India’s fiscal debates have traditionally revolved around how much revenue the Union government shares with states. But the more consequential question emerging today is different: Who will finance and deliver social services in the next phase of India’s development?
Over the past few years, Union budgets have steadily prioritized fiscal consolidation and capital expenditure. Where allocations to social sector schemes have risen in absolute terms, social spending by the Union government relative to GDP and total expenditure has declined, even as implementation and utilization gaps persist across several flagship programmes. Taken together, these trends suggest that India may be entering a new phase of fiscal federalism — one in which the Union government may gradually move away from steering welfare delivery through Centrally Sponsored Schemes (CSSs), leaving states and local governments to assume greater responsibility for financing and adapting programs to local needs.
What makes this moment significant is that this shift is occurring implicitly rather than through explicit policy choice. Yet, its consequences are already visible in state finances and scheme outcomes.
The Constitution envisages public services being delivered closest to citizens. The 73rd and 74th Constitutional Amendments entrusted local governments with responsibilities ranging from drinking water and sanitation to housing, local infrastructure, primary health and education. In practice, however, financing and program design have remained centralized through CSSs, which became the Union government’s principal mechanism for shaping welfare delivery. States implemented schemes, but program rules and funding patterns were largely determined at the Centre.
While imperfect, CSSs often provided the only significant non-wage fiscal space available to states, whose budgets remain dominated by salaries, pensions and interest payments. By tying funds to national priorities, they nudged investments in sectors such as health, housing and rural development. But this arrangement is increasingly difficult to sustain, and successive Finance Commissions — including the 16th — have argued that the CSS architecture itself now requires rationalization, with schemes periodically reassessed and those delivering limited returns discontinued so that scarce fiscal resources are not locked into legacy programs.
Against this backdrop, the 16th Finance Commission marks an important turning point. Its recommendations substantially increase transfers to local governments, especially urban bodies. For the first time, cities receive nearly half of all local government grants, and a larger share of these funds is untied, allowing local governments greater spending autonomy while linking transfers to improvements in revenue mobilization and transparency.
In effect, local governments are being fiscally strengthened just as the Union government’s own social sector spending footprint shrinks. Financing responsibility is gradually moving downwards.
But this shift collides with the reality that states themselves remain fiscally constrained. Even though tax revenues have grown, overall state expenditure relative to GSDP has stagnated due to fiscal responsibility limits on borrowing. For many poorer states — and particularly those in the North-East and Himalayan regions — public expenditure continues to be sustained by Union transfers. Expecting states to absorb additional social sector obligations without greater fiscal flexibility risks stretching already constrained budgets.
The strain is visible in the scheme implementation itself. Over time, scheme design has lagged economic reality. Under Pradhan Mantri Awas Yojana-Gramin (PMAY-G), Parliamentary committees and evaluation bodies have repeatedly flagged stagnant unit costs despite rising construction costs, forcing states or citizens to bridge funding gaps and often compromising quality. Urban housing programs reveal a related challenge: Houses are constructed but remain unoccupied because livelihood access, infrastructure and affordability concerns remain unresolved, as targets reward construction rather than habitation.
When schemes are extended or restructured, states are often left completing unfinished obligations — whether it is pending PMAY-Urban houses, wage cost sharing in the new VBGRAMG employment programme, or water supply infrastructure under Jal Jeevan Mission that states must sustain after central funding tapers.
Meanwhile, the Union’s spending priorities are visibly tilting toward national-level investments: Large infrastructure, national institutions and technology investments. There is a reasonable argument for this. National public goods often require central financing and coordination. But if this continues without redesigning intergovernmental financing, responsibility for everyday service delivery quietly shifts to states and local governments. Such a transition should work if planned properly. The difficulty is that India appears to be moving toward decentralization without explicitly redesigning the fiscal architecture that supports it.
Local governments continue to face weak revenue bases, uneven accounting systems and limited execution capacity. Increased FC transfers create opportunity, but money alone does not guarantee service delivery.
The deeper issue, therefore, is not merely declining Union social sector spending, but the absence of clarity on India’s future intergovernmental financing model. Should CSSs evolve into flexible transfers? Should the Union finance national minimum standards while allowing states program flexibility? Or should social sector delivery gradually become primarily a state and local responsibility supported by greater untied fiscal space? These questions are now unavoidable.
India’s fiscal federalism debate has long centered on tax devolution percentages. The next phase is about aligning responsibilities, financing and accountability across all levels of government. If the Union government intends to focus on national investments while states and cities take charge of local services, the transition must be explicit and supported by predictable fiscal space. Otherwise, India risks ending up with centralized control without fiscal commitment, and decentralized responsibility without fiscal capacity. And in public finance, such mismatches rarely end well.
Avani Kapur is founder and director, Foundation for Responsive Governance (ResGov). The views expressed are personal
