The recommendations of the Sixteenth Finance Commission (SFC) for the period 2026-31, which have been accepted by the Union government, have raised serious concerns about the future of federal balance.
The changes in the horizontal criteria, discontinuation of statutory grants, and tacit approval to the shrinking of the divisible pool have tilted the scales toward greater central leverage through discretionary transfers. This shift has come at the expense of statutory equity, further compounded by the doubling of transfers to the third tier. In making these unprecedented changes, SFC has taken liberties with the constitutional framework, thereby weakening the statutory backbone of fiscal federalism in India.
Even though the SFC retained the share of states at 41 per cent, it has overseen a reduction in their effective share from around 36 per cent to around 32 per cent. Further, by tweaking the devolution formula, 14 states, mostly the smaller states, have got a lower share in taxes than in the previous commission. The share in tax devolution, for example, of all northeastern states is 15.5 per cent lower than under the Fifteenth FC. This could have a crippling effect on the region.
More damaging is the discontinuation of revenue deficit grants, which had been accruing to the fiscally weaker states. So too the sector-specific grants, and state-specific grants-in-aid. These grants under Article 275(1) have been an important part of all the previous commissions’ awards.
Based on the combined states’ revenue deficit of 0.3 per cent of GDP, the SFC has reasoned, rather erroneously, that gap-filling has been rendered unnecessary. Not only should needs be assessed individually for states and not by aggregation, the SFC has failed to take cognisance of the post-GST reality. The shift from a producer-oriented to a consumer-oriented tax regime has altered the revenue dynamics of states. The consuming or the destination states may no longer show revenue deficits of the same magnitude as earlier. But this in no way obviates, let alone eliminates, the needs for equalisation: Special area administration and tribal welfare have been explicitly spelt out in Article 275.
Instead of abolishing the revenue deficit grants, the SFC should have redesigned gap-filling as equalising grants by replacing the single deficit criterion with multiple criteria, including SC/ST population or rural consumption patterns. The Commission has also remained largely agnostic to GST Council dynamics, IGST settlement issues, and cost-of-collection variations, missing an opportunity to align horizontal distribution with the current consumption-based indirect tax regime.
In an era of GST interdependence and growing regional disparities, the Commission should have acted boldly — recommending caps or partial inclusion of cesses in the divisible pool, reimagining Article 275 for contemporary needs of consumption-based equalisation, and guiding GST-related adjustments.
Worse still, the SFC has used Article 282 to dramatically double the grants to the third tier — panchayats and urban local bodies. It has recommended nearly Rs 7.91 lakh crore (roughly Rs 4.4 lakh crore for rural and Rs 3.6 lakh crore for urban), with basic (80 per cent) and performance-linked (20 per cent) components, plus urbanisation incentives.
This compositional shift — from tax shares and Article 275 statutory grants towards Article 282 discretionary mechanisms and third-tier focus — has three problematic dimensions. First, the move from criteria-based entitled transfers to more condition-based discretionary ones. Second, from statutory predictable flows charged on the Consolidated Fund to non-statutory flows with hardly any accountability. Third, from equity-driven (based on need, backwardness, social welfare) to efficiency-oriented (based on performance, GDP contribution) criteria.
The SFC’s approach of treating grants under Article 275 and Article 282 as interchangeable ignores the constitutional purpose of the two provisions, which is fundamental and intentional. Article 275(1) offers a safety net for equity and provides a targeted, statutory mechanism for fiscal support to states in need. These grants are charged directly on the Consolidated Fund of India, ensuring accountability, predictability, and parliamentary oversight. The Constitution envisages assistance based on genuine need — including tribal welfare and special area administration, viewed as national responsibilities — rather than narrow post-devolution revenue deficits, a limited criterion introduced by the Third Finance Commission. The Constitution speaks of assistance based on need, not narrow accounting gaps.
In contrast, Article 282 grants are purely discretionary. Both the Union and states “may” make grants for any public purpose. They are drawn from revenues of India and lack the same statutory obligation, transparency, and charging mechanism.
By abolishing statutory grants under Article 275 and replacing them with discretionary funding — including for centrally sponsored schemes — the Commission has diverted resources that should strengthen the divisible pool or statutory grants towards Centre-led initiatives. This mirrors past practices that weakened the Gadgil formula and proliferated conditional schemes, long regarded as detrimental to fiscal federalism.
Also, the SFC has, contrary to the Constitution, made local bodies effectively another stakeholder, besides the states, in the scheme of vertical distribution. Consequently, the horizontal distribution has been bifurcated: Formula-driven tax devolution primarily for the second tier (states), with grants increasingly tailored for the third tier (local bodies). This move of treating the two levels at par doesn’t sit well with the basic structure of the Constitution.
States are fundamental constituent units of the Union of India with a direct constitutional status under Part VI of the Constitution. In contrast, local bodies (panchayats and municipalities) which gained constitutional recognition only through the 73rd and 74th amendments (1992), remain subordinate to the states. Their powers, functions, and finances are devolved by state legislatures, not directly granted by the Constitution. Local bodies as institutions of self-government promote decentralisation but operate but under state oversight with limited and derived autonomy. While strengthening local governance is welcome, equating or subordinating state-level needs with that of the third tier dilutes the federal compact. Promoting decentralisation should not be used as a pretext to harm federalism.
The writer is former finance minister of Jammu and Kashmir
Promoting decentralisation should not be used as a pretext to harm federalism. 
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