Normative Shift in Fiscal Federalism

UPSC Syllabus: Gs Paper 2- Federalism

Introduction

Article 280 provides for the Finance Commission, whose role has traditionally been interpreted in equalisation terms. Fiscal transfers were largely designed to reduce differences in fiscal capacity and support balanced regional development across States. The Sixteenth Finance Commission marks an important shift by introducing contribution to national GDP as a criterion for horizontal devolution. This has triggered a debate on whether fiscal transfers should primarily support weaker States or increasingly reward economic performance, fiscal discipline, and growth contribution.

Equalisation as the Traditional Foundation of Fiscal Federalism

1. Constitutional Role of the Finance Commission: The Finance Commission was designed to address fiscal imbalances and regional disparities among States. Its objective was to ensure reasonably comparable public services at comparable levels of taxation.
2. Equalisation as the Guiding Principle: Equalisation was viewed as the core principle of federal transfers. It aimed to compensate States facing fiscal disabilities and lower revenue-raising capacity.
3. Use of Need-Based Devolution Criteria: Income distance, fiscal disability, infrastructural deficits, and demographic disadvantages were important criteria in horizontal devolution. These factors directed larger transfers towards weaker States.
4. Redistributive Justice in Federal Transfers: Successive Finance Commissions and the Planning Commission treated transfers as tools for reducing inequalities. The focus remained on correcting differences in fiscal capacity and expenditure needs.
5. Lakdawala Approach to Regional Development: Regional planning viewed transfers as instruments for reducing spatial inequalities. The objective was not to reward existing economic strength but to support lagging regions.
6. Limited Role of Performance Criteria: Factors such as tax effort and fiscal discipline were gradually introduced from the Tenth Finance Commission onwards. However, equalisation remained the dominant principle.
7. Support to Weaker States: This framework particularly benefited economically weaker and infrastructurally disadvantaged States, including many northern and north-eastern States.

Emergence of Performance-Oriented Fiscal Federalism

1. Introduction of GDP Contribution Criterion: The Sixteenth Finance Commission introduced contribution to national GDP as a criterion in horizontal devolution. It carries a 10% weight in the inter-se distribution formula.
2. Recognition of Economic Contribution: The rationale is that economically advanced States contribute significantly to national growth. Therefore, their contribution should be recognised in the transfer framework.
3. Shift from Pure Equalisation: The new criterion moves beyond a purely redistributive approach. It introduces a stronger link between transfers and economic performance.
4. Replacement of Earlier Performance Measure: Contribution to GDP replaced the earlier tax and fiscal effort criterion. This represents a significant change in the design of horizontal devolution.
5. Retention of Vertical Devolution Share: The Commission retained the States’ share at 41% of the divisible pool. The Union Budget 2026–27 accepted this recommendation and provided ₹1.4 lakh crore as Finance Commission grants.
6. Move Towards Competitive Federalism: The new framework gives greater importance to growth and productivity. This reflects a gradual shift from equalisation-oriented federalism towards competitive federalism.

Challenges, Contradictions and Policy Concerns in the New Approach

1. Dual Treatment of Income: Income now enters the formula in two opposite ways. Income distance benefits poorer States, while GDP contribution benefits richer States.
2. Weakening of Equalisation Logic: The same economic variable is used both as a measure of disadvantage and as a reward for economic strength. This creates a conceptual inconsistency within the devolution formula.
3. Impact on Distribution of Transfers: Middle-income States may benefit from this dual approach. Poorer States may lose because they have both lower income and lower contribution to national output.
4. Discontinuation of Revenue Deficit Grants: The Commission decided not to continue Revenue Deficit Grants (RDGs). The decision was based on the view that such grants may create dependence and weaken fiscal discipline.
5. Limitations of Aggregate Fiscal Estimates: Aggregate state surpluses may not reflect the financial difficulties of hill and north-eastern States, which face high service delivery costs and weak revenue bases.
6. Growing Role of Cesses and Surcharges: States receive 41% of the divisible pool, but cesses and surcharges are excluded from sharing. As their use increases, the effective transfer to States is estimated at only 29–30% of gross tax revenue.
7. Difficulty in Assessing State Finances: Variations in reporting debt, subsidies, and off-budget liabilities make fiscal comparisons difficult. As a result, claims about fiscal discipline may not always reflect the actual situation.

Impact on Less-Developed States and Regional Equity

1. Reduced Redistributive Support: Greater emphasis on GDP contribution may reduce the relative share of poorer States in horizontal devolution. Estimates suggested that the eight poorest States could receive about ₹14 lakh crore less during the award period than under the earlier framework.
2. Pressure on Developmental Expenditure: Lower transfers may affect spending on infrastructure, health, education, irrigation, and urban development. These sectors are important for long-term transformation.
3. Greater Burden on Public Investment: Less-developed States depend heavily on transfers and borrowings for development. Reduced fiscal support may limit their ability to sustain public investment.
4. Challenges for Structural Transformation: Many poorer States still face low industrialisation, limited urbanisation, and weak investment. Reduced support may slow their economic transformation.
5. Widening Regional Disparities: The shift from equalisation towards performance-based transfers may increase differences between developed and less-developed States.
6. Higher Fiscal Stress on Poorer States: The withdrawal of Revenue Deficit Grants may create additional pressure on States with weak tax bases and high developmental expenditure needs.

Debate on the Future Direction of Fiscal Federalism

1. Equity versus Performance Debate: The central question is whether tax devolution should prioritise correcting inequalities or rewarding economic contribution. The Sixteenth Finance Commission has intensified this debate.
2. Need to Protect Equalisation Objectives: Equalisation seeks to ensure that citizens receive basic public services regardless of their State’s fiscal capacity. This remains a key constitutional objective.
3. Need to Protect the Divisible Pool: The growing use of cesses and surcharges reduces the shareable tax pool. This weakens the Finance Commission’s role in correcting vertical imbalances.
4. Need for Better Incentive Design: Experience shows that incentives linked to fiscal improvement can work. Better-designed conditions may be more effective than complete withdrawal of support.
5. Importance of Fiscal Transparency: Stronger fiscal coordination requires comparable and reliable state-level data. Transparency is essential for assessing solvency, debt, subsidies, and liabilities.
6. Unresolved Issues in the Federal Framework: Local body grants, state finance commission reports, fiscal transparency, and the divisible pool remain areas requiring further attention.

Conclusion

The Sixteenth Finance Commission marks a shift from equalisation-oriented fiscal federalism towards greater recognition of economic performance and growth contribution. While efficiency and fiscal discipline remain important, significant inter-state disparities continue to require redistributive support. The key challenge is to balance growth incentives with regional equity while preserving the constitutional vision of cooperative and inclusive federalism.

Question for practice:

Evaluate the shift from equalisation-based fiscal federalism to performance-oriented devolution under the Sixteenth Finance Commission and its impact on inter-State equity.

Source: BussinessLine