Targeted Equalisation via Grants-in-Aid (Article 275): Conceived as a core design element to address specific, non-formulaic state needs that general tax devolution cannot solve.
Compensating Unpriced National Contributions : Recognizes states that sacrifice local fiscal health to deliver national public goods.
Complete dismantling of Revenue Deficit Grants (RDGs), sector-specific grants, and state-specific grants, restricting grants solely to local bodies and disaster management.
Introduced a in the horizontal tax devolution formula while reducing the weight assigned to income distance from 45% to 42.5%.
Example: Eight states, including several North-Eastern states and West Bengal, face a simultaneous decline in both tax devolution and grants.
GS 2 Fiscal federalism, efficiency versus equity concerns
Context: The 16th Finance Commission (FC-16) report (covering 2026–31) sparked intense federal debates by maintaining vertical tax devolution at 41% while halving the share of grants-in-aid from 19.4% to 8.3%.
Fiscal federalism, efficiency versus equity concerns
About Fiscal federalism, efficiency versus equity concerns :
What it is?
Fiscal federalism refers to the financial architecture governing the allocation of tax revenues, spending responsibilities, and intergovernmental transfers between the Central Government and State Governments.
In a diverse federation like India, fiscal policy must continually balance two competing priorities: efficiency (incentivizing fiscal discipline, revenue mobilization, and economic performance) and equity (providing compensatory transfers to overcome structural, geographical, and historical horizontal disparities among states).
The Constitutional Philosophy of Fiscal Federalism:
Correcting Structural Vertical Imbalance : The Constitution grants dominant tax-raising powers to the Union while burdening States with major social sector expenditures (education, health, agriculture), using the Finance Commission as a corrective bridge.
Example: Article 280 mandates five-yearly tax-sharing recommendations to ensure states remain fiscally viable.
Targeted Equalisation via Grants-in-Aid (Article 275): Conceived as a core design element to address specific, non-formulaic state needs that general tax devolution cannot solve.
Example: Providing top-up funding for hill states facing elevated infrastructure construction costs.
Compensating Unpriced National Contributions : Recognizes states that sacrifice local fiscal health to deliver national public goods.
Example: Punjab ensuring national food security at the cost of its taxable agricultural base, or Kerala investing in human capital that yields national remittances.
Preserving Union Unity through Equity: Treats fiscal federalism as a constitutional compact to manage regional diversity and prevent widening economic divergence between affluent and disadvantaged states.
FC-16’s New Fiscal Framework:
Retention of Vertical Devolution at 41%: Rejection of the demand by 18 states to increase the states’ share in the divisible central tax pool to 50%.
Rejection of the demand by 18 states to increase the states’ share in the divisible central tax pool to 50%. Dramatic Reduction in Grants-in-Aid : Reduced total recommended grants-in-aid to ₹9.47 lakh crore (2026–31) compared to ₹10.1 lakh crore under FC-15, halving grants’ share in total Finance Commission transfers from 19.4% to 8.3%.
Reduced total recommended grants-in-aid to ₹9.47 lakh crore (2026–31) compared to ₹10.1 lakh crore under FC-15, halving grants’ share in total Finance Commission transfers from 19.4% to 8.3%. Elimination of Gap-Filling Grants: Complete dismantling of Revenue Deficit Grants (RDGs), sector-specific grants, and state-specific grants, restricting grants solely to local bodies and disaster management.
Complete dismantling of Revenue Deficit Grants (RDGs), sector-specific grants, and state-specific grants, restricting grants solely to local bodies and disaster management. Inclusion of GDP Contribution Weight: Introduced a 10% weight for State GDP contribution in the horizontal tax devolution formula while reducing the weight assigned to income distance from 45% to 42.5%.
Introduced a in the horizontal tax devolution formula while reducing the weight assigned to income distance from 45% to 42.5%. Performance-Conditioned Local Body Funding : Allocated nearly ₹7.2 lakh crore to local governments (the third tier) but tied fund releases to strict compliance targets in water, sanitation, and audited accounts.
Allocated nearly ₹7.2 lakh crore to local governments (the third tier) but tied fund releases to strict compliance targets in water, sanitation, and audited accounts. Soft Approach on Cesses and Surcharges: Proposed a non-binding grand bargain encouraging the Centre to gradually merge non-shareable cesses into the divisible pool, rather than enforcing a mandatory rollback.
Equity vs. Efficiency: Major Critiques:
Double Burden on Vulnerable States: Reducing the income distance weight alongside removing RDGs creates a severe revenue hit for economically lagging regions.
Example: Eight states, including several North-Eastern states and West Bengal, face a simultaneous decline in both tax devolution and grants.
Assumption of Uniform Fiscal Capacity : Eliminating RDGs assumes all states possess equal capacity to raise revenue, ignoring structural constraints.
Example: Disadvantaged states cannot offset structural revenue deficits through domestic taxation alone.
Asymmetric Discipline Requirements: Enforces strict fiscal discipline on States by abolishing RDGs while allowing the Centre to retain non-shareable cesses and surcharges.
Example: Cesses remain an un-devolved revenue stream for the Union, eroding the effective divisible pool.
Erosion of Local Body Fiscal Autonomy : Replacing need-based grants with compliance-based conditionalities restricts local government flexibility.
Example: Gram Panchayats losing discretionary funds due to delayed procedural audits or rigid central project mandates.
Widening Regional Income Disparities: Prioritizing economic performance and GDP contribution risks funneling higher revenues back to wealthier, industrialized states.
Example: Highly developed coastal economies gaining larger shares while landlocked regions lag further behind.
The Way Forward:
Re-Institutionalizing Need-Based Equalisation Grants: Restore targeted Revenue Deficit Grants and state-specific assistance under Article 275 for regions facing permanent structural, geographic, or demographic handicaps.
Restore targeted Revenue Deficit Grants and state-specific assistance under Article 275 for regions facing permanent structural, geographic, or demographic handicaps. Cap and Cede Union Cesses and Surcharges: Amend constitutional provisions or set a strict statutory ceiling on non-shareable cesses, mandating their progressive inclusion into the divisible pool.
Amend constitutional provisions or set a strict statutory ceiling on non-shareable cesses, mandating their progressive inclusion into the divisible pool. Calibrating Horizontal Devolution Weights: Rebalance the horizontal formula by restoring higher weightage to income distance and forest cover to safeguard disadvantaged and ecologically vital states.
Rebalance the horizontal formula by restoring higher weightage to income distance and forest cover to safeguard disadvantaged and ecologically vital states. Providing Flexible Local Body Grants: Maintain a healthy balance between conditional performance incentives and un-tied basic grants to preserve local self-governance autonomy.
Maintain a healthy balance between conditional performance incentives and un-tied basic grants to preserve local self-governance autonomy. Evaluating States on Cost Disabilities: Incorporate explicit cost disability metrics—such as terrain, climate vulnerability, and border security duties—into transfer formulas to reflect the real cost of public service delivery.
Conclusion:
While the 16th Finance Commission introduces a technocratic shift toward performance and fiscal discipline, fiscal federalism in a diverse union cannot survive on market-like efficiency alone. Eliminating revenue deficit grants while preserving non-shareable central cesses risks expanding regional disparities and undermining the constitutional spirit of Article 275. Achieving long-term national cohesion requires a balanced framework that rewards high-performing states without abandoning those constrained by structural disadvantages.
