The Finance Commission (FC), constituted under the Constitution, determines the distribution of the Union’s gross tax revenues between Centre and States and among the States themselves to address vertical and horizontal fiscal imbalances. Following earlier commissions, the 16th FC has retained the vertical devolution share of 41% for the States and continued to emphasise equity as the guiding principle in determining horizontal transfers.

During consultations with the FC, States raised several concerns regarding the structure of fiscal transfers. Since cesses and surcharges exceeded 15% of gross tax revenues, they should either be included in the divisible pool or capped at around 8%-10%. In addition, the Centre receives substantial non-tax revenues from natural resource extraction, asset monetisation and surplus transfers from the Reserve Bank of India.

States and pressures

States also face mounting fiscal pressures. The COVID-19 pandemic, structural changes introduced by the Goods and Services Tax (and recent rate rationalisation from four rates to two principal rates), and mounting public debt further constrained their fiscal space. Moreover, the growing dominance of Centrally Sponsored Schemes has narrowed their fiscal autonomy (the restructuring of the National Rural Employment Guarantee programme requires States to bear 40% of programme costs), while buoyancy of central taxes has slowed. These factors could reduce the actual transfers to States, leading several States to demand a 50% vertical share.

Another concern is frequent changes in devolution criteria and their assigned weights across successive FCs in order to transfer more resources to fiscally weaker States, making it difficult for States to predict their future shares. Many States called for a reduced weight for the income-distance criterion and suggested adjusting it for purchasing-power differences to better reflect variations in the cost of living.

Over time, the shares of better-performing States have steadily declined compared with those of major beneficiary States. The combined shares of four major beneficiary States — Bihar (including Jharkhand), Madhya Pradesh (including Chhattisgarh), Uttar Pradesh (including Uttarakhand) and West Bengal — increased from 42.5% during the Sixth FC period to 51% under the 15th FC. In contrast, the combined share of the four southern States — Andhra Pradesh (including Telangana), Karnataka, Kerala and Tamil Nadu — declined from 24.8% to 15.8%, widening the gap to 35.2%. Continued reliance on unconditional equalisation transfers may weaken incentives for revenue mobilisation and fiscal discipline in weaker States. Moreover, rising transfers to poorer States have not eliminated disparities in public expenditure even on basic services. In 2022-23, Bihar spent ₹937 per person on health, against Arunachal Pradesh’s ₹10,148 (10.8 times lower), while Bihar’s per-student spending on elementary education in 2023-24 was ₹20,282 compared with Sikkim’s ₹1,30,498. These gaps show that fiscal transfers alone have not ensured convergence in public service delivery.

Recommendations of Finance Commission

The 16th FC accepted the Centre’s argument that cesses and surcharges cannot be shared because they often finance welfare and infrastructure programmes that indirectly benefit States and retained 41% vertical share. It also abolished revenue-deficit grants as well as sector-specific and State-specific grants and recommended that States discontinue off-budget borrowings, bring all liabilities onto their budgets and maintain fiscal deficits below 3%. These measures could increase short-term fiscal stress for States.

The FC made only modest adjustments to the criteria used by the 15th FC. Income distance received a weight of 42.5%; population 17.5%; area 10%; forest cover 10%; and the demographic criterion — modified by replacing the inverse fertility rate with population growth — 10%. It also introduced States’ contribution to national GDP, replacing tax effort, with a 10% weight. However, instead of using actual GSDP shares, the FC applied a square-root transformation to State GSDP shares, with a weight of just 10%, far below the expected 25%. This significantly reduced the advantage of economically stronger States and altered the rankings. Maharashtra’s actual GSDP share of 14.23% fell to 8.31% after the transformation, while Tamil Nadu’s declined from 9.09% to 6.67% and Karnataka’s from 8.95% to 6.59%. At the same time, the shares of many smaller States increased.

Consequently, overall devolution shares of 14 States rose marginally compared with the 15th FC. Karnataka gained the most (0.484 percentage point increase), followed by Kerala (0.457) and Gujarat (0.277). Tamil Nadu saw only a negligible rise, from 4.079% to 4.097%. Meanwhile, the shares of 14 States declined, with Madhya Pradesh experiencing the largest reduction (0.503 percentage points), followed by Arunachal Pradesh (0.403) and Uttar Pradesh (0.32).

From a longer-term perspective, however, disparities remain substantial. Under the 16th FC, the southern States’ share has risen slightly to about 17%, while the share of the largest beneficiary States has fallen to just under 50% — a shift of only about 1.2% in favour of the southern States. The balance between equity and efficiency has changed only marginally. Under the 15th FC, efficiency-related criteria accounted for 25% of the weight and equity criteria for 75%; under the 16th FC, this has shifted to 30% and 70%, respectively — an adjustment too small to significantly alter outcomes. Poorer States such as Uttar Pradesh (17.62%), Bihar (9.95%), Madhya Pradesh (7.35%) and West Bengal (7.22%) continue to receive larger shares than fiscally stronger and better-performing States.

Devolutions with alternative schemes

Alternative weighting schemes suggest that the outcomes could have been different. If the FC had assigned a 25% weight to the square root of GDP contribution while reducing the weight of income distance to 27.5%, Karnataka’s share would have increased from 4.131% to 4.928%, Maharashtra’s from 6.441% to 7.218%, and Tamil Nadu’s from 4.097% to 4.867%. Under an equal-weight scheme across the six criteria, their shares would have risen further to 5.544%, 7.845%, and 5.246%, respectively.

Had the FC used actual GSDP share (instead of square root formula) with 10% weight, the devolution shares of Maharashtra, Karnataka and Tamil Nadu would have increased to 7.033%, 4.367% and 4.342% respectively. With 25% weight (and 27.5% weight to income distance), they would have increased to 8.698%, 5.517% and 5.478%. With equal weighting scheme, their respective shares might have increased to 8.833%, 5.937% and 5.653%. That is, their respective shares increased by 2.392%, 1.806% and 1.556%.

Given that the 16th FC estimates total vertical transfers of ₹104 lakh crore over the award period, these differences are significant. A 2.392% increase in Maharashtra’s share would translate into an additional ₹2.49 lakh crore, or about ₹49,744 crore annually. Karnataka’s additional 1.806% share would yield about ₹1.88 lakh crore, or roughly ₹37,565 crore annually. Tamil Nadu’s 1.556% increase would amount to approximately ₹1.62 lakh crore, or ₹32,365 crore annually.

In India, unlike other large federations such as Australia and China, States with greater political influence in terms of parliamentary representation are not necessarily the economically stronger ones. Consequently, these States tend to receive higher fiscal transfers. The issue is likely to intensify after delimitation, as governments may have stronger incentives to favour politically influential States. Since the FC’s primary objective is to address both vertical and horizontal fiscal imbalances, future FCs should place greater emphasis on fiscal capacity and fiscal outcome indicators rather than relying predominantly on non-fiscal indicators. Additionally, they should adopt more data-driven approaches for assigning weights, such as the principal component analysis method.

K.R. Shanmugam is a former Director, Madras School of Economics, and Consultant to the Government of Tamil Nadu. The views expressed are personal