Fiscal Federalism, Efficiency versus Equity Concerns

UPSC Syllabus: Gs Paper 2 –  Issues and challenges pertaining to the federal structure.

Introduction

The 16th Finance Commission (2026–31) keeps the States’ share in central taxes at 41% but changes the structure of fiscal transfers, especially grants-in-aid. It gives greater importance to efficiency, fiscal discipline and performance, while reducing several equalisation grants. This has raised concerns that the Commission may be moving away from its constitutional role of reducing fiscal inequalities and protecting the interests of States. Fiscal Federalism, Efficiency versus Equity Concerns.

Constitutional Vision of Fiscal Federalism

1. Purpose of the Finance Commission: The Finance Commission was created to correct vertical and horizontal fiscal imbalances, protect State interests and strengthen India’s fiscal federal compact.
2. Correcting Vertical Imbalance: It was designed to address the imbalance between a fiscally dominant Union and States with greater expenditure responsibilities but limited revenue-raising powers.
3. Reducing Horizontal Inequalities: It aims to reduce fiscal disparities arising from differences in history, geography, institutional capacity and development levels among States.
4. Constitutional Logic of Grants-in-Aid: Article 275 provides grants-in-aid because formula-based tax devolution alone cannot meet the diverse financial needs of every State.
5. Need for State-Specific Support: States such as Kerala, Punjab, hill States, North-Eastern States and fiscally stressed States face unique responsibilities and structural constraints that require targeted financial assistance.
6. Equalisation through Grants: Revenue Deficit Grants (RDGs), sector-specific grants and State-specific grants were created to support States where tax devolution alone could not remove fiscal gaps.
7. Role of Earlier Finance Commissions: The 14th and 15th Finance Commissions retained these grants to continue the constitutional objective of fiscal equalisation.

Major Recommendations of the 16th Finance Commission

1. Tax Devolution Retained: The Commission retains the States’ share in the divisible pool at 41%, despite 18 States demanding an increase to 50%.
2. Reduction in Grants-in-Aid: Grants-in-aid decline from ₹10.1 lakh crore under the 15th Finance Commission to ₹9.47 lakh crore, reducing their share in total Finance Commission transfers from 19.4% to 8.3%.
3. Removal of Equalisation Grants: The Commission discontinues Revenue Deficit Grants, sector-specific grants and State-specific grants, limiting grants mainly to local bodies and disaster management.
4. Assumption of Greater Fiscal Capacity: It assumes that improved fiscal discipline will enable States to manage their finances without additional gap-filling transfers.
5. Shift towards Performance: Fiscal transfers increasingly emphasise efficiency, accountability and performance instead of unconditional financial support.
6. Changed Architecture of Fiscal Transfers: The recommendations fundamentally redesign the grant structure while retaining the existing level of tax devolution.
7. Beginning of a New Fiscal Approach: The report marks a significant shift in fiscal federalism by giving greater priority to performance-based transfers than earlier Finance Commissions.

Why Were These Changes Introduced?

1. Promoting Fiscal Discipline: The Commission believes States should strengthen their own finances and reduce dependence on recurring gap-filling support from the Centre.
2. Addressing Moral Hazard: It argues that Revenue Deficit Grants (RDGs) may discourage revenue mobilisation and encourage higher expenditure in expectation of future central assistance.
3. Reliance on Aggregate Fiscal Position: The Commission concludes that additional revenue support is unnecessary because the combined fiscal position of all States does not indicate severe financial stress.
4. Assumption of Self-Equalisation: It assumes that 41% tax devolution, together with better fiscal management, can largely meet the financial requirements of States without separate equalisation grants.
5. Improving Accountability: Greater use of performance-linked transfers aims to encourage efficient financial management and responsible use of public resources.

Efficiency versus Equity: Key Concerns

1. Questioning the Assumption of Uniform Fiscal Capacity: Fiscal capacity differs widely across States because of historical, geographical and institutional factors. Therefore, tax devolution alone cannot fully address the financial needs of every State.
2. Need for Equalisation Remains: Some States continue to face fiscal stress despite making major contributions to national development. A fiscal surplus in one State cannot compensate for the deficit faced by another State.
3. Weakening the Equalisation Role: The removal of Revenue Deficit Grants, sector-specific grants and State-specific grants reduces the Finance Commission’s traditional role of providing targeted support to States with special needs.
4. Efficiency Given Greater Priority than Equity: The new framework gives more importance to fiscal discipline and performance. This risks reducing the emphasis on constitutional fairness and equalisation among States.
5. From Need-Based Support to Compliance-Based Incentives: The Commission allocates nearly ₹7.2 lakh crore to local governments. However, the release of funds depends on conditions such as water and sanitation targets, revenue mobilisation and audited accounts, making grants more compliance-oriented.
6. Fiscal Discipline Cannot Replace Fiscal Justice: Accountability and better financial management are important. However, they cannot substitute the constitutional objective of supporting States that face structural disadvantages.

Federalism Concerns: Has the Union’s Fiscal Primacy Increased?

1. Different Approach towards RDGs and Cesses: The Commission removes Revenue Deficit Grantsin the name of fiscal discipline. However, it does not recommend any binding reduction in non-shareable cesses and surcharges, despite demands from many States.
2. The “Grand Bargain” Proposal: The Commission suggests that the Centre may gradually merge cesses into the divisible pool if States agree to a lower share in tax devolution. This proposal links one reform with another instead of recommending an immediate correction.
3. Unequal Fiscal Adjustment: States are expected to accept tighter financial discipline through the withdrawal of grants. At the same time, the Union retains greater flexibility over revenues collected through cesses and surcharges.
4. Risk of Reinforcing Vertical Imbalance: This different treatment may strengthen the fiscal position of the Union while limiting financial support available to States. It raises concerns that vertical fiscal imbalance may increase instead of being corrected.
5. Shift from Equalisation to Fiscal Primacy: The overall framework appears to protect the Union’s fiscal space while placing a larger adjustment burden on the States. This raises doubts about whether the Finance Commission is moving away from its traditional equalising role.

Impact on States

1. Reduced Transfers to Several States: Eight States, including most North-Eastern States and West Bengal, are expected to receive lower shares in both tax devolution and grants, while six other States face a decline in grant allocations.
2. Lower Weight for Income Distance: Reducing the weight of income distance from 45% to 42.5% and assigning 10% weight to GDP contribution changes the balance between equity and economic performance.
3. Double Fiscal Burden: The combined effect of lower devolution and the removal of RDGs, which formed about 20% of Finance Commission grants in 2024–25, reduces financial support for disadvantaged States.
4. Risk of Wider Regional Disparities: Greater emphasis on efficiency over equalisation may widen fiscal and developmental gaps among structurally disadvantaged States.
5. Need-Based Support Replaced by Performance Incentives: The shift from equalisation grants to conditional transfers reduces support based on fiscal need and increases dependence on compliance with performance targets.

Way Forward

1. Restore the Equalisation Function: Future Finance Commissions should continue targeted fiscal support for States facing structural and regional disadvantages.
2. Balance Efficiency with Equity: Fiscal discipline and performance incentives should complement, not replace, the constitutional goal of fiscal fairness.
3. Recognise Diverse State Needs: Fiscal transfers should continue reflecting differences in geography, fiscal capacity, development levels and social commitments among States.
4. Reward Performance without Ignoring Need: High-performing States should receive incentives while fiscally stressed States continue receiving support for genuine structural constraints.
5. Preserve Cooperative Fiscal Federalism: A balanced fiscal framework should protect both the Union’s fiscal strength and the financial autonomy of States.

Conclusion

The 16th Finance Commission gives greater importance to efficiency, fiscal discipline and performance, but raises concerns about its reduced focus on equity and equalisation. Fiscal federalism can remain strong only when it balances performance with fairness, protects States facing structural disadvantages, and continues to uphold the constitutional spirit of cooperative federalism.

Question for practice:

Examine the implications of the 16th Finance Commission’s recommendations for fiscal federalism, particularly in balancing efficiency with equity in Centre–State fiscal relations.

Source: The Hindu