Who Gets the Shared Rupee? The Equity–Efficiency Tension in India’s Fiscal Transfers

A rupee transferred from the Union to a State does more than move money between governments.

It also answers a difficult question: what should determine a State’s share of a common national resource?

Should a State receive more because it has more people? Because its people are poorer? Because it has a larger geographical area or greater forest cover? Or because it generates a larger share of the country’s economic output?

India’s fiscal federal system tries to accommodate all of these considerations at once.

That is why the debate over Finance Commission transfers is more complicated than the familiar comparison between what a State contributes and what it receives. The underlying problem is not simply how much money States get. It is how a common pool should be divided among States that begin from very different economic, demographic and fiscal positions.

The Sixteenth Finance Commission has made this tension more visible by introducing a new criterion: a State’s contribution to national GDP.

It is a relatively small change in the formula. But it reveals a much larger question about what India wants its fiscal federalism to accomplish.

The reason redistribution exists

India does not have economically equal States.

Their income levels, population sizes, geographical conditions, tax bases and costs of delivering public services differ substantially. A rupee raised nationally therefore does not have the same value when spent in every State.

This is the basic reason for horizontal devolution.

After determining the States’ overall share in the divisible pool, the Finance Commission has to distribute that share among the States. The formula is designed to account for differences between them.

One of the most important criteria has historically been income distance: the difference between a State’s per-capita income and that of the State with the highest per-capita income.

The logic is straightforward. A State with a weaker economic base has a smaller capacity to raise revenue on its own while still facing the need to provide public services. Transfers can therefore help narrow differences in the ability of governments to provide those services.

This is not an accidental consequence of the system. Equalisation is one of the purposes of intergovernmental transfers.

The alternative would be a system in which States largely retained resources according to where economic activity and taxable capacity happened to be concentrated. That would preserve a stronger connection between economic output and fiscal resources, but it would also leave poorer States with substantially less capacity to finance comparable public services.

India’s formula has therefore always involved a choice between competing objectives: redistribution towards need and recognition of economic performance.

The formula makes that trade-off visible

The evolution of the horizontal devolution formula shows how this balance has been constructed.

Under the 13th Finance Commission, income distance carried 47.5% of the weight. Under the 14th it rose to 50%, before falling to 45% under the 15th.

The 16th Finance Commission has reduced it further, to 42.5%.

The Commission describes per-capita GSDP distance as a dominant equity variable, reflecting differences in fiscal capacity between States. In the 16th Finance Commission’s formula, it carries 42.5% of the total weight.

At the same time, population based on the 2011 Census has increased from 15% under the 15th Finance Commission to 17.5%.

Area now carries 10%, down from 15%. Forest cover remains at 10%. Demographic performance, which had carried 12.5% under the 15th Finance Commission, has been reduced to 10%.

And then there is the new criterion:

State contribution to GDP — 10%.

The 16th Finance Commission describes contribution to GDP as a new criterion, based on each State’s share in GSDP and adjusted through a square-root transformation. It assigns the criterion a 10% weight and describes it as a surrogate for recognising efficiency.

The change is important not because 10% overturns the formula. It does not.

Its significance lies in introducing a different principle into a system historically dominated by measures of need and equalisation.

A State’s economic contribution is now explicitly recognised in determining how much of the common pool it receives. That changes the balance without abandoning its redistributive foundation.

Why richer States have questioned the old logic

The tension becomes clearer when looking at the experience of India’s more economically developed States.

Industrialised States such as Maharashtra, Gujarat, Karnataka, Tamil Nadu and Telangana had argued for the inclusion of their contribution to national GDP in the horizontal devolution formula. Their argument was not necessarily that poorer States should receive nothing.

It was that the formula should recognise that economic performance itself generates national resources.

This creates an uncomfortable question. If a State builds a larger productive economy, expands its tax base and contributes substantially to national output, how much should that achievement influence its share of future transfers?

A purely redistributive formula has an obvious answer: economic strength is precisely why the State can be expected to receive less. Resources should move towards States with weaker fiscal capacity.

A performance-sensitive formula introduces another consideration: the federation also has an interest in recognising where economic capacity is being created.

Neither principle can simply eliminate the other.

If redistribution dominates completely, economically stronger States may see a weak connection between the resources they help generate and the resources returned through the transfer system.

If contribution dominates completely, the transfer system begins to resemble a revenue-sharing arrangement rather than an equalisation mechanism.

The Finance Commission therefore has to decide not only who needs money, but also what kind of behaviour and economic structure the federation wants its transfer system to recognise.

Why “tax contribution” is not a simple answer

It is tempting to compare the taxes associated with a State with the amount it receives and treat the difference as a straightforward transfer between States.

But tax collection does not necessarily occur where all economic value is created.

A company may have its registered office in one State while producing goods or employing workers across several others. Individuals can work in one State while their formal tax records are connected to another. Large businesses can operate through multiple locations.

This makes State-level attribution of central tax collections imperfect.

For example, data for 2020-21 to 2024-25 show large differences between the shares of central tax collections associated with particular States and their shares of transfers. Maharashtra accounted for 36.1% of combined direct tax and GST collections in one dataset but received 6.64% of total central transfers. Karnataka and Tamil Nadu also had much larger collection shares than transfer shares. Uttar Pradesh and Bihar showed the opposite pattern.

But these numbers should not be read as a literal ledger of “what each State paid” versus “what it got back.”

They are evidence of a distributional difference, not proof that all the taxes attributed to a State were generated entirely within that State.

That distinction matters because the purpose of the Finance Commission is not to return each State’s tax collections to it.

It is to redistribute resources within a federation.

GDP enters the formula

The 16th Finance Commission’s response is significant because it does not simply use tax collections as the measure of contribution.

Instead, it introduces the State’s contribution to GDP.

The criterion carries a 10% weight.

But even here, the Commission did not simply use each State’s raw GSDP share. It applied a square-root transformation to reduce the effect of large differences between States. One analysis of the formula notes that Maharashtra’s actual GSDP share of 14.23% becomes 8.31% after the transformation; Tamil Nadu’s falls from 9.09% to 6.67%, and Karnataka’s from 8.95% to 6.59%.

That design choice reveals the institutional compromise.

The Commission wanted to recognise economic contribution, but it did not want that recognition to radically redistribute the pool away from States that depend more heavily on transfers.

The result is therefore not a shift from equity to efficiency.

It is a rebalancing within an equalisation system.

The 16th Finance Commission itself was guided by two principles: changes in State shares should be gradual, and efficiency—particularly States’ contribution to growth—should receive due recognition. The new GDP criterion was therefore structured to create a directional change without producing a drastic shift in State shares.

The numbers show how limited the shift is

The resulting changes are relatively modest.

Under the 16th Finance Commission, Karnataka’s share of the divisible pool rises from 3.647% to 4.131%, Kerala’s from 1.925% to 2.382%, and Tamil Nadu’s from 4.079% to 4.097%. Andhra Pradesh rises from 4.047% to 4.217%, while Telangana moves from 2.102% to 2.174%.

At the same time, some large States lose share. Madhya Pradesh experiences the largest decline among the major States cited in the analysis, while Uttar Pradesh’s share falls by 0.32 percentage points.

The important point is not which State gains or loses. It is the scale of the change.

One assessment places efficiency-related criteria at roughly 25% under the 15th Finance Commission and 30% under the 16th, while equity-related criteria fall correspondingly from 75% to 70%. The broad structure therefore remains recognisably redistributive.

The GDP criterion changes the balance at the margin.

It does not replace the underlying philosophy.

The deeper problem: equity is not the same as equal outcomes

This distinction is often lost in the political debate.

A State receiving a smaller share of the divisible pool than another State does not automatically mean that the formula treats it unfairly.

The purpose of equalisation is precisely to give States with weaker fiscal capacity access to a larger share of common resources.

The relevant question is therefore not simply:

“Does every State get back what it contributes?”

If that were the objective, there would be little reason for horizontal devolution at all.

The more meaningful question is:

“How much redistribution is necessary to allow States with different capacities to provide reasonably comparable public services, while still recognising differences in economic performance and fiscal effort?”

That is a much harder question because there is no purely mathematical answer.

Suppose two States have very different income levels. One has a large industrial and services base; the other has lower incomes and a much narrower tax base.

Giving both the same transfer per person would not necessarily give them the same fiscal capacity.

The poorer State may require a larger transfer to provide comparable services.

But if the transfer formula keeps increasing the advantage of lower-income States without recognising differences in economic capacity or fiscal performance, richer States can reasonably ask whether the system is sufficiently sensitive to the incentives and contributions that sustain the national economy.

The tension is therefore built into the objective itself.

And population makes the problem harder

India’s demographic transition adds another layer.

The 16th Finance Commission has increased the weight of population from 15% to 17.5%, while reducing demographic performance from 12.5% to 10%.

This matters because India’s States are no longer moving through the demographic transition at the same pace.

States that achieved lower fertility earlier now have older populations and slower population growth. States with younger populations continue to carry larger demographic pressures.

A transfer formula therefore has to decide what population represents.

Is it a measure of need?

Is it a measure of the number of citizens whose public services must be financed?

Or does giving it greater weight risk reducing the fiscal recognition of States that have already undergone substantial demographic transition?

There is no neutral answer. Each interpretation produces a different distributional outcome.

This is why the Finance Commission’s decision to reduce the demographic-performance weight while increasing the population weight is more than a technical adjustment. It reflects an attempt to prevent demographic performance from becoming an excessive penalty while still recognising population as a measure of need.

The real argument is about the kind of federation India wants

The most interesting feature of the 16th Finance Commission’s formula is not that it finally solved the equity–efficiency debate.

It did not.

Instead, it makes the underlying trade-off explicit.

For decades, horizontal devolution has largely asked:

Where is fiscal capacity weakest, and where are expenditure needs greatest?

The new GDP criterion adds another question:

Which States are contributing most strongly to the economic base from which the federation’s resources ultimately arise?

India now has both questions inside the same formula.

That is institutionally significant.

A federation cannot sustain itself merely by redistributing resources from richer regions to poorer ones. Nor can it rely entirely on the principle that economic contribution should determine fiscal return.

The first risks weakening the connection between performance and reward.

The second risks weakening the equalising function that allows poorer regions to participate in the federation on more comparable terms.

The Finance Commission’s job is therefore not to eliminate the tension.

It is to manage it without allowing either principle to consume the other.

The shared rupee is ultimately a shared bargain

The phrase “fiscal transfer” can make the process sound mechanical: collect money here, distribute it there.

But India’s system is really negotiating something deeper.

It is deciding what citizens in different States should be able to expect from belonging to the same fiscal union.

A poorer State needs transfers because its own economic base may not generate enough revenue to provide comparable public services. A richer State needs recognition that its economic capacity contributes disproportionately to the national pool.

Population matters because governments serve people. Income distance matters because fiscal capacity differs. Forests and area matter because geography affects costs. Demographic performance matters because demographic choices shape long-term fiscal pressures. GDP contribution matters because economic production is itself part of the federation’s resource base.

The formula is therefore not a contest between one “fair” criterion and one “unfair” criterion.

It is an attempt to place several legitimate principles inside a single allocation mechanism.

And that is why the shared rupee is never merely about the rupee.

It is about the bargain that holds a diverse federation together: how much India should redistribute to equalise opportunity, and how much it should recognise the economic capacity that creates the resources available for redistribution in the first place.

The 16th Finance Commission has moved that bargain slightly toward recognising contribution.

The larger question remains unresolved—and perhaps cannot be resolved permanently.

As India’s economic and demographic geography continues to diverge, the real test of fiscal federalism will not be whether one side wins the equity–efficiency argument.

It will be whether the formula can keep both principles credible enough for States with very different circumstances to continue seeing the shared pool as a common national resource rather than a contest over who deserves what.