Chairman of the 16th Finance Commission (16th FC) Aravind Panagariya on Tuesday hinted that two major demands put forward by Kerala were incompatible. On the one hand, Kerala wants the vertical devolution of funds (the share of all the states in the divisible pool) to be increased from 41% to 50%.

On the other, it wants cesses and surcharges imposed by the centre to be either abolished or capped; cesses and surcharges go directly to the Consolidated Fund of India and are not part of the divisible pool. Panagariya suggested that both demands cannot be met simultaneously.

In 2011-12, cesses and surcharges' share of the centre's revenue was just 9.4%. In 2022-23, it swelled to 22.8%. Since cesses and surcharges need not be shared with states, the effective size of the divisible pool in the Centre's gross revenue has dwindled.

Panagariya, who was in Kerala on a three-day visit with his other team members, conceded the point. "Over the years, the proportion of cesses and surcharges as a proportion of gross tax revenue of the central government has been rising.

"And this means that the share of the divisible pool in the gross tax revenue of the central government has been declining," he said on Tuesday after holding discussions with the representatives of the government, local bodies and political parties.

Nonetheless, Panagariya said the "cesses and surcharge route" was the Centre’s response to its shrinking fiscal space. "What happens is, as the share of the states in the divisible pool increased, the centre's fiscal space got reduced," the FC chairman said.

"At the time of the 13thFC, 32% was going to the states, and the remaining 68% was going to the centre. The 14thFC raised this to 42%. Consequently, the Centre's fiscal space dwindled by 10%," Panagariya said.

He said the only way for the Centre to deal with this fiscal crunch is to "raise more revenues using cesses and surcharges". "So it is a response, in a way, of the central government," he said.

The FC chairman said that 13 of the 14 states he had visited, including Kerala, had asked for the vertical devolution to be increased to 50%. One said 45%. "If the Commission accedes to the demand of the states, there is always the possibility of the centre then going yet more into the cesses and surcharges," he said, and added: "It's a complicated issue."

Further, Panagariya said that the Centre was constitutionally empowered to impose cesses and surcharges and keep them fully for itself. Former NITI Aayog Vice Chairman Arvind Panagariya was appointed the Chairman of the 16th Finance Commission in January 2024.

Full-time members are Ajay Narayan Jha, former member of the 15th Finance Commission and former Secretary of the Department of Expenditure; Annie George Mathew, former Special Secretary of the Department of Expenditure; Niranjan Rajadhyaksha, Executive Director of Artha Global. Soumya Kanti Ghosh, Group Chief Economic Advisor, State Bank of India, will function as part-time member. The 16th FC has to submit its report by October 31, 2025.