Centre-State Fiscal Transfers: 15th Finance Commission and Beyond – Economic Survey 2025-26
The federal fiscal architecture of India involves complex financial relationships between the Union Government and State Governments. The Economic Survey 2025-26 examines these relationships in detail, particularly in light of concerns about state-level fiscal health. Understanding Centre-State fiscal transfers is crucial for UPSC aspirants as this topic features prominently in both Prelims and Mains, touching on constitutional provisions, Finance Commission recommendations, and contemporary policy debates.
Constitutional Framework for Fiscal Federalism
India's Constitution establishes a system of fiscal federalism where both the Union and States have defined taxation powers and expenditure responsibilities. However, there is a vertical imbalance – the Union collects more taxes than it needs for its functions, while States have greater expenditure responsibilities than their tax revenues can finance. This necessitates transfer of resources from the Centre to States.
The primary constitutional mechanism for such transfers is the Finance Commission, appointed every five years under Article 280. The Finance Commission recommends the share of central taxes to be devolved to States and the principles governing this devolution. These recommendations are generally accepted by the government, making the Finance Commission crucial to federal fiscal relations.
15th Finance Commission: Key Recommendations
The 15th Finance Commission, chaired by N.K. Singh, submitted its recommendations for the period FY22 to FY26. Key aspects include:
Tax Devolution: The Commission recommended that 41 per cent of the divisible pool of central taxes be transferred to States. This represents a slight reduction from the 14th Finance Commission's recommendation of 42 per cent, primarily to accommodate the newly created Union Territories of Jammu & Kashmir and Ladakh.
Horizontal Distribution: The criteria for distributing funds among States include population (based on 2011 Census), area, forest and ecology, income distance (giving more to poorer States), and demographic performance (rewarding States that have achieved lower fertility rates).
Grants: Beyond tax devolution, the Commission recommended various grants including revenue deficit grants for States with fiscal stress, grants for local bodies, health sector grants, and disaster management funds.
The Economic Survey 2025-26 notes that these transfers form a significant portion of State revenues and are crucial for their developmental activities.
SASCI: Special Assistance for Capital Investment
Beyond Finance Commission transfers, the Union Government has introduced additional mechanisms to support State-level capital expenditure. The Special Assistance to States for Capital Investment (SASCI) scheme provides interest-free loans to States for capital projects.
This scheme was introduced during the pandemic period to encourage States to maintain capital expenditure despite fiscal stress. States receive these loans at zero interest rate for 50 years, making them highly concessional. The funds must be used for specified capital projects, ensuring that they contribute to productive asset creation rather than consumption.
The Economic Survey 2025-26 emphasizes the importance of such schemes in promoting state-level infrastructure development while maintaining fiscal discipline.
Concerns About State Fiscal Health
While discussing Centre-State transfers, the Economic Survey 2025-26 raises significant concerns about the fiscal health of several States. The survey notes that "concerns over fiscal populism, the crowding out of capital expenditure by cash transfers, and the rise of revenue deficits in states have increased in recent times."
Several States have implemented large unconditional cash transfer schemes promising monthly payments to various categories of citizens. While politically popular, these schemes have multiple economic implications:
Crowding Out Capital Expenditure: Cash transfers consume fiscal resources that could otherwise fund infrastructure. A State spending 2 per cent of its GSDP on cash transfers has that much less for roads, power, water supply, and other infrastructure.
Rising Revenue Deficits: When States borrow to fund consumption spending, it indicates fiscal stress. Revenue deficit means that States are not even covering their current expenses from current revenues, let alone generating surplus for investment.
Impact on Incentives: The survey raises a deeper concern – "the economic costs of the insidious impact that unconditional fiscal transfers have on the incentives for self-improvement, upskilling, and employability may be more significant in the long term."
General Government Finances: A New Assessment Framework
The Economic Survey 2025-26 highlights an important shift in how India's fiscal position is assessed globally. With Indian government bonds now included in global bond indices, international investors assess "general-government finances" – the combined fiscal position of Union and State governments – rather than just Union government finances.
This has significant implications. Even if the Union Government achieves excellent fiscal consolidation, weak State finances can raise the overall cost of government borrowing. The survey notes that India's 10-year bond yield is higher than Indonesia's despite identical credit ratings, suggesting that general government fiscal concerns may be a factor.
This means that fiscal discipline at the State level is no longer a local issue – it affects the nation's borrowing costs and economic competitiveness. State fiscal populism imposes costs not just on that State's citizens but on the entire country.
Tax Devolution and State Autonomy
A perennial debate in Indian fiscal federalism concerns the balance between fiscal transfers and State autonomy. States argue that greater devolution enhances their flexibility to address local priorities. The Union Government argues that tied transfers and centrally sponsored schemes ensure that national priorities are implemented uniformly.
The Economic Survey 2025-26 implicitly weighs in on this debate by emphasizing the importance of quality of expenditure over quantity. The issue is not just how much States receive but how they spend it. Transfers that end up funding consumption rather than investment do not serve long-term development objectives regardless of who decides the allocation.
GST Compensation and Beyond
When GST was introduced in 2017, States were promised compensation for any revenue shortfall below 14 per cent annual growth for five years. This compensation period ended in FY22, and States have had to adjust to a new fiscal reality.
GST collections have generally been robust, and many States have seen revenue growth meeting or exceeding expectations. However, the distribution of GST revenues among States remains a contentious issue, with consumer States arguing that the current formula favours producer States.
The Economic Survey 2025-26's mention of the most radical GST overhaul since 2017 suggests that further reforms to the GST framework may address some of these concerns while improving overall revenue efficiency.
Way Forward: Coordinated Fiscal Responsibility
The survey suggests that managing India's fiscal position requires coordination between Union and State governments. While constitutional provisions protect State autonomy, the reality of integrated bond markets means that fiscal irresponsibility anywhere affects borrowing costs everywhere.
The 16th Finance Commission, which will make recommendations for the period beginning FY27, will need to consider these dynamics. How to incentivize fiscal responsibility at the State level while respecting federal principles will be a key challenge.
The survey's emphasis on "policy credibility, predictability and administrative discipline" as strategic assets applies to both Union and State governments. Building and maintaining this credibility requires sustained effort across all levels of government.
UPSC Relevance: Fiscal Federalism
For UPSC, fiscal federalism appears across multiple papers:
- Polity: Constitutional provisions, Finance Commission, GST Council
- Economy: Fiscal policy, government budgeting, Centre-State financial relations
- Governance: Implementation of schemes, cooperative federalism
- Current Affairs: Finance Commission recommendations, GST reforms
Practice MCQs on Centre-State Fiscal Transfers - Economic Survey 2025-26
Q1. The 15th Finance Commission recommended what percentage of the divisible pool of central taxes for States?
(a) 32%
(b) 38%
(c) 41%
(d) 42%
Answer: (c) 41%
Q2. SASCI scheme provides States with:
(a) Revenue grants
(b) Interest-free loans for capital investment
(c) GST compensation
(d) Salary support
Answer: (b) Interest-free loans for capital investment
Q3. According to Economic Survey 2025-26, which factor affects India's sovereign borrowing cost despite Union fiscal consolidation?
(a) RBI policy rates
(b) State-level fiscal health
(c) External debt
(d) Trade deficit
Answer: (b) State-level fiscal health
Q4. The Finance Commission is appointed under which Article of the Constitution?
(a) Article 270
(b) Article 275
(c) Article 280
(d) Article 293
Answer: (c) Article 280
Q5. Which of the following is NOT a criterion for horizontal distribution of taxes among States under 15th Finance Commission?
(a) Population
(b) Forest and ecology
(c) Demographic performance
(d) Industrial output
Answer: (d) Industrial output
Conclusion
Centre-State fiscal transfers constitute the backbone of India's federal fiscal architecture. The Economic Survey 2025-26 highlights both the achievements and challenges in this area. While the Finance Commission framework continues to function effectively, emerging concerns about State fiscal health and the impact on national borrowing costs require attention. As India moves toward the 16th Finance Commission period, finding the balance between State autonomy and collective fiscal responsibility will be crucial for sustainable development.