Devolution dilemma: Centre, states and a way to share the pie better

Indian Express

28-06-2025

There is considerable debate surrounding the devolution of funds from the Centre to the states. The states have been advocating for an increase in their share from the current 41 per cent, a matter the Finance Commission is expected to deliberate on and provide recommendations for. There are strong arguments on both sides, which can be examined before suggesting a potential way forward.
Let us first consider the perspective of the states. To begin with, states are more closely in touch with citizens while the Centre operates at a much higher level. For better results across different programmes — which may vary from state to state in terms of priority — a higher share of central funds is necessary. Second, while the Centre has the power to levy a wider range of taxes than the states, it is only fair that a higher proportion of these collections be passed on to the states.
Third, over the years, the Centre has been garnering substantial resources through surcharges and cesses on various items. For FY26, these are projected to generate around Rs 4 lakh crore — funds that do not enter the divisible pool and thus are not shared with the states. Therefore, as compensation, the states' share in total collections needs to be increased, or alternatively, the surcharges/cesses must be included in the divisible pool.
Fourth, states are not in a position to increase non-tax charges, as this can be a barrier to investments, especially in a competitive environment where businesses weigh multiple states before deciding where to do business. Finally, once the divisible pool is enlarged, the 'special category' status for some states can be done away with, given that it tends to tilt the balance of allocation at times.
The opposing view also has its merits. First, the divisible pool has already been increased to 41 per cent from 32 per cent by the 14th Finance Commission in 2015. Therefore, there is less reason to increase it further. As the second level in the federal structure, while states are indeed more connected to citizens, there are many centrally-sponsored schemes that are financed from the balance 59 per cent but implemented through the states.
Third, higher devolution to states could end up being less prudent, especially given the tendency to announce populist schemes ahead of elections. Although some of these may be justified, a more liberal devolution could increase such practices.
Interestingly, the Centre, too, would like to have a larger share of the pie and hence may like the 41 per cent devolution rate to be lowered. The justification is that it undertakes numerous social development and infrastructure projects, which require significant funding. Initiatives such as the free food distribution scheme have also put pressure on the Centre's finances, strengthening the case for retaining a larger proportion of tax revenues.
Alongside, there is also a view that the current devolution formula requires some attention. Forty-five per cent of the formula is based on income criteria, ensuring more funds go to less developed states. Another 15 per cent is allocated based on population, linking the need for funds to the size of the state. However, this introduces an ideological dilemma: Nearly 60 per cent of the formula effectively rewards underperformance. Although there is a 12.5 per cent weightage for efforts to control population growth, a moral hazard arises — states may benefit from being less developed and receive more funds from the Centre. While, practically speaking, states rarely underperform intentionally for this benefit (which is marginal at best), from a theoretical standpoint, this is a valid argument.
Taking off from this, one can think of a compromise solution on the proportion of devolution. This can be increased by 5 per cent, but it can be made both 'conditional' and 'targeted'. This would be analogous to current grants and can be called a special devolution that would have to be approved by Parliament. In terms of conditions, it can be linked to fiscal performance, using the previous three years' audited data from the CAG as a benchmark.
A minimum threshold of reining in the fiscal deficit to less than 3 per cent can be one condition. A second can be a continuous decline in revenue deficit, which can be capped at not more than 1 per cent in the terminal year. The third condition could be a declining debt-to-GDP ratio. These would ensure that all three major fiscal prudence parameters are met and help in long-term fiscal consolidation.
Once the conditions are met, specific expenditures can be listed. A detailed analysis of state-wise expenditure across different headings can be undertaken by an independent agency like NITI Aayog. This will identify specific priorities or lacunae in different states that can be addressed through this pool of funds. For instance, if a state is spending less on, say, education, then the additional allocation will be earmarked for projects in this field. There can be a specific allocation for capex projects, including state highways, Metro systems, etc, which will also be aligned with the Centre's allocations on similar projects at the national level.
This targeted pool would be allotted funds again based on the formula used for the 41 per cent devolution. Further, the funds that are left over should ideally lapse and not be carried forward, thereby excluding states that do not perform from this additional devolution. As the Centre would know which states have met the criteria before the Union budget is presented, the amount to be transferred could also be revealed at the same time. More likely, the full amount will not be disbursed as all the states would not be meeting the criteria. This balance could be used by the Centre to finance its own expenditures.
The writer is chief economist, Bank of Baroda, and author of Corporate Quirks: The Darker Side of the Sun. Views are personal