Few countries embody the promise—and complexity—of multilevel governance as vividly as India. With a federal structure spanning more than 1.5 billion people, India’s intergovernmental fiscal system sits at the heart of its development trajectory. A recent World Bank technical report prepared for the Sixteenth Finance Commission provides a timely opportunity to reflect on how effectively India’s fiscal architecture is balancing resources across levels of government and across states.
At its core, the report tells a familiar but still unresolved story: India’s fiscal system assigns most major revenue sources to the central government, while giving states primary responsibility for delivering key public services. This deliberate mismatch creates a built-in need for intergovernmental transfers—not only to address the vertical gap between revenues and expenditures, but also to redistribute resources across states and reduce horizontal disparities arising from uneven economic development across the country.
A structurally imbalanced federation
Like many federations, India exhibits a classic vertical fiscal imbalance. The central government raises the majority of revenues—around 65 percent—while states are responsible for the bulk of public spending, accounting for roughly 60 percent of total expenditures.
This asymmetry is not accidental. It reflects constitutional choices about macroeconomic stability, tax efficiency, and administrative capacity. However, it also means that India’s system depends fundamentally on transfers from the center to the states to function effectively.
Because India’s fiscal system creates a built-in gap between where revenues are raised and where expenditures occur—and because of wide economic disparities across states—an independent mechanism is needed to guide the allocation of intergovernmental transfers. Finance Commissions are constitutionally mandated bodies, appointed every five years, that determine how revenues are shared between the central and state governments and how these resources are distributed across states to address both vertical and horizontal fiscal imbalances.
Over time, Finance Commissions have played a central role in mediating vertical and horizontal fscal imbalance by determining how revenues should be shared and allocated. Their efforts have not been trivial: transfers now finance more than one-third of state expenditures, and in lower-income states, more than half.
Yet even with this extensive system of transfers, a residual vertical gap persists—estimated at around 20 percent of state expenditure needs. This gap is typically filled through borrowing or other fiscal adjustments, raising concerns about fiscal sustainability and incentives.
Equalization: Effective, but uneven
Beyond vertical imbalances, India faces substantial horizontal disparities across states. Differences in income levels, fiscal capacity, and development outcomes create strong pressures for redistribution.
The analysis in the World Bank report finds that India’s system of intergovernmental fiscal transfers—guided by the recommendations of subsequent Finance Commission—has generally been equalizing. Lower-income states receive significantly higher per capita transfers than richer states, reflecting a deliberate effort to reduce inter-state disparities.
However, the strength of this equalization has fluctuated over time. Equalization reached its peak during the period 2000–2005 as a result of the Eleventh Finance Commission—when equity considerations, particularly “income distance,” were given substantial weight—and has moderated somewhat in subsequent periods.
A recurring concern in the design of equalization systems—one that is also relevant in India—is that strong redistributive transfers may weaken incentives for growth or fiscal effort by channeling relatively more resources to less productive or lower-income states. The evidence in the report suggests that India’s system has historically leaned toward equity. More recent Finance Commissions, however, have sought a more balanced approach by incorporating factors such as tax effort, fiscal discipline, and demographic changes, which modestly tilt the system toward efficiency and performance. While the overall transfer system remains clearly equalizing, these adjustments suggest a gradual shift toward a more “pro-growth” orientation at the margin—though not a fundamental departure from redistribution.
This evolution reflects a broader balancing act, shaped not only by technical considerations—such as measuring fiscal capacity, expenditure needs, and incentives for efficiency—but also by political economy forces, including inter-state bargaining, concerns about fiscal discipline, and the need to maintain legitimacy and buy-in across a diverse federal system. The result is a system that is directionally equalizing, but not anchored in a clearly defined equalization standard.
The growing complexity of fiscal transfers
One of the more striking insights from the report is how the broader transfer ecosystem has evolved beyond the Finance Commission itself.
While tax devolution remains the dominant channel of revenue-sharing between different government levels, a significant portion of transfers occurs outside the Finance Commission framework, including so-called Centrally Sponsored Schemes and other conditional grants. These instruments often serve sectoral or policy objectives, but they also shape the overall balance of fiscal power.
At the same time, trends in revenue policy—such as the growing use of cesses and surcharges that are excluded from the divisible pool—have complicated the equalization landscape. These instruments effectively reduce the share of revenues available for distribution to states, thereby reinforcing vertical imbalances even as nominal devolution rates increase.
This underscores a broader point: fiscal equalization cannot be understood in isolation from the wider system of intergovernmental finance.
Lessons from international experience
Drawing on global examples—including Australia, Canada, Brazil, and South Africa—the report highlights several lessons that resonate beyond India.
First, clarity matters. Countries that define explicitly what they aim to equalize—whether revenue capacity, expenditure needs, or fiscal gaps—tend to have more coherent and effective systems.
Second, data matters. Robust equalization systems depend on timely and reliable data on both fiscal capacity and expenditure needs. Weak data systems can undermine even well-designed formulas.
Third, the mix of transfer instruments matter. Equalization works best when it is embedded within a broader, well-coordinated system of transfers, rather than overloaded with multiple—and sometimes conflicting—objectives.
Toward a more coherent equalization framework in India
India’s intergovernmental fiscal system remains characterized by structural tensions: a persistent vertical fiscal gap, a somewhat diffuse equalization objective, and an increasingly complex mix of transfer instruments. But these challenges are intrinsic to any federal system—and many advanced federal systems struggle to deal with the vertical fiscal gap that results from centralized revenue-raising power and the desire to deliver public services closer to the people. As such, it is no small feat that India has successfully expanded the scale of transfers, strengthened the role of formula-based devolution, and maintained a broadly equalizing orientation across states.
Looking ahead, the challenge is not simply to increase transfers, but to sharpen the coherence of the system. This may involve clarifying the objective of equalization, strengthening the measurement of fiscal capacity and expenditure needs, and ensuring that the broader transfer architecture—including off-budget and non-devolved revenues—supports rather than undermines these goals.
Ultimately, India’s experience highlights a broader lesson for multilevel governance: equalization is not a one-time design choice, but an ongoing process of institutional calibration. As economic conditions evolve and policy priorities shift, the effectiveness of fiscal federal systems depends on their ability to adapt—while staying anchored in clear principles of equity, efficiency, and accountability.
Read the full report:
World Bank. 2025. India Intergovernmental Transfers and Fiscal Equalization: Report for the Sixteenth Finance Commission. Washington, DC: World Bank.
