Inter Governmental Transfers in India: Finance Commission and Beyond

Every year, billions of rupees flow from India’s central government to its states, and from states to local governments. This intricate system of financial transfers shapes everything from the quality of schools in a village to the condition of roads in a city. Understanding how these funds move through different layers of government is crucial to grasping how India’s federal structure actually works in practice.

How money flows through India’s federal system 🔗

India’s inter-governmental transfer system operates through multiple channels, creating a complex web of financial relationships. At the broadest level, resources flow from the Union government to state governments. From there, funds move to local governments-both rural panchayats and urban municipalities-sometimes directly from the Union through states, and sometimes directly from states themselves.

Think of it like a river system. The central government is the main source, feeding into state-level tributaries, which then branch out into smaller streams reaching villages and towns. But unlike a natural river, this flow is carefully regulated through constitutional mechanisms and policy decisions.

Two primary channels manage these transfers. The first is through the Finance Commission, which handles tax-sharing and non-plan grants. The second channel operates through Union Ministries, which implement various schemes and programs. The Planning Commission, which once played a significant role in this process, was abolished in 2015, and its functions were largely taken over by NITI Aayog.

The growing share for states 🔗

One of the most striking trends in India’s fiscal federalism has been the steady increase in the states’ share of central taxes. The 10th Finance Commission recommended that states receive 29% of the divisible pool of central taxes. By the time the 14th Finance Commission made its recommendations for 2015-2020, this had jumped dramatically to 42%.

However, the 15th Finance Commission slightly reduced this to 41% for 2020-2026, with the adjustment made to accommodate the newly formed union territories of Jammu and Kashmir and Ladakh. This one percentage point might seem small, but in absolute terms, it represents thousands of crores of rupees.

This evolution reflects a fundamental shift in thinking about federal finances. The higher devolution recognizes that states have greater responsibilities for delivering essential services like education, healthcare, and infrastructure, and they need adequate resources to fulfill these mandates.

How does each state get its share 🔗

Once the overall percentage for states is determined, the next challenge is deciding how to divide this among individual states. This is where the Finance Commission’s formula-based approach comes into play, using what’s called “horizontal devolution.”

The evolving criteria 🔗

The 15th Finance Commission uses five main criteria to determine each state’s share. The largest weight, 45%, goes to income distance-essentially measuring how far a state’s per capita income is from that of the richest state. This ensures that poorer states receive more resources to help bridge development gaps.

Area accounts for 15% of the weightage, recognizing that larger states have greater administrative and service delivery costs. Population based on the 2011 census gets another 15%, though this has been a contentious issue, with some southern states arguing they’re being penalized for successfully controlling population growth.

Two newer criteria have gained prominence in recent commissions. Demographic performance (12.5% weight) rewards states that have made progress in population control, with states having lower fertility rates scoring higher. Forest and ecology (10% weight) recognizes states that maintain dense forest cover, compensating them for conservation efforts that limit other economic activities.

Finally, tax effort (2.5% weight) incentivizes states to improve their own revenue collection efficiency. It’s measured as the ratio of a state’s per capita own tax revenue to its per capita state GDP.

Why these criteria matter 🔗

Consider two hypothetical states. State A is relatively prosperous with high per capita income, small geographical area, controlled population growth, but little forest cover. State B is less developed with low per capita income, large area, higher population, and significant forest cover. Under the current formula, State B would receive a substantially larger share because multiple criteria work in its favor-income distance, area, and forest cover.

This approach attempts to balance equity (helping poorer states) with efficiency (rewarding good governance and fiscal responsibility). However, it’s not without controversy. States like Tamil Nadu, Karnataka, and Maharashtra often argue they contribute more to the national tax pool than they receive back, creating tensions in the federal structure.

Union Ministries and scheme-based transfers 🔗

Beyond tax devolution, the Union government transfers substantial resources through various schemes. These fall into two broad categories. Central Sector Schemes are entirely funded and implemented by the central government. More significant for state finances are Centrally Sponsored Schemes, which involve partnership between the Union and states.

Understanding Centrally Sponsored Schemes 🔗

Centrally Sponsored Schemes cover subjects in the State or Concurrent List but are formulated by the Union government due to their national priority. Examples include flagship programs like MGNREGA, which guarantees rural employment, and Pradhan Mantri Gram Sadak Yojana, which focuses on rural road connectivity.

The cost-sharing arrangements vary based on the state category and scheme importance. For most schemes, the typical sharing ratios are 60:40 for general category states and 90:10 for northeastern and Himalayan states, with the first number representing the central government’s share. Some schemes critical for national priorities may have different ratios like 75:25 or even 50:50.

These schemes serve multiple purposes. They address national priorities that require uniform implementation across states. They help equalize access to essential services across rich and poor states. And they enable the Union government to influence policy priorities in areas that constitutionally fall under state jurisdiction.

The challenges with CSS 🔗

However, Centrally Sponsored Schemes aren’t without problems. States often complain about the “one-size-fits-all” approach that doesn’t account for local variations and needs. The requirement for matching contributions can strain the finances of poorer states, sometimes preventing them from accessing funds meant to help them.

There’s also the question of numbers. Over the years, the proliferation of schemes led to administrative complexity and overlap. The government has been working to rationalize these schemes, mandating third-party evaluation as a precondition for continuation of CSS and Central Sector schemes beyond March 2026.

The weakest link: State Finance Commissions 🔗

While the Union Finance Commission gets considerable attention, State Finance Commissions-responsible for allocating resources between state governments and local bodies-remain the most neglected part of India’s fiscal architecture. This matters enormously because local governments are the ones actually delivering most services to citizens.

The constitutional mandate ignored 🔗

The 73rd and 74th Constitutional Amendments of 1992 required every state to constitute a State Finance Commission every five years. By now, three decades later, all states should have constituted their Sixth Finance Commission covering 2021-2027. Yet only nine states have constituted their 6th SFC, and of these, only two are actually active.

The delays are staggering. States like Gujarat, Jharkhand, and Goa have constituted just three State Finance Commissions running until 2011, while Arunachal Pradesh has constituted only two. This means local bodies in these states have gone years without systematic reviews of their financial needs.

Why SFCs struggle 🔗

Multiple factors undermine the effectiveness of State Finance Commissions. The first is the ambiguous Terms of Reference given to these bodies, which often lack clarity about their scope and mandate. When an SFC is finally constituted, it frequently lacks basic infrastructure-office space, computers, and supporting staff.

Data availability poses another major challenge. Every time an SFC is constituted, it has to start from scratch to collect data because states don’t maintain systematic, updated databases on local government finances. This wastes precious time and resources.

The composition of SFCs also raises concerns. The majority of chairpersons and members are bureaucrats and politicians rather than public finance experts, which limits their ability to act as independent, technical bodies making evidence-based recommendations.

The Action Taken Report problem 🔗

Even when SFCs manage to submit their reports, the story doesn’t end there. States are constitutionally required to table Action Taken Reports before their legislative assemblies explaining which recommendations they’re accepting and why they’re rejecting others. In practice, many states either delay these reports indefinitely or provide lukewarm responses that essentially ignore major recommendations.

This creates a vicious cycle. Local bodies remain financially starved, unable to deliver services effectively. Citizens lose faith in local governance. And the constitutional vision of vibrant, empowered local democracy remains unrealized.

Recent efforts to strengthen SFCs 🔗

Recognizing these problems, the 15th Finance Commission introduced a strict condition: no grants will be released to local bodies of any state after March 2024 if the state hasn’t constituted its State Finance Commission and acted on its recommendations. This represents a significant push, using financial leverage to ensure compliance with constitutional requirements.

Whether this will work remains to be seen. It’s a classic federal dilemma-the Union Finance Commission can recommend and even conditionally withhold funds, but it cannot directly compel state governments to do what the Constitution requires them to do. Political will at the state level remains the ultimate determining factor.

Looking ahead 🔗

India’s system of inter-governmental transfers has evolved considerably over seven decades. The progressive increase in states’ share of central taxes reflects growing recognition of their responsibilities. The use of formula-based devolution criteria attempts to balance equity and efficiency objectives. And the recent push to strengthen State Finance Commissions acknowledges that financial empowerment must reach the grassroots.

Yet significant challenges remain. The exclusion of cesses and surcharges from the divisible pool reduces the effective devolution to states. Cesses and surcharges now account for around 23% of the Union government’s gross tax receipts, funds that aren’t shared with states. The proliferation and complexity of Centrally Sponsored Schemes continues to limit states’ flexibility in addressing local priorities. And the chronic weakness of State Finance Commissions undermines decentralization at its most critical level.

As the 16th Finance Commission begins its work for the 2026-2031 period, these questions will once again be debated. How much should states receive? What criteria should determine each state’s share? How can we ensure local governments get adequate resources? The answers will shape not just government budgets, but the lived reality of millions of Indians accessing schools, hospitals, roads, and basic services.

What do you think? Should states receive a larger share of central taxes even if it means reduced resources for national programs? How can we ensure State Finance Commissions function effectively when state governments seem reluctant to empower them?

References

1. https://prsindia.org/policy/report-summaries/report-15th-finance-commission-2021-26
2. https://www.policycircle.org/economy/state-vs-centre-tax-devolution-debate/
3. https://vajiramandravi.com/current-affairs/government-tightens-norms-for-css-and-cs-schemes-continuation-post-2026/
4. http://india.mongabay.com/2023/03/state-finance-commissions-in-poor-shape/