Horizontal devolution: the formula and the equity vs efficiency debate

Detail

1. Two steps of devolution: vertical and horizontal

• Divisible pool: the part of the Centre's gross tax revenue that is shared with the states under Art. 270. It leaves out cesses, surcharges and the cost of collecting taxes.
• Vertical devolution decides how much of the divisible pool goes to all states taken together.
• 14th FC (2015-20): raised the states' share to 42%, up from 32% under the 13th FC [4].
• 15th FC (2021-26): set it at 41%. The 1-point cut was made because Jammu & Kashmir and Ladakh became Union Territories, and the Centre now funds them directly [3].

• 16th FC (2026-31): kept it at 41% [2].

• Horizontal devolution is how the states' combined share is split among individual states. It uses weighted criteria such as population, area, income distance and forest cover.

• The Finance Commission (set up under Art. 280 every five years) recommends both steps. The 16th FC report was placed in Parliament on 1 February 2026 and covers 2026-27 to 2030-31 [2].

2. How the formula works

• Each criterion gives every state a score share (its % out of 100 on that measure).
• Formula: State's share = Σ (weight of criterion × state's share on that criterion)
• Worked example (made-up numbers, using 16th FC weights):
• State X has these shares: income distance 12%, population 8%, demographic performance 4%, area 6%, forest 5%, GDP contribution 7%.
• Share = 0.425×12 + 0.175×8 + 0.10×4 + 0.10×6 + 0.10×5 + 0.10×7
• = 5.10 + 1.40 + 0.40 + 0.60 + 0.50 + 0.70 = 8.70% of the states' pool.
• If the states' pool is ₹10 lakh crore in a year, State X gets ₹87,000 crore.

3. Criteria and weights (%)

Criterion	14th FC (2015-20)	15th FC (2021-26)	16th FC (2026-31)
Income distance	50	45	42.5
Population 1971	17.5	—	—
Population 2011	10	15	17.5
Area	15	15 (floor for small states)	10
Forest cover / forest and ecology	7.5	10	10
Demographic performance	—	12.5	10
Tax and fiscal effort	—	2.5	dropped
Contribution to GDP	—	—	10 (new)
Total	100	100	100

• The 15th FC and 16th FC weights above match the official summaries [2][3].
• Main trend: the weight on income distance keeps falling (50 → 45 → 42.5). The formula is slowly giving less weight to pure need.

4. What each criterion means

(a) Income distance: the equalising core

• Definition: a state whose per capita income (income per person) is further below a benchmark gets a larger share. It is the equalising core of the formula, because it moves money from richer states to poorer ones.
• Per capita GSDP = Gross State Domestic Product ÷ state population.
• 15th FC benchmark: the distance of a state's income from the state with the highest income. It used average per capita GSDP for 2016-17 to 2018-19 [3].
• 16th FC benchmark: the difference between a state's per capita GSDP and the average per capita GSDP of the top three large states. It uses the average for 2018-19 to 2023-24, leaving out the pandemic year 2020-21 [2].
• Why the top-three average? One state that is unusually rich cannot pull the benchmark up alone.

• Why leave out 2020-21? COVID made that year's income abnormal.

• Worked example (simplified):

• Benchmark = ₹3,00,000. State A = ₹1,00,000, so its distance is ₹2,00,000. State B = ₹2,50,000, so its distance is ₹50,000.
• A's distance is 4 times B's. For the same population, A gets far more under this criterion.

(b) Population (1971 → 2011)

• Population shows need: more people means more schools, hospitals and rations to pay for.
• Until the 14th FC, the 1971 population was used. This kept states that controlled population from being penalised. The 14th FC gave 1971 population 17.5% and 2011 population 10%.
• From the 15th FC, only 2011 population is used: 15% (15th FC) and 17.5% (16th FC).

(c) Demographic performance

• Definition: rewards states that controlled population growth. It offsets the switch to recent (2011) population data.
• 15th FC (12.5%): based on total fertility rate (TFR), the average number of children a woman has in her lifetime. A lower TFR gives a higher score [3].
• 16th FC (10%): redefined as lower population growth between 1971 and 2011. Slower growth gives a higher share [2].
• Worked example:
• State P grew from 3 crore (1971) to 3.5 crore (2011), a growth of 16.7%.
• State Q grew from 3 crore to 6 crore, a growth of 100%.
• P scores higher on demographic performance, even though Q scores higher on 2011 population.

(d) Area

• Area reflects cost disability. A bigger state spends more to deliver the same service, for example longer roads and more police stations per person.
• 15th FC: 15%, with a floor for small states. A floor is a minimum share, so very small states are not squeezed out.
• 16th FC: cut to 10% [2].

(e) Forest criterion

• The criterion pays states for keeping forests. Forests limit farming, industry and mining, so the state gives up income, while the whole country gains from the ecology.
• 14th FC: forest cover, 7.5%. 15th FC: forest and ecology, 10%.
• 16th FC (10%): combines the share of forest area with the increase in forest area (2015-23). It now counts very dense, moderately dense and open forest [2] (NCERT: "now counts open forest too").
• Counting the increase rewards states that add forest, not only states that already had it.

(f) Tax and fiscal effort

• Tax effort criterion: rewards states that collect more of their own tax relative to their tax base or income. It is an efficiency criterion.
• 15th FC measure: average per capita own tax revenue ÷ average per capita GSDP, for 2016-17 to 2018-19 [3].

• Example: own tax ₹8,000 per person ÷ GSDP ₹1,00,000 per person = 8% tax effort.

• The 15th FC gave it 2.5%. The 16th FC dropped it.

(g) Contribution to GDP (16th FC, new, 10%)

• Measured as the square root of a state's share of GSDP. The square root softens the advantage of the largest economies.
• Exact formula: State share = √(GSDP of state) ÷ Σ √(GSDP of all states). It uses nominal GSDP (GSDP at current prices) averaged over 2018-19 to 2023-24, excluding 2020-21 [2].
• Worked example:
• Two states have GSDP of ₹100 and ₹25. On plain shares, they get 80% and 20%.
• Square roots are 10 and 5, so the shares become 66.7% and 33.3%.
• The big economy is still rewarded, but by less.

5. Equity vs efficiency

• Equity criteria (based on need and cost disability): income distance, area, forest, and population as a measure of need.

• Aim: every state should be able to give similar public services at similar tax rates, whatever its income.

• Efficiency criteria (based on reward and incentive): demographic performance, tax effort (15th FC), contribution to GDP (16th FC).

• Aim: a state should not lose money for doing well, whether by controlling population, collecting taxes or growing its economy.

• Weight trend:

• Efficiency weights: 12.5 + 2.5 = 15% (15th FC) → 10 + 10 = 20% (16th FC).
• Income distance: 45% → 42.5%.

• So the formula is moving slowly towards efficiency.

• Why the 1971 → 2011 switch mattered:

• Southern states controlled population earlier.
• So using 2011 population cuts their share.
• Demographic performance is the compensation.

6. Resulting shifts (15th → 16th FC, % of the states' pool)

State	15th FC	16th FC	Change (points)
Uttar Pradesh	17.94	17.62	−0.32
Bihar	10.06	9.95	−0.11
Madhya Pradesh	7.85	7.35	−0.50
Maharashtra	6.32	6.44	+0.12
Karnataka	3.65	4.13	+0.48
Gujarat	3.48	3.76	+0.28
Kerala	1.93	2.38	+0.45

• The 15th FC figures match the official shares: UP 17.939, Bihar 10.058, MP 7.850, Maharashtra 6.317, Karnataka 3.647, Gujarat 3.478, Kerala 1.925 [3].
• UP has the highest share (17.62%) and Sikkim the lowest (0.34%) under the 16th FC [2].
• Kerala's share rises by about 23% relative to its old share (0.45 ÷ 1.93). Karnataka's rises by about 13%.
• What drove the change: the new GDP criterion, less weight on income distance, and less weight on area.
• The 16th FC also stopped revenue deficit grants, sector-specific grants and state-specific grants [2]. So the tax-share formula now matters even more for a state's total transfers.

7. Political context

• The "north-south" transfer debate: richer southern and western states pay more tax than they receive back. Poorer northern and eastern states receive more than they pay.
• Karnataka and Kerala's protests in Delhi (February 2024) were about their falling devolution shares.
• The pending Census and delimitation will reopen the question of which population year to use.
• Delimitation means redrawing constituencies by population.

Prelims Hooks

• States' share of the divisible pool: 32% (13th FC) → 42% (14th FC) → 41% (15th FC and 16th FC).
• Highest-weight criterion in every recent FC: income distance (50 → 45 → 42.5%).
• "Contribution to GDP" is new in the 16th FC (10%). It is measured as √GSDP of a state ÷ Σ√GSDP of all states.
• Tax and fiscal effort (2.5%) appeared only in the 15th FC. The 16th FC dropped it.
• Demographic performance: TFR-based in the 15th FC (12.5%), but 1971-2011 population growth in the 16th FC (10%).
• 1971 population was last used by the 14th FC (17.5%). The 15th and 16th FCs use only 2011 population.
• 16th FC income distance benchmark = average per capita GSDP of the top three large states, for 2018-19 to 2023-24 excluding 2020-21.
• 16th FC forest criterion counts open forest and the increase in forest area (2015-23).
• Trap: Art. 280 sets up the Finance Commission. Art. 270 covers the sharing of taxes. Art. 275 covers grants-in-aid, which are separate from tax devolution.
• Highest share under the 16th FC: Uttar Pradesh (17.62%). Lowest: Sikkim (0.34%).

Mains Points

• Equity vs efficiency trade-off:
• Income distance and area are needed for horizontal equity, so a citizen in Bihar gets services similar to one in Karnataka.
• But heavy equalisation can punish good performance and weaken states' own tax effort (a moral hazard problem).

• The 16th FC's square-root GDP criterion is a middle path: it rewards output but damps the gains of the largest economies.

• Demography and federal trust:

• Moving from 1971 to 2011 population data cut the shares of states that controlled population early.
• Demographic performance compensates them, but its weight fell from 12.5% to 10%.

• A new Census and delimitation will raise both fiscal and political representation issues.

• Forest criterion as green fiscal transfer:

• Paying states to keep and grow forests turns a national public good into a state-level reward.
• Counting the increase (2015-23) adds a performance incentive.

• Critics say open forest is a weaker proxy for ecological value.

• Beyond the formula:

• With revenue deficit grants ended under the 16th FC, the tax-share formula now carries almost all the equalisation work.
• The rise of cesses and surcharges outside the divisible pool shrinks what is shared. This deepens the north-south debate, and states such as Karnataka and Kerala have protested (February 2024).