What the Finance Commission does, and why states watch it

Why do states care so much about a commission that recommends how taxes should be shared? Because it helps decide the money available for public responsibilities. The Sixteenth Finance Commission's report records states pointing to the costs of health, education, agriculture, drinking water, sanitation, welfare, and law and order. Its award helps shape the resources available to them. Finance Commission transfers are one of several sources of money for these services.

To understand the award, start with two questions: how much of the shareable tax pool goes to states collectively, and how that amount is divided among them.

A constitutional job

Article 280 requires the President to set up a Finance Commission every fifth year, or earlier if necessary. It has a Chairman and four other members appointed by the President. This constitutional body makes recommendations; it does not run the Union Budget.

It recommends how to share taxes and sets out principles for grants-in-aid of states' revenues from the Consolidated Fund of India. It also recommends ways to add to a state's Consolidated Fund to support Panchayat and municipal resources. These proposals draw on recommendations from that state's Finance Commission. The Union and State Finance Commissions are separate institutions.

Article 281 requires the recommendations and an explanatory memorandum on action taken to be laid before each House of Parliament. Read the government's response alongside the recommendations.

Which award applies now?

The current award is the Sixteenth Commission's, covering 1 April 2026 to 31 March 2031, or the financial years 2026-27 to 2030-31. The Commission was constituted on 31 December 2023, with Dr Arvind Panagariya as Chairman, and submitted its report on 17 November 2025. The award therefore starts later than the Commission's formation.

The Union Budget's February 2026 explanatory memorandum records the government's acceptance of the tax-sharing recommendations. The Fifteenth Commission's 2021 to 2026 formula applies to the previous award.

The first division: Union and states

Vertical devolution divides shareable Union taxes between the Union and states collectively. Under the accepted Sixteenth Commission recommendation, states retain 41 per cent of the net proceeds in the divisible pool. The 41 per cent is shared by all states together.

The pool is smaller than gross Union tax revenue. It excludes cesses, surcharges and taxes accruing to Union Territories. Collection costs are deducted to arrive at net proceeds. To judge its size, look beyond headlines about total tax collections. Spending financed by a cess can still benefit states even though the cess itself is excluded from sharing.

The report records that 18 of 28 states sought an increase from 41 to 50 per cent. The accepted recommendation kept it at 41 per cent. This is why states watch both the rate and the revenue to which it applies.

The second division: among states

Horizontal devolution allocates the states' collective share among individual states. The Sixteenth Commission's report sets out six criteria, with weights totalling 100 per cent:

• Population, using Census 2011: 17.5 per cent.
• Demographic performance: 10 per cent.
• Area: 10 per cent.
• Forest: 10 per cent.
• Per capita gross state domestic product, or GSDP, distance: 42.5 per cent.
• Contribution to GDP: 10 per cent.

These weights determine how the collective state allocation is divided, rather than measuring shares of each state's budget. The Constitution leaves them open to change. The government accepted this formula and the resulting state shares.

The allocations make this clearer. Table 8.9 of the report assigns Karnataka 4.131 per cent and Kerala 2.382 per cent of the states' share. Read these percentages against the states' share, not the entire divisible pool or all Union tax revenue.

What the criteria are trying to balance

The largest weight goes to per capita GSDP distance. It directs more towards states with lower per capita GSDP to address differences in their capacity to fund public services. It supports state finances, without direct household payments or a promise of equal incomes.

Population and demographic performance do different jobs. The population criterion reflects each state's share of the combined Census 2011 population of the 28 states. Demographic performance uses inverse population growth between the 1971 and 2011 censuses, with the resulting per capita allocation multiplied by the state's 2011 population. So 2011 supplies the direct population count, while 1971 helps measure growth.

The forest criterion combines a state's share of weighted forest area with its share of the increase in weighted forest area, in an 80:20 ratio. The increase is measured between 2015 and 2023, and a decrease counts as zero for this change component. The measure therefore goes beyond counting forest hectares.

Contribution to GDP is new. The calculation takes the square root of each state's GSDP and divides it by the sum of those square roots for all states. It measures economic contribution rather than refunding taxes where they were collected. Together, the criteria balance population, income, economic output and other considerations.

Why an unchanged rate can still matter

The previous award also assigned states 41 per cent vertically, but its horizontal formula differed. For example, the Fifteenth Commission gave income distance a 45 per cent weight, compared with the current 42.5 per cent for per capita GSDP distance. The current formula has no separate tax-effort criterion.

With this two-stage calculation, rupee receipts can change even when the collective percentage stays the same. They also depend on the size of the divisible pool and a state's horizontal share. A growing pool can offset a lower horizontal percentage. To judge whether a state has gained or lost, look at the money as well as the percentages.

There is more to the award than taxes

The Commission recommended ₹7,91,493 crore for duly constituted rural and urban local bodies across the five-year award period, and the government accepted the local-body recommendations. The amount covers the whole period. It is a recommended allocation; actual payments need to be checked separately.

To qualify, local bodies must be duly constituted and make provisional and audited accounts publicly available. Eligibility also requires regular State Finance Commissions, with action-taken reports laid in the state legislature. These conditions matter alongside the allocations.

The Sixteenth Commission did not recommend revenue-deficit, sector-specific or state-specific grants. The Fifteenth had recommended revenue-deficit grants. Other Finance Commission grants continue.

How to read the next claim

When a tax-sharing figure appears in the news, first identify its award period and what its percentage measures. Then distinguish the collective state share from an individual state's allocation, and tax devolution from grants. Finally, check whether the number describes a recommendation, government acceptance or money actually received. These checks help you judge what a claim about state finances actually means.