Fiscal federalism in India

The first principle

The level of government that can raise money most efficiently is not the level that knows best how to spend it. Taxes on income, corporate profits and customs are best collected by the Union, because the base is mobile and national, while schools, police, hospitals and farms are run by States that are closer to the people. This gap between revenue power and spending duty, called vertical fiscal imbalance, has to be closed by transfers, and every debate in fiscal federalism is about how much is transferred, by what formula, and with how many strings attached.

The core

Two imbalances

• Vertical imbalance. States carry out about three fifths of general government spending but raise a much smaller share of its revenue, because the most buoyant taxes sit in the Union List. The Constitution answers this by sharing Union taxes and by grants.
• Horizontal imbalance. States differ in income, population, area and cost of providing services, so a rupee of tax capacity in a rich State does not equal a rupee in a poor one. Transfers are therefore shared among States by a formula that favours States with lower income, so that each can provide comparable services at comparable tax rates.

The constitutional machinery

• Tax sharing (Article 270). Since the Eightieth Amendment of 2000, the net proceeds of all Union taxes form a divisible pool that is shared with States, except surcharges (Article 271) and cesses levied for a specific purpose, which the Union keeps.
• Grants in aid (Article 275). Parliament gives grants to States in need of assistance, charged on the Consolidated Fund of India, on the principles recommended by the Finance Commission.
• The Finance Commission (Article 280). The President constitutes it every fifth year or earlier, with a chairman and four members. It recommends the vertical share of the divisible pool, the horizontal formula, the principles for grants and, since the Seventy Third and Seventy Fourth Amendments, measures to support panchayats and municipalities.
• Discretionary grants (Article 282). The Union or a State may make a grant for any public purpose even outside its own legislative field, and this Article carries the centrally sponsored schemes.
• Borrowing (Article 293). A State may borrow within India on the security of its Consolidated Fund, but while it owes money to the Union it needs the Union's consent to borrow, and the Union may attach conditions. This clause is how the Union enforces a net borrowing ceiling on every State.
• The Goods and Services Tax (GST) Council (Article 279A). Created by the One Hundred and First Amendment of 2016, it pools the indirect tax powers of both levels, so rate decisions are now joint; the taxation note covers it.

How a share is worked out

• The vertical share. Suppose the Union collects 100 rupees of gross tax, of which 15 are cesses and surcharges and 1 is the cost of collection. The divisible pool is 100 − 15 − 1 = 84, and 41 per cent of 84 is 34.4. States therefore receive about 34 rupees of every 100 collected, not 41, which is why the share of cesses and surcharges matters as much as the headline percentage.
• The horizontal share. Each criterion gives every State a share that adds to 100 across States, and the final share is the weighted sum. For income distance, a State's share is its population share times the gap between a benchmark income and its own income per head, divided by the total for all States. In the example below, State A has half the population and the lowest income, so it gets 69.1 per cent on distance and 59.6 per cent overall when population and distance carry equal weight.

Dimensions

• Economic. Untied money serves a State's own priorities and tied grants serve national ones, so their balance decides real autonomy.
• Equity. Income distance is the strongest equaliser, and with a weight above 40 per cent it moves money from richer southern and western States towards poorer northern and eastern ones.
• Efficiency and incentives. Equalisation can blunt the reward for raising one's own revenue, which is why Commissions have tried criteria for tax effort, demographic performance and, in the Sixteenth Commission, contribution to national output.
• Political. States that grew faster and controlled population feel penalised, while poorer States put need first; the shift from 1971 to 2011 population data sharpened this debate.

In practice

• The Fourteenth Finance Commission (chairman Y V Reddy, 2015-20) made the largest jump in history, from 32 to 42 per cent, and in return the Union cut its own scheme grants, so the share of untied money rose.
• The Fifteenth Finance Commission (chairman N K Singh, 2020-26) kept 41 per cent and used only 2011 population. Its weights were income distance 45, population 15, area 15, forest and ecology 10, demographic performance 12.5 and tax and fiscal effort 2.5 per cent, and it gave revenue deficit grants to States whose revenue could not cover their committed spending.
• The Sixteenth Finance Commission (chairman Arvind Panagariya) was constituted on 31 December 2023, submitted its report on 17 November 2025, and the report was laid before Parliament with the Union Budget on 1 February 2026 for the period 2026-27 to 2030-31. It kept the States' share at 41 per cent. Its weights are income distance 42.5, population (2011) 17.5, demographic performance 10, area 10, forest 10 and, for the first time, contribution to gross domestic product (GDP) 10 per cent. It recommended no revenue deficit grants, local body grants of Rs 7,91,493 crore over five years, and a State fiscal deficit limit of 3 per cent of gross state domestic product (GSDP), excluding the Union's interest free loans under the Special Assistance to States for Capital Investment (SASCI).
• What the Union accepted. The Explanatory Memorandum accepted the 41 per cent share, the horizontal formula, the local body grants and the disaster management grants, accepted the State borrowing ceilings in principle, and kept the recommendations on deficits, centrally sponsored schemes, power, subsidies and public enterprises under examination. Tax devolution is budgeted at Rs 15.26 lakh crore in 2026-27 (Union Budget 2026-27).
• Centrally sponsored schemes. A Sub Group of Chief Ministers set up by the National Institution for Transforming India (NITI Aayog) in 2015 divided them into core of the core schemes, such as the rural employment guarantee and social assistance, funded mainly by the Union; core schemes shared 60:40 between the Union and a State, or 90:10 for the northeastern and Himalayan States; and optional schemes.
• Borrowing limits. The Fifteenth Commission allowed States a fiscal deficit of 4 per cent of GSDP in 2021-22, falling to 3 per cent by 2023-24, with an extra 0.5 per cent for power sector reform. Since 2022-23 the Union counts borrowing by State companies that is serviced from the State budget against the State's ceiling, and it gives fifty year interest free loans for capital spending under SASCI, begun in 2020-21.

Issues and way forward

• The cess and surcharge leak. Because cesses and surcharges are outside the divisible pool, a rising share of them shrinks what States receive even when the headline share is unchanged. Bringing them under a cap, or folding long running cesses into the base rates, would restore the meaning of the Finance Commission's percentage.
• Too many tied schemes. Centrally sponsored schemes fix the design, the matching share and the reporting, so a State's budget is pre committed. Fewer, larger schemes with outcome conditions, as the 2015 Sub Group advised, would leave room for local choice.
• Fairness against reward. Southern and western States contribute more to the pool than they receive, and they argue that population based criteria penalise their success. The new criterion on contribution to GDP is one answer, though equalisation will always move money towards poorer States.
• Off budget borrowing and weak State finances. Several States borrow through their companies, guarantee loans and run arrears on power subsidies, which hides real debt. Full disclosure of guarantees and off budget liabilities in State budgets, and an independent fiscal council at both levels, would make the numbers trustworthy.
• Local bodies are the weakest link. Panchayats and municipalities raise little of their own revenue, so tying local body grants to timely State Finance Commissions and published accounts, as recent Commissions have done, is the lever.

Common confusions

• Finance Commission and the former Planning Commission. The Finance Commission is constitutional and gives formula based, mostly untied transfers, while the Planning Commission was an executive body that gave plan grants; NITI Aayog, its successor, gives no grants.
• Divisible pool and gross tax revenue. The divisible pool is gross tax revenue less cesses, surcharges and the cost of collection, so 41 per cent of the pool is well below 41 per cent of all Union taxes.
• Article 275 and Article 282 grants. Article 275 grants follow the Finance Commission's principles and are a charge on the Consolidated Fund, while Article 282 grants are at the Union's discretion and carry scheme conditions.
• Vertical and horizontal devolution. Vertical devolution decides how much goes to all States together; horizontal devolution decides how that amount is divided among them.

For the exam

• Keyword bank: vertical fiscal imbalance, horizontal equalisation, divisible pool, cesses and surcharges, income distance, demographic performance, contribution to GDP, untied transfers, centrally sponsored schemes, matching share, Article 293 consent, net borrowing ceiling, off budget borrowing, local body grants, cooperative federalism.
• Previous year questions: Practise the previous year questions on this topic →
• Use in an answer:
  • Introduction with data: The Sixteenth Finance Commission kept the States' share of the divisible pool at 41 per cent for 2026-31, but because cesses and surcharges stay outside the pool, States receive well under 41 per cent of the Union's gross tax revenue.
  • Introduction with a report: The Sixteenth Finance Commission, accepted by the Union in February 2026, added contribution to GDP as a criterion for the first time, answering States that felt penalised for growth.
  • Conclusion: Fiscal federalism works when transfers are predictable and largely untied, so capping cesses and consolidating schemes matter as much as the Finance Commission's percentage.
  • Conclusion: Equalisation and efficiency can be reconciled if poorer States receive more while every State is rewarded for raising its own revenue and keeping honest accounts.