Article 2: Fiscal Federalism Challenge
Why in News: The Sixteenth Finance Commission (2026–31) recommendations have sparked debate over fiscal federalism due to reduced effective state share and increased discretionary transfers to local bodies.
Key Details
- The Commission retained 41% vertical devolution, but effective state share declined to around 32%.
- Revenue deficit grants and sector-specific grants under Article 275 have been discontinued.
- Significant increase in grants to local bodies (~₹7.91 lakh crore) under discretionary mechanisms.
- Shift observed from statutory transfers to discretionary, performance-based transfers.
Finance Commission & Constitutional Framework
- Constitutional Body (Article 280): The Finance Commission is constituted every five years to recommend distribution of taxes between the Union and states, ensuring fiscal balance.
- Vertical & Horizontal Devolution: Vertical devolution deals with Centre-state share (currently 41%), while horizontal devolution distributes resources among states based on criteria like population and income distance.
- Role in Fiscal Federalism: It acts as a neutral arbiter ensuring equity, efficiency, and cooperative federalism, balancing regional disparities.
- Statutory vs Discretionary Transfers: Transfers under Article 275 are statutory and predictable, whereas Article 282 grants are discretionary, impacting transparency and accountability.
Changes Introduced by the Sixteenth Finance Commission
- Reduction in Effective State Share: Although nominal share remains 41%, exclusion of cesses and surcharges has reduced effective transfers to around 32%, limiting fiscal space of states.
- Alteration in Horizontal Criteria: Changes in formula have reduced shares of several states, particularly Northeastern states (decline ~15%), affecting regional equity.
- Discontinuation of Revenue Deficit Grants: Earlier commissions provided gap-filling support to fiscally weaker states, which has now been removed, impacting vulnerable states.
- Shift Toward Performance-Based Transfers: Increased emphasis on efficiency, urbanisation, and performance indicators instead of need-based criteria.
Article 275 vs Article 282: Constitutional Debate
- Article 275 (Statutory Grants): Provides need-based assistance, especially for tribal welfare and special areas, ensuring equity and constitutional obligation.
- Article 282 (Discretionary Grants): Allows Union and states to make grants for public purposes, but lacks statutory backing and predictability.
- Shift from Equity to Discretion: Replacement of Article 275 grants with Article 282 mechanisms reduces parliamentary oversight and fiscal certainty.
- Impact on Federal Balance: This shift increases central leverage, potentially undermining cooperative federalism.
GST Regime & Changing Fiscal Dynamics
- Shift to Destination-Based Taxation: GST transformed India into a consumption-based tax system, altering revenue patterns among producing and consuming states.
- Revenue Uncertainty for States: States have become dependent on GST compensation and transfers, increasing fiscal vulnerability.
- Ignored GST Council Dynamics: Issues like IGST settlement delays and compensation gaps were not adequately addressed by the Commission.
- Need for Equalisation Mechanism: Fiscal disparities persist, requiring targeted support rather than aggregate assessment of deficits.
Strengthening Local Bodies: Gains and Concerns
- Increased Allocation (~₹7.91 lakh crore): Significant boost to Panchayats and Urban Local Bodies (ULBs), promoting decentralisation.
- Basic vs Performance Grants: 80% basic grants ensure minimum funding, while 20% performance-based grants incentivise governance reforms.
- Urbanisation Incentives: Focus on urban governance aligns with rapid urban growth and Smart Cities initiatives.
- Concern of Bypassing States: Direct transfers weaken the role of states, which constitutionally supervise local bodies.
Federalism vs Decentralisation Debate
- States as Primary Federal Units: States have constitutional status under Part VI, forming the backbone of Indian federalism.
- Local Bodies as Subordinate Entities: Empowered through 73rd and 74th Amendments, but function under state control.
- Parallel Fiscal Channels: Treating local bodies as separate stakeholders in fiscal distribution may dilute state authority.
- Risk to Cooperative Federalism: Excessive centralisation through discretionary grants may disrupt Centre-State trust.
Equity vs Efficiency in Resource Distribution
- Equity-Based Approach: Earlier focus was on backwardness, need, and social justice, ensuring balanced development.
- Shift to Efficiency Criteria: Emphasis on performance, GDP contribution, and urbanisation may disadvantage poorer states.
- Regional Disparities: States with weaker fiscal capacity may face reduced support, widening inequality.
- Balancing Both Principles: A mix of equity and efficiency is essential for sustainable and inclusive growth.
Way Forward
- Reinforce Statutory Transfers: Restore and redesign Article 275 grants as equalisation tools using multi-dimensional criteria.
- Rationalise Divisible Pool: Include cesses and surcharges partially to increase transparency and fairness.
- Align with GST Realities: Address IGST settlement, compensation, and revenue volatility in devolution formulas.
- Strengthen Cooperative Federalism: Ensure greater consultation with states and the GST Council.
- Balanced Decentralisation: Empower local bodies without undermining states, maintaining constitutional hierarchy.
Conclusion
India must strike a careful balance between federalism and decentralisation, ensuring that strengthening the third tier does not weaken the foundational role of states.
EXPECTED QUESTIONS FOR UPSC CSE
Prelims MCQ
Q. Consider the following statements:
- Article 275 provides discretionary grants to states.
- Article 282 allows both Union and states to make grants for public purposes.
Which of the statements given above is/are correct?
(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2
Answer: (b)
Descriptive Question
Q. “Recent Finance Commission recommendations have shifted India’s fiscal federalism from statutory equity to discretionary centralisation.” Critically examine. (250 Words, 15 Marks)