Legacy IAS
16th Finance Commission — Complete Analysis
Recommendations, Devolution, Reforms & Practice MCQs
© 2025 Legacy IAS, Bangalore — For Aspirant Use Only
01
What is the Finance Commission?Constitutional Provision & Core Functions
Finance Commission — Constitutional Basis
High Priority
Asked in Prelims repeatedly
PYQ: Art. 280, composition, functions
- Article 280 — President constitutes the Finance Commission every five years
- Composition: 1 Chairman + 4 Members (expertise in finance, economics, or public administration)
- Primary function: Recommend sharing of net central tax proceeds between Union and States (vertical devolution)
- Horizontal devolution: Decides criteria for distributing the states’ share among individual states
- Grants-in-Aid: Recommends grants to revenue-deficient states under Article 275
- Local bodies: Suggests measures to strengthen finances of Panchayats and Municipalities
- Fiscal discipline: Advises on expenditure control, debt management, and fiscal reforms
- Advisory role: Examines any financial matter referred by the President
Mind Map — Finance Commission Functions
Finance Commission (Art. 280)
Vertical Devolution (Centre → States)
Horizontal Devolution (Among States)
Grants-in-Aid (Art. 275)
Local Body Finances
Fiscal Consolidation
Advisory on Referrals
02
16th FC — Composition & MandatePeriod: 2026-27 to 2030-31
Key Fact: The 16th FC report was tabled in Parliament on 1 February 2026. It covers the five-year period from 2026-27 to 2030-31.
16th FC — Members
Medium Priority
- Chairman: Arvind Panagariya (former Vice-Chairman, NITI Aayog)
- Full-time Member: Ajay Narayan Jha — Former member, 15th FC; ex-Secretary, Expenditure
- Full-time Member: Annie George Mathew — Former Special Secretary, Expenditure
- Full-time Member: Dr. Niranjan Rajadhyaksha — Executive Director, Artha Global
- Part-time Member: Dr. Soumya Kanti Ghosh — Group Chief Economic Advisor, SBI
Core Thrust of the 16th FC
High Priority
Link: Budget 2026-27, Fiscal Federalism debates
- Clear shift towards performance, transparency & long-term fiscal sustainability
- Recommendations span: tax devolution, local body financing, disaster management, fiscal consolidation, power-sector reforms, subsidy rationalisation, PSE restructuring
- Aims to promote inter-state equity, fiscal discipline, and aligned developmental priorities
03
Tax Devolution & CriteriaStates’ Share & Distribution Formula
41%
States’ Share in Central Taxes
Same
As 15th FC (Unchanged)
6
Criteria for Horizontal Devolution
Vertical Devolution — 41% Share Retained
High Priority
PYQ: Divisible pool concept asked often
- The 16th FC retains states’ share at 41% of the divisible pool — unchanged from the 15th FC
- Divisible pool = Gross Tax Revenue − Cost of Collection − Cesses − Surcharges
- Covers Income Tax, GST (Centre’s share), and other central taxes
Horizontal Devolution — Criteria & Weights
What Changed? The 16th FC introduced “Contribution to GDP” as a new criterion (10%), replacing “Tax & Fiscal Efforts” (2.5%). Weights for Income Distance and Area have been reduced, while Population (2011) weight has increased.
| Criterion | 15th FC (2021–26) | 16th FC (2026–31) | Change |
|---|---|---|---|
| Income Distance | 45% | 42.5% | ↓ 2.5% |
| Population (2011) | 15% | 17.5% | ↑ 2.5% |
| Demographic Performance | 12.5% | 10% | ↓ 2.5% |
| Area | 15% | 10% | ↓ 5% |
| Forest & Ecology | 10% | 10% | — No change |
| Tax & Fiscal Efforts | 2.5% | — | Removed |
| Contribution to GDP (New) | — | 10% | New ↑ |
| Total | 100% | 100% |
Key Criteria — How They Work
Income Distance (42.5%)
High Priority
- Measures gap between a state’s per capita GSDP and the average of the top 3 high-income large states
- Per capita GSDP averaged over 2018-19 to 2023-24 (excluding pandemic year 2020-21)
- States with lower per capita GSDP get a higher share — ensures equity
Demographic Performance (10%)
High Priority
Link: Population policy debates, South vs North friction
- 15th FC: Used Total Fertility Rate (TFR) to reward population control
- 16th FC: Redefined — now measures population growth between 1971 and 2011
- States with lower population growth during this period receive a higher share
Forest & Ecology (10%)
Medium Priority
- 16th FC considers both a state’s share in total forest area and increase in forest cover (2015–2023)
- Now includes open forests alongside dense and moderately dense forests
- 15th FC considered only dense & moderately dense forests — no reward for afforestation
Contribution to GDP (10%) — NEW
High Priority
New criterion — expect questions in 2026
- Replaces “Tax & Fiscal Efforts” criterion of the 15th FC
- Computed as: √(State GSDP) ÷ Σ√(All States’ GSDP)
- GSDP values = average nominal GSDP for 2018-19 to 2023-24 (excluding 2020-21)
- Benefits states with larger economies — rewards economic contribution
04
Grants-in-Aid & Local Body Financing₹9.47 Lakh Crore Over 5 Years
₹9.47L Cr
Total Grants (5 Years)
₹4.4L Cr
Rural Local Bodies
₹3.6L Cr
Urban Local Bodies
Grant Structure — What Changed
High Priority
- Grants limited to only two categories: Local Bodies + Disaster Management
- Discontinued: Revenue deficit grants, sector-specific grants, state-specific grants (all existed under 15th FC)
- This is a significant structural shift — reduces Centre’s discretionary role
Local Body Grants — Detailed Breakdown
Grant Components & Conditions
High Priority
- Basic Grants (80%): 50% untied + 50% tied to sanitation/solid waste management and/or water management
- Performance-based Grants (20%): Linked to reform compliance
- Special Infrastructure Grants (Urban only): For comprehensive wastewater management — cities with 10–40 lakh population (Census 2011) — ₹56,100 crore
- Urbanisation Premium Grants: One-time grants for merging peri-urban villages into urban areas + Rural-to-Urban Transition Policy — ₹10,000 crore
Entry-Level Conditions for Grant Release
Medium Priority
- Local bodies must be constituted as per the Constitution (73rd/74th Amendments)
- Public disclosure of provisional and audited accounts
- Timely constitution of the State Finance Commission
Flowchart — Local Body Grant Flow
16th FC Recommends Grants
→
Entry Conditions Met?
→
Basic (80%) + Performance (20%)
→
50% Untied + 50% Tied
→
Sanitation / Water Use
05
Disaster Management GrantsSDRF & SDMF Corpus
Disaster Management Funding
Medium Priority
- Total corpus: ₹2,04,401 crore for SDRF and SDMF over 5 years
- Centre’s share: ₹1,55,916 crore
- Cost-sharing: 90:10 for NE & Himalayan states; 75:25 for other states
| Category | Centre : State Ratio | Applicable To |
|---|---|---|
| NE & Himalayan States | 90 : 10 | Arunachal, Assam, Manipur, Mizoram, etc. + J&K, Uttarakhand, HP |
| General States | 75 : 25 | All remaining states |
06
Fiscal Roadmap & Structural ReformsDeficit Targets, DISCOMs, Subsidies, PSEs
Fiscal Consolidation Targets
3.5%
Centre’s Fiscal Deficit Target by 2030-31
3%
States’ Annual Deficit Ceiling (of GSDP)
73.1%
Projected Combined Debt by 2030-31
Fiscal Discipline Measures
High Priority
Link: FRBM Act, off-budget borrowings debate
- Centre’s fiscal deficit: reduce to 3.5% of GDP by 2030-31
- States’ annual fiscal deficit ceiling: 3% of GSDP
- Off-budget borrowings: Strict discontinuation; must be fully included in state budgets
- Recommended expanding the definition of fiscal deficit & public debt to uniformly capture all off-budget borrowings
- Combined Centre + States debt projected to decline: 77.3% → 73.1% of GDP (2026-27 to 2030-31)
Power-Sector (DISCOM) Reforms
DISCOM Privatisation & Debt Resolution
Medium Priority
- States advised to actively pursue privatisation of DISCOMs
- SPV mechanism: Create Special Purpose Vehicle to warehouse existing DISCOM debt — protect private investors from legacy liabilities
- Repayment supported through Special Assistance Scheme for Capital Investment
- States can access this assistance only after completing privatisation
Subsidy Rationalisation
Subsidy Reform Recommendations
Medium Priority
- Review and rationalise subsidy expenditure to improve efficiency
- Unconditional cash transfers often have large, untargeted beneficiary bases — need exclusion criteria
- End subsidy financing through off-budget borrowings
- Flagged lack of standardisation in subsidy classification across states — frequent misclassification
- Recommended a uniform framework for accounting and transparent disclosure of subsidies
Public Sector Enterprise (PSE) Reforms
PSE Restructuring & Disinvestment
Medium Priority
- Recommended review and closure of 308 inactive State PSEs
- States to frame a state-level PSE disinvestment policy targeting inactive and underperforming enterprises
- 3-out-of-4 rule: PSEs incurring losses in 3 out of 4 consecutive years → placed before Cabinet
- Cabinet decides: closure, privatisation, or continuation based on strategic importance
⚡ Rapid Revision — 16th FC Key Numbers
- States’ share: 41% (unchanged from 15th FC)
- Total grants: ₹9.47 lakh crore over 5 years
- Rural local body grants: ₹4.4 lakh crore
- Urban local body grants: ₹3.6 lakh crore
- Disaster corpus: ₹2,04,401 crore (Centre share: ₹1,55,916 Cr)
- Centre fiscal deficit target: 3.5% of GDP by 2030-31
- State fiscal deficit ceiling: 3% of GSDP annually
- Combined debt target: 73.1% by 2030-31 (from 77.3%)
- Inactive SPSEs for closure: 308
- New criterion: “Contribution to GDP” replaces “Tax & Fiscal Efforts”
07
Impact on States — South vs NorthDevolution Share Changes
Key Takeaway: Under the 16th FC formula, all five Southern states witnessed an increase in their devolution share, while large Northern states like UP and Bihar saw a decline.
Southern States — Share Increased
| State | 15th FC Share (%) | 16th FC Share (%) | Change |
|---|---|---|---|
| Karnataka | 3.647 | 4.131 | ↑ +0.484 |
| Kerala | 1.925 | 2.382 | ↑ +0.457 |
| Andhra Pradesh | 4.047 | 4.217 | ↑ +0.170 |
| Telangana | 2.102 | 2.174 | ↑ +0.072 |
| Tamil Nadu | 4.079 | 4.097 | ↑ +0.018 |
Northern States — Share Declined
| State | 15th FC Share (%) | 16th FC Share (%) | Change |
|---|---|---|---|
| Uttar Pradesh | 17.939 | 17.619 | ↓ −0.320 |
| Bihar | 10.058 | 9.948 | ↓ −0.110 |
Why the Shift? — Analytical Insight
Mains Relevance
- Introduction of “Contribution to GDP” criterion (10%) directly benefits economically larger Southern states
- Reduction in Area weightage (15% → 10%) reduces advantage of geographically large Northern states
- Shift in demographic performance measurement (TFR → 1971–2011 population growth) continues to reward states with better population management
- This addresses the long-standing South vs North fiscal federalism debate — Southern states contribute more tax revenue but received less devolution
08
Practice MCQs10 Prelims-Style Questions
Instructions: Select an option and click “Check Answer” to see the explanation. Track your score at the bottom.
0 / 10
Your Score
Question 01
The Finance Commission of India is constituted under which Article of the Constitution?
- Article 270
- Article 280
- Article 275
- Article 300A
Answer: (B) Article 280
Article 280 mandates the President to constitute a Finance Commission every five years. Article 275 deals with grants-in-aid, and Article 270 deals with taxes levied and distributed between the Union and States.
Article 280 mandates the President to constitute a Finance Commission every five years. Article 275 deals with grants-in-aid, and Article 270 deals with taxes levied and distributed between the Union and States.
Question 02
Consider the following statements about the 16th Finance Commission:
1. It has recommended a 42% share for states in the divisible pool.
2. It has introduced “Contribution to GDP” as a new devolution criterion.
3. It has discontinued revenue deficit grants.
Which of the above statements is/are correct?
1. It has recommended a 42% share for states in the divisible pool.
2. It has introduced “Contribution to GDP” as a new devolution criterion.
3. It has discontinued revenue deficit grants.
Which of the above statements is/are correct?
- 1 and 2 only
- 1 and 3 only
- 2 and 3 only
- 1, 2 and 3
Answer: (C) 2 and 3 only
Statement 1 is incorrect — the 16th FC retains the states’ share at 41% (not 42%), unchanged from the 15th FC. Statement 2 is correct — “Contribution to GDP” replaces “Tax & Fiscal Efforts.” Statement 3 is correct — revenue deficit grants have been discontinued.
Statement 1 is incorrect — the 16th FC retains the states’ share at 41% (not 42%), unchanged from the 15th FC. Statement 2 is correct — “Contribution to GDP” replaces “Tax & Fiscal Efforts.” Statement 3 is correct — revenue deficit grants have been discontinued.
Question 03
Under the 16th Finance Commission, the “Income Distance” criterion for horizontal devolution measures the gap between a state’s per capita GSDP and:
- The national per capita GSDP average
- The average per capita GSDP of the top three large, high-income states
- The per capita GSDP of the highest-income state
- The median per capita GSDP of all states
Answer: (B)
The 16th FC defines income distance as the gap between a state’s per capita GSDP and the average per capita GSDP of the top three large, high-income states. States with lower per capita GSDP get a higher share under this criterion.
The 16th FC defines income distance as the gap between a state’s per capita GSDP and the average per capita GSDP of the top three large, high-income states. States with lower per capita GSDP get a higher share under this criterion.
Question 04
Which of the following grants have been DISCONTINUED by the 16th Finance Commission?
1. Revenue deficit grants
2. Sector-specific grants
3. Disaster management grants
4. State-specific grants
Select the correct answer:
1. Revenue deficit grants
2. Sector-specific grants
3. Disaster management grants
4. State-specific grants
Select the correct answer:
- 1 and 2 only
- 1, 2 and 3
- 2 and 4 only
- 1, 2 and 4 only
Answer: (D) 1, 2 and 4 only
The 16th FC has discontinued revenue deficit grants, sector-specific grants, and state-specific grants. Disaster management grants continue — in fact, a corpus of ₹2,04,401 crore has been recommended.
The 16th FC has discontinued revenue deficit grants, sector-specific grants, and state-specific grants. Disaster management grants continue — in fact, a corpus of ₹2,04,401 crore has been recommended.
Question 05
The cost-sharing pattern for disaster management grants under the 16th FC for North-Eastern and Himalayan states is:
- 90:10 (Centre:State)
- 75:25 (Centre:State)
- 80:20 (Centre:State)
- 60:40 (Centre:State)
Answer: (A) 90:10
NE and Himalayan states have a 90:10 cost-sharing ratio, while general category states have a 75:25 ratio for disaster management fund allocation.
NE and Himalayan states have a 90:10 cost-sharing ratio, while general category states have a 75:25 ratio for disaster management fund allocation.
Question 06
With reference to local body grants under the 16th FC, consider the following:
1. Basic grants constitute 80% and performance grants 20%.
2. Among basic grants, 50% is untied and 50% is tied to sanitation/water management.
3. Special Infrastructure Grants apply to all urban local bodies irrespective of population.
Which is/are correct?
1. Basic grants constitute 80% and performance grants 20%.
2. Among basic grants, 50% is untied and 50% is tied to sanitation/water management.
3. Special Infrastructure Grants apply to all urban local bodies irrespective of population.
Which is/are correct?
- 1 only
- 1 and 3 only
- 1 and 2 only
- 1, 2 and 3
Answer: (C) 1 and 2 only
Statements 1 and 2 are correct. Statement 3 is incorrect — Special Infrastructure Grants are specifically for cities with 10–40 lakh population (Census 2011), not all urban bodies.
Statements 1 and 2 are correct. Statement 3 is incorrect — Special Infrastructure Grants are specifically for cities with 10–40 lakh population (Census 2011), not all urban bodies.
Question 07
The 16th Finance Commission has recommended that the Centre’s fiscal deficit be reduced to what level by 2030-31?
- 3.0% of GDP
- 3.5% of GDP
- 4.0% of GDP
- 4.5% of GDP
Answer: (B) 3.5% of GDP
The 16th FC recommends reducing the Centre’s fiscal deficit to 3.5% of GDP by 2030-31, while the annual fiscal deficit ceiling for states is fixed at 3% of GSDP.
The 16th FC recommends reducing the Centre’s fiscal deficit to 3.5% of GDP by 2030-31, while the annual fiscal deficit ceiling for states is fixed at 3% of GSDP.
Question 08
Which of the following is a NEW criterion introduced by the 16th Finance Commission for horizontal devolution, replacing an older criterion?
- Demographic Performance
- Forest & Ecology
- Income Distance
- Contribution to GDP
Answer: (D) Contribution to GDP
“Contribution to GDP” (10% weight) is the new criterion introduced by the 16th FC, replacing “Tax & Fiscal Efforts” (2.5%) of the 15th FC. Other criteria like Income Distance, Demographic Performance, and Forest have been retained (with modified weights).
“Contribution to GDP” (10% weight) is the new criterion introduced by the 16th FC, replacing “Tax & Fiscal Efforts” (2.5%) of the 15th FC. Other criteria like Income Distance, Demographic Performance, and Forest have been retained (with modified weights).
Question 09
Under the 16th FC recommendations on power-sector reforms, which mechanism is proposed to handle existing DISCOM debt before privatisation?
- Direct write-off by the Centre
- Transfer to the Consolidated Fund of India
- Creation of a Special Purpose Vehicle (SPV)
- Absorption by NITI Aayog
Answer: (C) Special Purpose Vehicle (SPV)
The 16th FC recommended creating an SPV to warehouse existing DISCOM debt, protecting private investors from legacy liabilities. Repayment may be supported through the Special Assistance Scheme for Capital Investment.
The 16th FC recommended creating an SPV to warehouse existing DISCOM debt, protecting private investors from legacy liabilities. Repayment may be supported through the Special Assistance Scheme for Capital Investment.
Question 10
Consider the following about the 16th FC’s “Demographic Performance” criterion:
1. The 15th FC used Total Fertility Rate (TFR) to measure this criterion.
2. The 16th FC measures population growth between 1971 and 2011.
3. States with higher population growth receive a higher share.
Which is/are correct?
1. The 15th FC used Total Fertility Rate (TFR) to measure this criterion.
2. The 16th FC measures population growth between 1971 and 2011.
3. States with higher population growth receive a higher share.
Which is/are correct?
- 1 only
- 1 and 2 only
- 2 and 3 only
- 1, 2 and 3
Answer: (B) 1 and 2 only
Statements 1 and 2 are correct. Statement 3 is incorrect — states with lower population growth receive a higher share, reinforcing incentives for demographic management.
Statements 1 and 2 are correct. Statement 3 is incorrect — states with lower population growth receive a higher share, reinforcing incentives for demographic management.
