Central-State Transfers – Explained Pointwise

Central transfers have become a subject of intense debate. In this article, we will explore the importance & criticisms against central transfers & what could be the way forward in this regard.

What does Central Transfers means?

• Central Transfers refer to the financial resources allocated by the central government to state governments in India to address fiscal imbalances and support public expenditure.
• These transfers primarily occur through tax devolution and grants recommended by the Finance Commission. They ensure equitable resource distribution across states with varying revenue capacities. Finance Commissions determine both the overall share to States & the formula for tax devolution.
• There are two main reasons for these transfers:
  1. Vertical Equity: Ensuring that states have enough money to perform the duties assigned to them by the Constitution.
  2. Horizontal Equity: Reducing the gap between rich and poor states. For example, a state with less industrial activity needs extra help to provide the same level of education or infrastructure as a wealthy state.

Types of Central Transfers:

What is the importance of Central Transfers?

1. Correcting Vertical Imbalance:
   • The Constitution gives the Centre more “buoyant” (high-growth) tax powers like Income Tax and Customs, while States handle high-expenditure items like health, education, and police.
   • Without transfers, states would perpetually be in debt or unable to fund basic public services. Central transfers ensure that states have enough liquidity to function effectively.
2. Promoting Horizontal Equity (Reducing Regional Gaps):
   • Not all states have the same economic potential. A highly industrialized state like Maharashtra can generate more revenue than a landlocked or mountainous state like Bihar or Himachal Pradesh.
   • Transfers use an “Equalization” principle. By giving a larger share of funds to poorer or geographically disadvantaged states, the system ensures that a citizen in a low-income state still gets access to a basic level of healthcare and schooling.
3. Maintaining Fiscal Stability & Insurance:
   • The Central government can borrow money on better terms than individual states and has a larger “reserve” to handle shocks.
   • During disasters (like floods or pandemics), the Centre provides emergency grants to help states recover without collapsing their local budgets.
   • If one region’s economy slows down, transfers act as a form of “inter-regional insurance,” keeping the local administration running despite the dip in local tax collection.
4. Implementing National Priorities:
   • The Centre often wants to achieve nationwide goals, such as “Electricity for All” or “Universal Vaccination.”
   • Through Centrally Sponsored Schemes (CSS), the Centre provides “tied” funds that incentivize states to follow a national development roadmap. This ensures that even while states have autonomy, the country moves toward common developmental targets.

What are the criticisms against Central Transfers?

1. The “North-South” Divide: States like Karnataka, TN & Maharashtra argue that they contribute disproportionately to central tax revenue but receive relatively smaller shares through tax devolution. Southern states criticize transfers for using population as a metric. They argue they are being “punished” for successfully implementing population control and growing their economies, while “failing” states receive more funds.
2. “Conditionality” and Tied Grants: Many transfers come as “conditional grants” (like Centrally Sponsored Schemes). This forces the states to spend on central priorities rather than local needs, turning states into mere “administrative arms” of the center.
3. One-Size-Fits-All Approach: Centralized schemes often fail to account for regional diversity. A scheme designed for a mountainous region may be irrelevant or inefficient for a coastal state, yet the state must implement it to receive the funding.
4. Political Favoritism: Discretionary grants (those not mandated by a formula) are criticized for being used as political tools to reward “friendly” state governments or penalize opposition-led ones.
5. Lax Tax Effort: If states know they will receive a guaranteed transfer from the center, they may have less incentive to broaden their own local tax base or collect taxes efficiently. This is often called a “perverse incentive.”
6. Gap-Filling Approach: When transfers are designed to cover state deficits, it encourages states to overspend, knowing the central government will eventually “bail them out” to maintain national stability.
7. Dependency Trap: Over time, states may become “transfer-dependent,” where their entire budget planning relies on central volatility rather than sustainable local growth.
8. Transfer of Inefficiency: Taking money from high-performing, industrialized states and giving it to low-performing ones can sometimes lead to a “transfer of inefficiency,” where capital is moved from high-return areas to low-productivity regions.
9. Transparency in the “Divisible Pool”: Central governments are often accused of using “cesses and surcharges” (which are not shared with states) to keep a larger portion of the tax revenue for themselves, shrinking the actual pool of money available for transfer.

What should be the way forward?

1. GSDP-based Formula: A higher weightage for GSDP share in the central transfer formula would better reflect the accrual of central tax revenues, acknowledge the contributions of States to national income, and improve the perceived fairness & credibility of India’s inter-governmental fiscal transfer system.
2. Expansion of the Divisible Pool: A major demand is to include Cesses and Surcharges in the pool of taxes shared with states. Currently, these are kept entirely by the Centre and have grown to over 10% of Gross Tax Revenue, effectively shrinking the states’ actual share below the recommended 41%.
3. Higher Devolution Target: Some experts and states are calling for the vertical share to be increased from 41% to 50% to account for the states’ increased burden in social sector spending (health, education, and climate resilience).
4. Rewarding Performance: Moving beyond just “population” and “income distance,” the 16th FC is expected to give higher weight to Tax Effort and Demographic Performance. This rewards states that have successfully controlled population growth and improved their own tax collection.
5. Equity vs. Efficiency: While “Income Distance” (giving more to poorer states) remains vital for national stability, there is a push to make the formula less “linear.” This ensures that developed states aren’t disincentivized from further growth.
6. Empowering Local Bodies: Recommendations suggest doubling the Inter-Governmental Transfers (IGT) to urban and rural local bodies, recognizing cities as “engines of growth” that require massive infrastructure funding.
7. Streamlining CSS: Centrally Sponsored Schemes (like MGNREGA or Ayushman Bharat) are often seen as “one-size-fits-all.” The states should be given more flexibility to adapt these schemes to local needs rather than imposing rigid 60:40 or 50:50 funding ratios.
8. Institutionalizing a “Loan Council”: To manage the high debt levels of both Centre and States, a permanent body could oversee fiscal deficit targets, replacing the ad-hoc nature of current limits.
9. Integrating Technology: Using AI and data analytics to track “Tax Accrual” vs. “Tax Collection.” This would help identify where economic value is actually created (e.g., in manufacturing hubs) versus where corporate taxes are filed (e.g., headquarters in Mumbai).