Finance Commission’s Balancing Act Is Misleading, A Closer Look at Fiscal Federalism
Numbers can reassure, but they can also distract. The editorial “Finance Commission strikes a new balance” invites readers to take comfort in the arithmetic of the 16th Finance Commission. Fiscal federalism, however, is not sustained by ratios alone. It rests on how power, responsibility, and risk are shared between the Union and the states. On that deeper measure, the sense of balance conveyed by the editorial appears less secure than suggested.
As Shubham Kumar argues in a pointed response, the headline numbers that seem to indicate stability and fairness may obscure deeper structural shifts that are eroding the fiscal space available to states. Understanding these shifts is essential for any honest assessment of India’s federal fiscal architecture.
The Illusion of Continuity
The centrepiece of the reassurance is the decision to retain states’ share in the divisible pool at 41 per cent. In isolation, this looks like continuity. The same share that applied under the 15th Finance Commission continues. States can take comfort, the reasoning goes, that their portion has not been reduced.
But the significance of this number depends on the size of the pool to which it applies. Over the last decade, the Centre has increasingly turned to cesses and surcharges that lie outside the divisible pool and are, therefore, not shared with states. These levies have grown from a relatively small component of Union revenues to a substantial one.
The numbers tell the story. Cesses and surcharges as a percentage of gross tax revenue have more than doubled over the past decade. They now constitute a significant and growing stream of revenue that flows entirely to the Centre, with no obligation to share with states.
As a result, the effective share of states in total Union tax collections is materially lower than what the 41 per cent headline implies. The divisible pool is shrinking relative to total revenues, even as the devolution rate remains constant. States are receiving a smaller piece of a larger pie, but this is hidden by the stability of the headline ratio.
This matters because states continue to shoulder the bulk of spending in welfare and infrastructure. Education, health, agriculture, urban development—these are primarily state subjects, yet the resources available to fund them are being squeezed.
The Erosion of Predictability
This erosion of the shared base matters more than the stability of the rate. States can plan, borrow, and reform when the rules governing their fiscal space are predictable. When the Centre’s revenue strategy steadily narrows what is shareable, continuity in the devolution ratio offers limited comfort.
A state finance minister preparing a budget needs to know not just what share of the divisible pool will come to the state, but how large that pool will be. If the pool is shrinking relative to total revenues, then even a constant share means declining resources.
It also complicates the Commission’s emphasis on fiscal discipline at the state level. States are being told to manage their finances prudently, to increase their own tax revenues, to reduce subsidies, to target spending more effectively. All of this is sound advice. But it operates within a shrinking pool of discretionary resources. States are being asked to do more with less, while the Centre retains an increasing share of total tax revenues outside the divisible pool.
The Southern States’ Adjustment
The editorial suggests that regional concerns, particularly those of southern states, have been addressed through a rise in their horizontal share from 15.8 per cent to 17 per cent. This is presented as a recognition of their concerns about being short-changed by a system that rewards population over performance.
Set against a longer historical arc, however, this is a modest adjustment. The southern region’s share exceeded 21 per cent under the 11th Finance Commission and declined steadily over successive Commissions. The increase to 17 per cent brings it back to a level last seen over a decade ago, but still far below its historical peak.
The southern states have a legitimate grievance. They invested early in education, public health, and population stabilisation. They did so in line with national priorities and generated benefits that extended well beyond their borders. Their reward has been a declining share of central revenues, as population-based criteria favour states that have not yet completed the demographic transition.
Equity and federal principles require that poorer and more populous states receive support. No one disputes that. At the same time, fairness in a federation also has a temporal dimension. States that followed the path the Centre encouraged should not be penalised for their success.
A framework that only marginally reflects such long-term effort risks appearing indifferent to outcomes that were once actively encouraged. The message to states is mixed: invest in development, but if you succeed, expect your fiscal share to decline.
The GDP Contribution Criterion
The introduction of a state’s contribution to GDP as a criterion is meant to acknowledge performance. In principle, this is a positive step. States that contribute more to the national economy should be recognised.
But its design limits its impact. GSDP captures structural and historical factors, many of which lie beyond current policy choices. A state with abundant natural resources, a favourable location, or historical industrial development will have a higher GSDP regardless of current policy. A state without these advantages cannot easily increase its GSDP through policy effort alone.
Its relatively small weight, combined with the dominance of population-related criteria, means that the recognition of contribution remains partial. The message is that performance matters, but not very much.
The removal of tax effort as a criterion further weakens the link between revenue mobilisation and fiscal reward. Under previous Commissions, states that made greater effort to raise their own tax revenues were rewarded. That incentive has now been removed. States may reasonably ask: why should we work hard to increase our own tax collections if it does not affect our share of central revenues?
Beyond the Headlines
None of this diminishes the seriousness with which the 16th Finance Commission has approached its mandate. Nor does it deny the need for reform in state finances. The Commission has produced a detailed and thoughtful report that grapples with complex issues.
The concern is narrower. By focusing on stability in headline ratios and modest shifts in shares, the editorial may overstate how far a new balance has been achieved. The headline numbers suggest continuity and modest adjustment. The underlying reality is more complex and less reassuring.
States face a shrinking divisible pool, a declining effective share of total revenues, a modest adjustment that does not fully restore their historical position, and the removal of incentives for tax effort. This is not a recipe for fiscal harmony.
Conclusion: The Real Balance
Fiscal federalism is not sustained by ratios alone. It rests on how power, responsibility, and risk are shared between the Union and the states. On that deeper measure, the sense of balance conveyed by the headline numbers is misleading.
The 16th Finance Commission has done its work. The question now is whether the underlying trends—the growth of cesses and surcharges, the shrinking divisible pool, the modest adjustments to horizontal shares, the removal of tax effort incentives—will be addressed in the ongoing dialogue between the Centre and states.
The numbers on the page tell one story. The reality of fiscal federalism may tell another.
Q&A: Unpacking the Finance Commission Critique
Q1: Why is the retention of states’ share at 41% potentially misleading?
While the 41% devolution rate remains constant, the divisible pool to which it applies has been shrinking as the Centre increasingly relies on cesses and surcharges that lie outside the divisible pool and are not shared with states. These levies have grown substantially over the past decade. As a result, the effective share of states in total Union tax collections is materially lower than the headline 41% implies, even as states continue to shoulder the bulk of welfare and infrastructure spending.
Q2: What is the significance of cesses and surcharges in this context?
Cesses and surcharges are levied by the Centre for specific purposes and are not required to be shared with states under constitutional provisions. Their share in gross tax revenue has more than doubled over the past decade, meaning a growing portion of total tax collections flows entirely to the Centre. This erodes the base available for devolution to states, reducing their effective fiscal space even while the formal devolution rate remains unchanged.
Q3: How have southern states fared in the horizontal distribution?
The southern region’s horizontal share has increased from 15.8% to 17%. While presented as an adjustment to their concerns, this is modest compared to historical levels—the southern share exceeded 21% under the 11th Finance Commission. States that invested early in education, public health, and population stabilisation in line with national priorities have seen their share decline steadily over successive Commissions. The modest increase does not fully restore their historical position.
Q4: What is problematic about the new GDP contribution criterion?
While introducing a state’s contribution to GDP as a criterion is meant to acknowledge performance, its design limits its impact. GSDP captures structural and historical factors beyond current policy choices, and its relatively small weight means the recognition of contribution remains partial. Additionally, the removal of tax effort as a criterion weakens the link between revenue mobilisation and fiscal reward, potentially discouraging states from working to increase their own tax collections.
Q5: What deeper issues in fiscal federalism does this critique highlight?
Beyond headline ratios, the critique points to fundamental questions about how power, responsibility, and risk are shared between Union and states. States face a shrinking divisible pool, declining effective share of total revenues, modest adjustments that don’t restore historical positions, and removal of incentives for tax effort. These underlying trends matter more for fiscal federalism than the stability of headline devolution rates. The real balance between Centre and states may be less secure than the numbers suggest.
