Finance Commission Transfers and Equity Issue

UPSC Syllabus: Gs Paper 2- issues and challenges pertaining to the federal structure, devolution of powers and finances up to local levels and challenges

therein.

Introduction

The Finance Commission decides the distribution of Union tax revenues between the Centre and the States and among the States themselves. The 16th Finance Commission retained the States’ 41% share in divisible taxes and continued to prioritise equity-based transfers. However, concerns have increased over declining fiscal autonomy of States, rising cesses and surcharges, unequal devolution outcomes, and limited weight to fiscal performance and economic contribution.

Constitutional Framework and Criteria of the 16th Finance Commission

1. Constitutional Role of Finance Commission: Articles 270 and 280 create the framework for fiscal federalism in India. The Finance Commission is constituted every five years to recommend tax devolution and grants between the Centre and the States.
2. Shift in Vertical Devolution: The States’ share increased from 32% to 42% after the Fourteenth Finance Commission because State plan grants were removed. It was later reduced to 41% after the reorganisation of Jammu and Kashmir, and the 16th FC retained this level.
3. Income Distance and Population Criteria: Income distance received the highest weight of 42.5% to support poorer States. Population based on the 2011 Census received 17.5% weight to reflect expenditure needs.
4. Demographic, Forest and Area Criteria: Demographic performance received 10% weight and used population growth instead of fertility rate changes. Forest cover and area also received 10% weight each, and open forests were included in the calculation.
5. GDP Contribution Criterion:

• The 16th FC introduced States’ contribution to national GDP with 10% weight, replacing tax effort. The square-root formula reduced the advantage of larger industrial States and increased the share of several smaller States.
• The formula also created internal tension because lower income increases share under income distance, while higher GDP contribution also increases share.

Major Recommendations and Devolution Outcomes

1. Retention of Equity-Based Transfers: The 16th FC retained the 41% vertical devolution share despite demands from States for an increase to 50%. Equity continued to dominate the formula, with 70% weight for equity criteria and only 30% for efficiency-related criteria.
2. Position on Cesses and Surcharges: The Commission accepted the Centre’s view that cesses and surcharges should remain outside the divisible pool. It argued that these funds support welfare and infrastructure programmes that indirectly benefit States.
3. Fiscal Discipline Measures: The FC abolished revenue-deficit grants and discontinued sector-specific and State-specific grants. It also asked States to stop off-budget borrowings and keep fiscal deficits below 3%.
4. Changes in State Shares: Karnataka recorded the highest gain of 0.484 percentage points, followed by Kerala and Gujarat. Tamil Nadu’s share increased only marginally from 4.079% to 4.097%, while Madhya Pradesh recorded the largest decline.
5. Long-Term Distribution Pattern: The combined share of Bihar, Uttar Pradesh, Madhya Pradesh and West Bengal increased from 42.5% during the Sixth FC to 51% under the 15th FC. In contrast, the share of southern States declined from 24.8% to 15.8%.

Major Concerns in Fiscal Transfers and Equity

1. Shrinking Fiscal Space of States: States face fiscal pressure due to COVID-19 debt, GST-related changes, and slower tax buoyancy. The growing role of Centrally Sponsored Schemes has also reduced fiscal autonomy.

• Effective transfers as a share of the Centre’s pre-transfer revenue receipts declined from 35.6% under the 14th FC to an estimated 32.7% in 2026-27.

2. Rising Cesses and Surcharges: Cesses and surcharges exceeded 15% of gross tax revenues, reducing the divisible pool available to States. Several States demanded that these should either be included in the divisible pool or capped at 8%-10%.
3. Declining Incentives for Fiscal Discipline: Continuous equalisation transfers may weaken incentives for revenue mobilisation in weaker States. The replacement of the tax effort criterion with GDP contribution reduced direct emphasis on fiscal discipline and revenue mobilisation.
4. Limited Improvement in Public Services: Higher transfers have not fully reduced social sector disparities. In 2022-23, Bihar spent ₹937 per person on health, while Arunachal Pradesh spent ₹10,148.
5. Concerns of Southern and Better-Performing States: Southern States argued that successful population control and stronger economic contribution are not adequately rewarded. Tamil Nadu, Karnataka and Maharashtra continued to receive lower shares than several poorer States.
6. Political Economy Concerns: Economically stronger States are not always politically dominant in Parliament. Future delimitation may further increase pressure to favour population-rich States in fiscal transfers.

Way Forward

1. Balance Equity and Efficiency: Future Finance Commissions should balance equalisation with fiscal performance. Poorer States need support, but economically stronger States should also receive fair recognition for revenue generation and governance outcomes.
2. Limit Cesses and Surcharges: Cesses and surcharges should be capped at around 8%-10% of gross tax revenue or gradually merged into the divisible pool. This will increase untied resources available to States.
3. Restore Revenue Gap and State-Specific Grants: Revenue-gap grants and State-specific grants should continue for States facing structural and geographical disadvantages. This can reduce regional disparities in health, education and infrastructure.
4. Use Better Fiscal Indicators: Future devolution formulas should give greater weight to fiscal capacity, tax effort and governance outcomes. Reliance only on non-fiscal indicators can weaken incentives for fiscal discipline.
5. Adopt Data-Driven Weighting Methods: Finance Commissions should use objective methods such as principal component analysis while assigning weights to criteria. This can improve transparency and predictability in transfers.
6. Strengthen Cooperative Federalism: Frequent meetings of the Inter-State Council and stronger State Finance Commissions can improve Centre-State coordination. Greater consultation can reduce tensions over devolution and fiscal autonomy.
7. Protect States’ Fiscal Space: The growing dominance of Centrally Sponsored Schemes should be reduced. States should have greater flexibility in spending according to local development needs and priorities.

Conclusion

The 16th Finance Commission continued India’s equity-oriented fiscal transfer system but made only limited changes towards efficiency and fiscal performance. Concerns over declining State autonomy, rising cesses, unequal transfers and weak incentives for fiscal discipline remain strong. Future Finance Commissions should create a better balance between equalisation, economic contribution, fiscal efficiency and development needs to strengthen cooperative and stable fiscal federalism in India.

Question for practice:

Evaluate the recommendations and devolution criteria of the 16th Finance Commission in balancing equity, fiscal efficiency, and cooperative federalism in India.

Source: The Hindu