Vertical Fiscal Imbalance

Vertical fiscal imbalance is the mismatch between the revenue-raising powers and expenditure responsibilities assigned to different levels of government in a federation. It generally arises when subnational governments perform substantial public functions but the central government controls broader and more productive revenue sources. It is distinct from horizontal imbalance, which concerns fiscal differences among governments at the same level.

Why the imbalance arises

Constitutions divide functions and revenue sources according to administrative efficiency, accountability and macroeconomic needs. These principles often assign expenditure and taxation differently.

• Public services requiring local knowledge and responsiveness are commonly entrusted to State or local governments, increasing their expenditure obligations.
• Broad, mobile or unevenly distributed tax bases are often assigned to the Union because centralized collection can reduce tax competition and improve efficiency.
• The Union also requires substantial resources for macroeconomic stability, national public goods and redistribution across regions.
• Consequently, the revenues directly available to lower levels may not match the cost of their constitutionally or legally assigned functions.

Indian constitutional setting

The Seventh Schedule, read with Article 246, distributes legislative subjects between the Union and States, while the Constitution separately assigns and shares taxation powers. This structure can produce a gap between States' own revenues and their expenditure responsibilities.

• Under Article 270, specified Union taxes form part of the divisible pool shared between the Union and States.
• Under Article 275, Parliament may provide grants-in-aid to States in need of assistance.
• The Finance Commission under Article 280 recommends vertical tax devolution and grants, thereby helping correct the Union-State fiscal mismatch.
• State Finance Commissions under Articles 243I and 243Y review financial relations between States and rural and urban local bodies.

How the gap is addressed

A vertical imbalance is managed through intergovernmental fiscal transfers, rather than by requiring every level to finance all functions solely from its own taxes.

• Tax devolution gives subnational governments a share in taxes collected by the Union.
• Grants can support general fiscal needs, specific services or constitutionally recognized purposes.
• A sound transfer system must balance expenditure autonomy and equity with incentives for fiscal responsibility and efficient service delivery.

How UPSC asks this