Fiscal federalism

Topic: Fiscal Federalism: Finance Commission, Devolution and Centre-State Finances · NCERT: Beyond NCERT

Meaning

Fiscal federalism is the way a country divides three things among its levels of government: the power to tax (who collects which tax), the duty to spend (who pays for which service), and transfers (money that moves from one level to another to close gaps).

It matters because in India the Centre collects the biggest and fastest-growing taxes, while the states run most daily services. How the money is shared decides whether a child in Bihar and a child in Karnataka get similar schools and clinics. It also decides how much freedom states have over their own budgets.

Explanation

Three levels, four constitutional anchors

• India has three levels of government:
• the Union (the Centre),
• the states,

• local bodies (panchayats and municipalities).

• Constitution 1950 anchors:

• Art. 270: central taxes are shared with states.
• Art. 275: grants-in-aid go to states that need help.
• Art. 280: a Finance Commission (FC) is set up every five years.

• Art. 293: rules for borrowing by states.

• 2000 amendment: before 2000, the Centre shared only income tax and Union excise duty on certain goods. A constitutional amendment in 2000 allowed all central taxes to be shared [1].

Who should do what: the assignment logic

• Decentralisation theorem (Wallace Oates): a public service should be given to the lowest level of government that covers its benefit area. The benefit area is the area whose people use and gain from the service.
• A street light helps one locality, so the municipality should run it.
• Defence helps the whole country, so the Centre should run it.

• Local governments know local needs better, so they waste less.

• Subsidiarity is the same idea: do not centralise what a smaller unit can do well.

• Stabilisation stays with the Centre. Stabilisation means managing booms and slumps.
• A state spends more in a slump to create demand.
• Much of that money buys goods made in other states, so the demand "leaks out".
• The state carries the debt, but other states get much of the benefit.

• So counter-cyclical policy (spend more in bad times, less in good times) belongs with the Centre.

• Redistribution stays with the Centre. Class 12 NCERT calls this the "redistribution function" of the budget.

• A state taxes the rich heavily.
• The rich move to a state with lower taxes.

• The tax base leaves, and the poor gain nothing.

• Mobile and buoyant taxes stay with the Centre.

• A buoyant tax is one whose revenue grows fast as GDP grows, e.g. income tax, corporation tax, customs.
• A mobile tax base can move easily across state lines, e.g. company profits, imports.

• If states taxed these, they would cut rates to attract firms. This tax competition ("race to the bottom") would lower revenue for everyone.

• Daily services stay with states. Health, school education, police, agriculture and water mostly fall in the State List of the Seventh Schedule. They cost a lot, and the cost keeps growing.

The two imbalances this design creates

• Vertical fiscal imbalance (VFI): the gap between levels. The Centre has the stronger tax powers, but states carry the larger spending duties. PRS describes this as states spending out of proportion to their own sources of revenue [1].
• Worked example (illustrative numbers):
• Total government spending = ₹100. Total revenue = ₹80.
• States do 60% of the spending = ₹60.
• States raise only 35% of the revenue = ₹28.

• Vertical gap = ₹60 − ₹28 = ₹32. This must come from the Centre as tax devolution (the states' share of central taxes) plus grants.

• Horizontal fiscal imbalance (HFI): the gap among states.

• Fiscal capacity is a government's ability to raise revenue from its own tax base. It is usually measured by per capita GSDP (Gross State Domestic Product ÷ population). It differs several-fold between high-income states (Goa, Sikkim, Telangana, Karnataka, Haryana) and low-income states (Bihar, UP, Jharkhand).
• Cost disabilities are natural or social conditions that make the same service costlier, such as hills, forests and a thin, spread-out population. North-East and Himalayan states are the main cases.

Equalisation and its limits

• Fiscal equalisation means designing transfers so every state can provide comparable services at comparable tax rates, even when fiscal capacity is unequal.

• Classic models: Canada (equalisation payments) and Australia (the Commonwealth Grants Commission).

• Incentive problems:

• Penalising efficiency: a state grows faster → its per capita GSDP rises → its income distance shrinks → its share of devolution falls. Good performance gets "taxed" by the formula.

• Moral hazard (taking more risk because someone else will pay): if the Centre covers every deficit, states have little reason to control spending or raise their own taxes.

• The core trade-off: equity (helping poorer states) and efficiency (rewarding states that perform) pull in opposite directions.

In India

• Divisible pool: the part of central tax revenue that is shared with states. It equals gross tax revenue minus cesses, surcharges and collection costs.
• States' share of the divisible pool (vertical devolution):
• 13th FC: 32%.
• 14th FC: 42% for 2015-20 [2].
• 15th FC: 41% for 2021-26. The 1-point cut reflects the new UTs of J&K and Ladakh [3].

• 16th FC (Chair: Dr Arvind Panagariya): report tabled on 1 February 2026 for 2026-27 to 2030-31. It kept the share at 41% [4].

• Size of VFI: states do about 60% of general government expenditure (Centre + all states together) but raise a much smaller share of revenue. The RBI tracks this as the expenditure decentralisation ratio = states' expenditure ÷ general government expenditure [6].

• Horizontal devolution formula (how the states' share is divided among states):

Criterion	15th FC (2021-26) [3]	16th FC (2026-31) [4]	What it corrects
Income distance	45%	42.5%	Low fiscal capacity (equity)
Population (2011)	15%	17.5%	Need
Area	15%	10%	Cost disability
Forest & ecology / Forest	10%	10%	Cost disability; reward for green cover
Demographic performance	12.5%	10%	Rewards population control
Tax & fiscal efforts	2.5%	— (dropped)	Efficiency
Contribution to GDP	—	10% (new)	Efficiency

• Income distance = the gap between a state's per capita GSDP and the highest per capita GSDP. A bigger gap gives a bigger share. The 16th FC says its purpose is to "maintain equity among states" [4].
• Contribution to GDP (16th FC) [4]:
• State share = √(GSDP of state) ÷ Σ √(GSDP of all states).
• It uses average nominal GSDP for 2018-19 to 2023-24, leaving out 2020-21 (the COVID year).

• Worked example: State A GSDP ₹400, B ₹100, C ₹25 → square roots 20, 10, 5 (total 35) → shares A ≈ 57%, B ≈ 29%, C ≈ 14%. By plain GSDP, A would get 400/525 ≈ 76%. The square root reduces the advantage of large states.

• Gap-filling grants:

• The 15th FC gave ₹2.9 lakh crore in revenue deficit grants to 17 states for 2021-26 [3]. (Revenue deficit = revenue spending − revenue receipts.)

• The 16th FC discontinued revenue deficit grants [4].

• Pressure on state budgets:

• In 2023-24, states spent 53% of their revenue receipts on salaries, pensions and interest, and another 9% on subsidies [5].
• After GST (2017), states' GST revenue is still below the pre-2017 level of the taxes it replaced [5].
• Untied transfers (money states can spend as they choose) declined during the 15th FC period [5].

Don't confuse with

• Vertical vs horizontal imbalance: vertical is Centre vs states (tax powers vs spending duties). Horizontal is state vs state (fiscal capacity and cost disabilities). Vertical devolution sets the 41% share; the horizontal formula divides that 41% among states.
• Divisible pool vs gross tax revenue: the divisible pool leaves out cesses, surcharges and collection costs. So states get 41% of the pool, not 41% of all central taxes.
• Grants vs loans to states (Union accounts): grants to states count as Union revenue expenditure, even if they build assets. Loans to states count as Union capital expenditure, because they create a financial claim. For example, a ₹1,000 crore grant to build a hospital raises the Union's revenue deficit. The effective revenue deficit takes such grants out.
• Tax devolution vs grants-in-aid: devolution is the states' share of central taxes (Art. 270). Grants-in-aid are extra payments to states that need help (Art. 275).

Prelims Hooks

• Decentralisation theorem = Wallace Oates: a service goes to the lowest level of government that covers its benefit area. Subsidiarity is the same principle.
• States' share of the divisible pool: 13th FC 32% → 14th FC 42% [2] → 15th FC 41% [3] → 16th FC 41% (2026-31) [4].
• 16th FC: Chair Arvind Panagariya; report tabled 1 Feb 2026; new criterion "Contribution to GDP" (10%) uses the square root of GSDP and replaces tax & fiscal effort; income distance cut from 45% to 42.5% but is still the largest criterion [3][4].
• The 16th FC discontinued revenue deficit grants. The 15th FC had given ₹2.9 lakh crore to 17 states [3][4].
• Since the 2000 amendment, all central taxes are shareable. Earlier, only income tax and some Union excise duties were [1].
• RBI's expenditure decentralisation ratio = states' expenditure ÷ general government expenditure. States' share is about 60% [6].

Mains Points

• VFI is built into the design; it is not an accident. Buoyant and mobile taxes sit with the Centre to stop tax competition. Daily services sit with states because they know local needs (Oates, subsidiarity).
• But the 41% share closes only part of the gap [4].
• Cesses and surcharges stay outside the divisible pool, which widens the gap.

• Fewer untied transfers weaken state autonomy [5] (GS-II: federalism).

• Equity vs efficiency:

• Income distance (42.5%) moves money to Bihar, UP and Jharkhand, but it penalises fast-growing states. This feeds the southern states' grievance: Karnataka, Kerala and Tamil Nadu pay more in central taxes than they get back, and they lose on the population criterion because they controlled population early.

• The 16th FC's square-root contribution to GDP (10%) and the end of revenue deficit grants reduce moral hazard, while equalisation still has the largest weight [4].

• Transfers alone cannot equalise. States spend 53% of revenue receipts on salaries, pensions and interest (2023-24), and GST revenue is below pre-2017 levels [5]. So states also need own-revenue reform and better GST buoyancy. Canada and Australia's CGC equalise both fiscal capacity and cost disability with explicit formulas. India's area and forest criteria only partly measure cost disability, which supports a clearer needs-based measure (GS-III: fiscal policy).

Related concepts

• Vertical fiscal imbalance
• Horizontal fiscal imbalance
• Fiscal capacity
• Fiscal equalisation

Read more

• Fiscal federalism: rationale and India's two imbalances