16th Finance Panel Likely to Come up with a New Formula for Centre-State Sharing of Tax Revenues

The Southern States have been raising their voices on the formula worked out by the 15th Finance Commission that the allocation of funds should be based on the population index. The greater the index, the higher will be the fund flow. The 16th Finance Commission will have to look into this issue with much-needed importance, writes Sutanuka Ghosal.

Kolkata:The 16th Finance Commission will have to tread cautiously over the allocation of Central funds to the states as a debate has already surfaced over whether the allocation of Central funds should be based on the population index of the state. The NK Singh-led 15th Finance Commission had said that the higher the population of a state as per the latest census, the higher the amount of funds it will get from the Central government for its spending needs. This has irked the southern states where the population growth has not been at par with states like Uttar Pradesh or Bihar.

The Centre has just formed the 16th Finance Commission led by Niti Aayog Vice-Chairman and Columbia University Professor Arvind Panagariya as the Chairman and has set October 2025 as the deadline for the Commission to submit its recommendations, so that they can be incorporated in the Budget exercise for 2026-27. The Finance Commission usually takes about two years to consult stakeholders in the States and Centre and arrive at their conclusions.

What is a Finance Commission

The Finance Commission is a constitutional body for the allocation of certain revenue resources between the Union and the State governments. It was established under Article 280 of the Indian Constitution by the President. It was created to define the financial relations between the Centre and the States. It was formed in 1951.

Lower devolutions to states

The debate over lower devolutions to states, especially due to the Centre’s higher reliance on cesses is not new. But, with general elections slated in April, or May 2024, the renewed intensity of this debate is significant.

At the heart of the devolution dispute lies two major issues. First, the devolution given to States has been significantly lower in the last few years compared to the recommended levels of the 15th Finance Commission.

Secondly, the share of devolution for the less populous and fiscally stronger Southern States tends to be lower, while few northern states, which are weaker on these metrics, get a larger share of Central taxes. Tax devolution refers to the distribution of net proceeds of Union taxes and duties by the Centre to the States. The allocated funds help the States to carry out spending on development, welfare and priority-sector projects and schemes.

At present, as per the recommendation of the 15th Finance Commission, 41 per cent of the divisible tax pool of the Centre is transferred to States in 14 instalments annually covering the five years of 2021-22 to 2025-26.

In FY25, the Union government has budgeted to share 35.5 per cent of the divisible tax pool (gross tax revenues net of cess and surcharges (excluding GST compensation cess) and taxes of Union territories) with States, lower than the suggested 41 per cent.

The Reserve Bank of India in its latest edition of State finances:A Study of Budgets of 2023-24 released on December 11, 2023, highlighted the same. “Due to increasing in cesses and surcharges, the divisible pool has shrunk from 88.6 per cent of gross tax revenue in 2011-12 to 78.9 per cent in 2021-22 despite the 10-percentage point increase in tax devolution recommended by the 15th Finance Panel.”

The Central Bank suggested that since the actual tax devolution hinges critically on the cesses and surcharges levied by the Centre, the States need to augment their fiscal capacity and reduce dependence on transfers.

North India Vs South India
The Southern States had raised their voices even before 2020, when the 15th Finance Commission submitted its report using the 2011 population census to decide the devolution of taxes from the Central government to the States, with a separate factor to reward some for controlling their population.

This was a shift from the previous commission, which used a combination of the 1971 and 2011 censuses as macro-indicators in the equalisation formula, with a much higher weight being given to the former. This was done to reward states that have effectively controlled population growth.

The NK Singh-led Commission's pivot to the 2011 census entirely, as one of the criteria for deciding the pattern of devolution, was done to be more responsive to existing population levels.

This means that the higher the population of a state as per the latest census, the higher the amount of funds it will get from the Central government for its spending needs. Therefore, the less populous States in the country stand to lose from the divisible pool of revenues.

This is where the North and South divide debate makes an entry. North Indian states like Uttar Pradesh and Bihar whose population has expanded rapidly since 1971 naturally get a relatively larger share of funds, thanks to the shift by the erstwhile 15th Finance Panel.

For instance, the population of the northern state of Uttar Pradesh, grew at the rate of over 20 per cent in the period between 2001 and 2011, while the southern state of Karnataka saw an increase of 15.60 per cent during the same period.

The situation would be different if the Finance Commissions still used part of the 1971 census as a criterion since both these states had a lower gap in the rate of increase in population with Uttar Pradesh seeing a rise of over 25 per cent between 1971-1981 while Karnataka witnessing an increase of over 26 per cent.

Tamil Nadu’s population grew by over 15 per cent between 2001 and 2011, whereas Bihar saw a much larger increase of over 25 per cent.

The statement showing the state-wise distribution of net proceeds of Union taxes and duties as per the Budget estimates for 2024-25 seemingly makes the impact of this divergence in population apparent. All five Southern states – Andhra Pradesh, Karnataka, Tamil Nadu, Telangana, and Kerala will be getting 15.8 per cent as a share of the total allocated amount for devolution for the next fiscal, while the northern states of Bihar and Uttar Pradesh alone account for nearly 28 per cent.

Though the specific details of this proposal are not available yet, one must separately note that in the Budget for 2024-25, the Centre announced the move to form a high-powered committee for "an extensive consideration of the challenges arising from fast population growth and demographic changes". It is not known if this would have an impact on the metrics used by finance commissions.

What makes matters even more complicated is that as admitted by the 15th Finance Commission in its report, most of the lower per capita income states are also more populous.

Therefore, many of the southern states that perform better on this metric would get a lower share compared to states with lower per capita income. This is a result of the income distance criteria, another metric used by the Finance Commission to decide on the pattern of devolution among states.

Since two of the indicators deciding the sharing pattern are population and the development parameter of a State compared to the national average, the states that rank higher on population and lower on development would predominantly get a larger share in devolutions.

This has led to allegations by some Southern States over the past few years that by getting a smaller share of tax revenues, they are getting penalised rather than being rewarded for effectively controlling the population.

In the current financial year, the Central government has released Rs 8.20 lakh crore of shareable proceeds in 12 instalments to the states till January 2024 against the Budget target of Rs 10.21 lakh crore, which has now been increased to Rs 11.04 lakh crore as per revised projections for FY24. For the next fiscal, the devolution of States’ share has been enhanced to Rs 12.20 lakh crore, which is 3.7 per cent of the GDP.

What adds to the misery of states is the nature of the Goods and Services Tax (GST). Some States alleged that the control they have over their own revenues has been reducing, with the rollout of the GST in July 2017 further lowering their ability to tinker with tax rates and increase revenues.

The way ahead
A senior bureaucrat, who did not want to be named, said that the Centre has little role to play in this, given that the Finance Commission is an independent entity.

“This demand has been coming for a while, so the 16th Finance Commission may look into it,” he said. The ball therefore clearly lies in the court of the newly constituted 16th Finance Commission. Since States are responsible for over 60 per cent of general government expenditure, lower than the recommended share of States in Central taxes coupled with cess and surcharges will remain an important issue before the 16th Finance Commission.

It seems that Arvind Panagariya has a tough task ahead as he steers the panel that will decide the new formula for sharing tax revenues between the Centre and States for five years starting April 1, 2026.