Vertical and Horizontal Devolution

Devolution refers to the transfer or distribution of financial resources and fiscal powers from a higher level of government to a lower level. In the context of Indian fiscal federalism, devolution represents the division of the Central Government’s tax revenue among the Union and the States, as well as among the States themselves. The constitutional mechanism for such division is provided under Articles 268 to 281 of the Indian Constitution, particularly through the institution of the Finance Commission, which is appointed every five years under Article 280.
The Finance Commission plays a critical role in recommending how the tax revenue collected by the Centre should be shared with the States. This sharing process has two dimensions — Vertical Devolution and Horizontal Devolution. While vertical devolution determines the proportion of the central tax pool that goes to all the States collectively, horizontal devolution determines how that share is distributed among individual States. Together, they ensure a fair and balanced fiscal relationship between the Union and the States, maintaining the federal equilibrium.

The Constitutional Framework for Devolution

India’s federal financial structure divides subjects of taxation and expenditure between the Centre and the States through three lists under the Seventh Schedule — the Union List, the State List, and the Concurrent List. However, this division inherently creates fiscal imbalances.

• The Union Government has wider and more productive sources of revenue such as income tax, customs duties, and corporate taxes, but its expenditure responsibilities are relatively limited.
• The State Governments, on the other hand, have narrow tax bases (mainly sales tax, excise, and stamp duty) but are responsible for implementing developmental, welfare, and infrastructure programmes that involve substantial expenditure.

This leads to two types of fiscal imbalances:

1. Vertical Imbalance, between the Centre and the States.
2. Horizontal Imbalance, among the States themselves.

The Finance Commission’s devolution formula addresses these imbalances through vertical and horizontal transfers of resources.

Vertical Devolution

Vertical devolution refers to the division of the net proceeds of central taxes between the Centre and all the States collectively. In other words, it decides how much of the total divisible pool of central taxes will go to the States as a group and how much the Centre will retain.

Purpose

The purpose of vertical devolution is to correct the vertical fiscal imbalance, which arises because the Centre controls the majority of revenue-raising powers, while the States bear a larger share of expenditure responsibilities.

Determination

The percentage of vertical devolution is recommended by the Finance Commission after a careful examination of:

• The revenue-raising capacity and expenditure responsibilities of the Centre and States.
• The need for fiscal consolidation and debt management.
• The overall macroeconomic situation of the country.

Evolution of Vertical Devolution Percentages

The percentage of the divisible pool allocated to the States has changed with successive Finance Commissions:

The 14th Finance Commission significantly increased the States’ share to 42% to enhance fiscal autonomy and reduce dependence on central grants. The 15th Finance Commission retained the share at 41%, accounting for the exclusion of the erstwhile State of Jammu and Kashmir after its reorganisation in 2019.

Importance of Vertical Devolution

1. Ensures Financial Balance: It provides States with resources to discharge constitutionally assigned duties effectively.
2. Strengthens Cooperative Federalism: A fair vertical share promotes trust and coordination between Centre and States.
3. Reduces Dependence on Grants: It minimises the reliance of States on discretionary grants or centrally sponsored schemes.
4. Encourages Fiscal Responsibility: The flow of assured funds enables States to plan budgets and manage expenditure efficiently.

Challenges in Vertical Devolution

• The Centre’s own fiscal constraints due to debt servicing and subsidies limit its flexibility.
• Increasing State responsibilities in social sectors require higher transfers.
• Balancing national priorities with State needs remains a challenge.

Horizontal Devolution

Horizontal devolution refers to the distribution of the States’ collective share of central taxes among individual States. It determines the proportion of the total State share that each State will receive from the divisible pool.

Purpose

The primary objective of horizontal devolution is to address horizontal fiscal imbalances — the disparities in fiscal capacity and developmental needs among different States. These differences arise due to variations in:

• Economic development and income levels.
• Natural resources and geographic conditions.
• Population density and demographics.
• Infrastructure, administrative costs, and social indicators.

Horizontal devolution aims to ensure equity, meaning that poorer and less-developed States receive proportionately larger shares to enable them to provide comparable levels of public services.

Criteria for Horizontal Devolution

The Finance Commission uses a combination of indicators to determine inter-State distribution. These criteria are revised periodically to reflect current national priorities.
For instance, the 15th Finance Commission (2021–26) adopted the following criteria and weightages:

Explanation of Key Parameters

• Income Distance: Measures the gap between a State’s per capita income and that of the richest State. States with lower income get a higher share to bridge fiscal disparities.
• Population (2011 Census): Reflects the demand for public goods and services, as more populous States require greater resources.
• Area: Larger States often incur higher administrative costs and infrastructure needs.
• Forest and Ecology: Recognises that forest-rich States face developmental constraints and need compensation for environmental services.
• Demographic Performance: Rewards States that have managed population growth through effective policies.
• Tax Effort: Encourages fiscal discipline and better revenue mobilisation at the State level.

Examples

Under these criteria, States like Uttar Pradesh, Bihar, Madhya Pradesh, and West Bengal receive higher allocations due to larger populations and lower per capita incomes. In contrast, economically advanced States such as Maharashtra, Haryana, and Gujarat receive relatively smaller shares.

Significance of Horizontal Devolution

1. Promotes balanced regional development by narrowing the fiscal gap between richer and poorer States.
2. Encourages responsible fiscal behaviour through incentive-based parameters like tax effort and demographic performance.
3. Enhances equity and inclusiveness, ensuring that every State has adequate funds to provide basic services.
4. Recognises environmental sustainability through the inclusion of forest and ecology criteria.

Challenges in Horizontal Devolution

• Difficulty in accurately measuring income distance and developmental needs.
• Contention between States regarding population criteria and demographic performance.
• Limited incentive for efficient States, leading to potential dissatisfaction.
• Dependence on outdated data and variation in fiscal capacity across States.

Comparison Between Vertical and Horizontal Devolution

Role of the Finance Commission

The Finance Commission is the constitutional body responsible for recommending the devolution formula. It ensures that devolution is carried out transparently and equitably based on objective criteria. It also considers issues such as debt sustainability, fiscal discipline, and performance-based incentives.
Over time, the Commission has shifted its emphasis from population-based and historical allocations to performance-linked and need-based criteria, reflecting India’s evolving fiscal federalism.