Why Centre-State Transfers are Crucial in Fiscal Federalism

Every year, when state governments sit down to plan budgets for schools, hospitals, roads and welfare schemes, most of them run into the same problem: their own tax collections simply don’t cover their spending needs. This isn’t a sign of poor planning. It is baked into how India’s Constitution divides taxing powers and spending duties between the Centre and the states. Centre-state transfers exist to fix this mismatch, and understanding why they are structured the way they are tells you a lot about how Indian federalism actually works on the ground.

The basic problem: states spend more than they earn 🔗

India’s Constitution gives the Union government the power to collect the most productive and easily administered taxes, like income tax and GST on interstate trade, while handing states the responsibility for expensive, people-facing services such as health, education, law and order, and agriculture. This creates what economists call a vertical fiscal imbalance. States collectively raise a relatively modest share of total revenue but are responsible for a much bigger share of total government spending, particularly on economic and social services.

The result is a structural fiscal gap. Even a well-run state with disciplined spending will fall short of the money it needs simply because the taxation powers assigned to it don’t generate enough revenue. Centre-state transfers, through tax devolution and grants, exist precisely to close this vertical gap so that states aren’t forced to cut essential services just because of how tax powers were divided.

Fiscal inequity: not all states start from the same place 🔗

Beyond the vertical gap between the Centre and states as a whole, there’s a second, equally real problem: states are not equal to each other. Maharashtra and Bihar don’t have comparable tax bases, industrial output, or per capita incomes. Left purely to their own resources, richer states would be able to fund excellent schools and hospitals while poorer states would struggle to provide even basic services, regardless of how hard their governments tried.

This is the horizontal fiscal imbalance problem, and it is arguably the more politically sensitive of the two. The economic rationale for addressing it is straightforward: a citizen’s access to a functioning primary health centre or a working school shouldn’t depend on which state they happen to be born in. Correcting this disparity is one of the core jobs of India’s Finance Commission, a constitutional body appointed every five years under Article 280 to recommend how central taxes should be divided both between the Union and the states, and among the states themselves.

How horizontal transfers are calculated 🔗

Each Finance Commission uses a formula built from criteria like population, income distance from the richest states, area, forest cover, and demographic performance to decide how much each state receives from the shareable pool of central taxes. States with lower per capita income typically receive a larger share relative to their population, which is a deliberate design choice meant to narrow, not just acknowledge, regional income gaps.

Fiscal inefficiency: rewarding good behaviour, not just need 🔗

A transfer system built only around “who needs the most” runs into a subtle trap. If states know that running larger deficits or under-collecting their own taxes will simply be compensated by bigger transfers from the Centre, there is little incentive to manage finances responsibly. Economists studying India’s transfer system have flagged this as a genuine risk, sometimes described as a moral hazard problem, where softer budget constraints reduce the pressure on states to raise their own revenue efficiently.

This is why transfers aren’t designed purely as a needs-based safety net. Many grants and formula weights build in rewards for tax effort, fiscal discipline, and efficient spending, so that a state isn’t penalised for improving its own revenue collection and isn’t rewarded for letting finances slide. Getting this balance right is difficult, and every Finance Commission report wrestles with how much weight to give equity versus efficiency in its formula.

Interstate spillovers: when one state’s spending benefits another 🔗

Some public spending by a state doesn’t stay within its borders. Vaccination programmes, pollution control, disease surveillance, and river-basin management in one state directly affect the wellbeing of people in neighbouring states. If a state bore the full cost of such programmes while other states enjoyed the benefits for free, it would rationally under-invest in them, even though the spending is valuable for the country as a whole.

This is the classic case for spillover-correcting or conditional grants. When the benefits of a service extend beyond the state providing it, central grants tied to that specific purpose help ensure the state doesn’t scale back spending just because it isn’t capturing the full return. Public finance literature on intergovernmental grants describes this as central government support that boosts spending in priority areas with cross-border benefits, correcting a gap that market forces and state-level budgeting alone would leave unaddressed.

Merit goods and national minimum standards 🔗

A related idea is the “merit good” argument. Certain services, like basic education, immunisation, or nutrition support, are considered so important for the nation’s overall human development that the Centre has a stake in making sure every state provides them at a reasonable minimum standard, even if a particular state government wouldn’t have prioritised that level of spending on its own. Centrally sponsored schemes in health and education are often built around this logic.

Fiscal harmonization: keeping the federation coherent 🔗

The final piece of the rationale is less about money and more about coordination. In a large, diverse federation, states can pursue very different tax rates, subsidy policies, or borrowing practices. Left unchecked, this can lead to wasteful tax competition between states, duplicated or conflicting programmes, and macroeconomic instability that affects the whole country, not just the state that caused it.

Transfers, along with the institutional process of the Finance Commission itself, act as a coordinating mechanism. They encourage states to work within broadly consistent fiscal frameworks and support national priorities like fiscal responsibility targets, without stripping away state autonomy entirely. This coordinating role has become more visible since the rollout of GST, which itself required unprecedented tax harmonization between the Centre and states, backed by compensation transfers during the transition period.

What makes a transfer system actually work well 🔗

Knowing why transfers are needed is only half the picture. Economists and Finance Commissions have also laid out what makes a transfer system well-designed, as opposed to just well-intentioned. These design principles matter because poorly structured transfers can undermine the very goals they’re meant to serve.

No transfer system perfectly satisfies all eight principles simultaneously, since some of them naturally pull in opposite directions. Predictability and autonomy, for instance, can be in tension with incentivizing performance and aligning with shifting national priorities. Each Finance Commission effectively has to decide how to trade these off, and comparing successive Commission reports is a good way to see how that balance has shifted over time.

Two main channels: devolution and grants-in-aid 🔗

In practice, Centre-state transfers flow through two broad routes. The first is tax devolution, where a fixed share of the divisible pool of central taxes is automatically passed to states, largely without conditions attached. This channel scores well on autonomy and predictability. The second is grants-in-aid under Article 275 of the Constitution, along with various centrally sponsored schemes, which are more targeted and often come with specific conditions or matching requirements from states, addressing spillovers, merit goods and national priorities more directly.

Research on India’s federal transfer system notes that statutory transfers, which include tax devolution, tend to preserve state fiscal autonomy far more than discretionary or scheme-based grants, which can reduce a state’s fiscal independence even as they address specific needs. This is part of why the ratio between devolution and grants is such a closely watched number every time a new Finance Commission report is released.

Why this still matters today 🔗

Fiscal federalism isn’t a settled, one-time arrangement. GST reforms, changing cess and surcharge structures, and evolving centrally sponsored schemes keep reshaping how much fiscal room states actually have. Every new Finance Commission has to revisit the same underlying rationale, fiscal gaps, inequity, inefficiency, spillovers and harmonization, and re-decide how much weight each deserves given the economic realities of that period. Understanding this rationale is what separates memorising the formula from actually understanding why Indian fiscal federalism is designed the way it is.

What do you think? If you were designing India’s transfer formula today, would you weigh equity for poorer states more heavily, or lean further toward rewarding states with stronger fiscal discipline and tax collection? And do you think GST has made fiscal harmonization between the Centre and states easier, or created new points of friction?

References

1. https://www.sciencedirect.com/science/article/pii/S2667111523000051
2. https://fincomindia.nic.in/
3. https://www.adb.org/sites/default/files/publication/30214/economics-wp-343-federal-transfers-fiscal-discipline-india.pdf
4. https://link.springer.com/article/10.1007/s10797-023-09816-7
5. https://journals.sagepub.com/doi/10.1177/09722661241260627