Fiscal federalism: rationale and India's two imbalances

Detail

1. What fiscal federalism means

• Fiscal federalism is the way a country divides three things between its levels of government:
• the power to tax (who collects which tax),
• the duty to spend (who pays for which service),

• the transfers (money that moves from one level to another to close gaps).

• India has three levels:

• the Union (the Centre),
• the states,

• local bodies (panchayats and municipalities).

• Constitutional anchors (Era line):

• Art. 270 covers sharing of central taxes with states.
• Art. 275 covers grants-in-aid to states that need help.
• Art. 280 sets up the Finance Commission every five years.

• Art. 293 covers borrowing by states.

• Scope of sharing widened in 2000: before 2000, the Centre shared only income tax and Union excise duty on certain goods with states. A constitutional amendment in 2000 allowed all central taxes to be shared [2].

2. Who should do what: the assignment logic

• Decentralisation theorem (Wallace Oates): a public service should be provided by the lowest level of government that covers its benefit area.
• Benefit area means the area whose people actually use and gain from the service.
• A street light helps one locality, so the municipality should run it. A national defence force helps the whole country, so the Centre should run it.

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

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

What sits with the Centre

• Stabilisation means managing booms and slumps in the economy.
• Why a state cannot do it alone:
  • A state spends more during a slump to create demand.
  • Much of that money is spent on goods made in other states, so the demand "leaks out".
  • The state carries the debt while other states get much of the benefit.

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

• Redistribution means moving income from rich to poor. Class 12 NCERT calls this the "redistribution function" of the budget.

• Why a state cannot do it alone:

  • 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 tax bases belong with the Centre.

• Buoyant tax: tax revenue grows fast as GDP grows. Examples are income tax, corporation tax and customs.
• Mobile tax base: the thing being taxed can shift easily across state lines, such as company profits or imports.
• Why centralise them: if states taxed these bases, they would cut rates to attract firms. This tax competition (a "race to the bottom") would reduce revenue for everyone.

What sits with states

• Services people use daily: health, school education, police, agriculture, water and local services.
• Most of these fall in the State List of the Seventh Schedule. They cost a lot, and the cost grows over time.

3. India's two imbalances

(a) Vertical fiscal imbalance (VFI)

• Definition: the gap between levels of government. The Centre has the stronger tax powers, while states carry the larger spending duties.

• PRS describes it as states incurring expenditures that are out of proportion to their own sources of revenue [2].

• Size: states account for about 60% of general government expenditure but raise a much smaller share of total revenue.

• General government means the Centre and all states taken together.

• The RBI tracks this as the expenditure decentralisation ratio: states' expenditure ÷ general government expenditure [7].

• Worked example (illustrative numbers):

• Say total government spending = ₹100 and total revenue = ₹80.
• States spend 60% of all spending, which is ₹60.
• States raise only 35% of all revenue, which is ₹28.

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

• How the gap is closed: by tax devolution and grants (§§3-6 of the parent note).

• 13th FC: states got 32% of the divisible pool.
• 14th FC: raised this to 42% for 2015-20 [3].
• 15th FC: set it at 41% for 2021-26 [4]. The 1 point cut reflects the new UTs of J&K and Ladakh.
• 16th FC (Chair: Dr Arvind Panagariya): report tabled on 1 February 2026 for 2026-27 to 2030-31. It kept the share at 41% [5].

• The divisible pool is the part of central tax revenue that is shared with states. It is gross tax revenue minus cesses, surcharges and collection costs.

• Pressure on state budgets:

• In 2023-24, states spent 53% of their revenue receipts on salaries, pensions and interest.
• They spent another 9% on subsidies [6].

• So little money is left for building assets.

• GST and untied transfers:

• After GST (2017), states' GST revenue is still below the pre-2017 level of the taxes that GST replaced [6].
• Untied transfers (money states can spend as they choose) from the Centre declined during the 15th FC period [6].
• Both trends make the vertical gap harder for states to manage.

(b) Horizontal fiscal imbalance (HFI)

• Definition: the gap among states. States differ in how much they can raise and how much they need to spend.
• Fiscal capacity is a government's ability to raise revenue from its own tax base.
• It is usually proxied by per capita GSDP (Gross State Domestic Product divided by population).
• It differs several-fold between high-income states (Goa, Sikkim, Telangana, Karnataka, Haryana) and low-income states (Bihar, UP, Jharkhand).

• PRS notes that states with lower per capita incomes have limited fiscal space to spend on growth-enhancing items [6]. Fiscal space means room in the budget after fixed costs are paid.

• Cost disabilities are natural or social conditions that make the same service costlier to deliver.

• Examples are hills, forests and a thin, spread-out population.

• The North-East and Himalayan states are the main cases. A school or clinic there costs more per child or patient.

• How FCs correct HFI: through the horizontal devolution formula, which divides the states' share among states.

Criterion	15th FC (2021-26) [4]	16th FC (2026-31) [5]	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 (rewards the states that produce more)

• Income distance is the gap between a state's per capita GSDP and the highest per capita GSDP. The larger the gap, the larger the share.

• The 16th FC says the purpose is to "maintain equity among states" [5].

• Contribution to GDP formula (16th FC) [5]:

• 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 has GSDP ₹400, State B ₹100 and State C ₹25.
  • The square roots are 20, 10 and 5, which add up to 35.
  • The shares are A = 20/35 ≈ 57%, B ≈ 29% and C ≈ 14%.
  • By plain GSDP, A would have got 400/525 ≈ 76%. Taking the square root dampens the advantage of large states, so equity is not lost entirely.

4. Fiscal equalisation and its limits

• Fiscal equalisation means designing transfers so that every state can provide comparable services at comparable tax rates, even though fiscal capacity is unequal.
• Classic models are Canada (equalisation payments) and Australia (the Commonwealth Grants Commission).

• In India, the heavy weight on income distance is the main equalising tool [4][5].

• Gap-filling grants:

• The 15th FC gave ₹2.9 lakh crore in revenue deficit grants to 17 states for 2021-26 [4]. A revenue deficit is revenue spending minus revenue receipts.
• The 16th FC discontinued revenue deficit grants [5]. This is a clear move away from gap-filling.

Incentive problems

• Penalising efficiency:
• A state grows faster, so its per capita GSDP rises.
• Its income distance shrinks, so its share of devolution falls.

• Result: good performance is "taxed" by the formula.

• Moral hazard of gap-filling: moral hazard means taking more risk because someone else will pay.

• The Centre covers every deficit.
• States then have little reason to control spending or raise their own taxes.

• This is why deficit grants are now being withdrawn [5].

• Southern states' grievance:

• Karnataka, Kerala, Tamil Nadu and others contribute more to central taxes than they get back.
• They are also penalised on the population criterion because they controlled population growth early.
• FCs responded with demographic performance (12.5% → 10%) and the new contribution to GDP (10%) criteria [4][5].

Accounting link (Class 12, Government Budget and the Economy)

• Grants to state governments count as Union revenue expenditure, "even though some of the grants may be meant for creation of assets".
• Loans to states count as Union capital expenditure, because they create a financial claim.
• Worked example: the Centre gives a state a ₹1,000 crore grant to build a hospital.
• In the Union accounts, this is recorded as revenue expenditure.
• So it raises the Union's revenue deficit, even though an asset is created. (The effective revenue deficit concept removes such grants.)
• If the same ₹1,000 crore is given as a loan, it is capital expenditure.

The core trade-off

• Equity (equalisation) and efficiency (rewarding performance) pull in opposite directions throughout §§3-6.
• Trend:
• 15th FC: efficiency (tax effort) got 2.5%.
• 16th FC: efficiency (contribution to GDP) gets 10%, and deficit grants have ended [4][5].
• So the balance is shifting towards efficiency, but equity (income distance at 42.5%) is still the largest weight.

Prelims Hooks

• Decentralisation theorem: Wallace Oates. A service goes to the lowest level of government covering its benefit area. Subsidiarity is the same principle.
• Vertical imbalance = Centre vs states (revenue powers vs spending duties). Horizontal imbalance = state vs state (fiscal capacity and cost disabilities). Exam trap: do not swap the two.
• States account for about 60% of general government expenditure. RBI's expenditure decentralisation ratio = states' expenditure ÷ general government expenditure [7].
• States' share of the divisible pool: 13th FC 32% → 14th FC 42% [3] → 15th FC 41% [4] → 16th FC 41% (2026-31) [5].
• 16th FC: Chair Arvind Panagariya. Report tabled 1 Feb 2026. New criterion "Contribution to GDP" (10%) uses the square root of GSDP. It replaced tax & fiscal effort [5].
• Income distance weight: 45% (15th FC) → 42.5% (16th FC). It is the largest criterion in both [4][5].
• The 16th FC discontinued revenue deficit grants. The 15th FC gave ₹2.9 lakh crore to 17 states [4][5].
• Since the 2000 amendment, all central taxes are shareable. Earlier, only income tax and some Union excise duties were [2].
• Grants to states = Union revenue expenditure. Loans to states = Union capital expenditure (NCERT Class 12).
• Stabilisation and redistribution are central functions. Stabilisation is central because of spending leakage across states. Redistribution is central because the rich can move.

Mains Points

• VFI is built into India's design, not an accident. Buoyant, mobile taxes sit with the Centre to prevent tax competition. Daily services sit with states for better local knowledge (Oates/subsidiarity).
• The 41% devolution share closes only part of the gap [5].
• A falling share of untied transfers weakens states' autonomy [6].

• Cesses and surcharges sit outside the divisible pool, which widens the gap further.

• Equity vs efficiency:

• Income distance (42.5%) transfers money to Bihar, UP and Jharkhand. But it penalises fast-growing states, which feeds the southern states' grievance.

• The 16th FC's square-root contribution to GDP criterion (10%) and the end of revenue deficit grants reduce moral hazard while keeping equalisation dominant [5].

• Shrinking fiscal space limits equalisation:

• States spend 53% of revenue receipts on salaries, pensions and interest (2023-24) [6].
• GST collections are below pre-2017 levels [6].

• So transfers alone cannot ensure "comparable services at comparable tax rates". States also need own-revenue reform and better GST buoyancy (GS-III: fiscal policy; GS-II: federalism).

• International lesson: Canada and Australia's CGC equalise both fiscal capacity and cost disabilities using explicit formulas. India's area and forest criteria are partial proxies for cost disability. This supports a case for a more explicit needs-based measure.