As India prepares for the next Finance Commission's report, the discourse around Centre-state fiscal relations has never been more pertinent. Karnataka, a state that contributes 8.4% to India's GDP with only 5% of the population, finds itself at the heart of a growing concern. Despite its substantial contribution to national revenue, Karnataka receives just 15 paisa for every rupee it sends to the Centre. This imbalance, which has been accentuated over time, calls for a recalibration of the criteria governing the devolution of funds from the Centre to the states.
While the current system emphasises equity — ensuring that poorer states receive more resources — it has failed to adequately reward states that are efficient, productive and significantly contributing to national growth. As Karnataka pitches for a shift towards efficiency in the 16th Finance Commission, the challenge is to find a balance between equity and performance, while addressing the larger implications this shift could have on India’s fiscal architecture.
The case for rebalancing equity and efficiency
Karnataka's submission to the Finance Commission reflects a fundamental concern: the current devolution formula is heavily skewed toward factors like population and income distribution — criteria that may have been relevant decades ago but do not align with the realities of modern India. The state has lost ₹79,770 crore between 2021-2026 as a result of the 15th Finance Commission's reduction of its share from 4.713% to 3.647%, alongside the ₹11,495 crore grant it did not receive. Karnataka's case is straightforward: while equity must remain a core principle, efficiency—measured by Gross State Domestic Product (GSDP), tax collection efforts, and demographic performance—needs to play a much greater role in determining how funds are distributed.
At present, equity-based factors such as population account for 45% of the weightage in the devolution formula, with minimal consideration given to the economic contributions of states. Karnataka argues for a reduction in this weightage to 25% and a corresponding increase in the weight given to efficiency metrics. This adjustment, Karnataka contends, would provide a more balanced approach to fiscal transfers — one that supports the poorer states while rewarding states that drive the national economy.
This recalibration is not simply about Karnataka's share — it's about creating a system that incentivises performance and encourages states to strengthen their governance, improve tax compliance, and contribute more to national development. It is also about ensuring that high-performing states are not penalised for their success, a point that resonates across other high-growth states like Tamil Nadu and Maharashtra.
Rethinking the exclusion of cesses and surcharges
In addition to advocating for changes in the weightage of devolution criteria, Karnataka has raised a critical issue regarding cesses and surcharges, which are currently excluded from the divisible pool. The state estimates that this exclusion has cost it ₹53,359 crore between 2017 and 2024. These taxes, levied by the Centre, have grown significantly in recent years, contributing to a shrinkage of the divisible pool and depriving states of much-needed resources.
Karnataka's call for the inclusion of cesses and surcharges in the divisible pool is not just about increasing its own share but about ensuring greater transparency and fairness in the system. At present, these levies are used at the discretion of the Centre, leaving states with little say over their utilisation. By including them in the divisible pool, the Finance Commission can ensure that states receive their fair share of all central taxes, not just a portion.
This also ties into a larger issue: the lack of transparency and accountability in the application of cesses and surcharges. While these levies are introduced for specific purposes, these funds are not always used efficiently. A Comptroller and Auditor General (CAG) Report, had highlighted that a significant portion of cess collections remained unutilised or not spent on their designated purposes, with nearly 40% of cess collections in 2018-19 retained in the Consolidated Fund of India instead of being transferred to the respective funds; raising concerns about inefficiency and a lack of transparency in their management.
Expanding vertical devolution
While Karnataka’s core argument focuses on the rebalancing of efficiency and equity, there is an equally important conversation around the total pool of resources available for distribution. Legal scholar Alok Prasanna Kumar has suggested that expanding vertical devolution — the share of taxes allocated to states — could alleviate some of the pressures within the current system.
Currently, the Centre retains 59% of all tax revenues, with only 41% shared among the states. By increasing this share, every state — whether economically strong or weak — would stand to gain. However, expanding the divisible pool does not negate Karnataka’s call for efficiency-based rewards. Vertical devolution must work in tandem with a recalibration of the distribution formula, ensuring that high-performing states like Karnataka are recognised for their contributions while ensuring that poorer states are still supported.
This proposal could also serve as a practical short-term solution while the Finance Commission deliberates over longer-term reforms. Increasing the size of the cake provides more flexibility to adjust the formula without causing immediate disruptions to states that are heavily dependent on central funds.
A new fiscal paradigm for India
The current system of fiscal transfers, with its heavy emphasis on equity, often rewards politicians in the poorer states for driving their states to the bottom, rather than pushing for the economic transformation seen in states like Karnataka. Instead of penalising high-performing states, the system should recognise the drivers of national growth — states like Karnataka that generate revenue, manage resources, and foster innovation — so they can become blueprints for model governance.
As the 16th Finance Commission prepares to chart the course for the next five years, it must move toward a more balanced approach by laying the foundation for a fiscal system that promotes both equity and performance— rewarding states that contribute to national growth while ensuring that no state is left behind.
The need for high-performing states to come together on fiscal matters has never been more urgent, given that the impending delimitation exercise, expected to take place after 2026, will redistribute parliamentary seats based on population data. States like Karnataka and other southern states, which have controlled population growth through effective governance, stand to lose political representation to more populous northern states. If high-performing states are unable to unite on fiscal matters now, they may lose their say entirely in the future. This is not just about economic fairness — it's about ensuring that states driving national growth have a voice in shaping the future of the country.
(Jehosh Paul is a lawyer and research consultant. He holds an LLM in Law and Development from the Azim Premji University, Bengaluru.)
