By Dr. Asit Ranjan Mohanty,
Professor in Finance XIMB,
XIM University
Bhubaneswar: The 16th Finance Commission has maintained the vertical tax devolution share at 41 percent for the five-year period starting April 1, 2026. This continues the precedent set by the 15th Finance Commission, which adjusted the share from 42 percent to account for the transition of Jammu and Kashmir and Ladakh into Union Territories. While the vertical split remains stable, the commission has introduced significant changes to the horizontal devolution formula, which dictates how the divisible pool is distributed among individual states.
The updated formula includes several key weighting adjustments. The weight assigned to population has increased from 15 percent to 17.5 percent, which benefits more populous states and supports the delivery of urban services and infrastructure. Conversely, the weight for demographic performance has been lowered from 12.5 percent to 10 percent. This change reduces the emphasis on rewarding states for lower fertility rates, acknowledging current labor and consumption needs over historical demographic trends.
The weight for income distance has been reduced from 45 percent to 42.5 percent. By redefining the benchmark against the per-capita income of top-performing states, the commission aims to narrow extreme equalization and allow economically stronger states to retain more resources for growth. Meanwhile, the weights for area and forest and ecology remain at 15 percent and 10 percent respectively, ensuring continued support for states with structural or environmental disadvantages.
A notable exclusion in the new framework is the tax and fiscal effort parameter, which previously held a 2.5 percent weight and has now been dropped to zero. This shift suggests a move away from rewarding revenue mobilization in isolation. In its place, the commission has introduced a 10 percent weight for contribution to Gross State Domestic Product. This is a major structural change intended to reward states that drive national economic output and capital formation.
This revised architecture reflects a move toward performance-augmented federalism. By combining traditional equity measures with growth incentives, the framework encourages states to invest in digital public goods and productivity-enhancing sectors. However, several concerns persist regarding these shifts. The emphasis on GSDP contribution could widen regional disparities by favoring advanced states, while the removal of the fiscal effort weight might weaken sub-national fiscal discipline. Additionally, the reduced weight for demographic performance may lessen the focus on long-term investments in health and education.
There are also practical risks associated with the new model. High population and GSDP weights may disadvantage smaller or slower-urbanizing states. Furthermore, GSDP is sensitive to economic cycles, meaning states could face volatility in their transfers during downturns.
Current projections suggest that the horizontal shifts favour higher-population, growth-performing states like Karnataka (+0.48%), Kerala (+0.46%), and Gujarat (+0.28%), while Uttar Pradesh (-0.33%) and Bihar (-0.11%) see minor reductions; southern states gain overall.