Thank the Finance Commission for a tax-sharing formula tilt that promotes better state-level fiscal policy

The 16th FC’s report covers four broad areas—namely, revenue-deficit grants, local-body grants, disaster-management funds and public finances—apart from the two main aspects of horizontal and vertical devolution; the latter refers to the binary split-up of taxes between the Union and states taken together.

The report poses five questions. One, how should the share of states be allocated among 28 states over the award period of 2026-27 to 2030-31? Two, what principles should govern grants-in-aid to top up state revenues and how much should be given? Three, how to supplement the resources of states for third-tier governance? Four, what should be done to finance disaster-relief initiatives? And five, how can public finances be put on a sound footing?

To its credit, the 16th FC has tried to combine gradualism with ‘directional change.’ It has kept the vertical devolution to states at 41% of the tax pool, ensuring continuity, but tweaked the horizontal formula by rewarding states that have contributed more to economic growth.

This addresses a key grouse of relatively prosperous states that they get too little in return for their role in expanding the economy and filling tax coffers. It also sends a signal to poorer states that they must get their acts together.

This division among states has long been based on a set of criteria with each criterion assigned a weight. Population had a major weight, which gave more populous states a resource edge over those with better records on social indices. The 16th FC correctly argues that given India’s growth imperative, we should tilt the criteria slightly towards efficiency.

So its formula includes the share of a state’s gross state domestic product (GSDP) in GDP. The rationale is that this captures the effect of various efficiencies, including efficient spending and fiscal prudence.

The 16th FC takes the same approach to grants-in-aids; it breaks with the past by doing away with revenue-deficit grants altogether. By and large, earlier FCs favoured ‘gap-filling’: the gap between the funds a state was capable of raising on its own and what it needed for the delivery of public services would be estimated and plugged.

The 16th FC recognizes that such grants have not led to policies that reduce revenue deficits, but have instead created perverse incentives. The expectation of such grants has resulted in persistent deficits arising from profligacy, with states seeing little need to address the causes of their revenue shortage.

As for local-body grants, the 16th FC has sought to incentivize speedier urbanization on the logic that this acts as a catalyst for faster economic growth. On disaster management, it has not broken new ground, opting instead to carry forward the work of the 15th FC on the rationale that we need more time to see how these arrangements are working.

On public finances, the report would have the country improve its fiscal management overall, ensure the long-term stability of power distribution companies, rationalize subsidies, restrain the expansion of subsidy regimes and make public-sector enterprises more efficient and competitive. It is hard to quarrel with any of that. What makes the report stand out, however, is its directional change on horizontal devolution.