How India's Finance Commission Actually Decides Who Gets What

Every five years, a constitutional body most Indians have never heard of makes decisions that affect every state government's budget, every district's infrastructure spending, and ultimately every citizen's access to public services. The Finance Commission of India determines how tax revenue collected by the central government is divided among states — a process called fiscal devolution that transfers lakhs of crores annually.

This is not a technocratic exercise conducted in isolation. It is an intensely political negotiation dressed in the language of formulae and criteria, where states lobby aggressively, the Centre tries to retain maximum fiscal flexibility, and the outcome shapes the economic trajectory of entire regions for five years.

What the Finance Commission Does

Article 280 of the Indian Constitution mandates the President to constitute a Finance Commission every five years. The Commission has two primary tasks.

First, it recommends the share of central tax revenue that should be transferred to states — this is called the vertical devolution. The 15th Finance Commission (2021-2026) recommended that 41% of the divisible pool of central taxes be transferred to states. The divisible pool includes income tax, corporate tax, GST (Centre's share), customs duties, and excise duties, minus surcharges and cesses (which are not shared with states).

Second, it recommends how this 41% should be distributed among the 28 states — this is called the horizontal devolution. This is where the politics gets intense, because the formula used to distribute funds across states directly determines how much money each state receives.

The Formula Wars

The horizontal distribution formula uses multiple criteria, each with an assigned weight. The 15th Finance Commission used the following: population (15%), area (15%), forest and ecology (10%), income distance (45%), tax and fiscal effort (2.5%), and demographic performance (12.5%).

Each of these criteria is contested.

Population is the most politically sensitive. The 15th Finance Commission used the 2011 Census population, departing from the earlier practice of using the 1971 Census. This was a significant shift that benefited high-population states like Uttar Pradesh, Bihar, and Madhya Pradesh at the expense of states like Tamil Nadu, Kerala, and Andhra Pradesh that had successfully controlled population growth. Southern states argued — with considerable justification — that they were being penalized for good governance. States that invested in education, healthcare, and family planning saw their share of central funds decrease because they had fewer people relative to states that had not made similar investments.

The "demographic performance" criterion was introduced partly to address this concern, rewarding states with lower fertility rates. But at 12.5% weight, it does not fully offset the advantage that high-population states receive from the population criterion at 15%.

Income distance measures how far a state's per-capita income is from the state with the highest per-capita income. Poorer states receive more because they have greater "distance" to cover. This is the largest component at 45% weight, and it serves an important equalization function — without it, rich states would get richer while poor states would lack the resources to invest in catching up.

But income distance also creates a perverse incentive. A state that grows rapidly and increases its per-capita income sees its income distance shrink, which reduces its share of devolution. In theory, this means states are financially penalized for growing faster. In practice, the effect is marginal because the formula uses lagged data and the absolute amount of devolution grows as the total tax pool expands. But the optics are poor, and faster-growing states resent the redistributive structure.

Why Cesses and Surcharges Matter

One of the most consequential fiscal trends in India is the increasing use of cesses and surcharges by the central government. Health cess, education cess, agriculture infrastructure cess, compensation cess under GST — these are levied on top of existing taxes and can be substantial.

The critical difference between a cess/surcharge and a regular tax is that cesses and surcharges are not part of the divisible pool. They go entirely to the Centre. This means that when the Centre raises revenue through a cess rather than by increasing the base tax rate, it keeps 100% of the additional revenue instead of sharing 41% with states.

The share of cesses and surcharges in total central tax revenue has increased significantly over the past decade. This effectively reduces the actual percentage of total central revenue that reaches states, even though the nominal devolution percentage remains at 41% of the divisible pool.

States have repeatedly raised this issue, arguing that the growing use of cesses amounts to a backdoor reduction in fiscal devolution. The Finance Commission has acknowledged the concern but has limited power to address it, since the decision to levy cesses rests with Parliament and the executive.

Grants-in-Aid: The Other Channel

Beyond tax devolution, the Finance Commission also recommends grants-in-aid to states for specific purposes. These include grants for local bodies (municipalities and panchayats), disaster management, health, and state-specific needs.

The grants for local bodies are particularly important. The 73rd and 74th Constitutional Amendments mandated the creation of elected local governments (panchayats and municipalities) with devolved functions and finances. In practice, most states have devolved functions on paper but not the corresponding financial resources. Finance Commission grants attempt to fill this gap by channeling funds directly to local bodies, bypassing state governments that might otherwise redirect the money.

However, the effectiveness of these grants depends on the capacity of local bodies to absorb and spend the funds — a capacity that varies enormously across states and between urban and rural local bodies. Many grants remain unspent or are spent on recurrent expenditure (salaries and maintenance) rather than capital creation, limiting their developmental impact.

The Political Economy of Devolution

Fiscal devolution is ultimately a question of political power. The Centre's ability to direct spending through centrally sponsored schemes — where the Centre determines priorities and states contribute matching funds — gives it significant influence over state policy, even in areas that are constitutionally state subjects like health, education, and agriculture.

States with stronger political leverage — either because they are electorally important to the ruling coalition at the Centre or because they are governed by assertive regional parties — tend to negotiate more effectively for grants, scheme allocations, and other fiscal transfers that exist outside the Finance Commission framework.

The tension between Centre and states over fiscal resources is a permanent feature of Indian federalism. It plays out in Finance Commission recommendations, GST Council negotiations, centrally sponsored scheme funding patterns, and the allocation of borrowing permissions. Understanding this tension is essential for understanding why public services vary so dramatically across states, why some states can afford to build world-class infrastructure while others struggle to pay salaries, and why fiscal federalism remains one of the most consequential and least understood dimensions of Indian politics.

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