the States’ share in it,” it said.

The Commission proposed a 'grand bargain' to create a more efficient, broad-based tax system. Under this arrangement, the Union would integrate a significant portion of its cess and surcharge revenue into the basic tax rate. In exchange, the States would accept a smaller percentage share of this now-expanded divisible pool, ensuring that total revenue remains stable for both parties.

According to DK Srivastava of EY India, the 16th Finance Commission has maintained the 15th FC’s criteria for distributing funds among States, but with a twist. A new weightage has been introduced to reward states based on their individual contributions to GDP, balancing traditional needs with economic performance. “This factor is meant to reward states that have given a higher per capita GSDP contribution to overall GDP. The FC16 has dropped, recommending revenue deficit grants altogether,” he said.

GDP overestimate

There is an overestimation of nominal GDP growth in the base year of 2025-26, as a figure of ₹364.2 lakh crore was used vis-à-vis NSO’s First Advance Estimate at ₹357.1 lakh crore. This difference in the base year is likely to be carried forward in the projection years. Using only the tax devolution formula for the horizontal allocation implies undue reliance on these broad-based criteria for targeting and reflecting state-specific needs and differences in cost conditions.

“The main losing states in their tax devolution dispensation are Madhya Pradesh, Arunachal Pradesh, Uttar Pradesh, West Bengal, Odisha, Meghalaya, Chhattisgarh, Bihar, Nagaland, Manipur and Tamil Nadu,” Srivastava said.

Published on February 1, 2026