Five Fault Lines the 16th Finance Commission Can’t Ignore

Let the 16th Finance Commission recommend distribution of shareable pool of central taxes among states.

The Central government has grossly misused its authority of levying cesses and surcharges on central excise duties.

(Photo: Namita Chauhan/The Quint) 

The 16th Finance Commission, mandated to submit its report by 31 October 2025, has been given barebone terms of reference as listed in the Constitution—recommend share of states in central taxes; inter-se distribution amongst the states; grants-in-aid to states’ revenues; augmentation of states’ consolidated funds to meet the needs of local bodies; and any other matter in interest of ‘sound finance.’

The 16th Finance Commission has to figure out the matters of sound finance on its own.

Over the years, Finance Commissions have settled many key issues affecting Centre-state financial relations, such as expanding the pool of shareable taxes from income tax and excise duties to all central taxes, fixing a single rate (41 percent in the 16th Finance Commission) share in central taxes, and addressing states’ indebtedness.

There are five issues, in my opinion, which the 16th Finance Commission must deal with:

• Hemorrhage of states’ share in central taxes by cesses and surcharges

• Determination of states’ shares in central taxes on a long-term basis

• Equitable distribution of shareable pool amongst the states

• Restoration of borrowing sovereignty of states, and

• A stable arrangement for financing local bodies

How can and will it deal with any or all of these real issues?

Make Cesses and Surcharges Shareable

The Central government has the constitutional authority to levy cesses and surcharges on central taxes (except GST which has been entrusted to the GST Council) to meet exceptional needs for a temporary period.

However, the Central government has grossly misused its authority of levying cesses and surcharges on central excise duties. It has milked the excise duties through the cesses and surcharges to such an extent that less than 10 percent of it are currently shared with the states.

Prior to the 10th Finance Commission, there were allegations of the Central government neglecting income tax and making better use of corporation taxes as the latter was not shareable with states. The 10th Finance Commission made all central taxes shareable. This happy state continued until the Narendra Modi government, particularly, decided to use cesses and surcharges extensively on income taxes and customs duties.  

As a result, the share of states in gross central taxes fell by 3-4 percent of its gross taxable receipts (GTRs). The 16th Finance Commission must put a stop to this misuse by recommending a share in GTRs inclusive of cesses and surcharges.

It can meet current constitutional bar of cesses and surcharges not being shareable by making two recommendations:

• One, by asking the Central government to amend the Constitution to make all cesses and surcharges shareable (excluding those levied during war or external aggression, and for no more than a year after hostilities cease)

• Two, recommending a higher share for states—by 5–10 percent—until such an amendment is passed

Fix States’ Share at 40 percent

The 14th Finance Commission recommended 42 percent share of states in central pool of taxes (reduced to 41 percent by the 15th Finance Commission as Jammu and Kashmir was re-organised in two union territories), raising from 32 percent earlier.

Currently, UTs with legislatures—Delhi, Jammu and Kashmir, and Puducherry—don’t get a share in shareable pool and have to depend on the Centre’s discretion to get central grant funding.

This iniquitous arrangement can be ended by making UTs with legislatures eligible to receive a share in shareable central taxes.

Many states have demanded 50 percent share in central taxes, which seems excessive. A 40 percent share in GTR—including cesses and surcharges—would be a fair and sustainable long-term formula for the Centre as well as for the states and UT.

Ensure Fair and Equitable Distribution Among States

Finance Commissions have historically used various weights to determine inter-se state shares. The more a state’s per capita income is at a distance from the per capita income of the highest income state, the higher share it gets, multiplied by its population.

That explains why Bihar, Uttar Pradesh, and Odisha have been getting disproportionately larger shares in divisible pool. Despite such favourable allocation for last 75 years, however, these states have remained at the bottom of poverty line.

Another misplaced sympathy has favoured fiscally profligate states: Punjab, Andhra Pradesh, Kerala, and others who have been provided with substantial revenue deficit grants on the ground that their resources, after factoring in their recommended share in central taxes, were not sufficient to meet their expenditure needs.

It is time this misplaced munificence is done away with.

There are three good criteria for the 16th Finance Commission to take into consideration to recommend inter-se share of states:

• Population (right proxy for fiscal needs)

• Area and unfavourable terrain (right proxy for higher cost of delivering public services)

• Tax contribution in central pool (recognises the efficiency)

Let the 16th Finance Commission recommend distribution of shareable pool of central taxes among the states (including UTs with legislature), assigning 50 percent weight to population, 25 percent to area and unfavourable terrain (hills and desert), and 25 percent to tax contribution of states.

The ability to raise borrowings, without the Central government’s permission, is a very important attribute of states’ fiscal sovereignty.

Following the 12th Finance Commission recommendations, the Central government discontinued loan financing of states, including loan portion of central assistance to states’ plans and transferring bilateral and multilateral loans to states on back-to-back basis (on original terms).

As a consequence, major states were moving towards eliminating all outstanding loans to the Central government, freeing them from the requirement to take the Central government’s permission to raise loans. Introduction of interest free 50-year capital expenditure loans in 2020 by the Central government has put the clock back.

The 16th Finance Commission must recommend that the Central government stop the loan financing of states completely. In addition, it should also allow the states to make early repayment of all Central government loans at their discretion.

Many states could regain their borrowing sovereignty within a few years under such an arrangement.

Establish a Stable Mechanism for Local Body Financing

Ever since inclusion of this additional terms of reference in the Constitution in 1992, Finance Commissions have been struggling to come up with an appropriate solution to meet this obligation. 

It is time to use the simplicity and effectiveness of a single shareable rate from the central tax pool to provide adequate resources to local bodies.

The 15th Finance Commission can fix it between 1 percent and 2 percent of gross tax revenues of the Central government, and recommend its distribution among the local bodies using three factors—population, terrain difficulty, and the local bodies’ own tax revenue generation.

States should be required to transfer these funds to the local bodies within two weeks of receiving them from the Centre, without tying the money to specific schemes.

Will the 16th Finance Commission Bite the Bullet?

The 16th Finance Commission's composition does not inspire much confidence.

Chairperson Dr Arvind Panagariya and part-time member Soumya Kanti Ghose are overly sympathetic to the Central government.

Members Ajay Jha and Annie George, former expenditure department officials in the Modi government, are known to toe the Central government line of thinking. Only Manoj Panda’s preferences are not adequately predictable.

Whether the 16th Finance Commission acted impartially—and as an independent arbiter between the Central government and the states—will be seen from whether it makes any serious move with respect to any or all the five key issues outlined above.

Come October, we will know.

(Subhash Chandra Garg is the Chief Policy Advisor, SUBHANJALI, and Former Finance and Economic Affairs Secretary, Government of India. He's the author of many books, including 'The $10 Trillion Dream Dented, 'We Also Make Policy', and 'Explanation and Commentary on Budget 2025-26'. This is an opinion piece, and the views expressed above are the author’s own. The Quint neither endorses nor is responsible for the same.)