# Fiscal Federalism & the 16th Finance Commission: 41% Devolution, New Formula, Local Body & Disaster Grants (UPSC) Source: https://tracknation.in/story/fiscal-federalism-the-16th-finance-commission-41-devolution-new-formula-local-body-disaster-grants-upsc (TrackNation — free UPSC notes with PYQs) > Centre–State financial relations and the Finance Commission for UPSC — Arts 270, 275, 280, 281, 293, vertical vs horizontal imbalance, past devolution shares, and the 16th Finance Commission (chair Arvind Panagariya, 2026-31): 41% vertical share retained, the new horizontal formula (income distance 42.5%, contribution to GDP 10%), no revenue-deficit grants, ₹7.91 lakh crore local-body grants, ₹2.04 lakh crore disaster corpus and fiscal ceilings of 3% of GSDP and 3.5% of GDP — with practice quest ## Centre–State Finances and the Finance Commission 🎯 **Exam priority: High-yield.** *The 16th Finance Commission's report (November 2025) governs 2026-31 and is the freshest source of exam facts: the vertical share, the new horizontal formula, local-body and disaster grants, and the fiscal ceilings. The 2025 paper asked 15th-FC details; expect the 16th next.* India is a union of States that share one tax base. Every five years a constitutional body decides how the pie is cut — and every State argues about it. ## Centre–State financial relations - The Constitution (Part XII, Arts 268–293) allocates **taxing powers** — the Union gets income tax (non-agricultural), corporation tax, customs; States get land, agricultural income, alcohol, electricity sales; **GST** is concurrent (Art 246A) — but States' spending needs (health, education, police) exceed their own revenues. This **vertical imbalance** is closed by transfers; **horizontal imbalance** (rich vs poor States) is closed by the formula. - **Transfers:** (i) **tax devolution** — a share of the Union's net tax proceeds (**Art 270**); (ii) **grants-in-aid** to needy States (**Art 275**) and for local bodies/disaster relief; (iii) **Centrally Sponsored Schemes** (Centre and State share costs) and Central Sector schemes; (iv) loans — e.g., the **Special Assistance to States for Capital Investment (SASCI)** that incentivises State capital spending (States kept capex at about 2.4% of GDP in FY25). - **Borrowing:** Art 293 — States may borrow within India but need the Centre's consent while owing it a loan (293(3)); States' fiscal responsibility laws and net-borrowing ceilings (a percentage of GSDP) apply. ## The Finance Commission - **Article 280:** the President constitutes a Finance Commission **every five years** (or earlier) — a chairman and four members. It recommends the **distribution of net tax proceeds between Centre and States (vertical)** and among States (horizontal), the principles of **grants-in-aid**, measures to supplement State funds for **Panchayats and Municipalities** (based on State Finance Commissions, Arts 243I/243Y) and any other matter referred to it. - Its recommendations are **advisory**; the Government lays them before Parliament with an **explanatory memorandum on action taken (Art 281)**. In practice Governments have accepted the tax-devolution recommendations almost entirely. - **Past vertical shares:** 10th FC 29%, 11th 29.5%, 12th 30.5%, 13th 32%, **14th 42%** (a big jump), **15th 41%** (42% less 1% for the new Union Territories of J&K and Ladakh). The 15th FC (chair N.K. Singh) covered 2021-22 to 2025-26; its horizontal criteria were income distance 45%, population (2011) 15%, area 15%, demographic performance 12.5%, forest and ecology 10% and tax and fiscal effort 2.5%. ## The 15th Finance Commission and Federal Fiscal Institutions To read the 16th FC properly you need its predecessor and the other bodies that shape Centre–State money. ## The 15th Finance Commission (2021-26) at a glance | **Feature** | **15th FC** | | Chair; period | N.K. Singh; 2021-22 to 2025-26 | | Vertical share | **41%** (42% less 1% for the UTs of J&K and Ladakh) | | Horizontal formula | Income distance 45%, population (2011) 15%, area 15%, demographic performance 12.5%, forest & ecology 10%, **tax and fiscal effort 2.5%** | | Performance-based incentives | **₹4,800 crore** (2022-23 to 2025-26) to incentivise States to improve educational outcomes; **₹45,000 crore** as performance-based incentive for States carrying out agricultural reforms; sector-specific grants such as health | | Why UPSC asked it (2025) | Which of the statements are correct? — grants for education outcomes ✔; 41% (*not* 45%) ✔; ₹45,000 crore agricultural-reform incentive ✔; tax-effort criterion ✔. The distractor was '45 per cent of net proceeds to be shared with States'. | ## Other institutions of fiscal federalism - **GST Council** (Art 279A) — a federal body where the Centre has one-third and States two-thirds of the weighted vote. - **NITI Aayog** (2015) replaced the **Planning Commission** — it advises rather than allocates funds; the earlier Plan/non-Plan transfers ended and **Gadgil–Mukherjee-style plan assistance** was replaced by Finance Commission transfers and CSS. - **Inter-State Council** (Art 263) and **Zonal Councils** (States Reorganisation Act 1956) — consultative forums for Centre–State and inter-State issues; **State Finance Commissions** (Arts 243I and 243Y) recommend how the State shares revenue with Panchayats and Municipalities. - **Cesses and surcharges** are excluded from the divisible pool; as their share of gross tax revenue grows, States' effective share of Union revenue falls below 41% — a standing demand of States for the 16th FC era. **Centrally Sponsored Schemes** require State matching contributions, which squeezes State budgets; the 16th FC recommends rationalising them. ## The 16th Finance Commission: Constitution, Vertical Share and the New Formula The 16th Finance Commission is the first to work with a post-GST economy and a debt anchor. ## The 16th FC: who, when - **Constituted on 31 December 2023** with **Dr. Arvind Panagariya** (former NITI Aayog Vice-Chairman) as **Chairman**; members included Annie George Mathew, Manoj Panda, Soumya Kanti Ghosh and T. Rabi Sankar (Ajay Narayan Jha served until April 2025). The report was **submitted to the President on 17 November 2025** and covers **2026-27 to 2030-31**; the Government laid it with the explanatory memorandum on 1 February 2026. ## Tax devolution — vertical and horizontal - **Vertical:** the Commission **retained the States' share at 41%** of the divisible pool; the Government accepted it and also accepted that the Union should disclose the divisible pool figures **as certified by the CAG under Article 279** to make the devolution transparent. - **Horizontal (inter se) formula:** | **Criterion** | **16th FC weight** | **15th FC weight** | | **Per-capita GSDP distance** (equity — poorer States get more) | **42.5%** | 45% (income distance) | | Population (2011) | 17.5% | 15% | | Demographic performance (inverse population growth 1971–2011; replaces TFR) | 10% | 12.5% | | Area (State's minimum share cut from 2% to 1.5%) | 10% | 15% | | Forest (small reward for increase in weighted forest area) | 10% | 10% (forest and ecology) | | **Contribution to GDP** (new — rewards growth) | **10%** | — (the 15th had 2.5% tax and fiscal effort instead) | - The Commission says the reward for low population growth should be **phased out over time** ("India may grow old before it grows rich"), so it cut its weight. **State shares** (selected): **Uttar Pradesh 17.619%**, Bihar 9.948%, Madhya Pradesh 7.347%, West Bengal 7.215%, Maharashtra 6.441%, Rajasthan 5.926%, Karnataka 4.131%, Tamil Nadu 4.097%, Telangana 2.174%, **Kerala 2.382%**. ## Grants, Disaster Funds and Fiscal Ceilings Beyond tax devolution the Commission redesigned grants and set fiscal ceilings. ## Grants and funds - **No revenue-deficit grants** and no sector-specific or State-specific grants (the first Commission to recommend none at all of the latter) — the Commission found "significant scope" for States to raise revenues and rationalise spending. - **Local bodies:** ₹**7,91,493 crore** for rural and urban local bodies over 2026-31, split 60:40 between rural and urban (basic + performance components); inside each, **80% basic and 20% performance** (the performance half shared between local bodies and the State). Urban grants add a **special infrastructure component of ₹56,100 crore** for wastewater management in growth centres and an **urbanisation premium of ₹10,000 crore** to reward rural-to-urban transition (merging peri-urban villages into larger ULBs). Rural grants are distributed 90:10 by rural population and area; urban 90:10 by urban population and own-source revenue. Half of the basic grant is **tied** to sanitation/solid-waste and water management; untied money cannot pay salaries and no more than 20% can go on roads. Entry conditions: duly constituted bodies, publicly available accounts, and a regular State Finance Commission with an action-taken report in the Legislature within six months. - **Disaster management:** a total corpus of **₹2,04,401 crore** for the State Disaster Response Fund (₹1,63,521 crore) and the State Disaster Mitigation Fund (₹40,880 crore) — an 80:20 split — with the **Union share ₹1,55,915.85 crore** and the States' share ₹48,485.15 crore (cost-sharing **75:25** for non-North-Eastern/Hilly States and **90:10** for North-Eastern and Hilly States); ₹79,406 crore for the national funds NDRF and NDMF. Disaster grants from 2027-28 require complete data feeding in the NDMIS portal. - The Union Budget 2026-27 provides **₹1.4 lakh crore** to States as Finance Commission grants (local body and disaster grants) and total transfers of ₹25.44 lakh crore. ## Path to fiscal stability - **States' fiscal deficit capped at 3% of GSDP** (excluding loans under SASCI), to be "strictly enforced" under **Art 293(3)**; **off-budget borrowings must stop** and be brought on the Budget with a reporting format; State fiscal responsibility laws should be made uniform. - The **Union should bring its fiscal deficit down to 3.5% of GDP by the end of the award period** (FY31). The Government accepted the State net-borrowing ceilings in principle and will examine the other fiscal recommendations (and those on Centrally Sponsored Scheme rationalisation, power-sector reform, subsidies and PSE reform) separately. ## Why this matters for UPSC - Typical tests: the 41% share (and what the 14th/15th gave); which Article creates the FC (280) and requires the memorandum (281); the grants provisions (275); the new criteria (contribution to GDP; no tax-effort criterion); and the fiscal limits (3% GSDP / 3.5% GDP). Distractors: "45% to States", "revenue-deficit grants recommended", "tax effort re-introduced" — all *not* the 16th FC. ## Further Reading - NCERT Economics textbooks (Class 11–12), the Economic Survey, the Union Budget documents and RBI publications cited in this note — the primary sources behind every figure above. ## Test Yourself: Practice Questions & PYQs Ten practice questions on the Finance Commission mechanism and the 16th FC's recommendations, followed by real UPSC questions on fiscal federalism. ## Practice Questions **Q1.** Consider the following statements about the Sixteenth Finance Commission: 1. It was chaired by Dr. Arvind Panagariya. 2. It retained the States' share in the divisible pool of Union taxes at 41 per cent. 3. It recommended revenue deficit grants to States. Which of the statements given above are correct? - (a) 1 and 3 only - (b) 2 and 3 only - (c) 1, 2 and 3 - (d) 1 and 2 only **Answer: (d)** — It did not recommend revenue deficit grants (nor any sector- or State-specific grants), so 3 is wrong. **Q2.** The period covered by the recommendations of the Sixteenth Finance Commission is - (a) 2025-26 to 2029-30 - (b) 2026-27 to 2030-31 - (c) 2021-22 to 2025-26 - (d) 2027-28 to 2031-32 **Answer: (b)** — Its report covers the five years commencing 1 April 2026. **Q3.** Which Article of the Constitution requires that the recommendations of the Finance Commission be laid before Parliament with an explanatory memorandum on action taken? - (a) Article 281 - (b) Article 275 - (c) Article 270 - (d) Article 280 **Answer: (a)** — Art 280 constitutes the FC; Art 281 requires the memorandum; Art 270 deals with the distribution of taxes; Art 275 with grants-in-aid. **Q4.** Which of the following is a criterion used by the Sixteenth Finance Commission for horizontal devolution? - (a) Poverty ratio - (b) Tax effort - (c) Fiscal discipline - (d) Contribution of the State to GDP **Answer: (d)** — The 16th FC introduced 'contribution to GDP' (10%) and gave per-capita-GSDP distance the largest weight (42.5%); it dropped the 15th FC's tax-effort criterion. **Q5.** Statement-I: The Finance Commission is a constitutional body whose recommendations are binding on the Union Government. Statement-II: The Union Government lays the Commission's report before Parliament with an explanatory memorandum. Which one of the following is correct in respect of the above statements? - (a) Statement-I is not correct but Statement-II is correct - (b) Both Statement-I and Statement-II are correct and Statement-II explains Statement-I - (c) Both Statement-I and Statement-II are correct but Statement-II does not explain Statement-I - (d) Statement-I is correct but Statement-II is not correct **Answer: (a)** — The recommendations are advisory, not binding; the Government is only required to table them with an action-taken memorandum. **Q6.** According to the Sixteenth Finance Commission, the fiscal deficit of States should be capped at - (a) 3 per cent of GSDP - (b) 2 per cent of GSDP - (c) 3.5 per cent of GSDP - (d) 4 per cent of GSDP **Answer: (a)** — States: 3% of GSDP (excluding SASCI loans); Union: 3.5% of GDP by the end of the award period. **Q7.** The 15th Finance Commission fixed the States' share of the divisible pool at - (a) 41 per cent - (b) 45 per cent - (c) 42 per cent - (d) 32 per cent **Answer: (a)** — 41% (the 14th FC had given 42%, then 1% was set aside for the new UTs of J&K and Ladakh). **Q8.** Under the 16th Finance Commission's local-body grants, which of the following is correct? - (a) No conditions are attached to the grants - (b) The basic and performance components are in the ratio 80:20 - (c) The grants are split 80 per cent performance and 20 per cent basic - (d) Untied grants may be used to pay staff salaries **Answer: (b)** — 80% basic, 20% performance; untied grants cannot be used for salaries and entry-level conditions apply. **Q9.** Which of the following is a reason why States depend on Union transfers? - (a) Vertical fiscal imbalance — States' expenditure responsibilities exceed their own revenue capacity - (b) The Union has no expenditure responsibilities - (c) Article 265 - (d) States have no power to borrow **Answer: (a)** — Vertical imbalance is closed by tax devolution, grants and schemes; horizontal imbalance by the inter se formula. **Q10.** The Union Budget 2026-27 provides Finance Commission grants to States of about - (a) ₹14,000 crore - (b) ₹1.4 lakh crore - (c) ₹14 lakh crore - (d) ₹25 lakh crore **Answer: (b)** — ₹1.4 lakh crore for FY27 (local body and disaster management grants); total transfers to States are ₹25.44 lakh crore. ### UPSC Previous Year Questions (PYQs) *Real UPSC Prelims questions, checked against the official paper and answer key.* **Q1.** (2023) Consider the following: 1. Demographic performance 2. Forest and ecology 3. Governance reforms 4. Stable government 5. Tax and fiscal efforts For the horizontal tax devolution, the Fifteenth Finance Commission used how many of the above as crite- ria other than population area and income distance? - (a) Only four - (b) Only three - (c) Only two - (d) All five **Answer: (b)** — The 15th FC used demographic performance, forest and ecology and tax-and-fiscal effort in addition to population, area and income distance — three of the five. Governance reforms and 'stable government' were not criteria. **Q2.** (2025) Which of the following statements with regard to recommendations of the 15th Finance Commission of India are correct? I. It has recommended grants of ₹4,800 crores from the year 2022–23 to the year 2025–26 for incentivizing States to enhance educational outcomes. II. 45% of the net proceeds of Union taxes are to be shared with States. III. ₹45,000 crores are to be kept as performance-based incentive for all States for carrying out agricultural reforms. IV. It reintroduced tax effort criteria to reward fiscal performance. Select the correct answer using the code given below. - (a) I, II and III - (b) I, II and IV - (c) II, III and IV - (d) I, III and IV **Answer: (d)** — The 15th FC recommended ₹4,800 crore for education outcomes (I ✔), ₹45,000 crore for agricultural-reform incentives (III ✔) and a tax-effort criterion (IV ✔). The States' share was 41%, not 45% (II ✗). ### Mains Practice Questions Use these to frame full-length answers. You don't have to answer one exactly — they show the angles UPSC tests, so let them guide which points you cover. - Explain the role of the Finance Commission in India's fiscal federalism. How are its recommendations given effect? - Discuss the horizontal devolution formula of the Sixteenth Finance Commission and the controversy over demographic performance and income distance. - Examine the 16th Finance Commission's recommendations on local body grants, disaster financing and fiscal ceilings for States. - 'Vertical imbalance is solved by devolution; horizontal imbalance by the formula.' Explain with reference to Indian federalism. ### UPSC Mains — Previous Years’ Questions on this topic (last 10 years) These are the **actual GS Mains questions** UPSC has asked on this theme — real proof of how, and when, it is tested. Try to write a full answer to each. - 2025 (GS-II): Examine the evolving pattern of Centre-State financial relations in the context of planned development in India. How far have the recent reforms impacted the fiscal federalism in India? - 2025 (GS-III): Explain how the Fiscal Health Index (FHI) can be used as a tool for assessing the fiscal performance of states in India. In what way would it encourage the states to adopt prudent and sustainable fiscal policies? - 2024 (GS-II): What changes has the Union Government recently introduced in the domain of Centre-State relations? Suggest measures to be adopted to build the trust between the Centre and the States and for strengthening federalism. - 2021 (GS-II): How have the recommendations of the 14th Finance Commission of India enabled the States to improve their fiscal position? - 2020 (GS-III): Explain the rationale behind the Goods and Services Tax (Compensation to States) Act of 2017. How has COVID-19 impacted the GST compensation fund and created new federal tensions? - 2018 (GS-II): How is the Finance Commission of India constituted? What do you know about the terms of reference of the recently constituted Finance Commission? Discuss.