Fiscal Equalisation

The equalisation function of intergovernmental fiscal transfers is to reduce differences in the fiscal capacity of governments within a federation. It seeks to ensure that subnational governments can provide reasonably comparable public services despite unequal revenue bases, expenditure needs and service-delivery costs. Equalisation concerns governmental fiscal capacity, not the equalisation of individual incomes or identical spending across regions.

Fiscal imbalances addressed

Equalisation responds to two structural imbalances created by the assignment of taxation and expenditure responsibilities in a federation.

• Vertical fiscal imbalance arises when the revenue powers and expenditure responsibilities assigned to different levels of government do not match.
• Horizontal fiscal imbalance arises because governments at the same level differ in tax capacity, population needs, geography and the cost of delivering public services.
• Transfers therefore supplement the resources of lower tiers and redistribute resources among subnational units according to assessed capacity and need.

How equalisation transfers work

Equalisation may operate through shared taxes and grants distributed using objective criteria. A transfer formula can account for revenue capacity, expenditure needs and cost disabilities while also rewarding fiscal responsibility.

• General-purpose transfers give recipient governments greater freedom to meet locally determined needs.
• Specific-purpose grants support designated services or national minimum standards, but provide less spending autonomy.
• Sound design balances equity with efficiency, because excessive compensation can weaken tax effort, encourage spending indiscipline or create persistent transfer dependence.
• Equalisation usually aims at comparable service capacity under comparable tax effort, rather than complete fiscal equality.

Constitutional mechanism in India

India's principal equalisation mechanism is the periodic Finance Commission, constituted under Article 280. It recommends the distribution of divisible tax proceeds between the Union and states and among the states, and the principles governing grants-in-aid.

• Article 270 provides for the distribution of specified Union taxes between the Union and the states.
• Article 275 provides for grants-in-aid of the revenues of states in need of assistance.
• Finance Commission transfers address both the Union-state resource gap and differences in fiscal capacity and needs among states.

How UPSC asks this