Union Budget 2026: In devolution formula, South gains, but North loses little

No change in tax transfers, Finance Commission cautions on cash transfer surge

When the 16th Finance Commission began work, one concern for the southern states was a fall in their share of tax transfers from the Centre. Having invested in population control and human development over decades, they did not want to be penalised for outperforming much of North India on these counts.

The Finance Commission, headed by economist Arvind Panagariya, appears to have addressed these concerns by factoring states’ contribution to states’ combined GDP into the resource allocation formula. “This criterion captures the effect of various forms of efficiencies, including efficient spending and fiscal rectitude,” it said. Second, demographic performance has been defined as the inverse of population growth between 1971 and 2011. Third, the forest and ecology criteria have also been reworked.




As a result, barring Tamil Nadu, the four southern states are better off, receiving a larger share of the devolution, which has been retained at 41% of the Centre’s tax collection. Similarly, Maharashtra and Gujarat are among gainers, while Madhya Pradesh, Uttar Pradesh, West Bengal, Bihar and Rajasthan are among those that see a marginal decline in their share, although these states will still receive over 48% of total transfers (see table on right).

It was a tough balance to strike for the Finance Commission, whose award period stretches from April 2026 to March 2031. In all, 18 of the 28 states pitched for a 50% share of the divisible pool, arguing that they needed additional resources for health, education, agriculture, drinking water, sanitation, welfare schemes and law and order.

The Centre — without putting a number on it — argued for moderation in tax devolution, citing the need for higher spending on defence and for macroeconomic management. Many states, including those that pitched for under a 50% transfer, also argued that the Centre was increasingly relying on cesses and surcharges, which are not shared with states.

The five-member panel rejected this plea, stating that these levies are meant for specific purposes and including them in the divisible pool would defeat their objective. The Centre’s subsidies are now more focused and better delivered, and the quality of spending has improved, the Finance Commission said. It praised tax reforms — both direct taxes and GST— while noting that there remains scope for further reforms in tax policy and administration to improve collections.

In the states, however, the Commission flagged concerns over tax collections rising at a slower pace than economic growth. This has made states increasingly reliant on transfers from the Centre. Northeastern states, along with Uttar Pradesh, Bihar, West Bengal and Jharkhand, are among the most reliant on tax devolution, while Telangana, Haryana, Karnataka and Maharashtra lie at the other end of the spectrum, the report noted.

The panel also cautioned states on rising subsidies and off-budget borrowings, and pointed to persistent stress in power distribution companies (discoms), recommending privatisation as a solution. Power accounts for the largest subsidy burden on states, estimated at 27% of total subsidies and transfers. For the Finance Commission, the bigger worry is the rapid rise of unconditional cash transfers across states, which will account for nearly a fifth of subsidies and transfers this year, compared with just 3% in 2018-19. These transfers are projected to touch close to Rs 2lakh crore.

“The largest unconditional transfer schemes, as per the 2025-26 budget estimates, are the Majhi Ladki Bahin Yojana in Maharashtra, Gruha Lakshmi in Karnataka and Lakshmir Bhandar in West Bengal,” the report said.