A cautious nudge, Pg8

Key Highlights:

• The Sixteenth Finance Commission (FC-16) recommended retaining the vertical devolution ratio at 41% for 2026-31.
• The FC-16 acknowledged the tightening fiscal space faced by states under the GST framework.
• The "tax effort" criterion has been reworked into a broader "contribution to GDP" measure with increased weightage.
• Weight accorded to demographic performance has been reduced, while weight for population size has been modestly increased.

Detailed Insights:

• States have criticized projected devolutions but cautiously welcomed the tweak in the horizontal devolution formula.
• The change in horizontal devolution aims to reward productive and efficient states by linking governance outcomes with fiscal transfers.
• Restructuring of horizontal devolution is to be undertaken gradually to avoid abrupt redistributive shocks to states dependent on transfers.
• The FC-16 flags the shrinking of the effective divisible pool due to cesses and surcharges but does not recommend their inclusion.
• A stronger signal could have been sent through a staggered increase in vertical devolution to expand discretionary fiscal space while preserving stability.
• A significant portion of the increase in total transfers to states is from revenue transfers under Centrally Sponsored Schemes.
• The recommendations recognize stresses in state finances but do not push for the structural change needed to restore balance in fiscal federalism.

Key Concepts Involved:

• Vertical Devolution: Sharing of taxes collected by the Union government with state governments.
• Horizontal Devolution: Allocation of funds among different states from the divisible pool.
• Fiscal Federalism: Division of financial powers and responsibilities between the central and state governments.
• Centrally Sponsored Schemes: Programs implemented by states but funded and designed by the central government.