The 16th Finance Commission has initiated a paradigm shift in Indian fiscal federalism, pivoting toward a framework that incentivises states to deploy financial resources with greater strategic foresight. This shift is most evident in the introduction of a new parameter: contribution to GDP, assigned a weight of 10 percent. The demographic performance metric also underwent a critical recalibration.
These structural adjustments resulted in a redistribution of the divisible pool, bolstering the horizontal shares of southern states. Specifically, Kerala’s share rose from 1.9 percent to 2.4 percent, while Karnataka’s rose from 3.6 percent to 4.1 percent.
For Karnataka, which relies heavily on internal revenue to anchor its annual budget, this may represent a victory. However, for Kerala, the situation is far more nuanced. While the state’s horizontal share was raised, it lost the revenue deficit grant of over ₹37,000 crore that was available during the 15th FC period. The new state government, scheduled to take office in May 2026, must navigate a fiscal landscape increasingly constrained by central diktats and global volatility.
Inequity begins with vertical devolution between the Centre and the states. While the central government distributes tax revenue based on Finance Commission recommendations, it has increasingly turned to the imposition of cesses and surcharges, which do not have to be shared with the states.
During the 15th FC, states should have received ₹12.2 lakh crore annually; in reality, they received only ₹9.5 lakh crore, reducing their share to less than 33 percent as against 41 percent recommended. The share of cesses surged from 11.4 percent in 2015-16 to 25 percent in 2020-21, with projections remaining near 17 percent for fiscal 2025-26. The Union finance minister stoutly defended this consolidation in March 2026.
The ethical and legal justification for such an expansion of non-divisible levies remains contentious. The Comptroller and Auditor General released a review in 2025 revealing that, since the mid-1970s, approximately ₹3.69 lakh crore collected via cesses had never been transferred to dedicated reserve funds.
In his paper, ‘The Great India Cesspool: Funds and the Fiscal Deficit Shell Game’, P Sesh Kumar, former director general of audit at the CAG, noted that the short transfer of these funds allows the Union to suppress its reported revenue deficit artificially. This practice presents a sanitised version of national finances—a manoeuvre Kumar likened to a household neglecting its bills to boast about its savings. Such findings suggest national fiscal deficit figures have been repeatedly obfuscated by whittling down the states’ share.
Centrally-sponsored schemes introduce further structural friction. Under the current regime, states are mandated to bear 40 percent of the costs of most schemes, yet they have little agency in designing them. Because central schemes are designed with a one-size-fits-all rigidity, states like Kerala often find them ill-suited to their unique demographics.
Furthermore, the Centre’s share is released through a digital just-in-time mechanism, meaning funds are disbursed only once existing balances are fully depleted. This lack of liquidity contributed to Kerala’s share of total central disbursements falling to 1.8 percent during 2024-25, even though the state’s population share is 2.8 percent.
Adding to these pressures is the Finance Commission’s adoption of the Union’s stance on state borrowing. The commission has recommended a limit of 3 percent of the state’s GDP, a ceiling that encompasses off-budget borrowings—a policy currently under litigation in the Supreme Court.
This restriction directly cripples the Kerala Infrastructure Investment Fund Board. Originally conceptualised as a self-sustaining vehicle for developmental borrowing, KIIFB transitioned to an entity that receives earmarked budgetary resources spent at the discretion of its board, often bypassing budget and plan provisions. While I do not advocate fiscal profligacy—Kerala’s debt-to-GSDP ratio has ballooned to 38.2 percent—the Centre’s insistence on state-level discipline lacks moral authority, given its own fiscal deficit reached 4.4 percent in 2025-26 and is projected at 4.3 percent for 2026-27.
Excluding non-tax revenue from the divisible pool further tilts the scales. The Centre derives 18-20 percent of its revenue from dividends issued by the RBI, Sebi and public sector undertakings. While Kerala reports that 8-10 percent of its revenue is non-tax, this figure is a statistical illusion. Much of this comprises gross lottery ticket sales; once payouts and administrative overheads are deducted, the net contribution to the exchequer is marginal.
Consequently, Kerala finds itself caught in a tightening fiscal vise. Committed expenditures—salaries, pensions and interest payments—now consume over 70 percent of the state’s total revenue. The current trajectory suggests that the new pay commissions in the Centre and the state may further increase the burden on the state. Compounding the crisis is the rupee’s precipitous depreciation. This currency volatility implies that the state’s external debt of more than ₹10,000 crore must now be serviced at costs 10 percent higher than when the obligations were originally incurred. Deprived of the revenue deficit grant, Kerala has emerged as a net loser. The silver lining is the state’s growing GSDP, which promises more revenue if effectively harnessed.
The administration taking power in May will inherit a profound financial quagmire. While manifestos are replete with populist guarantees, the reality is that it remains easier to spend than to earn. The government’s inaugural task must be to create an unvarnished, transparent map of the state’s finances as Telangana did in 2023. This assessment must account for global geopolitical risks and potential economic disruption.
Success will require the courage to take unpopular decisions: rationalising user charges, addressing public-sector losses, restructuring establishment expenditure and plugging leakages in social spending. This strategic clarity is essential for achieving sustainable long-term growth and maintaining macroeconomic stability in an era of unprecedented fiscal centralisation. It is also necessary for all the ‘single-engine’ states to band together and raise their collective voice against the growing arrogation of resources by the Centre and the inequities in distribution, a can of worms left unopened by the Finance Commission.
K M Chandrasekhar | Former Cabinet Secretary and author of As Good as My Word: A Memoir
(Views are personal)
(kmchandrasekhar@gmail.com)