The Sixteenth Finance Commission (16th FC) has retained the vertical devolution of central taxes to states at 41% of the divisible pool for the period FY26-27 to FY30-31, in line with the Fifteenth Finance Commission’s award, but changes in horizontal devolution criteria are expected to alter the inter-se share of states, according to rating agency ICRA.
In a report on state government finances released this week, ICRA says the key impact of the 16th FC lies not in the size of the divisible pool but in changes to the criteria and their respective weights used to determine state-wise tax shares.
Criteria Retained, but Weights and Methodology Changed
ICRA noted that the 16th FC has retained five of the six horizontal devolution criteria used by the 15th FC, while introducing changes in weights and calculation methodology. One of the significant modifications concerns the area criterion, whose weight has been increased to 10%, a move expected to lower the inter-state share of states with very large and very small geographical areas.
Another key change highlighted by ICRA is the replacement of the ‘tax and fiscal effort’ criterion, which carried a 2.5% weight under the 15th FC, with a new criterion—contribution to gross domestic product (GDP)—which is assigned a 10% weight.
This change is one of the key factors in enhancing the inter-se share of states with largely healthy economic management without attributing outcomes to governance quality or demographic performance.
Half of States to Gain in Inter-se Share
Based on the vertical devolution and the inter-se shares recommended by the 16th FC, ICRA estimates that 14 out of 28 states will see an increase in their share of the divisible pool during FY26-27–FY30-31 compared with the previous award period.
Karnataka is expected to be the biggest gainer. Other states projected to benefit include Kerala, Gujarat, Haryana, Punjab, Andhra Pradesh, Assam, Maharashtra, Himachal Pradesh, Telangana, Mizoram, Jharkhand, Uttarakhand and Tamil Nadu, ICRA says.
Sharp Rise in Local Body Grants
On the grants front, the 16th FC has continued the practice of linking releases to specific reforms and sectoral conditions, while significantly increasing allocations for local bodies.
ICRA pointed out that local body grants have been sharply raised to Rs7.9 trillion for FY26-27–FY30-31, from Rs3.9 trillion transferred during FY21-22 to FY25-26 (revised estimates). Of this, 60% are conditional but untied, while the remaining 40% are conditional and tied to sanitation, solid waste management and water management.
Given that around 90% of largely conditional local body grants recommended by the 15th FC were released, ICRA says this provides confidence that states will be able to meet the conditions stipulated by the 16th FC and access higher allocations.
Disaster Management, Revenue Deficit Grants
For disaster management, the 16th FC has recommended a Union government contribution of Rs1.6 trillion, about 27% higher than the amount recommended during the 15th FC period.
However, the commission has discontinued unconditional and untied revenue deficit grants (RDG), citing their limited effectiveness. After factoring in nil RDG, total grants recommended by the 16th FC amount to Rs9.5 trillion, a moderate 11% increase over the Rs8.5 trillion recommended by the 15th FC, which had included Rs2.9 trillion in RDG for 17 states.
As many as 13 of the 17 states that received RDG under the 15th FC are expected to receive lower total grants during FY26-27 to FY30-31 due to the withdrawal of these grants, ICRA says.
Fiscal Deficit Discipline and Borrowing Limits
The 16th FC has reiterated the requirement for states to adhere to a fiscal deficit ceiling of 3% of GSDP during FY26-27 to FY30-31, the same target prescribed by the 15th FC for the latter part of its award period.
However, unlike the previous commission, the 16th FC has not provided for additional reform-linked borrowing and has also discontinued the carry-forward of unutilised borrowing limits to subsequent years. ICRA cautioned that this could incentivise some states to fully exhaust their annual borrowing limits and carry forward unspent cash balances.
Capex Push Through Central Support
At the same time, the Union government has budgeted a higher allocation for 50-year interest-free capex loans to states at Rs1.9 trillion in FY26-27, up from Rs1.4 trillion in FY25-26 (RE). These loans are over and above states’ net borrowing limits.
In addition, grants-in-aid for capital assets have been raised to Rs4.9 trillion in FY26-27 (BE) from Rs3.1 trillion in FY25-26 (RE), shifting a greater share of incremental capital spending responsibility to states.
Spending Priorities May Recalibrate
ICRA says that higher capex support from the Union government, combined with the absence of revenue deficit grants and additional borrowing headroom, may lead to a recalibration of state spending priorities towards capital expenditure rather than welfare schemes.
The 16th FC has also recommended that states entirely discontinue off-budget borrowings and bring all such liabilities onto their budgets to improve transparency and fiscal discipline.
