​A fair share: on divisible pool of tax collections

The Sixteenth Finance Commission (SFC), whose recommendations on financial devolution will be valid from April 1, 2026, faces a piquant situation. Its chairman Arvind Panagariya had noted last week that 22 out of 28 States, including many ruled by the Bharatiya Janata Party (BJP), had asked for a larger share of the divisible pool of tax collections, from 41% to 50% — a legitimate demand. The Union government has effectively shrunk the divisible pool by disproportionately increasing its revenue through non-shareable cesses and surcharges, whose share of the Centre’s gross tax revenue soared from 12.8% between 2015-16 to 2019-20 (pre-pandemic years) to 18.5% between 2020-21 and 2023-24 (Budget expenditure). Thus, the effective share of States in the Centre’s gross tax revenues averaged close to 31% in the 2020-21 to 2023-24 period — it was 35% in the previous corresponding period. Compounding this is the post-GST reality, where limited avenues for States to raise their revenue, make them critically dependent on central transfers. While GST collections have been fairly good in recent years, this has still not addressed the issue of the reduced avenues for States to increase their revenue. Further, the existing formula for horizontal devolution, with a heavy weightage given to population and income distance, is seen by economically progressive States (the South), as a penalty for performance and responsible governance.

Keeping the status quo would go against the grain and the idea of cooperative federalism that the BJP-led government has emphasised. Mr. Panagariya also remarked that a sudden nine-point jump to 50% would “[upset] too many carts”, indicating that the Centre would be loath to lessen its share because of rising expenditure on defence and other capital-intensive projects. This means that the Finance Commission would be less inclined to engage with States’ demands, also explaining why it might keep the devolution share unchanged at 41%. Yet, doing so would be a missed opportunity to forge a new federal compact. A modest increase in the vertical devolution, meeting States’ demands half-way, would be a welcome signal. The Finance Commission must also recommend a mechanism that will rein in the arbitrary use of cesses and surcharges, maybe even capping them at a fixed percentage of the gross tax revenue of the Centre and including any surplus collection in the divisible pool, as some have suggested. It must fine-tune the horizontal distribution criteria to create a more equitable balance between a State’s needs, its area, and its performance. Crafting a formula that is fiscally prudent and one that strengthens the federal structure at its roots, the States, is imperative.