When the Transfer Formula Doesn’t Fit the Fiscal Problem

A fiscal transfer can be perfectly rational on paper and still fail the State that needs it.

That is because not every fiscal problem looks alike. Some arise from persistent differences in income and revenue capacity. Others appear suddenly, after a flood or landslide. Some emerge because a city is expanding faster than its municipal finances. And some are created by structural events such as the division of a State, which can permanently alter its capacity to raise revenue.

A system built mainly around predictable formulas has an obvious advantage: it reduces discretion. But the same predictability can become a weakness when the problem itself is exceptional.

This creates a less visible question in India’s fiscal federalism: what happens after the ordinary transfer formula has done its job, but the fiscal problem does not fit the formula? That is where the architecture of transfers becomes as important as the amount transferred.

The formula works best when the problem is predictable

The basic logic of fiscal transfers is straightforward. Different levels of government have different responsibilities and different abilities to raise revenue. Transfers help bridge that gap. The Finance Commission’s tax devolution provides a rules-based mechanism for sharing resources among States, while grants and other transfer arrangements address specific requirements.

But these instruments do not all perform the same function. An unconditional transfer can give a State flexibility over how to spend money. A tied grant directs resources towards a particular purpose. A performance-linked transfer can attach conditions to the release of funds. A disaster fund is designed to respond to an exceptional event. A special package can address an unusual structural circumstance.

The distinction matters because fiscal need is not one-dimensional. A State facing a persistent revenue-capacity gap is different from a State rebuilding after a landslide. A municipality struggling to finance basic services is different from a State whose fiscal capacity has been permanently altered by territorial reorganisation.

Treating all of these problems through the same transfer logic creates a basic design tension: the more standardised the system becomes, the easier it is to administer and scrutinise; but the less easily it may respond to circumstances that standard rules were never designed to capture.

India’s transfer architecture therefore has to solve two problems simultaneously: preventing arbitrary discretion and retaining enough flexibility to respond to genuine differences in need.

The tension becomes visible most clearly in disaster financing.

When a disaster does not fit the formula

India’s disaster-response financing system is built around the State Disaster Response Fund (SDRF) and the National Disaster Response Fund (NDRF).

The SDRF is the primary State fund for responses to notified disasters. The Centre contributes 75% of the SDRF allocation for general States and 90% for specified north-eastern and Himalayan States. The NDRF supplements the SDRF when a disaster is of severe nature and adequate funds are not available in the SDRF.

The institutional division is clear enough: States manage immediate response, while the Union can provide additional support when the scale of a disaster exceeds ordinary response capacity.

The difficulty arises when the fiscal consequences of an event do not map neatly onto the categories through which assistance is released.

The Wayanad landslides in July 2024 illustrate the problem. The official record shows that Kerala had ₹782.99 crore available in its SDRF account. The State sought ₹214.68 crore in additional assistance under the NDRF, while the High-Level Committee approved ₹153.47 crore, subject to adjustment of part of the SDRF balance and with assistance also covering specified rescue-and-relief and debris-clearance costs. For reconstruction and recovery, a further ₹529.50 crore was made available under the Special Assistance to States for Capital Investment.

These figures cannot, by themselves, establish that the transfer architecture was inadequate. They do, however, show why disaster assistance cannot be understood by comparing a State’s claimed requirement with a single Union release. Different instruments address different stages and purposes of the fiscal response.

The deeper issue is therefore one of classification and trigger design.

A disaster may be geographically concentrated but financially overwhelming. Another may affect a larger population while imposing a smaller fiscal burden relative to the State’s economic capacity. A uniform trigger may not capture those differences.

Possible approaches could therefore include objective indicators such as rainfall intensity, fatalities or losses relative to State economic capacity. These are design possibilities, not established features of India’s current system.

The broader lesson is that a transfer mechanism designed around normal fiscal conditions may require a separate escalation mechanism when the underlying shock is abnormal.

Local governments reveal another version of the same problem

The same question appears at the urban level, although the nature of the fiscal pressure is different.

Indian cities are responsible for increasingly complex infrastructure and public services, while municipal finances remain constrained. Transfers to urban local governments therefore have to answer two questions simultaneously: how much money should reach cities, and how much discretion should cities have over its use?

The 16th Finance Commission recommended ₹7,91,493 crore for rural and urban local bodies for 2026-27 to 2030-31, including ₹3,56,257 crore for urban local governments, alongside special infrastructure and urbanisation components.

The amount alone, however, does not determine how useful these transfers will be. Their design also matters. The grants contain basic and performance components. Eligibility conditions include having a duly constituted local body, maintaining online provisional and audited accounts and meeting requirements relating to State Finance Commissions. Performance components can also depend on conditions such as growth in own-source revenue and the transfer of resources by States to local bodies.

This creates a different version of the same institutional trade-off.

A tied grant can ensure that resources are directed towards an identified public-service objective. An untied grant gives a local government greater ability to respond to needs that may not be visible to a distant funding authority.

Neither principle is sufficient by itself. If every transfer is untied, accountability over its use can become harder. If every transfer is tightly conditioned, the receiving government may possess resources without having much room to determine its priorities.

The design problem is therefore not simply central control versus local autonomy. It is about determining how far conditions can promote accountability without making the transfer too rigid to respond to actual local circumstances.

And even here, the Union cannot be treated as the sole source of the problem. Weak municipal finances can also reflect the limited fiscal capacity and institutional choices of States themselves, including the extent to which States devolve functions and resources to urban local governments.

Transfer design cannot substitute for functioning institutions at the receiving end.

Some fiscal shocks are created by structural change

Disasters are sudden. Urban fiscal pressures accumulate gradually. Territorial reorganisation presents yet another possibility: a fiscal shock that can remain embedded in the structure of a State for years.

When a State is divided, political and administrative boundaries change, but fiscal capacity does not necessarily divide in the same proportion.

The evidence from State reorganisations illustrates the point. After the creation of Uttarakhand, Chhattisgarh, Jharkhand and Telangana, the carved-out States recorded gains in per-capita own revenue relative to the residual States. The decline for the rump Andhra Pradesh was 23.2% in the year after bifurcation, while Bihar’s decline was 31.6%; the corresponding declines for the residual Uttar Pradesh and Madhya Pradesh were smaller.

These figures do not mean that territorial reorganisation is the sole explanation for subsequent fiscal outcomes. State finances are shaped by many factors. But they do demonstrate that a territorial division can produce a measurable change in the fiscal capacity available to the residual State.

Andhra Pradesh makes this structural problem particularly visible.

After Telangana was carved out of Andhra Pradesh in 2014, the residual State lost Hyderabad, the dominant economic centre of the undivided State. Andhra Pradesh subsequently sought special-category status, citing the fiscal consequences of bifurcation. The demand remained contested, including because the earlier form of special-category assistance had itself been substantially diluted.

The more useful fiscal question is not simply whether a residual State is poorer after reorganisation. It is whether an externally created and measurable reduction in fiscal capacity should be treated differently from an ordinary difference in fiscal capacity.

One possible approach discussed in the supplied material is to establish a threshold beyond which a documented loss of fiscal capacity following territorial division could qualify for time-bound assistance. The precise threshold is only one possible design. The larger principle is that exceptional assistance could be governed by identifiable criteria rather than negotiated afresh in every case.

That distinction matters.

A discretionary package can respond to unusual circumstances, but it creates uncertainty about eligibility, scale and duration. A formula creates greater predictability, but a formula that is too rigid can fail precisely when circumstances depart from the assumptions built into it.

The institutional challenge is therefore not to eliminate either formulas or discretion.

It is to determine where each belongs.

The danger lies at both extremes

There is an understandable attraction to a completely formula-based fiscal system. If eligibility, allocation and release are governed by objective rules, States know what to expect. Political discretion is reduced. Comparable situations can be treated comparably. Fiscal planning becomes easier.

But formulas can create their own blind spots. A disaster does not respect the historical distribution of fiscal capacity. A rapidly urbanising municipality does not necessarily have expenditure needs proportional to its existing revenue base. A State created through territorial reorganisation may inherit a fundamentally different economic structure from the State that existed before it.

At the other extreme, a system dominated by discretionary packages may become unpredictable and vulnerable to political bargaining.

The Andhra Pradesh example captures this dilemma. There have been precedents for special packages associated with Odisha, Bundelkhand and Bihar. The broader institutional concern is that one-off arrangements can make exceptional treatment dependent on circumstances that are difficult to reproduce consistently across States.

The alternative is not necessarily to abolish special assistance.

It is to make the exceptional legible.

If a particular kind of shock justifies additional assistance, the conditions for that assistance should ideally be identifiable before the shock occurs. If a disaster produces losses beyond a defined fiscal threshold, the mechanism should be capable of responding without requiring the State to negotiate from scratch. If a structural reorganisation permanently reduces fiscal capacity, there should be a way of recognising that loss without converting every such case into a political bargain.

This is where formula and flexibility can reinforce rather than contradict each other.

The real question is not how much to transfer

India’s fiscal federalism is often discussed through the size of transfers: how much the Centre gives, how much States receive, and how the Finance Commission distributes the divisible pool.

Those questions matter. But once the money reaches the transfer system, another question becomes unavoidable:

Is the architecture capable of matching the form of assistance to the form of need?

A predictable need can be handled through a predictable formula. A service obligation may justify a conditional transfer. A local problem may require greater untied flexibility. A sudden disaster may require rapid, rules-based escalation. A structural fiscal shock may require time-bound compensation linked to measurable loss.

These are different problems. They do not necessarily require the same instrument.

That is the deeper significance of the transfer debate. Fiscal federalism is not only a question of distribution. It is a question of institutional fit.

A transfer can be equitable in aggregate and still be poorly designed for a particular shock. A grant can be large and still be too conditional for a local government. A formula can be objective and still overlook a structural change that permanently alters a State’s fiscal capacity.

The strongest transfer architecture, therefore, is unlikely to be the one with the most discretion or the one with the most rules. It is the one that knows when a rule is sufficient, when flexibility is necessary, and how that flexibility can itself be governed by rules.

That is the problem India now faces as its federal economy becomes more complex. The question is no longer merely how to divide the fiscal pie. It is whether the system can recognise that, when the problem changes, the shape of the transfer may need to change with it.