41% illusion: a quiet re-engineering of India’s fiscal landscape

Why in the News?

The Union government accepted the Sixteenth Finance Commission’s recommendation to retain States’ share in the divisible pool at 41%. However, the effective share of States has declined because the divisible pool itself has shrunk relative to gross tax revenues. Simultaneously, the Union has increased reliance on cesses and surcharges that are not shareable with States, while discontinuing several revenue deficits and state-specific grants. The result is a structural shift toward greater fiscal centralisation, even though the headline devolution figure remains unchanged.

Why is the “41% devolution” being called an illusion?

1. Headline Continuity vs Real Decline: Retention of 41% vertical devolution creates an impression of continuity. However, the divisible pool is not the same as gross tax revenue, reducing the effective share transferred to States.
2. Rise of Cesses and Surcharges: Cesses and surcharges are retained entirely by the Union and excluded from the divisible pool. Their growing share reduces the amount available for distribution to States.
3. Shrinking Shareable Pool: The divisible pool averaged 89.2% of gross tax revenue during FC-XIII, declined to 82.1% during FC-XIV, and further to 78.3% during FC-XV.
4. Effective Devolution: When calculated as a share of total Union tax revenue, the States effectively receive about 41% of a shrinking pool, lowering the real transfer.

How has the divisible pool evolved over time?

1. FC-XIII Period (2010-15): Divisible pool averaged around 89.2% of gross tax revenue, ensuring larger transfers to States.
2. FC-XIV Period (2015-20): States’ share increased to 42%, but the divisible pool reduced to 82.1% of gross tax revenue.
3. FC-XV Period (2020-25): States’ share reduced to 41%, while the divisible pool further declined to 78.3%.
4. Trend: Declining shareable revenue base despite stable devolution percentage.

Why are cesses and surcharges central to the fiscal federal debate?

1. Exclusion from Divisible Pool: Cesses and surcharges are not shared with States under Article 270.
2. Growing Fiscal Instrument: The Union increasingly uses cesses and surcharges to finance schemes, bypassing revenue sharing.
3. Impact on State Finances: Rising non-shareable revenues reduce States’ fiscal autonomy.
4. Example: Education cess, infrastructure cess, and other targeted levies contribute to Union revenues but do not increase States’ transfers.

What structural changes in Finance Commission transfers affect States?

1. Discontinuation of Revenue Deficit Grants: FC-XVI proposes removal of revenue deficit grants, previously used to support fiscally weaker States.
2. End of State-specific Grants: Instruments providing targeted relief for State fiscal stress have been discontinued.
3. Shift toward Conditional Grants: Transfers increasingly depend on States’ compliance with Central monitoring requirements.
4. Change in Devolution Formula: Criteria such as tax and fiscal effort have been removed, while contribution to GDP has been introduced.

How does the new horizontal devolution formula affect States?

1. Income Distance (42.5% weight): Continues to prioritise poorer States with lower per-capita income.
2. Population (17.5% weight): Based on 2011 Census, increasing weight relative to earlier formulas.
3. Demographic Performance (10% weight): Rewards States with better population control outcomes.
4. Area (10%) and Forest Cover (10%): Recognises geographical and ecological constraints.
5. Contribution to GDP (10% new criterion): Rewards States contributing more to national output.

What fiscal stresses among States shaped the Commission’s approach?

1. Punjab: Debt-to-GSDP ratio around 42.9% in 2023-24; revenue deficit estimated at 3.7% of GSDP.
2. Rajasthan: Outstanding liabilities around 37.9% of GSDP.
3. Andhra Pradesh: Debt levels approximately 34.6% of GSDP.
4. Observation: States increasingly borrow to finance salaries and service existing debt rather than build capital assets.

Why is the shift toward conditional transfers significant?

1. Performance-linked Transfers: Local body grants divided into basic and performance components.
2. Conditionality: Access to funds linked to timely audits, compliance with Central databases, and performance benchmarks.
3. Governance Impact: States with weaker administrative capacity may receive lower actual transfers despite formal entitlement.

What broader implications does this have for fiscal federalism?

1. Centralisation of Fiscal Power: Increasing Union control over tax revenue and grants.
2. Reduced Fiscal Autonomy: States depend more on conditional transfers rather than formula-based devolution.
3. Structural Imbalance: Growing gap between State expenditure responsibilities and fiscal resources.
4. Long-term Concern: Persistent asymmetry may weaken cooperative federalism.

Conclusion

The retention of the 41% devolution figure conceals deeper structural changes in India’s fiscal architecture. The shrinking divisible pool, rising use of cesses and surcharges, and growing conditionality of grants indicate a gradual centralisation of fiscal authority. Sustaining cooperative federalism will require greater transparency in tax sharing and a stronger balance between Union and State fiscal powers.

PYQ Relevance

[UPSC 2021] How have the recommendations of the 14th Finance Commission of India enabled the states to improve their fiscal position?

Linkage: The PYQ Tests understanding of Finance Commission’s role in fiscal federalism and tax devolution between Centre and States. The issue of retaining 41% devolution while the divisible pool shrinks due to rising cesses and surcharges highlights emerging tensions in Centre-State fiscal relations and effective resource transfers.