Tax Devolution Retained at 41%, South Gains

Tax Devolution Retained at 41%, South Gains

Why in the News?

The Union government accepted the 16th Finance Commission’s recommendation to retain 41% tax devolution to States, while revising the horizontal distribution formula, resulting in a higher share for five southern States from 2026–27 onwards. This decision comes as the government also considers the implementation of ex post facto environmental clearances for certain projects.

Vertical Devolution: Continuity in Centre–State Sharing:

  • The 16th Finance Commission recommended retaining the vertical devolution of 41% of the divisible pool of taxes to States, unchanged since 2021.
  • Finance Minister Nirmala Sitharaman confirmed that the Centre has accepted this recommendation in the Union Budget 2026–27.
  • The government has allocated ₹1.4 lakh crore to States as Finance Commission Grants for FY 2026–27.
  • These grants include Rural Local Body Grants, Urban Local Body Grants, and Disaster Management Grants, supporting grassroots governance and potentially aiding in environmental impact assessments at the local level.
  • The Commission noted that the Centre’s main fiscal lever is its own share of taxes, as States’ share cannot be reduced further without affecting federal balance and the ability to implement crucial environmental regulations.

Horizontal Devolution: Formula Tweaks and Southern States’ Gains

  • While the vertical share remains unchanged, the horizontal distribution formula—which decides inter-State allocation—has been revised.
  • Population weightage has increased to 17.5% from 15%, reflecting service delivery needs and potential environmental challenges.
  • Demographic performance (rewarding population control) has been reduced to 10% from 12.5%, a shift impacting States that performed well earlier.
  • Area now carries 10% weightage, down from 15%, while forest cover remains unchanged at 10%, highlighting the importance of the Forest Conservation Act in fiscal considerations.
  • Per capita GSDP distance retains the highest weightage at 42.5%, slightly reduced from 45%, benefiting relatively poorer States while still aiding fiscally disciplined ones.
  • As a result, southern States see marginal but significant gains:

○ Andhra Pradesh: 4.217% (from 4.047%)

○ Karnataka: 4.131% (from 3.647%)

○ Kerala: 2.382% (from 1.925%)

○ Tamil Nadu: 4.097% (from 4.079%)

○ Telangana: 2.174% (from 2.102%)

About Finance Commission and Fiscal Federalism :
● The Finance Commission is a constitutional body under Article 280, tasked with recommending tax devolution and grants-in-aid to States.
  • Vertical devolution refers to the Centre–State share, while horizontal devolution concerns distribution among States.
  • Rising cesses and surcharges (not shareable with States) have reduced the divisible pool from 89.1% of gross tax revenue (2014–15) to about 74–80% during 2020–24.

● This trend constrains States’ fiscal space and is a recurring issue in Centre–State relations, potentially affecting the implementation of environmental regulations and the precautionary principle in development projects.