Equity, merit and the balance of fiscal federalism

India’s fiscal federalism runs on a deceptively simple bargain: the Union collects most broad-based taxes, while the states carry the front-line responsibility for essential public services – schools, hospitals, policing, local roads, water supply, and much else. The tax revenues and spending duties do not match. Indeed, states have two-thirds of expenditure obligations, but have control over only one-third of the revenues. Hence, the Constitution created a neutral referee – the Finance Commission (FC) – to periodically recommend how the “divisible pool” of Central taxes should be shared between the Union and the states (vertical devolution) and among the states (horizontal devolution).

The Commission is reconstituted every five years, so that the division formula can adapt to changing realities. Its core job follows from Article 280 and the implementation of recommendations from Article 281. In practice, FC awards become the financial “operating system” of Indian federalism. They affect the monthly cash states receive, their budget space for welfare and capital spending, and even their ability to borrow.

With the 16th Finance Commission (FC-16) report now accepted by the Union government and placed before Parliament, the new formula will shape Centre-state fiscal relations for 2026-31. The key question is not just “who gets how much,” but what incentives the system creates – especially in a federation where prosperity and political power are unevenly distributed.

FC-16 has retained the states’ share at 41% of the divisible pool. There was a demand from 22 states to increase this to 50% – partly due to their grievance concerning the trend of the Union’s rising reliance on cesses and surcharges, which typically sit outside the divisible pool and therefore are not shared. As per the FC-16 report, since the total size of the divisible pool will nearly double from 55 trillion to 90 trillion rupees during the FC-16 period, the states will have considerably more resources. But if the Union continues to expand non-shareable levies, the “41%” can feel smaller in effect than in headline.

The most striking innovation is on the horizontal side: FC-16 introduces “contribution to national GDP” as a criterion with 10% weight. The Commission does this by reducing weights elsewhere – cutting per capita income distance and demographic performance by 2.5 percentage points each, trimming area by 5 percentage points, and removing the (small) tax effort weight used by FC-15. It is as if the Commission now seeks a balance between its central role of “gap-filling” of resource shortfall, with a new reward for states that contribute more to the national output.

Why is this a big deal? Because it shifts the moral language of transfers. For decades, the dominant logic was: help states provide comparable basic services, despite differences in income and capacity, and offset structural disadvantages. Economists call this “equalisation”. The new GDP-contribution criterion says, in effect, performance and contribution also matter. This is not really contrary to the spirit of the Constitution, but the change in emphasis is path-breaking. Constitutionally, the Commission is to recommend a fair distribution of shareable taxes so that different levels of government can discharge responsibilities. The FC has always mixed criteria – some anchored in equity (income distance, population, area, forest) and some trying to recognise efficiency (tax effort, fiscal discipline, demographic performance).

So adding “contribution to GDP” is not automatically unconstitutional. The deeper question is normative: what should be the dominant objective of tax devolution? Introducing GDP contribution can conflict with the revenue-disability logic. Besides, states are not on a level playing field. A rich state often has better infrastructure and institutions that make it easier to respond to “performance incentives”, while a poorer state may not be able to do so quickly. Some so-called backward states are incentivised to keep their forest cover and slow down urbanisation, thereby causing slower GDP growth. So, rewarding “contribution” can harden advantages, unless compensated by investment in capacity and human capital in the lagging states.

Returns and risks

The FC-16 report emphasises that equalisation remains the “centre of gravity”, with per-capita income distance still dominant. But incentives matter because they influence political narratives and administrative choices. There are three possible behavioural effects. First, high-performing states will feel less penalised. This may reduce resentment in parts of the South and West. Second, lagging states may face weaker “gap-filling” comfort and push harder for other compensations – special packages, centrally sponsored schemes, or discretionary grants. Third, the conversation may shift from “need” to “merit”. This is politically potent and risky for cooperative federalism, since poorer regions will believe that the system doesn’t provide safety nets anymore.

The political centre-of-gravity is in the North and East, whereas the economic weight is more in the South. This structural imbalance cannot be addressed by the FC-16 alone. But given the sensitivities, any change in formula becomes a proxy for larger anxieties: representation, voice, and fairness.

The other issue of increasing dependence on non-shareable levies like cesses and surcharges is still unresolved. Additionally, the surplus transfer from the Reserve Bank of India, budgeted at Rs 3.1 trillion for the next fiscal, is almost 10% of Union revenues; it is non-shareable and is on a rising trend.

FC-16 nudges India’s fiscal federalism away from a pure “gap-filling” narrative towards a mixed model that also acknowledges contribution and growth. To some extent, it prevents fiscal bargaining between the Union and states from becoming a permanent political tug-of-war. But its legitimacy depends on fair and transparent rules, and certainly not encouraging stealth through non-shareable levies. India needs both: a credible equalisation system so every citizen can access minimum quality public services regardless of birthplace, and a governance culture that rewards growth, reforms, and revenue effort without locking poorer states into permanent dependence.

If that balance fails, we will not just argue about percentages – we will argue about the very idea of cooperative federalism.

The writer is an economist; Syndicate: The Billion Press

(Disclaimer: The views expressed above are the author's own. They do not necessarily reflect the views of DH.)