Fiscal federalism in India: decoding the 15th finance commission & centre-state Fund Flows

The Financial Lifeline: Understanding Centre-State Fiscal Relations

Imagine the Indian Union as a large, diverse family. The central government is the primary earner, while the states are family members with varying needs and earning capacities. Fiscal Federalism is the principle that governs how the family’s income is shared to ensure everyone thrives. It’s the constitutional mechanism for the division of taxation and expenditure powers between the Centre and the States, a cornerstone of India’s quasi-federal structure. The flow of funds from New Delhi to the state capitals is not mere accounting; it is the financial lifeblood that powers everything from rural roads to public health, making this a critical topic for the UPSC exam.

While the 14th Finance Commission significantly enhanced the states’ share, the current landscape is defined by the recommendations of the 15th Finance Commission (XV-FC), chaired by N.K. Singh, for the period 2021-22 to 2025-26. This has reshaped the dynamics of fiscal transfers, which primarily occur through three channels:

1. Devolution of Taxes: The states’ share in the net proceeds of Union taxes.
2. Grants-in-Aid: Financial assistance provided to states, as recommended by the Finance Commission.
3. Centrally Sponsored Schemes (CSSs): Jointly funded programs to achieve national objectives.

Analogy: Think of the divisible pool of taxes as a large pizza. Vertical devolution decides how many slices the Centre keeps and how many are given to the states collectively. Horizontal devolution then decides how the states’ collective portion is sliced up among them based on their individual needs and performance.

The 15th Finance Commission: The New Rulebook (2021-26)

The XV-FC’s report has been pivotal in steering Centre-State financial relations in the post-pandemic era. Its recommendations balance the principles of need, equity, and performance.

Vertical Devolution: The 41% Share

The commission recommended that 41% of the divisible pool of Union taxes be devolved to the states. This is a marginal reduction from the 42% recommended by the 14th FC. The 1% adjustment was made to account for the newly formed Union Territories of Jammu & Kashmir and Ladakh, whose funding requirements would now be met directly by the Centre.

Horizontal Devolution: Slicing the Pie Fairly

Once the states’ collective share is determined, the next challenge is its inter-se distribution. The XV-FC established a nuanced formula with specific weightage to different criteria to ensure an equitable and performance-oriented allocation.

Mnemonic for Horizontal Devolution Criteria: To remember the six key criteria, use the acronym “I P.A.F. DeTox”

• I - Income Distance
• P.A. - Population & Area
• F - Forest & Ecology
• De - Demographic Performance
• Tox - Tax Effort

Fun Fact: The total transfers recommended by the 15th Finance Commission (tax devolution + grants) for the 2021-26 period amount to a staggering ₹52.5 lakh crore (approx.), which is roughly 34% of the Union’s estimated Gross Revenue Receipts.

Beyond Devolution: Grants and Schemes

Beyond tax sharing, the Centre supports states through various grants.

• Revenue Deficit Grants: Under Article 275, these are provided to states that face a revenue gap even after receiving their tax share. The XV-FC recommended nearly ₹3 trillion in such grants for 17 states over its award period.
• Sector-Specific & State-Specific Grants: The commission also recommended performance-based grants for sectors like health, education, and agriculture, along with grants for specific state needs.

Centrally Sponsored Schemes (CSSs) remain a major, albeit contentious, channel of funding. They are designed to pursue national priorities, but critics argue they limit states’ spending flexibility. Responding to these concerns, the government, through NITI Aayog, is undertaking a major rationalization exercise. As reported in August 2024, the aim is to potentially reduce the number of CSSs from 75 to around 50 by merging or phasing out schemes to improve efficiency.

The Current State of State Finances: A 2024-25 Snapshot

The fiscal health of states is a dynamic variable. According to the RBI’s report on State Finances for 2024-25, states are showing signs of fiscal consolidation post-pandemic.

• Fiscal Deficit: States have managed to contain their consolidated Gross Fiscal Deficit (GFD) within 3% of GDP for 2022-23 and 2023-24, though it is budgeted to rise slightly to 3.2% in 2024-25.
• Capital Expenditure: A positive trend is the focus on asset creation, with capital expenditure budgeted to rise to 3.1% of GDP in 2024-25.
• Debt Burden: However, states’ combined debt-to-GDP ratio, while declining, remains elevated at around 28.5% (as of March 2024), higher than the pre-pandemic level.

Statistic: According to a November 2025 PRS Legislative Research report, the aggregate revenue for states from taxes that were subsumed under GST fell to 5.5% of GDP in 2023-24, down from 6.5% in 2015-16, highlighting the fiscal challenges in the post-compensation era.

Critical Policy Appraisal

Analytical Lens: UPSC Focus (Mains & Prelims)

Conceptual Basis:

The entire framework of fiscal federalism is anchored in the Constitution of India. The two most critical articles are:

• Article 280: Mandates the constitution of a Finance Commission by the President every five years to make recommendations on the distribution of financial resources between the Union and the States.
• Article 270: Governs the distribution of net tax proceeds collected by the Union between the Centre and the States.

UPSC Integration: Connecting the Dots

1. Polity (GS Paper 2): Directly links to Centre-State Relations, the nature of Indian Federalism (cooperative, competitive, and confrontational), and the role of constitutional bodies like the Finance Commission.
2. Economy (GS Paper 3): Connects with Public Finance, Fiscal Policy, GST, and issues of inclusive growth and regional disparities. The fiscal health of states is crucial for national macroeconomic stability.
3. Governance (GS Paper 2): Relates to the implementation and effectiveness of social sector schemes, the role of NITI Aayog in policy evaluation, and the financial empowerment of local governments (Panchayats and Municipalities).

Future Impact & Policy Relevance:

The future of Indian fiscal federalism will be shaped by the recommendations of the upcoming 16th Finance Commission (chaired by Dr. Arvind Panagariya). Key debates will revolve around enlarging the divisible pool to include cesses and surcharges, giving states more borrowing flexibility, and designing a sustainable support mechanism in the post-GST compensation era. The balance between promoting national goals and respecting state autonomy will remain a central theme of India’s governance.

Prelims Practice MCQ:

Which of the following criteria has the highest weightage in the horizontal devolution formula recommended by the 15th Finance Commission?

a) Population (2011) b) Demographic Performance c) Income Distance d) Forest & Ecology

Explanation: The correct answer is (c) Income Distance. The 15th Finance Commission gave the highest weightage of 45% to the ‘Income Distance’ criterion to promote equity by allocating a larger share of resources to states with lower per capita income.

Mains Sample Question (15 Marks):

“While the 15th Finance Commission has attempted to balance the principles of equity and efficiency in resource allocation, the growing centralization of revenues and the cessation of GST compensation pose significant challenges to cooperative fiscal federalism in India.” Critically analyze this statement in light of recent developments.

Mind Map Outline (Revision Structure)

• Fiscal Federalism in India
  • Core Concept: Division of financial powers between Centre and States.
  • Constitutional Basis:
    • Article 280 (Finance Commission)
    • Article 270 (Distribution of Taxes)
    • Article 275 (Grants-in-Aid)
  • Mechanisms of Fund Transfer:
    • Tax Devolution
    • Grants-in-Aid
    • Centrally Sponsored Schemes (CSS)
• 15th Finance Commission (2021-26)
  • Chairman: N.K. Singh
  • Vertical Devolution:
    • Recommended Share: 41% for States.
    • Reason for 1% reduction from 14th FC.
  • Horizontal Devolution (Criteria & Weightage):
    • Income Distance (45%)
    • Population & Area (15% each)
    • Forest & Ecology (10%)
    • Demographic Performance (12.5%)
    • Tax Effort (2.5%)
• Recent Developments & State Finances (2024-2025)
  • RBI Report on State Finances:
    • Fiscal Deficit Trends
    • Capital Expenditure Focus
    • Elevated Debt Levels
  • GST Compensation:
    • Cessation in June 2022.
    • Formation of GoM (Sept 2024) for new mechanism.
  • Centrally Sponsored Schemes (CSS):
    • Ongoing rationalization exercise by NITI Aayog.
• Critical Analysis & Challenges
  • Challenges:
    • Centralization (Cess & Surcharge issue)
    • Regional Disparities (North vs. South)
    • State Autonomy vs. National Goals
  • Way Forward:
    • Strengthening Cooperative Federalism
    • Performance-based Incentives
    • Empowering Local Governance