States that had sought a higher share of the Union government’s divisible pool of tax revenue are likely to be disappointed when the Sixteenth Finance Commission tables its recommendations for the next five financial years.
The commission—a constitutional body set up to recommend the distribution of tax revenues between the Centre and states from 1 April 2026 to 31 March 2031—is expected to recommend retaining states’ share at 41%, two people said.
However, even at 41%, the amount of tax revenue devolved to states by the Central government every year is expected to go up in absolute terms depending on nominal GDP growth and tax buoyancy.
Arvind Panagariya, chairman of the Sixteenth Finance Commission, said last week that at least 22-23 of India’s 28 states had made a case for increasing their share in the divisible pool of tax collections from 41% to 50%.
The Sixteenth Finance Commission is not keen to deviate much from the Fifteenth Finance Commission’s recommendations that were accepted by the government, said the first of the two people mentioned above. “There is a fair chance to go with 41% for vertical devolution,” said the second person. Both of them spoke on condition of not being named.
The Sixteenth Finance Commission has to navigate a tight balance between managing the expectations of states and the Centre’s need for stepping up defence spending and sustaining capital expenditure.
“Centre’s fund requirements are also rising, including for defence,” said a third person who is privy to the Central government’s submissions before the Sixteenth Finance Commission (SFC), also speaking on condition of anonymity.
“However, every one is accustomed with the existing formula of 41% for devolution of central tax revenue with states. If the SFC proposes to retain 41% devolution to states plus or minus a small variation, it should be in the interest of everyone,” this person said.
While the commission has till October to submit its recommendations to the government, its report is likely to be ready by September, said the first person mentioned above.
The Union finance ministry and the Sixteenth Finance Commission did not reply to queries emailed on Wednesday.
‘Too large a jump’
Panagariya, chairman of the Sixteenth Finance Commission that was set up on 31 December 2023, said after meeting Uttar Pradesh officials in Lucknow last week, that while the commission hadn’t made a decision yet he could speculate that the states’ share would not be 50% because “it is too large a jump” and that “such a large jump upsets too many carts”.
The erstwhile Fifteenth Finance Commission under chairman N.K. Singh had recommended that states be given 41% of the divisible tax pool during 2020-21 and the five years from 2021-22 to 2025-26. That was one percentage point lower than the level recommended by the Fourteenth Finance Commission chaired by former Reserve Bank of India governor Y.V. Reddy, to adjust for Jammu and Kashmir, which had become a union territory by then.
In addition to the tax revenue shared by the Centre, states mobilise revenue via state goods and services tax, taxes on auto-fuel, stamp duty on property transactions, state excise duty on liquor, taxes and levies on automobiles, and royalty on minerals.
For states to raise their revenue resources, some out-of-the-box thinking may be needed, said N.R. Bhanumurthy, director, Madras School of Economics.
“State governments levying income tax, a suggestion recently made by Dr. Rangarajan, has the potential for adding a new revenue stream to states,” Bhanumurthy said.
“Revenue position of states in the last few years got a major fillip on account of both the sharply higher devolution from the Centre as well as on account of the robust goods and services tax revenue buoyancy. Strong GST revenue collection growth increases states’ own state GST receipts as well as the transfers from Centre’s divisible pool,” he added.
When it comes to resource management, one key area for states to pay attention is the efficiency of their expenditure, added Bhanumurthy.
The divisible pool of the Centre’s tax revenue includes direct and indirect taxes, but does not include cess collected for various specific purposes.
The fund allocation conundrum
Finance commission recommendations have often been controversial as some states including Kerala and Tamil Nadu have questioned the way in which the total available share to states are apportioned.
While finance commissions seek to achieve equity and income re-distribution through its fund allocation formula to benefit states that have large populations and lag behind those with better per capita income, the southern states, which have performed better in population control and some of the social indicators, believe they are not adequately rewarded.
The Fifteenth Finance Commission sought to address this concern by adding ‘demographic performance’ as a factor in deciding the formula for sharing funds among states.
Not including the Centre’s revenue collection from the cess levied for various purposes in the tax revenue shared with the states has also been a source of grievance for states.
On 7 June, the Union government appointed RBI deputy governor T. Rabi Sankar as a part-time member of the 16th Finance Commission after former finance secretary Ajay Narayan Jha resigned on personal grounds.
Retired bureaucrat Annie George Mathew and economist Manoj Panda are full-time members of the 16th Finance Commission. Soumya Kanti Ghosh, group chief economic advisor at the State Bank of India and a member of Prime Minister Narendra Modi’s economic advisory council, is a part-time member.
