Finance Commission transfers in India: An alternative approach to the devolution process

Abstract

The study aims to identify significant missing dimensions that can enhance the existing formula-based devolution by the Finance Commission in its objectives towards vertical and horizontal fiscal balance. Horizontal devolution of the central divisible pool by the Finance Commission has been so far undertaken on a formula-based approach. The Commission includes certain criteria in the devolution formula as a proxy to address the differences in revenue capacity, fiscal need, and the cost of providing public goods of the states to eliminate horizontal fiscal imbalances. However, the methodology has been strongly questioned in its inclusiveness, ability to address the inherent complexities and actual needs of different states. The paper attempts to address the plausibility of incorporating new dimensions in the devolution formula of the Finance Commission to making it a more effective instrument facilitating vertical and horizontal equity in the backdrop of the huge diversity among the recipient states. The empirical analysis highlights significant impact of five criteria on fiscal imbalance of the states; income distance, fiscal performance index, demographic performance, geographic disadvantage index and state energy and climate index, which justify their inclusion in the devolution formula.