How Finance Commission becomes an anchor of fiscal discipline

• The distribution of Union taxes between the Centre and states (Vertical Devolution).
• The allocation of this share among States (horizontal). 
• The principles governing the grant-in-aid to states under Article 275.   

Article 270 provides the basis for sharing central taxes, while Article 275 allows the Union to support states that require additional resources. 

The Finance Commission was, therefore, designed as an impartial constitutional body. Its recommendations, presented to Parliament under article 281, influence how resources flow across states, how responsibilities are financed, and how the federal compact evolves. 

How has the Finance Commission evolved?  

Since its first meeting in 1951, the Finance Commission has shaped the fiscal balance of the Indian Union. But its role has evolved over time. In the early decades (1950s-1980s), the focus was on equalisation. The commission relied heavily on revenue deficit grants to ensure that states could meet basic expenditures. The approach was simple: If a state’s revenues fell short after tax devolution, the centre would bridge the gap.

By the 1990s, the approach began to change. The Finance Commission moved from gap-filling to normative assessments, estimating what state finances should look like under reasonable fiscal effort. The 2000s saw the emergence of the fiscal responsibility framework to encourage discipline. During this phase, the Finance Commission became an anchor of fiscal discipline, encouraging states to manage deficits and debt more prudently. 

A major shift came with the 14th Finance Commission (2015-20). It raised the share of states in the divisible pool of central taxes and duties from 32 per cent to 42 per cent, thereby expanding fiscal autonomy. But the 15th Finance Commission (2021-26) revised the share to 41 per cent following the reorganisation of Jammu and Kashmir, and the 16th Finance Commission (2026-31) retained it. 

Hence, the role of the Finance Commission evolved from bridging revenue gaps to shaping a more rule-based fiscal federalism, where transfers are linked to incentives, discipline, and accountability. 

Vertical devolution: stability or constraint?

The issue of fiscal imbalance has persisted in India. The centre controls the more buoyant sources of revenues – income tax, corporate tax, and a large share of Goods and Services Tax (GST) – while states shoulder much of the spending. The Finance Commission bridges this gap by recommending how Union taxes are shared. It does not distribute revenue but shapes the working of fiscal federalism. 

The Finance Commission decides how the Union tax revenues are shared with states – a process known as vertical devolution. As mentioned earlier, the 16th Finance Commission retains the states’ share in the divisible pool of central taxes and duties at 41 per cent. 

However, this share is applied to the divisible pool only, and not to the centre’s entire tax revenues. After excluding cesses and surcharges, which are not shared with states, the divisible pool constituted about 81 per cent of the centre’s gross tax revenue in 2025-26. This means that even with a stable 41 per cent devolution, the effective fiscal space available to states depends on how the centre raises its revenue. 

Many states have been demanding to increase their share to 45-50 per cent and put a limit on cesses and surcharges. But the Finance Commission declined these demands. The headline number therefore remains unchanged, but the underlying debate continues: is 41 per cent stability or a constraint in a shrinking pool? 

Horizontal devolution: Shifting incentives and equity

Once the share of Union taxes between Centre and states is fixed, the next step is horizontal devolution, deciding how this pool is divided among states. Traditionally, the guiding principle has been equity, with poorer states receiving large transfers to address regional disparities. 

The 16th Finance Commission retains this approach. Different factors are taken into account in horizontal devolution, including:

Income distance – It measures how far poorer states’ per capita income lags behind the richer states. The 16th Finance Commission has assigned this factor 42.5 per cent weight in order to promote fiscal equity. 

Population (2011) – It accounts for 17.5 per cent.

Demography performance, area, and forest cover – Each receives 10 per cent weight. 

Contribution to Gross Domestic Product (GDP) – A new element in the formula, which has been assigned 10 per cent weight.

The addition of the contribution to GDP seeks to recognise the role of the economically stronger states in generating national output. The formula, therefore, attempts a balance: supporting poorer states, while also rewarding economic performance. 

Table 1: Criteria for Horizontal Devolution of Central Taxes

Grants-in-aid: From support to conditional transfers 

The third important component of the Finance Commission’s recommendations is grants-in-aid to states. The previous commissions often used revenue deficit grants to bridge the gap between a state’s income and expenditure. The 16th Finance Commission departs from this approach and has discontinued such grants. 

Instead, it recommends about 9.47 crore in grants over five years, of which 7.91 lakh crore is allocated to rural and urban local bodies. These transfers are divided into 80 per cent basic grants and 20 per cent performance-linked grants. Their release depends on conditions such as audited accounts and the functioning of State Finance Commissions. 

The shift suggests a change in emphasis. Transfers continue, but they are now linked to institute performance and fiscal discipline rather than simple revenue support. 

Table 2: Grants-in-Aid 15th vs 16th Finance Commission

Emphasis on fiscal discipline

The Finance Commission places strong emphasis on fiscal discipline. In recent times, several states relied on off-budget borrowings through public agencies to finance spending, while formally keeping deficits within limits. The Finance Commission recommends that such borrowings be disclosed and incorporated into state budgets to strengthen transparency in public finances. 

This concern is tied to India’s broader debt trajectory. The combined debt of the Central and state governments is about 77.3 per cent of the total economy (GDP) in 2026-27. If fiscal consolidation targets are followed, the goal is to bring that down to 73.1 per cent by 2030-31.

To support this path, the Commission reiterates that states should keep their fiscal deficit within 3 per cent of Gross State Domestic Product (GSDP), while the Centre should reduce its deficit to 3.5 per cent by the end of the award period. 

Table 3: Fiscal Targets Recommended by the 16th Finance Commission

Thus, the 16th Finance Commission keeps the cooperative federalism structure intact. Yet, several changes signal a shift in approach, such as the removal of revenue deficit grants, the introduction of GDP contribution, deficit limits, and greater conditionality in transfers. This raises an important question: Does this framework encourage responsible finances or limit the fiscal autonomy of states?

Post read questions

How does the Finance Commission act as an anchor of fiscal discipline in India’s federal system? Explain.

Explain the concepts of vertical and horizontal devolution. How do they shape fiscal relations between the Union and the states?

Discuss how the recommendations of recent Finance Commissions attempt to balance fiscal discipline with the fiscal autonomy of states.

Income distance remains the most important criterion in horizontal devolution. Discuss its significance in addressing regional disparities.

(Pushpendra Singh is an Assistant Professor of Economics at Somaiya Vidyavihar University, Mumbai, and Archana Singh is an Assistant Professor of Gender and Economics at the International Institute for Population Sciences, Mumbai.)

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