The Success Penalty, How India’s Fiscal Federalism Punishes Efficiency and Rewards Stagnation

The Success Penalty, How India’s Fiscal Federalism Punishes Efficiency and Rewards Stagnation

When Telangana was carved out of Andhra Pradesh in 2014, it was heralded as the birth of a new, dynamic State—one that would leverage its strengths in technology, pharmaceuticals, and human capital to script a distinctive development story. A decade later, that story is undeniable. Hyderabad’s Genome Valley supplies nearly one-third of the world’s vaccines. The State accounts for almost 10 per cent of India’s total proposed investments. Its per capita income has consistently outpaced the national average. By any rational measure, Telangana is a national asset, a growth engine contributing disproportionately to the central exchequer and the country’s global competitiveness.

Yet, when the 16th Finance Commission’s interim report was tabled on February 1, 2026, Telangana received its latest reward for this decade of achievement: a tax devolution share of approximately 2.17 per cent—a marginal increase of just 0.07 per cent from the 2.10 per cent it received under the 15th Finance Commission, and still significantly below the 2.43 per cent it enjoyed under the 14th Finance Commission. Gujarat, a State with broadly similar industrial profile, received 3.48 per cent. This is not an anomaly. It is the arithmetic expression of a deepening dysfunction in India’s fiscal federalism: the systematic penalisation of high-performing States. As Telangana’s experience demonstrates, when a State improves its per capita income, stabilises its population, and demonstrates fiscal discipline, its reward is a reduced share in central taxes, denial of strategic industrial projects, and a progressively tightening fiscal noose. Efficiency, in this perverse framework, has become a liability.

The Architecture of Inequity: How the Finance Commission Formula Creates Losers

To understand Telangana’s grievance, one must first understand the mechanics of horizontal devolution. Under Article 280 of the Constitution, the Finance Commission recommends the distribution of the divisible pool of central taxes among States. The 15th Finance Commission adopted six criteria: Income Distance (45 per cent), Population (2011 Census) (15 per cent), Area (15 per cent), Forest & Ecology (10 per cent), Demographic Performance (12.5 per cent), and Tax Effort (2.5 per cent).

The overwhelming dominance of Income Distance—which measures the gap between a State’s per capita income and that of the poorest State—is the primary instrument of the success penalty. The logic appears benevolent: States with higher incomes need less central support; the finite divisible pool should be directed towards poorer States to promote equity and convergence. In theory, this is unobjectionable. In practice, it creates a perverse incentive structure that punishes the very behaviour India claims to desire.

Consider Telangana. Its per capita income has risen faster than the national average. Its demographic indicators are among the best in the country. Its tax effort, while weighted at only 2.5 per cent, is robust. Yet each improvement in these metrics widens its Income Distance from the poorest State, thereby reducing its assessed “need” for central resources. The State that generates more wealth, contributes more revenue, and manages its population growth more responsibly is, in the Commission’s arithmetic, less deserving of its own share of the taxes its citizens have paid.

This is not equity; it is disincentivisation by design. It tells high-performing States that their efficiency will be rewarded not with greater fiscal autonomy or recognition but with a progressively shrinking share of the common pool. It tells lagging States that there is no urgent imperative to improve, because stagnation carries its own fiscal subsidy. And it tells the citizens of States like Telangana, Tamil Nadu, Karnataka, and Maharashtra that their success is a national resource to be extracted, not a national achievement to be celebrated.

Beyond Devolution: The Selective Geography of Industrial Policy

The tax devolution formula is the most visible manifestation of the success penalty, but it is far from the only one. Equally telling is the selective allocation of central-sector mega projects that shape a State’s long-term economic trajectory.

Telangana’s experience with the Information Technology Investment Region (ITIR) is instructive. Promised to Hyderabad in 2013, the ITIR was projected to attract Rs 2.19 lakh crore in investment and generate nearly 15 lakh jobs. It was exactly the kind of transformative infrastructure project that could have consolidated Telangana’s position as India’s premier technology hub. Yet the Centre scrapped the ITIR, citing “policy changes”—a phrase that, in practice, functions as a bureaucratic black hole into which inconvenient commitments disappear.

Simultaneously, massive public resources were channelled into Gujarat: GIFT City, semiconductor clusters at Dholera and Sanand, generous Production-Linked Incentive (PLI) subsidies, and a continuous stream of central flagship schemes. The Union Budget 2026-27 reinforces this asymmetry. The newly announced “Biopharma Shakti” scheme, with an outlay of Rs 10,000 crore, makes no reference to Telangana—despite Hyderabad’s Genome Valley being India’s largest life-sciences ecosystem and the producer of nearly one-third of the world’s vaccines. To exclude the nation’s undisputed pharmaceutical capital from a national biopharma initiative is not merely political oversight; it is economic self-harm disguised as industrial policy.

The pattern is unmistakable. High-performing States are not merely denied their fair share of devolution; they are systematically excluded from the very central schemes that could help them maintain and extend their competitive advantage. The message is clear: generate wealth, but do not expect central assistance to sustain it. Innovate, but do not anticipate recognition. Excel, but understand that excellence is not a qualification for support—it is a disqualification.

The Off-Budget Stranglehold: Borrowing, Retrospection, and Fiscal Space

Perhaps the most consequential, and least visible, dimension of Telangana’s fiscal marginalisation lies in the Centre’s treatment of State borrowing. The sequence is illuminating.

When the Centre rejected NITI Aayog’s recommendation to grant Telangana Rs 24,000 crore for Mission Bhagiratha—a critical drinking water and irrigation project serving millions of rural households—the State faced an impossible choice. It could abandon the project, denying its citizens access to safe water. Or it could borrow to finance the infrastructure itself. It chose the latter, funding not only Mission Bhagiratha but also the ambitious Kaleshwaram irrigation project and other core infrastructure through its own resources.

These were not “populist schemes” in the pejorative sense deployed by fiscal conservatives. They were essential public goods—water security, drought mitigation, agricultural resilience—that in other States would have attracted substantial central grant assistance. Telangana, denied that assistance, did the responsible thing: it self-financed its development.

The Centre’s response was not appreciation but retroactive penalisation. Borrowings of state-run corporations, previously treated as off-budget and external to the State’s Net Borrowing Ceiling (NBC), were retrospectively included within Telangana’s borrowing limits. This “off-budget correction” sharply compressed the State’s fiscal space, leaving it unable to finance other critical infrastructure projects—including the Regional Ring Road (RRR) and Hyderabad Metro Phase II—both of which found no mention in the February 2026 Budget speech.

The result is a fiscal pincer movement. Telangana is denied central grants for essential infrastructure, forced to borrow to fill the gap, and then penalised for that borrowing through retroactively tightened ceilings. Its debt is projected to exceed Rs 5 lakh crore by 2026. This is not, as central officials sometimes imply, evidence of Telangana’s fiscal indiscipline. It is the direct, predictable outcome of systematic denial of central support. The State is being strangled by its own success—denied resources, denied projects, denied borrowing space, and then blamed for the fiscal stress that this triple denial inevitably produces.

The National Cost of Penalising Performance

The Telangana story is not merely a regional grievance; it is a national problem with national consequences. India’s economic growth is not a zero-sum game. When a high-performing State is penalised, the entire country loses.

Telangana accounts for nearly 10 per cent of India’s total proposed investments (DPIIT investment intention data, 2025-26). Its pharmaceutical ecosystem is not a local asset; it is India’s frontline in global vaccine diplomacy and generic drug manufacturing. Its IT sector generates export revenues and high-value employment that benefit the national balance of payments and the Union tax pool. Its per capita income growth raises the national average and expands the domestic market for goods and services produced across India.

When the Finance Commission reduces Telangana’s devolution share because its per capita income has risen, it is not merely penalising Telangana; it is taxing the nation’s own success. When the Centre denies Hyderabad an ITIR and then lavishes resources on competing hubs, it is not practising “competitive federalism”; it is arbitrarily picking winners and losers based on criteria that remain opaque. When the borrowing ceiling is retroactively tightened, it is not enforcing fiscal discipline; it is crippling the very States that generate the revenue needed to service national debt.

The framing of fiscal federalism as a redistributive mechanism—transferring resources from “rich” States to “poor” States—is a conceptual anachronism. In a modern, integrated economy, all States are interdependent. The prosperity of Maharashtra benefits Bihar through remittances, tax transfers, and market integration. The industrial output of Gujarat contributes to the central pool that funds welfare schemes in Uttar Pradesh. To treat high-income States as merely “donors” to be milked rather than “partners” to be nurtured is to misunderstand how national wealth is actually created and sustained.

The Call for Reform: What the 16th Finance Commission Must Address

The 16th Finance Commission, whose interim report has now been tabled, has an opportunity—and an obligation—to correct these structural distortions. Several reforms are urgently needed:

1. Rebalance the Criteria Weights
The 45 per cent weight assigned to Income Distance is excessive and produces perverse outcomes. A more balanced formula would reduce this weight and increase the weight assigned to contribution to central tax revenues, fiscal effort, and economic output. States that generate more wealth should be recognised, not penalised, for their contribution to the national exchequer.

2. Recognise Demographic Performance
Telangana’s demographic indicators are exemplary. Yet under the current formula, improved demographic performance—lower population growth, better health outcomes—actually reduces a State’s devolution share, because the 2011 Census population weight is fixed while the Demographic Performance weight penalises States that have successfully stabilised their populations. This is absurd. The Commission should reward, not punish, successful population management.

3. Separate Devolution from Project Allocation
The Finance Commission’s mandate is tax devolution; it does not control the allocation of central-sector industrial projects. But the Commission can, and should, highlight the systematic bias in project allocation and recommend that the Centre adopt transparent, criteria-based mechanisms for distributing discretionary investments. The current practice of opaque, politically-influenced project allocation undermines the very principle of cooperative federalism.

4. Protect Borrowing Autonomy
The retrospective inclusion of off-budget borrowings within State ceilings sets a dangerous precedent. The Commission should recommend clear, prospective, and transparent rules for the treatment of State-owned enterprise borrowings, ensuring that States are not penalised for financing infrastructure through legitimate instruments.

5. Institutionalise a “Reward for Performance” Component
The current framework assumes that equity and efficiency are in tension. They need not be. The Commission should introduce a dedicated performance-based incentive component within the devolution formula, explicitly rewarding States that demonstrate superior outcomes in economic growth, fiscal management, social development, and governance. This would transform the current “success penalty” into a “success bonus,” aligning the incentives of States with national development priorities.

Conclusion: Federalism as Partnership, Not Patronage

The Telangana experience is a stress test for Indian federalism. It reveals a system that has drifted far from the constitutional vision of cooperative partnership between the Union and the States. In that vision, the Centre was not intended to be a gatekeeper of patronage, distributing favours to favoured States and withholding them from others. It was intended to be a partner in development, ensuring that all States—regardless of their political complexion or economic starting point—had access to the resources and opportunities needed to fulfil their developmental potential.

That vision is now in peril. The combination of reduced tax devolution, denial of industrial projects, and restrictive borrowing ceilings has created a fiscal trap for high-performing States. They are expected to generate national wealth but denied the resources to sustain their own infrastructure. They are praised for their efficiency but penalised for its consequences. They are treated as donors, not partners; as competitors, not collaborators.

This is not merely unfair to Telangana. It is economically irrational and nationally self-defeating. As India aspires to become a developed nation by 2047—Viksit Bharat—it cannot afford to systematically disincentivise its own growth engines. It cannot preach cooperative federalism while practising selective patronage. It cannot reward stagnation and penalise success and then wonder why its high-performing States feel alienated and resentful.

The 16th Finance Commission has the tools to correct this trajectory. Whether it possesses the will depends on the quality of evidence, advocacy, and political mobilisation that States like Telangana can bring to bear. The stakes are not merely fiscal; they are constitutional. At issue is the fundamental character of Indian federalism: whether it remains a partnership of equals or degenerates into a hierarchy of favoured and unfavoured States. For Telangana—and for every State that has laboured to convert its potential into prosperity—the answer to that question will determine not only its budget but its future.

Q&A Section

Q1: What is the “success penalty” in the context of India’s fiscal federalism, and how does it operate?
A1: The “success penalty” refers to the paradoxical outcome of India’s tax devolution formula, wherein States that improve their per capita income, demographic indicators, and fiscal performance receive reduced shares of central taxes. This occurs primarily through the Income Distance criterion, which carries 45 per cent weight in the 15th Finance Commission’s formula. Income Distance measures the gap between a State’s per capita income and that of the poorest State. When a State successfully raises its per capita income, this gap widens, making the State appear “less needy” and therefore deserving of a smaller share of the divisible pool. Thus, the very act of improving economic performance triggers an automatic reduction in central resource transfer—a perverse incentive structure that punishes efficiency and, implicitly, rewards stagnation.

Q2: How does Telangana’s tax devolution share compare with Gujarat’s, and why is this comparison significant?
A2: Under the 15th Finance Commission (2021-26), Telangana received 2.10 per cent of the divisible pool, while Gujarat received approximately 3.48 per cent. The 16th Finance Commission’s interim report (2026-27 onwards) raises Telangana’s share marginally to about 2.17 per cent—still far below Gujarat’s allocation. This comparison is significant because both States share broadly similar industrial profiles, with strengths in manufacturing, pharmaceuticals, and services. The divergence in treatment suggests that the devolution formula is not neutrally technocratic but produces systematically disparate outcomes. Telangana’s higher per capita income and better demographic performance, which should be celebrated, are instead used to justify its lower share, while Gujarat’s similar economic profile does not attract equivalent penalisation. This inconsistency fuels perceptions of political bias in fiscal federalism.

Q3: What is the ITIR, and why does its cancellation matter for understanding central bias?
A3: The Information Technology Investment Region (ITIR) was a mega-project promised to Hyderabad in 2013, projected to attract Rs 2.19 lakh crore in investment and generate nearly 15 lakh jobs. It was exactly the kind of transformative infrastructure that would have consolidated Telangana’s position as India’s premier technology hub. The Centre later scrapped the ITIR, citing “policy changes”—an explanation that critics view as a bureaucratic euphemism for selective project allocation. Simultaneously, massive central resources were directed to Gujarat: GIFT City, semiconductor clusters at Dholera and Sanand, and generous PLI subsidies. The ITIR’s cancellation is significant because it demonstrates that Telangana’s marginalisation extends beyond tax devolution into the discretionary allocation of industrial infrastructure. The State is denied not only its fair share of routine transfers but also the transformative projects that shape long-term economic trajectories.

Q4: What is the “off-budget stranglehold,” and how has it constrained Telangana’s fiscal space?
A4: The “off-budget stranglehold” describes the Centre’s treatment of borrowings by State-run corporations. When the Centre rejected NITI Aayog’s recommendation to grant Telangana Rs 24,000 crore for Mission Bhagiratha, the State borrowed to finance this critical drinking water and irrigation project, along with others like Kaleshwaram. These borrowings were initially treated as “off-budget”—external to Telangana’s Net Borrowing Ceiling (NBC). Subsequently, the Centre retroactively included these borrowings within the NBC, sharply compressing the State’s fiscal space. This meant Telangana could not borrow further for other essential infrastructure projects, including the Regional Ring Road and Hyderabad Metro Phase II. The “stranglehold” thus operates in three stages: denial of central grants, forced borrowing to fill the gap, and retrospective penalisation of that borrowing. The predictable outcome is debt accumulation (projected to exceed Rs 5 lakh crore by 2026) coupled with infrastructure paralysis.

Q5: What specific reforms does the article propose for the 16th Finance Commission to address the success penalty?
A5: The article proposes five structural reforms:

1. Rebalance criteria weights: Reduce the excessive 45 per cent weight on Income Distance and increase weights for contribution to central tax revenues, fiscal effort, and economic output.

2. Recognise demographic performance: Reward States that have successfully stabilised population growth and improved health outcomes, rather than penalising them through reduced devolution.

3. Separate devolution from project allocation: Recommend transparent, criteria-based mechanisms for discretionary central-sector industrial investments to eliminate opaque, politically-influenced allocation.

4. Protect borrowing autonomy: Establish clear, prospective rules for treating State-owned enterprise borrowings, preventing retrospective inclusion that cripples fiscal space.

5. Institutionalise a performance bonus: Introduce a dedicated component explicitly rewarding superior outcomes in growth, fiscal management, social development, and governance—transforming the “success penalty” into a “success bonus.”