Fiscal transfers: Changing methodology | Photo Credit: Deepak Verma

The Constitutional framework of India visualised the Finance Commission as an institution responsible for addressing fiscal imbalances and regional disparities among States.

The principle underlying intergovernmental transfers has historically been that States should be enabled to provide reasonably comparable levels of public services at comparable levels of taxation. The equalisation approach was reflected in the recommendations of successive Finance Commissions as well as the broader planning framework pursued by the Planning Commission.

Income distance, fiscal disability, infrastructural deficits, and demographic disadvantages were therefore treated as important criteria for horizontal devolution.

The Sixteenth Finance Commission marks an important departure from this tradition. By introducing contribution to national GDP as a criterion for devolution, the Commission has brought in a competing principle that rewards economic performance alongside fiscal disability. This article critically examines this normative shift and evaluates its implications for inter-State equity and balanced regional development.

Fiscal Federalism

The role of the Finance Commission under Article 280 has traditionally been interpreted in equalisation terms. DK Srivastava, associated with the Twelfth Finance Commission and NIPFP, described equalisation as the guiding principle of transfers in federations.

Similarly, the Ninth Finance Commission argued that equitable federal transfers require equal treatment of equals and unequal treatment of unequals. The Planning Commission also treated Finance Commission transfers as instruments for correcting fiscal disabilities and compensating for differences in fiscal capacity and expenditure needs across States.

The Lakdawala approach to regional planning viewed transfers as mechanisms for reducing spatial inequalities rather than rewarding existing economic strength. While performance criteria such as tax effort and fiscal discipline were gradually introduced from the Tenth Finance Commission onwards, the dominant orientation of the transfer system remained redistributive justice and equalisation.

This benefitted economically weaker and infrastructurally disadvantaged States, including many in northern and north-eastern India.

Competitive Federalism

The Sixteenth Finance Commission has introduced contribution to national GDP as a criterion in horizontal devolution. The rationale offered is that economically advanced States contribute disproportionately to national growth and therefore deserve recognition within the transfer framework.

However, this introduces a conceptual contradiction. Income enters the devolution formula both negatively and positively. Through income distance, lower-income States receive larger transfers because low per capita income signifies fiscal disability. Through contribution to GDP, economically stronger States also gain larger transfers because of their higher contribution to national production.

The same economic variable thus operates simultaneously as a measure of disadvantage and as a reward for economic strength. This weakens the internal consistency of the equalisation principle and signals a movement from equalisation-oriented federalism towards competitive federalism (Table 1).

Structural constraints

Several less developed States have recorded relatively high growth rates during the past two decades. However, structural transformation remains incomplete. Manufacturing continues to account for a relatively small share of Gross State Domestic Product, industrial diversification is limited, and urbanisation levels remain below the national average.

The growth of small and medium towns, agro-processing centres, and manufacturing clusters has been inadequate. Private investment and foreign direct investment remain concentrated in a few developed States.

Consequently, these less developed States continue to depend heavily on public investment financed through transfers and borrowings. A reduction in redistributive transfers may therefore adversely affect capital expenditure on infrastructure, health, education, irrigation, and urban development precisely at a stage when sustained public investment in these is essential for long-term transformation.

Grants, conditionality

The discontinuation of Revenue Deficit Grants (RDGs) represents another important shift. Earlier Finance Commissions used normative assessments of revenue and expenditure to estimate post-devolution deficits and provided grants to bridge a significant part of these gaps.

The Sixteenth Finance Commission was instructed by the government that the continuation of RDGs created a cyclical dependence on grants and weakened incentives for fiscal discipline. This was the case with the Fifteenth Commission as well which tried reducing it by tapering it off over its five-year period. The present Commission, however, has chosen not to recommend RDGs during its award period.

The revenue deficits of poorer States are often rooted in structural conditions such as low income levels, weak tax bases, limited industrialisation, and high developmental expenditure obligations. The withdrawal of grants may therefore aggravate regional disparities and constrain developmental expenditure.

Structural reforms

The Sixteenth Finance Commission recommends that States improve governance, rationalise subsidies, restructure public enterprises, and undertake reforms in electricity distribution companies.

While these reforms may be desirable in principle, the expectation that poorer States can overcome structural fiscal constraints primarily through governance reforms appears unrealistic.

Historical backwardness, weak industrialisation, low urbanisation, and limited private investment cannot be addressed merely through administrative efficiency. Richer States with stronger markets and larger private sectors are likely to be better positioned to implement reforms, whereas poorer States may face higher economic and social costs.

Inclusive federalism

The recommendations of the Sixteenth Finance Commission indicate an important shift in the normative foundations of Indian fiscal federalism. The historical emphasis on equalisation and balanced regional development is increasingly being replaced by an emphasis on performance and contribution to national growth. (Table 2)

While fiscal discipline and efficiency are important objectives, equalisation-oriented transfers remain essential in a country characterised by deep structural inequalities across States. Without adequate redistributive support, the emerging framework risks widening regional disparities and undermining the Constitutional vision of cooperative and inclusive federalism.

The writer is Visiting Professor, MANU University, Hyderabad

Published on June 22, 2026