Context

• The Finance Commission is a cornerstone of India’s fiscal federalism, created to correct the imbalance between a fiscally stronger Union and financially constrained States.
• Its role extends beyond revenue distribution to promoting fiscal equity, equalisation and cooperative federalism.
• The 16th Finance Commission (FC-16), covering 2026–31, marks a significant shift by retaining States’ tax share at 41% while restructuring grants.
• Its emphasis on fiscal discipline and performance raises an important question: can efficiency replace equalisation?

Constitutional Logic of Grants-in-Aid

• Article 275 recognises that formula-based tax devolution alone cannot address India’s vast inter-State disparities.
• States face different geographical, demographic and economic challenges.
• Kerala’s human-capital investments, Punjab’s contribution to national food security, the high infrastructure costs of hill States and connectivity constraints in the north-east illustrate these differences.
• Grants-in-aid were therefore designed as instruments of equalisation, enabling States with special needs to maintain essential services.
• The 14th and 15th Finance Commissions retained Revenue Deficit Grants (RDGs), sector-specific and State-specific grants for this purpose.

The FC-16’s Departure from the Traditional Approach

• FC-16 recommends approximately ₹9.47 lakh crore in grants, compared with ₹10.1 lakh crore under FC-15.
• Their share in total Finance Commission transfers falls sharply from 19.4% to 8.3%. More importantly, RDGs, sector-specific grants and State-specific grants have been removed, with grants concentrated on local bodies and disaster management.
• The rationale is fiscal discipline: RDGs may create moral hazard by encouraging weak revenue mobilisation or excessive expenditure.
• While this concern is legitimate, treating States as fiscally comparable overlooks major differences in their revenue capacity and structural constraints.

The Problem of Unequal Fiscal Capacity

• Aggregate fiscal indicators can conceal serious inter-State disparities.
• A State with strong revenues cannot compensate for another facing geographical disadvantages, weak economic capacity or high social-sector obligations.
• RDGs were intended to address precisely these structural differences.
• Their withdrawal could therefore disproportionately affect States whose fiscal difficulties are not necessarily the result of poor governance.
• Fiscal discipline must distinguish between inefficiency and structural disadvantage.

The Asymmetry of Cesses and Surcharges

• The treatment of RDGs becomes more contentious when contrasted with Union cesses and surcharges, which remain outside the divisible pool.
• FC-16 proposes a grand bargain under which the Centre would gradually merge cesses into the divisible pool in exchange for States accepting a lower devolution share.
• This creates an asymmetry: States face greater fiscal discipline while the Union retains fiscal flexibility.
• Such an arrangement could reinforce rather than correct the existing vertical fiscal imbalance.

A Double Burden on Disadvantaged States

• The States’ share remains at 41%, despite demands from 18 States to raise it to 50%.
• At the same time, the weight assigned to income distance falls from 45% to 42.5%, while contribution to GDP receives a 10% weight.
• Although rewarding economic performance can encourage growth, it may disadvantage poorer States with greater developmental needs.
• Combined with the abolition of RDGs, some States could face a double burden of reduced devolution and fewer compensatory grants, potentially widening regional inequalities.

Performance-Based Grants and Local Governments

• FC-16’s allocation of nearly ₹7.2 lakh crore to local governments is significant.
• Linking grants to water, sanitation, revenue mobilisation and audited accounts can strengthen accountability and institutional capacity.
• However, excessive conditionality can reduce fiscal autonomy.
• The shift from need-based equalisation to performance- and compliance-based transfers must therefore be balanced with adequate untied resources.

Efficiency Versus Equity

• The central challenge is balancing efficiency with equity. Performance-based transfers can encourage fiscal prudence, better governance and revenue mobilisation.
• Yet an excessive focus on performance risks penalising States whose disadvantages are structural.
• A sustainable model should therefore reward high-performing States while supporting structurally disadvantaged States.
• Fiscal responsibility and equalisation should reinforce, rather than undermine, each other. 

The Larger Federal Question

• The Finance Commission’s broader purpose is to manage the economic tensions within a highly diverse federation.
• The contrasting treatment of RDGs and cesses raises concerns that the burden of fiscal adjustment may increasingly fall on States.
• If States are required to strengthen fiscal discipline while the Union retains considerable control over non-shareable revenues, the framework could gradually strengthen Union fiscal primacy instead of correcting vertical imbalance.

Way Forward

• Future Finance Commissions should adopt a balanced approach.
• Need-based transfers should coexist with performance incentives, while fiscal discipline should distinguish genuine structural constraints from poor financial management.
• Greater transparency is needed regarding cesses and surcharges, and local governments should receive both accountability mechanisms and sufficient fiscal autonomy.

Conclusion

• The FC-16’s emphasis on fiscal discipline, performance and accountability addresses genuine weaknesses in India’s fiscal system.
• However, eliminating RDGs and other targeted grants amid persistent State-level disparities creates concerns about fiscal equalisation.
• India needs a fiscal federal framework that rewards performance without abandoning solidarity, promotes discipline without undermining autonomy, and encourages growth without widening regional disparities.
• Ultimately, fiscal federalism is an instrument of national integration. Its legitimacy depends on ensuring that States perceive the federal system as both efficient and fair.