HIGHLIGHTS OF THE 16TH FINANCE COMMISSION RECOMMENDATIONS

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Context

The Government accepted the 16th Finance Commission's recommendation to keep the states' share of central taxes at 41% for the five-year period from April 1, 2026, to March 31, 2031.

What is Finance Commission?

It is a constitutional body established under Article 280 of the Constitution to define the financial relationship between the central and state governments.

Objectives: Recommend how tax revenues should be shared between the Centre and States. 

Structure and Appointment

• Constituted by the President every five years (or earlier if needed).
• Composed of a Chairman and four members with relevant expertise.
• Recommendations are advisory. 

Key Functions

The Commission advises the President of India on: 

• The distribution of tax proceeds between the Union and States, and among the States.
• Distribution of tax revenues between the Centre and the states (Vertical Devolution) and among the states themselves (Horizontal Devolution).
• The principles for providing grants-in-aid to States from the Consolidated Fund of India.
• Measures to support local bodies (Panchayats and Municipalities) by augmenting a State's Consolidated Fund.
• Other matters referred by the President concerning sound financial management, like disaster management financing. 
• 

16th Finance Commission (2026–2031)

• Chairman: Dr. Arvind Panagariya.
• The report, tabled on February 1, 2026, recommended maintaining the States' share in central taxes at 41%.
• The devolution formula for 2026–31 considers factors such as Income Distance, Population, Demographic Performance, Area, Forest, and Contribution to GDP. 

Key Recommendation 1: Vertical Devolution

The 16th FC recommended keeping the states' share of the central divisible tax pool at 41%, maintaining the 15th FC's status quo.

• Reason for Continuity: Share decreased from the 14th FC's recommended 42% to 41% after Jammu & Kashmir's reorganization into two Union Territories, as the Centre now directly meets their financial needs.
• Centre's Stance: Central government retains substantial revenue because of major spending on defence, internal security, and large infrastructure projects.
• Analytical Point: Though 41% suggests stability, the actual fund flow to states is affected by the size of the "divisible pool," which excludes revenue from cesses and surcharges.

Key Recommendation 2: Horizontal Devolution

The 16th FC reformed the distribution criteria to address the historical grievance of Southern states, balancing need-based support with rewarding economic efficiency and population control efforts

Shift in Devolution Criteria: Rewarding Efficiency

The Commission introduced a new criterion, "State’s Contribution to GDP," and adjusted the weights of other parameters, shifting the formula to a hybrid "Need + Efficiency" model from a purely "Need-based" one.

Impact of New Formula

• State Gain:
• The combined share of Southern states has increased from 15.8% to 17%.
• Industrial powerhouses like Gujarat and Maharashtra also benefit due to their high contribution to the national GDP.
• State Lose: States like Uttar Pradesh, Bihar, Madhya Pradesh, and Rajasthan have seen a relative decline in their share.

Major Recommendations on Fiscal Reforms

The 16th FC has proposed strict measures to improve the fiscal health of states, aligning with concerns raised by the Economic Survey and the RBI. 

End Off-Budget Borrowings

• Problem: States often use their Public Sector Enterprises (PSEs) to borrow from the market, bypassing the borrowing limits set under Article 293(3). This hides their true fiscal deficit.
• Recommendation: All such borrowings must be stopped. State borrowing must be transparent and included within the budget.

Rationalize Subsidies with Sunset Clauses

• Problem: Un-targeted subsidies or "freebies" strain state finances, as highlighted by the RBI Report on State Finances.
• Recommendation: The FC advocates for introducing "Sunset Clauses" for subsidy schemes, ensuring they have a fixed end date and are not continued indefinitely.

Conclusion

The 16th Finance Commission has achieved a balancing act by rewarding economic efficiency, addressing Southern states' concerns, and maintaining fiscal support for states with greater needs.

Source: INDIANEXPRESS