On February 1, while presenting the Budget for FY27 in the Lok Sabha, Finance Minister Nirmala Sitharaman also tabled the 16th Finance Commission report which determines the tax revenue devolution between the Centre and states for the five-year period of FY27 to FY31. She said the government has accepted the 16th Commission’s recommendations, retaining a 41% tax devolution share for states while emphasising fiscal discipline, prompting a change from entitlement-based fund transfers to performance- and compliance-driven fiscal federalism.
The 16th Finance Commission, chaired by Arvind Panagariya, illustrates both continuity and contestation in India’s fiscal federal trajectory. While it retained the states’ share in the divisible pool, it recalibrated the ‘horizontal formula’ by increasing the weight of population based on the 2011 census and introducing contribution to national GDP as a new parameter. These changes have intensified debates around the North–South divide, demographic justice, and the appropriate balance between need-based equalisation and recognition of economic performance.
Constitutional origins
The Finance Commission of India is a constitutionally entrenched institution that lies at the heart of the country’s fiscal federal architecture. Established under Article 280 of the Constitution, it is mandated to be constituted every five years (or earlier if required) to recommend the distribution of Union tax revenues between the Centre and the states and the principles governing grants-in-aid. The framers of the Constitution treated intergovernmental fiscal transfers not as a matter of executive discretion but as a constitutional necessity for sustaining the federal balance. Unlike federations where transfers evolve through political bargaining, India constitutionalised the transfer mechanism to ensure regularity, predictability, and relative insulation from day-to-day political pressures (Rao and Singh 2005). The First Finance Commission, constituted in 1951 under K C Neogy, inaugurated a quinquennial process of fiscal adjudication that has since become a defining feature of Indian federalism.
India’s fiscal constitution carries strong colonial legacies, particularly from the Government of India Act, 1935, which had centralised major taxation powers. Personal income tax, levied and collected by the Centre, was envisaged as the principal instrument to correct vertical fiscal imbalances between the Union and the provinces. While colonial commissions such as the Otto Neimeyer Commission had proposed fixed provincial shares in income tax, the Constituent Assembly consciously rejected rigid formulas. Instead, it opted for a dynamic and adaptive mechanism through periodically constituted Finance Commissions. Three foundational debates shaped this choice: the tension between central authority and state autonomy; the choice between permanent tax assignment and flexible tax sharing; and the preference for expert, quasi-judicial adjudication over political determination of transfers (Austin 1999).
Divisible pool
The institutional design of fiscal federalism is anchored in the distinction between the Consolidated Fund of India and the Central Divisible Pool. Article 266 establishes the Consolidated Fund as the repository of all Union revenues, including tax receipts, non-tax revenues such as dividends from public sector enterprises, licence fees, and interest receipts, as well as all loans raised by the Union government. Parliamentary authorisation is required for any expenditure from this fund, reinforcing legislative oversight over public finance.
However, the Constitution deliberately distinguishes between revenues that merely accrue to the Consolidated Fund and those that are mandatorily shareable with states. The Central Divisible Pool, defined under Article 270, consists of that portion of Union tax revenues that must be devolved to states based on Finance Commission recommendations.
Initially, only personal income tax and certain Union excise duties were included in the divisible pool. This narrow scope generated persistent state grievances, as buoyant taxes such as corporation tax and customs duties remained outside the sharing arrangement. A decisive shift occurred with the Eightieth Constitutional Amendment in 2000,
implemented following the recommendations of the Tenth Finance Commission. This amendment replaced tax-by-tax sharing with the principle that all Union taxes and duties would form part of the divisible pool, except cesses and surcharges. Operationalised in the early 2000s, this reform significantly strengthened fiscal federalism by expanding the resource base available for devolution.
Devolution process – vertical and horizontal
The devolution process operates in two sequential stages. In the first stage, the total divisible pool is determined and split between the Union and the states as a collective—this is vertical devolution. The percentage share assigned to states reflects the extent of vertical fiscal imbalance arising from the mismatch between the Centre’s revenue-raising powers and the states’ expenditure responsibilities. In the second stage, the states’ aggregate share is distributed among individual states through horizontal devolution, using a formula that incorporates multiple parameters such as income distance, population, area, forest and ecological cover, demographic performance, and indicators of fiscal effort or economic contribution. Each parameter is assigned a weight, and a state’s share is calculated according to its relative position across these criteria.
The outcomes of horizontal devolution across recent Finance Commissions are illustrated in Table 1, which presents the state-wise shares in central taxes under the Fourteenth, Fifteenth, and Sixteenth Finance Commissions. The table highlights both continuity and recalibration: large, lower-income states such as Uttar Pradesh and Bihar continue to receive substantial shares, while shifts in weights and parameters have led to marginal redistributions among middle- and higher-income states.
What’s not shared
Despite the expansion of the divisible pool, Article 270 explicitly excludes cesses and surcharges from sharing. While revenues from these levies accrue to the Consolidated Fund of India, they are not devolved to states. Over the past two decades, the growing reliance of the Union government on cesses and surcharges has generated significant constitutional and political controversy. Scholars argue that this practice enables fiscal centralisation by expanding Union revenues outside the sharing framework, thereby weakening state finances, particularly in the post-GST period (Rao 2020; Chakraborty 2021).
Expanding scope
The evolution of horizontal devolution criteria over time reflects changing conceptions of equity, need, and performance. Early Finance Commissions relied overwhelmingly on population and discretionary assessments of need. From the late 1980s onwards, income distance became the dominant equalisation parameter, while additional criteria such as area, fiscal discipline, tax effort, demographic performance, forest and ecological cover, and more recently contribution to national GDP were progressively incorporated. This evolution is summarised in Table 2, which traces the changing weights and parameters across successive Finance Commissions.
Overall, the Finance Commission remains the central constitutional instrument through which India negotiates the competing imperatives of equity, efficiency, autonomy, and macroeconomic stability.
The commission’s evolving design reflects not only technical adjustments but also deeper political and normative debates about the nature of Indian federalism in a context of demographic divergence, economic restructuring, and increasing fiscal centralisation.