India’s fiscal pivot: Efficiency or equity?

A prudent balance in devolution will be critical to mending the strained ties between the Centre and states.

The Sixteenth Finance Commission submitted its report to President Droupadi Murmu on November 17, 2025. The report is expected to be tabled before the Parliament in the upcoming budget session in February. 

The Commission’s recommendations are crucial in the context of strained fiscal relations between the Union and state governments. One of the key arguments is that the efficiency criterion would benefit the fiscally effective/prudent states in gaining their due share of the allocated funds.

This looks like a substantive line of reasoning in terms of procedure; however, it is unclear how this could be achieved, considering the wide fiscal and non-fiscal disparities that exist between the Union and state governments.

Economic efficiency is a key indicator/variable to incentivise states that demonstrate effective fiscal management. The efficiency criteria used by the 10th to 15th FCs were largely based on tax effort and fiscal discipline. Among these, fiscal discipline has seen less prominence, except for the 13th FC, which assigned 17.5% in combined weightage.

There has been a marked fall in weightage to equity or income distance (the distance between a state’s income and that of the state with the highest income): from 70% (during the 11th FC) to 45% (15th FC). This indicates a steady transition in the Commission’s approach towards economic efficiency. However, this transition has also met with inconsistency, as the criterion for efficiency has changed during the period between the 10th and 15th commissions.

Economic efficiency, as a criterion, needs to be contextualised based on the allocative efficiency of financial resources. This criterion is based on per capita developmental expenditure, along with revenue generation and prioritisation. What is significant here is the collective efficiency in taxation and the capability to prioritise developmental needs.

In a policy transition that reduces the significance of equity and emphasises efficiency, or fiscal prudence, there are clear pointers to changing parameters that determine the extent of horizontal devolution of funds across the states. However, a change in economic philosophy must complement this – a focus shift, from maximisation of output to maximisation of revenue, among the fiscally underperforming states. The fiscal requirements of states need to be prioritised in allocations. This vertical devolution needs to undergo a reformation, with the involvement of local governments.

The new scheme of fiscal equalisation shall be a composite of priorities among the Union, state, and local governments. Leaving out local governments from the process of overall fiscal devolution negates the spirit of federalism and the principle of subsidiarity. Boadway (2019) proposes, “unconditional formula-based equalisation transfers contribute to effective decentralisation of decision-making to the states”. This needs further extension to the local governments in India, in the ratio of 40:30:30 to the Union, state, and local governments. The fiscal guarantee to local governments through a Finance Commission equalisation can effectively deliver economic development and social justice to the citizens.

A tough balancing act

The challenge for the 16th FC is to strike a balance between these two broad criteria and arrive at a rational basis for the devolution of funds. It has to play a significant role in restructuring the strained fiscal relations between the Union and the state governments.

Balancing equity (the model invariably provides larger resource shares for states grappling with higher populations) and efficiency (where states with better fiscal management are incentivised) is the key to this effort. Incentivising states that perform better in fiscal management is critical; however, the path is delicate because it also needs to be balanced with other criteria, such as measures undertaken to stabilise population and to reduce poverty.

These varied considerations present a formidable challenge for the Commission because this is a balancing act critical to the idea of federalism, with major political implications.

The 16th Financial Commission was mandated to present its report covering five years, commencing on April 1, 2026. Its recommendations cover the distribution of taxes between the Union and the states, as well as grants-in-aid to states and other proceeds. Covering the award period of 2026-27 to 2030-31, the report consists of two volumes; while the recommendations are in the first volume, the annexures are accommodated in the second.

India’s pathway to balanced Union-state fiscal ties will hinge on a structural shift to its devolution approach. And central to this shift will be the optimum weightage accorded to efficiency and equity; any policy skewed towards the equity consideration risks undermining the principles of economic efficiency.

(The writer is an assistant professor at the Symbiosis Law School – Symbiosis International [Deemed University], Pune)