The Finance Commission, an institutional innovation embedded in India’s constitutional architecture, was never intended to be a routine allocator of funds. It was designed as a central pillar of India’s fiscal federal compact and as a corrective institution that would mediate the inherent asymmetry between a fiscally dominant Union and structurally constrained States, while also addressing deep horizontal inequalities arising from history, geography, and institutional capacity. In a country marked by uneven development at Independence, the Commission’s central mandate was to safeguard the interests of the States and thereby preserve a strong Union.
Each successive Commission, cognisant of its historical context, has interpreted this mandate in its own way, yet all have contributed to sustaining India’s fiscal federal compact. The recently submitted report of the 16th Finance Commission (FC-16), chaired by Arvind Panagariya and covering the period 2026-31, marks a decisive turning point. While it retains the vertical devolution of central taxes to the States at 41%, it fundamentally re-engineers the structure of fiscal transfers, particularly grants-in-aid. In doing so, it prioritises efficiency and performance but raises serious concerns about equity and constitutional intent. At the heart of the issue lies a deeper question: has the Commission moved away from its equalising role toward one that implicitly protects the Union’s fiscal primacy?
The constitutional logic of grants-in-aid
Evidently, the provision for grants-in-aid under Article 275 was not an afterthought; it was a foundational design element. In a country more diverse than any other in the world, tax devolution, however sophisticated its formula, cannot account for the diversity of State-specific needs. For instance, Kerala’s “export-oriented” human capital development strategy has accounted for nearly 23% of India’s total remittances, thereby strengthening the country’s external sector. However, this has come at a cost to the State’s fiscal health, as it has had to rely on borrowing to finance investments in education.
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Similarly, Punjab has played a critical role in ensuring national food security, but at the cost of its revenue base, by focusing on the production of wheat and rice, which are non-taxable apart from paying the price of being a border State. The same is true of the hill States, which face high infrastructure costs; the north-eastern States, which grapple with connectivity constraints; and fiscally stressed States burdened by demographic pressures and social sector commitments.
Grants-in-aid were therefore conceived as instruments of equalisation, enabling targeted support for States with special needs where formula-based tax devolution falls short. The F-14 and the FC-15 recognised this reality by retaining Revenue Deficit Grants (RDGs), sector-specific grants, and State-specific grants.
The FC-16 departs sharply from this tradition. It recommends grants-in-aid of ₹9.47 lakh crore, compared with ₹10.1 lakh crore under the FC-15, while their share in total Finance Commission transfers has more than halved, from 19.4% to 8.3%. By restricting grants-in-aid to local bodies and disaster management, it eliminates RDGs, sector-specific grants, and State-specific grants.
While retaining the States’ share in the divisible pool at 41%, despite the demand from 18 States to raise it to 50%, the Commission presumes that improved fiscal discipline should enable States to manage their finances without additional gap-filling transfers. However, this reasoning rests on a problematic assumption: that fiscal capacity across States is sufficiently uniform for devolution to be self-equalising.
Empirically and historically, this assumption is untenable. The Commission’s justification for doing away with RDGs is rooted in concerns about fiscal prudence. It argues that RDGs create moral hazard by incentivising States to underperform in revenue mobilisation or overspend in the expectation of central support.
It also points to aggregate data suggesting that the States, taken as a whole, are not in severe fiscal distress. Yet, this aggregate view masks deep inter-State disparities, with some States remaining fiscally stressed despite contributing disproportionately to national development and continuing to require fiscal assistance. The very purpose of RDGs was to recognise this heterogeneity, as a fiscal surplus in one State cannot offset a fiscal deficit in another.
More troubling is the contrast between the Commission’s stance on RDGs and its treatment of cesses and surcharges. While advocating fiscal discipline for States through the withdrawal of RDGs, it stops short of recommending any binding rollback of these non-shareable union levies ignoring the demand by many States.
Dual shift
Instead, it proposes a “grand bargain”, whereby the Centre would gradually merge cesses into the divisible pool in exchange for States accepting a lower devolution share. This asymmetry is difficult to overlook. RDGs are removed in the name of discipline, yet cesses — arguably a more distortionary instrument from a federal perspective — are only gently nudged toward reform. The resulting framework imposes stringency on States while preserving fiscal flexibility for the Union. This dual shift, protecting Union revenues while constraining State support, raises a fundamental concern: is the Commission inadvertently reinforcing vertical imbalance rather than correcting it?
The consequences are particularly severe for States that already face structural disadvantages. As many as eight States, including most of the disadvantaged north-eastern States and fiscally stressed West Bengal, are set to experience a reduced share in both tax devolution and grants-in-aid, while another six States have seen a decline in their share of grants. The problem is further compounded by the reduction in the weight assigned to income distance (from 45% to 42.5%) and the introduction of a 10% weight for contribution to GDP. When combined with the removal of the RDGs, which accounted for about 20% of Finance Commission grants in 2024-25, this creates a double burden: lower tax devolution and the absence of compensatory grants. The Commission’s implicit assumption that efficiency should trump equity risks widening regional disparities.
Another defining feature of the FC-16 is its emphasis on tied and performance-based grants, particularly for local governments. While the allocation of nearly ₹7.2 lakh crore to the third tier is commendable, the conditionalities attached to these grants are stringent, linking the release of funds to targets in water and sanitation, revenue mobilisation, and audited accounts. This approach promotes accountability, but it also reduces fiscal autonomy. In effect, the architecture of grants shifts from need-based equalisation to compliance-based incentivisation. Fiscal discipline, while necessary, cannot substitute for fiscal justice.
Efficiency versus equity
The FC-16’s report is bold in ambition but uneven in balance. The dismantling of the RDGs and the shift toward performance-based transfers reflect a technocratic confidence in market-like incentives, even though fiscal federalism is a political and constitutional arrangement designed to manage diversity. The contrast between the Commission’s strict stance on RDGs and its accommodative approach to cesses and surcharges, along with its hesitation to raise the States’ share in the divisible pool to 50% despite demands from several States, reveals a deeper tension.
It suggests a framework that, intentionally or otherwise, protects the fiscal space of the Union while placing a greater adjustment burden on the States. In doing so, the Commission may have moved away from its core mandate of acting as an equalising force within the federation. If the Finance Commission is to continue playing its historic role in holding India together, future Commissions must reward high-performing States while supporting those that continue to face structural disadvantages.
For a country as diverse as India, fiscal federalism cannot be sustained on performance alone; it must be anchored in fairness.
K.J. Joseph is Director, Gulati Institute of Finance and Taxation, Thiruvananthapuram, Kerala; Sumalatha B.S. is Assistant Professor, Gulati Institute of Finance and Taxation, Thiruvananthapuram, Kerala. The views expressed are personal
