Fiscal Federalism, Transfers, and the Case for an Independent Anchor

India’s fiscal federal framework is facing a quiet but consequential crisis of credibility. This is not a dispute over headline devolution percentages or aggregate transfers, but a deeper erosion of trust among States in the transparency, predictability, and fairness of the system through which resources flow from the Centre. Over the past decade, States have increasingly come to view fiscal transfers—whether through tax devolution, central sector schemes, or centrally-sponsored schemes—not as neutral instruments of national development, but as discretionary, conditional, and politically mediated flows. This perception is not political rhetoric; it is grounded in fiscal arithmetic and institutional design.

The Institutional Vacuum After the Planning Commission
The abolition of the Planning Commission removed more than a symbol of centralised planning; it dismantled an institutional buffer that mediated between macroeconomic constraints and intergovernmental resource allocation. Under the earlier Plan framework, transfers—despite their inefficiencies—were embedded in a medium-term macroeconomic assessment, negotiated with States, and processed through an institution insulated from day-to-day cash-management pressures. This separation created predictability and analytical distance between fiscal arithmetic and political discretion.

What replaced it was not an equivalent institutional substitute. The Finance Commission continues to perform its vital constitutional role in tax devolution and grants, but it operates episodically and was never designed to oversee the evolving architecture of discretionary transfers, scheme design, or conditionalities. NITI Aayog has a strategic intent but lacks fiscal instruments. As a result, effective control over transfers and schemes has migrated to the Department of Expenditure and line ministries, where annual budget pressures, cash-flow management, and political considerations inevitably dominate.

When Arithmetic Undermines Federal Trust
India’s federal transfers are now under measurable strain, marking a clear departure from the previous 15 years. From the mid-2000s through the mid-2010s, cesses and surcharges—levies outside the divisible pool—typically accounted for about 8–10% of gross tax revenue, rising only modestly even as revenues expanded. After 2014, their share increased gradually but largely remained below 12% until the pandemic.

This pattern changed sharply during the pandemic years. Cesses and surcharges rose to about 20.2% of gross tax revenue in 2020–21 and, while declining since, still stood at roughly 14–15% in 2023–24, well above the historical norm. By contrast, constitutional tax devolution to States has remained broadly stable across Finance Commission cycles, generally ranging between around one-third and two-fifths of central tax receipts, with changes driven by rule-based awards rather than annual discretion.

These arithmetic facts convert a governance problem into a fiscal one. As the non-divisible component of central revenues expands, States become increasingly dependent on discretionary transfers and scheme flows for both non-plan spending and public investment. Volatility in this component translates directly into planning shortfalls, project delays, and heightened fiscal risk.

Conditionality and the Real Burden on States
Empirical work and official reviews confirm that conditionality and off-budget instruments have increased the effective fiscal burden on States. Analyses document a steady rise in centrally sponsored, prescriptive schemes that limit State discretion while shifting implementation and compliance costs downward. These grants are often too small to alter State behaviour meaningfully, yet large enough to impose administrative and reporting burdens.

The Reserve Bank of India, in its State Finances: A Study of Budgets, has repeatedly noted that such uncertainty leads States to re-phase or compress capital expenditure and maintenance spending, contributing to volatility in State-level capex and weakening asset durability. This is a macroeconomic concern, not merely an accounting one.

States Push Back — Quietly but Clearly
Political and administrative reservations have followed. Over the past few years, States across the political spectrum have raised concerns about the opaque timing of releases, retroactive conditions, and proliferating scheme-specific reporting requirements. These concerns appear in State budget documents, representations to the Centre, press reporting, and submissions to Finance Commission consultations.

Importantly, these are not simply demands for larger transfers. They signal a loss of faith in the system's predictability and neutrality. Cooperative federalism cannot function when States cannot anticipate resource flows or adapt programmes to local conditions with reasonable certainty.

MGNREGA and Policy Instability
Recent changes in the design and financing of large central programmes illustrate the problem starkly. Adjustments to the MGNREGA framework—through altered funding norms and tighter administrative controls—have imposed transitional fiscal and administrative burdens on States. Managing wage liabilities and work-in-progress has become more difficult in the absence of predictable funding flows.

For a programme with a large and recurring fiscal footprint, policy redesign without an independent medium-term framework disproportionately shifts risk to States. Beyond its immediate impact on rural livelihoods, such instability reinforces perceptions that central commitments are contingent and reversible.

Why This Is a Structural Macroeconomic Issue
At its core, India’s fiscal federalism challenge is institutional rather than purely fiscal. Trust in a federal system is sustained not by political alignment or ad hoc negotiation, but by credible, rule-based institutions that separate allocation frameworks from political discretion. In their absence, even well-intentioned reforms are experienced as arbitrary, and transfers begin to resemble instruments of leverage.

This institutional weakness has direct macroeconomic consequences. It lowers the quality of public investment, weakens counter-cyclical capacity, and undermines productivity growth. In an economy in which States undertake the bulk of capital expenditure and service delivery, persistent fiscal uncertainty at the subnational level becomes a binding constraint on national growth.

The Case for an Independent Fiscal Anchor
Restoring confidence requires anchoring fiscal federalism in an independent, analytically credible institution that provides a transparent medium-term framework for discretionary transfers, central schemes, and centrally sponsored programmes. This does not require reviving the Planning Commission or weakening fiscal discipline. It requires an arm’s-length mechanism that sets clear allocative envelopes—based on macroeconomic constraints, developmental gaps, and absorptive capacity—within which political choice can operate.

Fiscal federalism, in this sense, is not a political accommodation. It is a structural reform essential to macroeconomic stability and higher long-term growth. Large federations such as Brazil, Australia, and Canada have learned—often through crisis—that macroeconomic stability depends not on ad hoc bargaining, but on independent, rule-based institutions that depoliticise intergovernmental transfers; India’s current drift shows the costs of ignoring that lesson.