6 minute read 4 Apr 2024
Economy watch March 2024

Key challenges facing the Sixteenth Finance Commission

By D. K. Srivastava

EY India Chief Policy Advisor

A noted economist, D.K. Srivastava is an Honorary Professor at Madras School of Economics and Member of the Advisory Council to the 15th Finance Commission.

6 minute read 4 Apr 2024
Related topics Tax

Show resources

The Sixteenth Finance Commission (FC16) will need to address five critical imbalances in the Indian economy.

In brief

  • FC16 was constituted on 31 December 2023 and is currently deliberating on its Terms of Reference (ToR).
  • The Commission would submit its recommendations by 31 October 2025, covering a period of five years commencing 1 April 2026.
  • Five imbalances that need resolution relate to the vertical, horizontal, fiscal, demographic, and environmental dimensions.

From a growing vertical imbalance to the increasing disparity in per capita income across states, FC16 faces multiple challenges while providing its recommendations. Concerns regarding fiscal sustainability, state-differentiated demographics, and environmental costs borne by resource-rich states underscore the multifaceted nature of the task at hand.

In the backdrop of these contemporary realities, this article explores the various dimensions of imbalances that require resolution by FC16 to ensure that transfers to states are determined in an efficient and equitable manner. 

Vertical imbalance: Heavy reliance of Government of India (GoI) on cesses and surcharges

Vertical imbalance, as provided by constitutional design, provides relatively larger resources to the GoI and relatively larger responsibilities to the states. To address this imbalance, fiscal transfers from the GoI to states are made through tax devolution and grants.   

Chart 1 shows three distinct phases in the trends in tax devolution. In Phase 1, the pre-devolution vertical imbalance was resolved, after devolution, into a continuing but lower imbalance in favor of the GoI. In Phase 2, there is a long period of stability reflecting a post-devolution balance between GoI and states. In Phase 3, beginning FY2011, that is the first year of FC13’s recommendation period, the post-devolution imbalance favored states. This trend accentuated after FC14’s recommendations. After a trough of 41.3% in FY2019, the GoI attempted to recover some of the lost fiscal space by increasing its reliance on non-sharable cesses and surcharges otherwise meant for limited and temporary use. 

Chart 1: Post-devolution shares of GoI and states in combined revenue receipts (%)

Considering tax devolution and grants together (Chart 2), there is a long phase of a stable pattern where on average, states accessed 62% of combined revenue receipts and the GoI accessed 38% (Phase B). This was disturbed FY2011 onwards (Phase C). 

Chart 2: Post-transfer shares of GoI and states in combined revenue receipts (%)

Horizontal imbalance: Challenges of delivering equalization

The well-established principle for resolving horizontal imbalance consistent with equity and efficiency, as practiced by major federal countries, is called fiscal capacity equalization. The underlying idea is that fiscal transfers compensate for a deficiency in fiscal capacity, but not that in tax effort. In India, fiscal capacity equalization is delivered at least partially through the ‘distance criterion’. The distance criterion is supplemented by a number of other devolution criteria. 

The distance criterion involves a re-distribution from states with higher fiscal capacity to lower fiscal capacity. For lower per capita GSDP states, the distances from the benchmark and the relative population size have both increased, accompanied by a lowering of weight attached to the distance criterion. This implies larger redistribution to achieve the same degree of equalization.

After FC14’s recommendations, the GoI has shown reluctance to accept state specific and purpose specific grants that facilitated augmenting the extent of equalization or delivery of other welfare objectives by finer targeting. In this context, either the share of states in tax devolution may be reduced from 42% or 41% of the sharable pool or tax devolution framework should be modified to impart to it greater targeting capacity. There is a need to evolve the next generation of devolution criteria1.

Fiscal imbalance: Issues of debt and deficit sustainability

The FC16 has not been directly asked to examine the sustainability of debt and fiscal deficit for the GoI and the states. However, FC16 should and can consider this under the provisions of Articles 280 (d) making a reference to ‘interest of sound finance’ and under constitutional articles 292 and 293 dealing with central and state borrowing. Also, FC grants to states ‘in need of assistance’ as per article 275 (1), cannot be normatively determined until there is a normative determination of the interest payments and revenue expenditures of states. Thus, fiscal, vertical, and horizontal imbalances require to be jointly resolved. 

The issue of symmetry in fiscal deficit targets for the GoI and the states is linked to the way vertical transfers from the GoI to states have evolved. Here, it is important to compare the share of GoI in the combined revenue receipts after fiscal transfers with its share in the combined primary expenditures (Chart 3)

Chart 3: Share of GoI in combined primary expenditure and combined revenue receipts after transfers (%)

GoI’s share in combined primary expenditures has consistently been higher than its share in combined revenue receipts after transfers. This implies that on a systematic basis, GoI would need a higher share in combined primary deficit (and combined fiscal deficit). The 2018 amendment to the union government’s FRBM Act, however, provides for equal levels of fiscal deficit for the GoI and the states. 

Demographic imbalance: Accounting for state-differentiated profiles

The latest available Census figures in India still pertain to 2011, as the 2021 Census has not been conducted. The Ministry of Health and Family Welfare, however, provides state-wise population projections up to 2036. There are considerable differences in the way the size and age profiles of the state-wise population are expected to evolve. Consequently, the median age of different states also shows varying profiles.

For optimally utilizing the emerging patterns of the age profile of population across states, there is a need for increased allocation for education and health in states with higher young and old age dependency ratios, respectively. For the working age population, both health and educational services need to be equalized across states to avoid migration for seeking better standards for these services.

Environmental imbalance: Need for a more comprehensive coverage

Some aspects of ecological and environmental externalities have been captured through devolution criteria such as the forest criterion under which states with a higher share of forest area in all-India forest area receive higher share in tax devolution as compensation for the loss that they bear on behalf of other states for absorbing CO2 while bearing the opportunity cost of their area under forests. There are, however, some aspects where environmental costs are heavy and fiscal transfers do not take these into account. One example relates to the extraction of minerals, particularly coal. Pollution hazards and related costs are quite large for mineral rich states, whereas the benefits are shared across the country. Further, these coal and mineral rich states have a relatively larger share of tribal population requiring greater attention on their health and education indicators.

The Government of India is set for the general elections in 2024, and the current government is due to present their last budget on 1 February 2024, under the leadership of Hon’ble Finance Minister Nirmala Sitharaman.

Know more

Show resources


The Sixteenth Finance Commission has a chance to recast principles used to determine fiscal transfers such that it better reflects India’s present realities. The FC needs to jointly address imbalances in five inter-related dimensions.  

About this article

By D. K. Srivastava

EY India Chief Policy Advisor

A noted economist, D.K. Srivastava is an Honorary Professor at Madras School of Economics and Member of the Advisory Council to the 15th Finance Commission.

Related topics Tax