Opinion: Devolution of Funds — Need for fiscal equalisation approach

The Sixteenth Finance Commission must ensure fair devolution across Union, State, and Local governments

By Nayakara Veeresha

The Constitution of India has unique provisions for the allocation of funds from the Union to the States and the States to Local governments. The financial relationship among the three tiers of governance — Union, State, and Local governments — is critical to achieving the developmental goals enshrined in the Directive Principles of State Policy. The Constitution’s aim to facilitate decent living standards for every citizen requires a scientific assessment of the basic needs of the people.

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Under Articles 243(I & Y), 275, and 280(1), (3), the Union and State Finance Commissions have the mandate to assess financial needs and recommend the quantum of funds to be devolved to local governments and the States, respectively.

All Eyes on 16th Panel

Currently, the Sixteenth Finance Commission is working towards submitting its reports to the Union government by the end of October 2025. All eyes are on its recommendations, particularly because of the reduced allocation of funds during 2020-2025 by the Fifteenth Finance Commission. The southern States have been assertive in raising objections to the criteria and methods adopted by the Commission, which has led to a decline in their share of devolved funds compared to the Fourteenth Finance Commission period.

More pertinently, the Terms of Reference (ToR) of the Fifteenth Finance Commission have widened the fiscal gap between the Union and southern States by using the 2011 population census instead of the 1971 census, which was in use until the 13th Finance Commission. Due to this change in the variables, the southern States, which initiated population stabilisation measures, were disadvantaged in terms of tax devolution.

Southern States argue that despite paying more taxes, they receive less funds through the Finance Commission — a concern that deserves attention. Except for Tamil Nadu, the share of finances for all other southern States has come down between the Fourteenth and Fifteenth Finance Commissions. As 2026 marks the 75th year of fiscal federalism, the Sixteenth Finance Commission has a crucial role in restructuring Union-State financial relations.

Fiscal Federalism

The Chief Ministers of Karnataka, Kerala, and Tamil Nadu have been vocal in raising concerns about devolution of funds, and the alleged discrimination by the Union government in withholding these funds on political grounds. In June 2025, the Tamil Nadu government formed a High-Level Committee on Union-State relations under the chairmanship of retired Supreme Court judge Justice Kurian Joseph. This follows the precedent set in 1969 by then Chief Minister CN Annadurai, who formed the Centre-State Relations Inquiry Committee headed by PV Rajamannar.

A 40:30:30 Union-State-Local devolution formula could reshape grassroots development and uphold the spirit of fiscal federalism and the principle of subsidiarity

A detailed analysis of the criteria used for fund devolution from the First to the Fifteenth Finance Commission reveals an interesting pattern. The First to Tenth Finance Commissions prioritised indicators such as population, level of development, and fiscal capacity/weakness of the States. This was in line with the idea of promoting human development equally in all the States, especially meeting basic needs.

A paradigm shift occurred from the Eleventh to Fifteenth Finance Commissions, which emphasised equity and efficiency in financial governance. However, the aspects of social justice, index of devolution, efforts of States in achieving SDG-1 (zero poverty) also needs to be factored in along with equity and efficiency.

Equalisation Approach

The methodology of the Sixteenth Finance Commission is pivotal in balancing the demand for increased funds by the fiscally prudent States with that of those with poor fiscal prudence. The goal of bringing less-developed States on a par with States with better human development is important; it should not penalise States that have shown fiscal responsibility and better human development outcomes.

A balanced approach is necessary, revisiting indicators by taking into account both revenue raising capacity and development needs of the State. This is largely based on Canadian economist Robin Boadway’s paper on “Designing a Central-State Equalization System,” published by the Aarthika Charche, a journal of the Fiscal Policy Institute, Government of Karnataka, in 2019. Such a fiscal equalisation approach integrates three major schools of thought on fiscal decentralisation: Macro Economy (maximisation of benefits) — growth focus; Political Economy (State Efficiency) — welfare and distributive justice, and Institutional Economy (Institutional autonomy) — sustainability of growth.

While the suggested design is imperative for fiscal equalisation, it is also vital to include the local government in this framework. This will strengthen the fiscal autonomy of local governments and decentralise the development process in a country as large as India. Leaving out the local governments in the scheme of overall fiscal devolution negates the spirit of fiscal federalism and the principle of subsidiarity. Fiscal autonomy for the local governments has to be mandatory rather than making them as dependent upon the Union and State governments for their financial needs.

As Boadway (2019) notes, “unconditional formula-based equalization transfers contribute to effective decentralization of decision-making to the states”. Extending this to local governments, a devolution ratio of 40:30:30 among Union, State and local governments, respectively, would ensure fiscal freedom at the grassroots. This fiscal guarantee would empower local bodies to deliver economic development and social justice more effectively.

(The author is Assistant Professor, Symbiosis Law School, Pune, Symbiosis International (Deemed University), Pune. Views are personal)