The issue of inter-state disparities has occupied a central place in India’s development discourse since Independence. Large differences in income levels, infrastructure, social development and fiscal capacity across states were recognised as a major challenge to national integration and balanced development. Consequently, institutions such as the Planning Commission and the Finance Commission were expected to play an equalising role by directing larger resources towards less developed regions.The Finance Commission, in particular, evolved a framework of fiscal transfers based on the principle that states should be able to provide reasonably comparable levels of public services at reasonably comparable levels of taxation. This required compensating states that suffered from fiscal disabilities arising from their low-income levels, weak tax bases or special geographical constraints. Income distance consequently emerged as the most important criterion in the horizontal distribution of central taxes. States with lower per capita incomes received larger transfers because they possessed lower fiscal capacity.The equalisation principle was not merely a technical feature of transfer formulae. It reflected a broader constitutional vision of cooperative federalism in which regional disparities were viewed as a national concern. The objective was not to reward existing economic strength but to create conditions for a more balanced pattern of development across states.A new criterion in horizontal devolutionThe recommendations of the Sixteenth Finance Commission suggest an important shift in this approach. While retaining income distance as a criterion, the Commission has introduced the contribution of states to national Gross Domestic Product (GDP) as an additional factor in determining horizontal devolution. The rationale is that states making larger contributions to national production should receive recognition within the transfer system. This reflects growing demands from economically advanced states that their role in national growth be explicitly acknowledged.The inclusion of GDP contribution introduces a conceptual tension into the transfer framework. Income now enters the allocation formula in two different ways. Through income distance, lower-income states receive larger transfers because they are fiscally disadvantaged.Through GDP contribution, richer states receive larger transfers because they contribute more to national output. The same economic variable thus becomes both a measure of disadvantage and a source of reward.This marks a movement away from the traditional equalisation framework towards one that places greater emphasis on economic performance. Earlier, Finance Commissions assigned the largest weights to indicators of fiscal disability and developmental need. Performance indicators such as tax effort or fiscal discipline were gradually introduced, but they remained supplementary to the central objective of reducing disparities. The Sixteenth Finance Commission alters this balance by attaching greater importance to performance-related considerations.Implications for inter-state disparitiesThe implications for inter-state disparities are significant. States with larger economies, stronger industrial bases and higher shares in national output stand to gain from the new criterion. States whose claims historically rested on fiscal disability and developmental need, experience a relative decline in their share of transfers. Although the changes may appear modest in percentage terms, their impact on the volume of resources available to less developed states can be substantial. Equally important is their normative significance. They signal a redefinition of the purpose of transfers – from correcting unequal starting positions towards rewarding differential outcomes.Revenue deficit grants and fiscal equityThe shift in the transfer framework is reinforced by the discontinuation of Revenue Deficit Grants. These grants had traditionally been used to assist states whose revenue capacities remained inadequate even after tax devolution. The argument for their discontinuation is that they create dependence and weaken incentives for fiscal discipline. Yet their withdrawal also reduces an important instrument through which the Union sought to address fiscal disparities among states.The changing approach reflects a broader transition in Indian federalism. The era of planning emphasised balanced regional development and special support for backward regions. Contemporary policy discourse increasingly emphasises competitiveness, rankings, performance incentives and investment attractiveness. Fiscal transfers are increasingly expected to support this philosophy.From cooperative to competitive federalismThe movement from cooperative to competitive federalism does not merely change the criteria used in allocation formulae. It changes the rationale of intergovernmental transfers. Under cooperative federalism, transfers compensate for unequal starting positions. Under competitive federalism, transfers increasingly reward differential outcomes. The former treats regional inequality as a problem requiring correction; the latter risks viewing it as a consequence of varying performance.The challenge before Indian fiscal federalism is therefore not to choose between equalisation and efficiency but to reconcile the two. Performance incentives may be necessary for promoting growth and fiscal responsibility.However, in a country characterised by persistent disparities in income and fiscal capacity, equalisation remains more important. A transfer system that rewards performance without adequately compensating disadvantage may inadvertently widen regional inequalities. The long-term legitimacy of fiscal federalism depends on maintaining an appropriate balance between these competing objectives.Amitabh Kundu is Professor Emeritus, LJ University, Ahmedabad.