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• Vertical imbalance refers to the disparity in revenue-generating capacity and expenditure responsibilities between different levels of government within a federal or decentralized system. In the context of fiscal federalism, vertical imbalance specifically pertains to the fiscal relationship between the central government and the state governments in a country.
• When there is a vertical imbalance, it means that the central government has a relatively larger revenue base or revenue-raising capacity compared to its expenditure responsibilities, while the state governments have relatively smaller revenue bases but significant expenditure responsibilities. This imbalance can lead to various challenges and issues in terms of funding essential services and carrying out developmental activities at the state level.
• To address vertical imbalance, fiscal transfers are often used as a mechanism to ensure that state governments receive a fair share of financial resources from the central government.
• These transfers can be in the form of grants-in-aid, revenue-sharing arrangements, and other mechanisms recommended by Finance Commissions or other relevant bodies. The goal is to promote equity and balanced development by bridging the fiscal gap between the central and state governments.
• Vertical imbalances occur because the central government has the power to levy and/or appropriate more taxes than the states. As a result states do not have sufficient tax revenues to fund their expenditures. This is resolved by allocating some taxes from a common divisible tax pool to states.

• Horizontal imbalance refers to the economic disparity or inequality in terms of revenue generation and expenditure needs among different states or regions within a country. In the context of fiscal federalism, horizontal imbalance specifically pertains to the fiscal relationship among state governments in a federal system.
• When there is a horizontal imbalance, it means that some states have a higher capacity to generate revenue due to factors like industrialization, better economic conditions, or geographical advantages, while other states have a lower revenue-generating capacity due to factors like economic underdevelopment, lesser industrialization, or geographical constraints.
• Horizontal imbalance can lead to unequal levels of development and service delivery among states. States with higher revenue generation capacity might be better equipped to provide quality public services and invest in developmental projects, while states with lower revenue generation capacity might struggle to meet essential expenditure requirements.
• To address horizontal imbalance and promote equitable development, fiscal transfers are often used to transfer resources from economically stronger states to weaker states. These transfers can be in the form of grants, allocations from a shared pool of central taxes, and other mechanisms as recommended by Finance Commissions or other relevant bodies.
• The goal is to bridge the gap between financially stronger and weaker states and ensure that all regions have the opportunity for balanced growth and development.
• Horizontal imbalances occur because states have different levels of development, income and expenditure. Some states have high incomes, and can deliver public services such as roads, schools, and hospitals from their own revenues. Others may struggle to even pay salaries of civil servants. The aim of the Finance Commission is to ensure that all states have enough resources to fund a minimum level of expenditure each year.

• The centre has more power to levy and appropriate taxes than states. So to avoid the deficiency of funds, centre provide fund from divisible poolto states through vertical devolution.

• The key idea behind vertical devolution is to allocate a share of the total financial resources collected by the central government to the state governments. This allocation is often done based on certain criteria such as population, area, revenue generation capacity, and other factors that reflect the needs and capacities of different states.
• Vertical devolution is an essential component of fiscal federalism. It ensures that state governments have a predictable and assured source of revenue to meet their expenditure requirements. This distribution of resources aims to balance the fiscal powers between the central and state governments, allowing the states to fulfill their responsibilities effectively while promoting cooperative federalism.
• In India, vertical devolution is carried out by Finance Commissions, which are constituted at regular intervals to recommend the sharing of tax revenues between the central and state governments. These commissions use various criteria and formulae to determine the proportions in which the financial resources should be distributed.

DIVISIBLE POOL: The divisible pool is that portion of the gross tax revenue which is distributed between Centre and States .It consist of all taxes excepts surcharges and cess levied for specific purpose ,net of collection charges . The divisible pool is a crucial concept in fiscal federalism, referring to the portion of tax revenue collected by the central government that is shared with state governments, excluding certain specific-purpose levies. This sharing of funds supports the financial autonomy and responsibilities of different levels of government within a country.

2. Allocation between the States of the respective shares of such proceeds (commonly known as horizontal devolution- Formula Criteria for Transfers). (between states)