[26th May 2026] The Hindu OpED: Finance Commission transfers and equity issue 

PYQ Relevance[UPSC 2021] How have the recommendations of the 14th Finance Commission of India enabled the States to improve their fiscal position?Linkage: It directly examines the role of the Finance Commission in Centre-State fiscal relations and State finances. The present article extends this debate by questioning whether Finance Commission transfers under the 15th and emerging 16th FC framework are ensuring equity or disproportionately benefiting certain States while penalising economically stronger ones.

Mentor’s Comment

Consultations for the 16th Finance Commission have revived the debate on the fairness of tax devolution, with several States demanding changes in transfer criteria and a higher share in central taxes. The issue has gained urgency as large disparities in health and education spending persist despite decades of fiscal transfers. At the same time, the southern and economically stronger States argue that current formulas disproportionately favour poorer States.

Why has the Finance Commission become central to the debate on fiscal federalism?

The Finance Commission (FC) is central to the fiscal federalism debate because it acts as the primary constitutional arbitrator balancing the financial powers of the Centre with the development responsibilities of the States .

1. Correction of Structural Imbalances: Under Article 280, the FC resolves the vertical imbalance (Centre vs. States) and horizontal imbalance (richer vs. poorer States) to ensure uniform national development.
2. Tension over Resource Sharing through Vertical Devolution: While the 15th FC maintained a 41% vertical devolution to States, the actual money transferred has shrunk due to the Centre’s increasing reliance on cesses and surcharges, which are not shared with States.
3. The Equity vs. Efficiency Dilemma: Horizontal distribution criteria like “income distance” favor less-developed States. This leads to growing protests from highly performing southern States that feel penalized for their demographic and economic successes.
4. Compounded Fiscal Stress: The aftermath of the GST transition, volatile public debt levels, and rigid fiscal deficit targets have left States highly dependent on FC recommendations for survival.
5. Erosion of Autonomy: The proliferation of Centrally Sponsored Schemes (CSS) forces States to spend their own matching funds on federal priorities, severely limiting their local budgeting freedom.

Why are States dissatisfied with the present structure of fiscal transfers?

1. Cesses and Surcharges: Exceeded 15% of gross tax revenues and remain outside the divisible pool, reducing States’ effective share to around 8-10% lower than expected transfers.
2. Non-Tax Revenues: Centre retains significant revenues from natural resource extraction, asset monetisation, and RBI surplus transfers, limiting fiscal decentralisation.
3. GST Constraints: Structural changes after GST reduced States’ tax flexibility and independent fiscal capacity.
4. Borrowing Restrictions: States face tighter fiscal discipline norms despite increasing expenditure obligations.
5. CSS Burden: Restructuring of schemes such as MGNREGA requires States to bear 40% programme costs, increasing expenditure pressure.
6. Demand for Higher Share: Several States demanded 50% vertical devolution, citing shrinking fiscal space.

How have Finance Commission criteria altered interstate equity outcomes?

1. Changing Criteria: Successive Finance Commissions frequently changed weights assigned to devolution criteria, creating uncertainty for States.
2. Reduced Role of Income Distance: States argued for lower weightage or purchasing-power adjustments due to cost-of-living variations.
3. Shift in State Shares: Combined share of four major beneficiary States, Bihar, Madhya Pradesh, Uttar Pradesh and West Bengal, increased from 42.5% under the 15th FC period to 51% under the 16th FC calculations.
4. Southern States’ Decline: Share of Andhra Pradesh, Telangana, Karnataka, Kerala and Tamil Nadu fell from 24.8% to 15.8%, widening perceived inequities.
5. Fiscal Incentive Concern: Heavy reliance on unconditional equalisation transfers may weaken incentives for revenue mobilisation and fiscal discipline.

Why have fiscal transfers failed to ensure convergence in public service delivery?

Evidence: Bihar spent ₹937 per capita on health (2022-23) compared to Arunachal Pradesh’s ₹10,148, despite transfer mechanisms. Bihar’s per-student elementary education expenditure stood at ₹20,282, compared to Sikkim’s ₹1,30,498 (2023-24).

1. The Absorptive Capacity Deficit: Fiscally weaker states often lack the administrative machinery, technical staff, and institutional systems required to efficiently deploy and spend massive inflows of capital.
2. Input-Centric Transfer Architecture: Financial allocations are traditionally tied to rigid, historical spending inputs rather than measurable quality-of-service metrics or regional development outcomes.
3. Conditional Funding Rigidities: Centrally Sponsored Schemes (CSS) enforce strict, uniform guidelines across the country, preventing states from adapting funds to meet unique regional needs.
4. Distorted Capital-to-Revenue Mix: A massive portion of devolved funds is consumed by fixed revenue expenditures, such as state salaries and pensions, leaving minimal capital for public infrastructure.
5. Varying Cost of Delivery: Geographical terrain, population density, and existing infrastructure deficits mean the actual cost of delivering identical healthcare or education units varies drastically between states.
6. Limited Outcome Orientation: Existing transfer systems prioritise redistribution rather than measurable governance outcomes.

What major changes did the 15th Finance Commission introduce and why are they contested?

1. Retention of State Share: Maintained 41% vertical devolution.
2. Removal of Revenue Deficit Grants: Abolished revenue-deficit grants, sector-specific grants, and State-specific grants.
3. Fiscal Discipline Measures: Recommended States discontinue off-budget borrowings, integrate liabilities into budgets, and maintain fiscal deficit below 3% of GSDP.
4. Criteria Weightage: Assigned:
   1. Income Distance: 42.5%
   2. Population: 17.5%
   3. Area: 10%
   4. Forest Cover: 10%
   5. Demographic Performance: 10%
   6. Contribution to National GDP: 10%
5. Square Root GSDP Formula: Used square-root transformation of GSDP shares rather than actual GDP shares, reducing the advantage of economically stronger States.
6. Major Reduction in Shares:
   1. Maharashtra: From 14.23% to 8.31%
   2. Tamil Nadu: From 9.09% to 6.67%
   3. Karnataka: From 8.95% to 6.59%
7. Marginal Gains: Smaller States witnessed increased allocations.

Would alternative devolution criteria produce fairer outcomes?

1. Higher GDP Weightage Scenario: A 25% weight to square-root GDP contribution with reduced income-distance weight could increase:
   1. Karnataka: 6.441% – 7.131%
   2. Maharashtra: 4.928% – 7.218%
   3. Tamil Nadu: 4.097% – 4.867%
2. Equal Weight Formula: Could increase shares further:
   1. Karnataka: 5.544%
   2. Maharashtra: 7.845%
   3. Tamil Nadu: 5.246%
3. Actual GSDP Share Formula: Even 10% weight using actual GSDP shares would increase:
   1. Maharashtra: 8.698%
   2. Karnataka: 5.517%
   3. Tamil Nadu: 5.478%
4. Financial Implications: Under estimated transfers of ₹104 lakh crore, changes could yield annual gains:
   1. Maharashtra: ~₹49,744 crore
   2. Karnataka: ~₹37,565 crore
   3. Tamil Nadu: ~₹32,365 crore

How does the Finance Commission reflect the broader tension between equity and efficiency?

1. Equity Principle: Supports fiscally weaker States through redistributive transfers to reduce regional inequality.
2. Efficiency Principle: Rewards States demonstrating higher tax effort, demographic control, fiscal prudence, and stronger economic output.
3. Political Economy Concern: States with greater parliamentary representation often receive higher transfers despite weaker fiscal performance.
4. Delimitation Anxiety: Southern States fear demographic success may reduce political representation while redistribution continues to favour higher-population States.
5. Future Challenge: Balancing need-based redistribution with performance-based incentives.

Conclusion

Finance Commission transfers remain central to India’s cooperative federal architecture. The debate increasingly reflects a deeper conflict between redistributive justice and fiscal efficiency. While poorer States require sustained support to ensure minimum public service standards, economically stronger States seek recognition for fiscal prudence and demographic performance. Future Finance Commissions may need to adopt outcome-based indicators, fiscal capacity measures, and balanced weighting frameworks to preserve both equity and federal trust.