Finance Commission Report reinforces Centre’s fiscal dominance over States

Governments of the day rarely do things that have a long-term impact on society, in terms of policy. And when they do, it is often by accident. They don’t know which policy will work and which ones won’t. Or why.

Post-independent India’s most successful policy experiment, the noon meal scheme re-launched by M.G. Ramachandran in Tamil Nadu in 1982, was one such idea. When M.G. Ramachandran went to seek additional funds from the Union government in 1985, a member of the Planning Commission thought the entire policy was a political stunt. Something we would now derisively call a freebie. Said member of the Planning Commission even asked MGR if his government was running schools or restaurants.

That member was Manmohan Singh. One could argue that he was a neoliberal who only cared about balancing the books, if one were a harsh critic. Or, instead, one could, to be kind, say there was no evidence supporting the policy at that point, and he was acting in good faith with the information he had. But the question we need to ask ourselves is this: Why was he, a person whom the people of Tamil Nadu did not elect, in a position to impact and fund the policies that ran their lives in ways their own elected politicians weren’t? That story, of unelected bureaucrats in New Delhi determining the structure of government that subsumes policymaking in the far corners of the country, continues to this day. And many of the States that constitute India’s far corners happen to be larger than the most populous European countries.

This vice-like grip of New Delhi’s administrative structure over the States has only tightened further in recent years. One of the most important ways in which that structure gets reinforced in shaping our democracy is the Finance Commission’s Report (FCR). The money that governments have determines the powers they have over our lives; this report decides which government gets how much money. So, viewed thus, the Finance Commission is more important than electing our individual MLA or MP in many ways. After all, that elected representative of ours works downstream in the structure defined by this report.

The 16th Finance Commission, which tabled its report recently, was constituted at a crucial time in India’s development trajectory. The divergence amongst various States—in terms of governance outcomes, prosperity, and population growth—has made the political bargain that makes the Indian Union work a little tricky. Its predecessor, the 15th Finance Commission, for instance, saw loud complaints from southern States about being punished for their success in controlling their population while still achieving higher economic growth. They received low allocation ratios.

At first glance, the 16th Finance Commission’s report would appear to address those concerns. It arrests, and for the first time in decades, reverses the sliding in allocation ratios for the southern States in horizontal devolution—the ratio in which States share the revenues that are meant to be shared amongst themselves. When one looks at the allocation ratios from the 8th Finance Commission onwards, it appears the southern States have finally seen their floor. And can stop worrying about losing further; that they won’t return to where they were 40 years ago is perhaps a reality pill too bitter for them to swallow. Regardless, an uptick after decades of tumbling down is a worthy moment.

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Consider Kerala, Karnataka, Tamil Nadu, and Rajasthan. These States retained their boundaries for 40 years and lend themselves to an apple-to-apple comparison. The steep increase in Rajasthan’s allocation and subsequent stabilisation over the last decade, in contrast to the steep decline and stabilisation for the other States, is the story of India’s devolution dynamics. The table and chart below show how Tamil Nadu, which had 7.54 per cent in the 8th Finance Commission, dropped down to 4.1 per cent in the 16th Finance Commission, while Rajasthan went up from 4.45 per cent to 5.93 per cent in the same period.

The slight increase in allocation ratios for Kerala and Karnataka, from the 15th to 16th Finance Commission, may seem like the entire point: protests work in limited ways in a democracy. Two factors: one on demographic performance and another on GDP contribution, were added to assuage the southern States; the effect of that is the change in the trendline seen in the chart. And one could also see the slight decline in the last two Finance Commission periods for Rajasthan’s allocation ratio—as well as that of Uttar Pradesh and Bihar (which aren’t part of this chart)—as the grand bargain the country arrived at.

One may seriously disagree with this bargain, given how steep the fall had been for States such as Tamil Nadu over the years. But the response will be that this correction cannot be abrupt and that this is the way to gradually correct extreme imbalance and perverse incentives while still giving poorer States the necessary support. Sounds fair; that is what the Union government and the 16th Finance Commission would like us to believe.

Challenge of vertical devolution

However, there exists a greater problem—one that precedes the horizontal devolution’s allocation ratio: vertical devolution. The FCR’s most important task is to allocate the tax revenues that accrue to the Consolidated Fund of India (CFI) to various governments. Therefore, the FCR’s first step is to decide the amount the Union government shares with the States. Or devolves vertically. The horizontal devolution of the previous section acts on this already devolved money. How much that pot of money contains is what determines how much the States eventually get. Over the past decade, this pot has been seeing some strange pulls in opposite directions.

The overall vertical devolution from the Union to State governments changed in 2000. Until then, only Income Taxes and Central Excise Duties were shared. After the 80th Constitutional Amendment (passed in 2000), most Central taxes, except cesses and surcharges, became part of what’s called the divisible pool, the pot of money meant to be shared with States. In the 14th Finance Commission, States’ share of this divisible pool was increased to 42 per cent, up from 32 per cent in the previous five-year period. The reason for that was solid: the Union government collected two-thirds of all taxes while it was responsible for only a third of expenses. The case for the States was the reverse. It followed then that the States needed a larger share of the taxes collected to run effective governments that citizens demand. After all, most “governance” that citizens come into contact with is run by State and local governments.

The Union government’s response to this increase has been Machiavellian. It almost doubled the collection of cesses and surcharges as a ratio of its overall collections, knowing they are outside the purview of vertical devolution. In 2010-11, the effective share of gross tax revenues, which includes cess and surcharges, devolved to States was 28.73 per cent; in 2026-27, the Budget estimate is 32.16 per cent (this is shown in the tables below). That is, the Union has managed to change the name under which it collects monies to eschew a 10 per cent increased sharing burden and brought it down to about 4 per cent.

What is even worse is that this amount the Union shares with the States is often not shared on time, has political conditions riding on it at times, and when it eventually does get disbursed, it’s below what’s stipulated after discounting for the Cess & Surcharge. The 16th Finance Commission notes this and then proceeds to accept the Union Government’s weak defence: that the Union needs additional monies for defense and foreign affairs. It’s an argument that doesn’t pass the small test and won’t impress a high school student.

The 16th Finance Commission’s serious economists, instead of playing their part as independent umpires, seem to view themselves as the Centre’s defence attorneys. Any increasing and exceptional burden in funding the defence and external affairs, which the Union government has claimed, should reflect in budgetary spending. Notably, spending has been declining as a ratio of the GDP over the last decade. And it’s now well below 2 per cent.

And it’s not as if the Union government is shrinking its defence spending as a ratio of GDP because it’s starved of funds. A look at its spending on State subjects and concurrent list items, areas it has little reason to spend on in the first place, in comparison to defence and external affairs, makes it obvious. The Union government is spending money that ideally should be sent to the States, on State subjects that State governments ought to be spending on. And this is at the expense of defence spending, which the Centre uses as a fig leaf to seek even more funds for itself! And worse, this gap, between where it ought not be spending and where it ought to be, is widening at a rapid pace, as shown in the chart below.

The southern States have indeed complained loudly about their allocation ratios declining in comparison to their northern counterparts. But what this entirely misses is that the bigger problem is the Union not devolving enough in the first place. Most States asked for a 50 per cent devolution ratio in the consultative process, as the report notes. But the FCR decided to retain the 41 per cent vertical devolution. It bought the argument that the Union needs more funds for strategic spending despite the evidence to the contrary. Further, many States wanted to either decrease or eliminate Cess & Surcharge. Some wanted to arrive at a formal mechanism to share Cess & Surcharge collection with the States. Again, the 16th Finance Commission seems to bought into the Union’s easily disprovable claim of needing funds for defence and has decided to let cess and surcharge remain as such.

Every State’s needs are vastly different. For instance, Kerala’s metrics in health are at par with Organisation for Economic Co-operation and Development (OECD) countries, and it requires funds for tertiary care as opposed to primary care. Madhya Pradesh, by contrast, needs funding for primary healthcare facilities, given its health metrics are comparable to those of Afghanistan. Spending on basic care is what will move health metrics in the right direction in such a society. A singular policy for just these two States, let alone all States, is not feasible. States have policy needs that are orthogonal to each other, given how divergent they are. Except that such a unified approach is exactly what the Union government seems to be pursuing. And this kind of spending on a mathematically implausible goal of achieving a single policy for States at the opposite end of the spectrum is the driving force behind the increasing expenditure on State subjects seen in the chart above.

The 16th Finance Commission cites the Constitution, continuity and predictability when it comes to agreeing with the Centre’s case. Which then means, one’d expect it to be consistent—if one disagrees with it—and allow for grants-in-aid to continue, as has been the practice thus far. States got additional grants to cover their revenue deficits in previous Finance Commissions. Except, it’s here, on the backs of already beleaguered State governments who are starved of funds, that the 16th Finance Commission wants to balance books on and set things right which historically weren’t textbook perfect anyway.

Calling Finance Commission’s decision-making prowess into question

The report has called for an end to State-specific grants and revenue deficit grants. One may even agree with the rationale here, in theory, if one believes in fiscal prudence as the guiding principle. But the question is: why does the Finance Commission, which is one reason why States don’t have enough money in the first place, have the one to do that? And why is it that the same Commission that wants fiscal prudence from the States, treats the Union’s even higher fiscal deficits with kid gloves?

The third part of the solution addresses the horizontal devolution issues, while the first two parts of the solution address the vertical devolution. We could have a 40 per cent lower floor and 60 per cent ceiling for the third part. That is no state receives less than 40 per cent of its budget expenditure as central transfers; nor does it receive more than 60 per cent. For example, Telangana receives about 20 per cent of its budget expenditure as Central transfers; for Bihar, that figure is 72 per cent. The above solution will equalise these two but still make more money available to Bihar than it is currently receiving, as the pot of money that States are sharing will be much larger owing to increased vertical devolution that the first two parts of the solution will yield.

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The 16th Finance Commission appears to have considered the criticisms that surfaced against the 15th Finance Commission. However, it has not fully addressed these concerns and sought to sidestep them by offering limited transparency on its methodology. For instance, the 15th Finance Commission had introduced “Demographic Performance” in horizontal devolution, but it remained highly correlated with the population factor it was meant to offset. The 16th Commission has revised this formula and added a GDP contribution factor. While overall allocations suggest some correction for southern States, as intended, the inter-se shares for each factor are not disclosed, making it difficult to verify how well these new formulas are working.

Serious scholars often do not want to wade into political debate. Arvind Panagarya, the Chairman of the 16th Finance Commission, and his colleagues seem to have had some measure of that as their instinct. It may be a worthwhile goal. The Finance Commission’s report is no place to pick battles with the incumbent government. But what the members of the Commission seem to have forgotten is that there is no reason to make the report a more sophisticated version of the Union government’s argument for a world where State governments implement the Union’s priorities with little resources and still balance their books somehow. That may make the Union government stronger in the short run but will surely weaken the Union itself over time.

R.S. Nilakantan is a data scientist and the author of South vs North: India’s Great Divide.