Finance Commission recommendations are not a Centre-versus-states debate

Centrally Sponsored Schemes have complemented state fiscal capacity by improving access to essential public services while reducing regional disparities

The design of federal fiscal transfers is ultimately an exercise in balance.  A serious debate on federal transfers must begin with a distinction that is often blurred: what a Finance Commission is constitutionally mandated to do, and what it chooses to do within the discretion available to it. Any critique/discussion on federal transfers in the context of FC recommendations is always welcome and healthy, but when such discussions are based on unverified rhetorics, it needs to be examined. In commentaries on the 16th Finance Commission recommendations, members of the 14th FC have argued in separate columns on the need to examine the same. 

To begin with, quoting from the relevant article that appeared in Business Standard on the 16th FC recommendations by a member of the 14th Finance Commission: “The Commission (read 16th FC) is obsessed with the view that the 14th Finance Commission was unduly generous to the states in increasing tax devolution from 32 per cent to 42 per cent and repeats this assertion in several places in the report. It sounds most irresponsible of the 14th Commission to have done so! Ironically, nowhere does the Commission recognise the fact that the 14th Commission, unlike past Commissions, had to consider both plan and non-plan requirements of the states and had to subsume the Gadgil formula grants.” 

To start with, to state that the 16th FC was obsessed with the14th FC recommendations, is a pure stretch of imagination. The maximum that the 16th FC report has said in two occasions is that the changes have been significant and there have been consequences.   

Coming now to the Terms of Reference/ToR of the 14th Finance Commission, it does not support the language of compulsion of raising the share from 32 to 42 per cent as has been strongly emphasised by the same member. In principle, the core mandate of the 14th Finance Commission was to recommend the distribution of net tax proceeds between the Union and the states, the principles governing grants-in-aid, and measures to augment state consolidated funds for panchayats and municipalities. The ToR of the 14th Finance Commission also had asked the Commission to review Union and state finances, deficit and debt levels, and to consider the resources and demands on both levels of the government. But it did not explicitly direct the Commission to subsume Plan Grants, Normal Central Assistance or Gadgil formula transfers into tax devolution. 

Surprisingly, the 14th Finance Commission had stated: “We have taken a comprehensive approach to the assessment of expenditure needs by taking both Plan and non-Plan expenditure in the revenue account.” While this statement reflects the Commission’s chosen approach, it does not convert that approach into a mandate that was never recommended in the first place. Hence, it must not be described as the only option before the Commission. 

What is interesting is the timing of the Plan/Non-Plan merger and relating it to the 14th Finance Commission recommendations. The Budget Circular for 2017-18 states that the merger of Plan and Non-Plan expenditure was announced in 2016-17 Budget speech and was to be implemented after the 12th Plan period came to an end. The 14th Finance Commission’s award period began only in 2015-16 and the recommendations were submitted on December 15, 2014. How can a budget reform implemented from 2017-18 be retrofitted as an explicit mandate for a Commission that was wound up in December 2014? Earlier Finance Commissions largely confined their normative assessment to non-plan revenue expenditure, with Plan expenditure being addressed through Planning Commission transfers. The 14th Finance Commission departed from this established methodology by assessing both Plan and Non-Plan revenue expenditure together, but purely on its own volition.

There is another dimension to this entire process. In 2011, the Rangarajan Committee report on ‘Efficient Management of Public Expenditure’ had recommended that Plan and Non-Plan distinction in the Budget should be removed, thereby facilitating linking expenditure to outcomes and better public expenditure management. The removal of the distinction between Plan and Non-Plan would mean that the entire expenditure will need to be taken into consideration for planning, instead of deleting the non-plan one that was significant. Thus, the abolition of the Planning Commission, replacing it with Niti Aayog, from August 2014 was a logical corollary of the 2011 report. It was never an explicit mandate as the 14th Finance Commission may have led us to believe. 

The arithmetic behind the claim also requires greater precision. If the argument is that Gadgil formula grants were subsumed, the quantum of those grants must be large enough to explain the 10 percentage-point rise—from 32 to 42 per cent—of the divisible pool. It was not. The Indian Public Finance Statistics for 2014-15 lists Normal Central Assistance, which is the formula-based Gadgil component at about ₹28,951 crore for states and Union Territories in 2014-15. That figure is too small to explain the full increase in vertical devolution. This constituted only about 2 per cent of the ₹11 trillion divisible pool for that year. Even after including other components of plan grants, the total remains below 4–5 per cent of the divisible pool. Consequently, while the incorporation of Normal Central Assistance may have justified a modest upward adjustment in tax devolution, it cannot by itself account for the 10 per cent increase in the states’ share of the divisible pool. 

In this context, it is worth mentioning that the states’ share in the gross tax revenue  was 2.9 per cent of the GDP in 2011 12, leaving the Union Government with a net tax revenue of 7.2 per cent only. Till 2014-15, net tax revenue remained at or above 7.2 per cent. This recommendation led to an increase in the states’ share in the divisible pool from 2.7 per cent of GDP in 2014 15 to 3.7 per cent in 2015 16. Total transfers to states rose from 48.8 per cent of gross tax revenue under the 13th Finance Commission to 56.4 per cent under the 14th FC. Thus, the recommendations of the 14th Finance Commission was never a marginal change. 

Furthermore, another member of the 14th FC did state that the 16th Finance Commission did not undertake a normative assessment of revenue deficit grants. However, rather than disregarding the fiscal position of the states, the Commission evaluated the effectiveness of the normative approach adopted by successive Finance Commissions in achieving sustained fiscal correction. It was found that there has been little systemic relationship between revenue deficit grants and actual revenue deficit. 

Over the past three decades, actual revenue deficits remained above 0.5 per cent of the GDP in most years, while normatively assessed deficits generally did not exceed this threshold. The combined revenue balance of the states, which had recorded surpluses in certain years, subsequently reverted to deficit, while the number of revenue-deficit states increased from 5 in 2011–12 to 14 in 2025-26 and remained in double digits since then. Over the same period, the magnitude of revenue deficit grants rose from 1.1 per cent of gross tax receipts under the 13th Finance Commission to 2.2 per cent and 1.9 per cent under the 14th and 15th Finance Commissions, respectively. In this context, the Commission’s decision to discontinue revenue deficit grants may be interpreted not as an abandonment of normative assessment, but as a reassessment of the effectiveness of a recurring gap-filling mechanism in promoting durable fiscal adjustment and appropriate fiscal incentives. 

The criticism by the same member that the 16th Finance Commission does not adequately address the proliferation of Central “freebie” schemes also warrants qualification. The Commission itself notes the existing budgetary classification of subsidies across the Centre and states is neither uniform nor always reflective of their underlying economic character. In this context, it is difficult to treat all Union-funded schemes as a homogeneous category of “freebies”. Schemes that finance food security, rural drinking water, affordable housing or transport infrastructure are fundamentally different from untargeted consumption subsidies, as they create durable public assets, strengthen human capabilities and generate positive externalities that extend across states. The relevant policy question, therefore, is not whether such expenditure should exist, but whether it is efficiently targeted, transparently classified and fiscally sustainable.   

There is also a critique regarding the contribution of Centrally Sponsored Schemes in India’s progress by both the members. The suggestion that such schemes (cost sharing basis between the Centre and states) have made little contribution to nation-building is equally difficult to sustain. Such schemes have served as important instruments for advancing nationally agreed development priorities through state-level implementation. For example, under the Jal Jeevan Mission, rural tap water coverage has increased from 32.3 million households in 2019 to 158.3 million on last count. Under the Pradhan Mantri Awas Yojana, over 30 million rural houses and 9.86 million urban houses have been completed, significantly expanding access to affordable housing. Far from being peripheral to India’s development strategy, these outcomes demonstrate that Centrally Sponsored Schemes have complemented state fiscal capacity by improving access to drinking water, housing, connectivity and other essential public services while reducing regional disparities across the federation. 

In this context, an equally important dimension of India’s fiscal architecture is the contribution of Central Sector Schemes of which the Centre bears 100 per cent of the cost, that the members of the 14th Finance Commission have completely overlooked. 

The argument that the expenditure undertaken directly by the Union Government has little bearing on the welfare of the states presents only a partial picture of fiscal federalism, since a significant proportion of the Union expenditure finances infrastructure, food security, agriculture and other public goods whose benefits accrue across all states. 

In the Union Budget 2026–27, Central Sector Schemes account for an allocation of ₹17.72 trillion. Among the largest allocations are ₹3.10 trillion for the Ministry of Road Transport and Highways, ₹2.78 trillion for the Ministry of Railways, ₹2.28 trillion for the Department of Food and Public Distribution, of which ₹2.27 trillion is provided under the Pradhan Mantri Garib Kalyan Anna Yojana (PMGKAY), and ₹63,500 crore under PM-Kisan for direct income support to farmers. These expenditures finance national highways, railway infrastructure, food security for over 810 million beneficiaries, and offer direct income support to farming households across the country entirely funded by the central government. 

The PMGKAY Act is the largest free food grain programme running in the world and legally entitles food security to up to 75 per cent of the rural population and up to 50 per cent of the urban population (nearly 67 per cent citizens as per 2011 census). This programme allows particularly migrant beneficiaries to claim either full or part foodgrains from any Fair Price Shop (FPS) of choice, anywhere in the country (district/state/country) through existing ration card in a seamless manner and also allows their family members back home (if any), to claim the balance foodgrains on the same ration card. 

The economic and social benefits thus accrue directly to the states by strength-ening connectivity, lowering logistics costs, supporting agriculture incomes, enhancing food security and stimulating regional economic activity. Ignoring these investments while assessing Centre–State fiscal relations provide an incomplete assessment of the developmental role played by the Union.

A debate on fiscal federalism should not turn every question about vertical devolution into a Centre-versus-states argument. The real issue is the appropriate balance among unconditional tax devolution, formula-based grants, specific-purpose transfers, and fiscal space for national commitments. That balance can and should be debated

 

The author is member, PMEAC; member, 16th Finance Commission; and group chief economic advisor at State Bank of India. Views are personal