Introduction: The Bedrock of Fiscal Federalism
India's Constitution establishes a federal system with a clear division of powers between the Union and the States. Financial relations, enshrined primarily in Part XII (Articles 268 to 293), form the bedrock of this fiscal federalism. These provisions delineate the allocation of taxing powers, the distribution of tax revenues, the mechanism for grants-in-aid, borrowing powers, and inter-governmental tax immunities. The Goods and Services Tax (GST) regime, introduced through the 101st Constitutional Amendment Act, 2016, marks a significant evolution in India's fiscal federalism, fostering greater cooperative federalism but also raising new challenges concerning revenue autonomy and centralisation. These arrangements aim to ensure both financial autonomy for states and a strong centre to address regional imbalances and national priorities.
12.4.1: Allocation of Taxing Powers
The Seventh Schedule of the Constitution divides legislative subjects into three lists: Union List, State List, and Concurrent List. Taxing powers are primarily concentrated in the Union and State Lists, with specific exclusions.
12.4.1.1: Parliament's Exclusive Powers (Union List)
Parliament has exclusive power to levy taxes on Union List subjects (List I).
- Customs duties
- Corporation Tax, Income Tax (other than on agricultural income)
- Service Tax (before GST), Excise duties (except on alcoholic liquors, opium, narcotics, medicinal/toilet preparations)
- Estate Duty/Succession duties on non-agricultural property
- Terminal taxes on goods/passengers by railway, sea, or air.
12.4.1.2: State Legislature's Exclusive Powers (State List)
State Legislature has exclusive power to levy taxes on State List subjects (List II).
- Land Revenue, Taxes on agricultural income, Taxes on lands and buildings
- Excise duties on alcoholic liquors, opium, etc.
- Taxes on mineral rights, Octroi, Taxes on consumption/sale of electricity
- Taxes on vehicles, animals, boats, professions, trades, callings, employments
- Capitation taxes, Taxes on luxuries (entertainments, amusements, betting, gambling)
- Stamp duty (except on Union List documents).
12.4.1.3: No Taxing Powers in Concurrent List (List III)
Unlike legislative powers, taxation is not a concurrent subject. This means that neither the Centre nor the States can levy taxes on subjects mentioned in the Concurrent List.
12.4.1.4: Residuary Power of Taxation (Article 248)
Parliament has the exclusive power to make any law with respect to any matter not enumerated in the Concurrent List or State List, including any tax not mentioned in either of those lists.
Examples: Gift Tax, Wealth Tax, Expenditure Tax (mostly abolished/subsumed).
12.4.1.5: Restrictions on Taxing Powers of States:
Professions Tax (Art 276)
Cannot impose tax on professions, trades, callings and employments exceeding Rs. 2,500 per annum (increased from Rs. 250 in 1988).
Sale/Purchase of Goods (Art 286)
- Cannot tax sale/purchase outside the state.
- Cannot tax sale/purchase during import/export.
- Cannot tax inter-state trade/commerce (now significantly altered by GST).
Electricity (Art 287, 288)
Cannot tax electricity consumed by/sold to Centre (Art 287).
Cannot tax electricity generated by Parliamentary authority for inter-State river projects (Art 288).
Water (Art 288)
Cannot tax storage, generation, consumption, distribution or sale of water by any authority established by Parliament for inter-State river or river valley development.
12.4.2: Distribution of Tax Revenues (Pre-GST Framework)
Before the Goods and Services Tax (GST) regime, the distribution of tax revenues followed a complex framework laid out in the Constitution. The 101st Amendment Act, 2016, significantly altered this.
Article 268: Union Levies, States Collect & Appropriate
Stamp duties on financial instruments and excise duties on medicinal & toilet preparations (before GST for most excises). Revenue flows entirely to states.
Article 269: Union Levies & Collects, Assigned to States (Pre-GST)
Taxes on inter-state sale/purchase (Central Sales Tax - CST) and consignment. Entire proceeds went to states.
Evolution: Significantly altered by 101st Amendment, now primarily deals with IGST (Art 269A).
Article 270: Union Levies & Collects, Shared between Union & States
The primary mechanism for vertical devolution. All Union List taxes (except those under 268, 269, 269A, 271, and cesses) are subject to mandatory sharing as prescribed by the Finance Commission.
Article 271: Surcharge for Union Purposes
Parliament can levy a surcharge on taxes under Article 270. Proceeds go exclusively to the Centre, not shared with states, providing flexible revenue.
State List Taxes: Levied, Collected & Retained by States
Taxes on subjects exclusively in the State List (e.g., Land Revenue, Professions Tax, Excise on alcohol, entertainment tax). Exclusive revenue for states, not shared with Union.
Summary Table: Pre-GST Tax Distribution Articles
| Article | Nature of Tax | Levy by | Collection by | Appropriation/Distribution | Forms part of CFI? |
|---|---|---|---|---|---|
| 268 | Stamp duties, Excise on medicinal/toilet preparations | Union | States | States (appropriated by them) | No |
| 269 | Taxes on inter-state sale/consignment (Pre-GST) | Union | Union | Assigned to States (where leviable) | No |
| 270 | All Union List taxes (except 268, 269, 269A, 271) | Union | Union | Shared between Union & States (as per FC) | Yes (net proceeds) |
| 271 | Surcharge on Art 270 taxes | Union | Union | Exclusively for Union | Yes |
| State List Taxes | E.g., Land Revenue, Excise on alcohol | States | States | States (retained exclusively) | Yes (State CFI) |
12.4.3: Goods and Services Tax (GST) Regime
The 101st Constitutional Amendment Act, 2016, introduced the Goods and Services Tax (GST), a landmark reform aiming to create a unified national market.
12.4.3.1: "One Nation, One Tax, One Market"
GST replaced multiple indirect taxes levied by the Centre and States (e.g., Central Excise Duty, Service Tax, VAT, Octroi, CST, Entry Tax, Luxury Tax) into a single tax. It is a destination-based consumption tax.
12.4.3.2: Concurrent Power (Article 246A)
A significant departure from the earlier clear-cut division of taxing powers. Both Centre and States have concurrent power to tax supply of goods or services or both. Parliament has exclusive power for GST on inter-state supply.
12.4.3.3: Integrated GST (IGST) - Article 269A
IGST is levied on inter-state supplies of goods and services, as well as on imports. It is levied and collected by the Union. The proceeds are apportioned between the Union and the States based on GST Council recommendations.
12.4.3.4: GST Council (Article 279A)
Constitutional body to make recommendations on GST rates, exemptions, threshold limits, model GST laws, etc.
- Composition: Union Finance Minister (Chairperson), Union Minister of State (Finance), State Finance/Taxation Ministers.
- Decision Making: Decisions by a 3/4th majority of weighted votes (Centre's vote 1/3rd, States' votes collectively 2/3rd).
12.4.3.5: Compensation to States
The GST (Compensation to States) Act, 2017, provided for compensation to states for revenue loss for five years (July 1, 2017, to June 30, 2022), based on 14% projected growth. Funded via a compensation cess.
Current debates: States sought extension. While 5-year period ended, cess collection extended till March 2026 to repay loans taken during pandemic.
12.4.3.6: Impact of GST on Fiscal Federalism
- Cooperative spirit: GST Council is a unique example of cooperative federalism.
- Issues of state autonomy: States gave up significant indirect tax powers, raising concerns about reduced fiscal autonomy and dependence.
- Revenue concerns: Initial uncertainties necessitated compensation; collections have stabilized.
- Standardisation vs. differentiation: Reduces states' discretion to vary tax rates, impacting regional development goals.
12.4.4: Grants-in-Aid to the States
Grants-in-aid are financial transfers from the Centre to the States, designed to bridge vertical and horizontal fiscal imbalances and to promote specific national priorities or developmental objectives.
12.4.4.1: Statutory Grants (Article 275)
- Parliament may make grants to states in need of financial assistance, identified by the Finance Commission.
- Charged on the Consolidated Fund of India.
- Specific grants for promoting welfare of Scheduled Tribes or raising administration level of Scheduled Areas.
12.4.4.2: Discretionary Grants (Article 282)
- Both Union and a State can make grants for any public purpose, even if outside their legislative competence.
- Discretionary in nature (Centre not bound).
- Historically based on Planning Commission recommendations (now NITI Aayog advisory role). Significant in volume, influencing centralisation.
12.4.4.3: Other Grants
Constitution also provides for grants for specific purposes (e.g., in lieu of export duty on jute products - Art 273, now obsolete). Centre also provides conditional grants for Centrally Sponsored Schemes (CSS) and Central Sector Schemes (CS).
12.4.5: Finance Commission (Article 280)
The Finance Commission is a pivotal constitutional body in India's fiscal federalism, tasked with recommending the distribution of financial resources between the Union and the States.
12.4.5.1: Structure & Formation
- Quasi-judicial body, constituted by President every 5 years or earlier.
- Consists of a Chairman and four other members appointed by the President.
- Members are eligible for re-appointment.
12.4.5.2: Key Roles & Recommendations
The Commission has the duty to make recommendations to the President on:
- Distribution of net proceeds of taxes between Union and States (vertical devolution).
- Principles governing grants-in-aid of States' revenues out of the CFI (statutory grants under Art 275).
- Measures needed to augment the Consolidated Fund of a State to supplement resources of Panchayats and Municipalities (based on State Finance Commission recommendations).
- Any other matter referred to it by the President (e.g., debt relief, disaster relief financing).
12.4.5.3: Advisory Nature of Recommendations
While the recommendations are not legally binding, the Union government typically accepts them to maintain fiscal harmony and cooperative federalism.
12.4.5.4: Key Recommendations of Recent Finance Commissions
| Feature | 14th Finance Commission (2015-2020) | 15th Finance Commission (2020-2026) |
|---|---|---|
| Chairman | Y.V. Reddy | N.K. Singh |
| States' Share in Divisible Pool (Vertical Devolution) | Increased from 32% to 42% (significant increase, more untied funds) | Recommended 41% (1% decrease due to creation of J&K and Ladakh UTs, now centrally funded) |
| Horizontal Devolution Criteria (Inter-state distribution) |
|
|
| Key Shift / Focus | Greater untied funds to states, emphasizing fiscal autonomy. | More weight to demographic performance and tax effort; reduced weight of 1971 population; introduced "Forest & Ecology." Also recommended grants for health, disaster management, etc. |
12.4.6: Protection of States' Interest
Certain constitutional provisions are designed to protect the financial interests of the states from unilateral central action.
12.4.6.1: Bills affecting taxation require President's recommendation (Article 274)
Bills imposing/varying any tax/duty in which states are interested, or affecting principles of money distribution to states, or varying 'agricultural income' definition, require President's prior recommendation for introduction in Parliament. This ensures states' financial interests are considered.
12.4.7: Borrowing by the Centre and the States
Both the Union and the States have powers to borrow funds to meet their financial requirements, but with specific limitations.
12.4.7.1: Centre's Borrowing Power (Article 292)
The Centre can borrow within India or outside upon security of the Consolidated Fund of India (CFI), within limits set by Parliament.
Note: Parliament has not yet fixed any such limit for the Centre's borrowing.
12.4.7.2: State's Borrowing Power (Article 293)
A State can borrow within India upon security of its Consolidated Fund, within limits set by State Legislature. State cannot borrow abroad directly.
Restrictions on State Borrowing:
- Cannot borrow abroad directly; only Union can.
- Needs Centre's consent to borrow if it has any outstanding loan from the Centre or Centre has given a guarantee. Centre can impose conditions.
This restriction significantly enhances central control over state finances.
12.4.8: Inter-Governmental Tax Immunities
To prevent conflicts and ensure smooth functioning of the federal structure, the Constitution provides for mutual tax immunities between the Union and State governments.
12.4.8.1: Exemption of Union property from State taxation (Article 285)
The property of the Union shall, save in so far as Parliament may by law otherwise provide, be exempt from all taxes imposed by a State or by any authority within a State.
SC held: A corporation created by a Central Act is not immune from state taxation.
12.4.8.2: Exemption of State property and income from Union taxation (Article 289)
The property and income of a State shall be exempt from Union taxation.
Exceptions:
- Union can tax income of a State if it arises from a trade or business carried on by the State.
- Parliament can declare that any trade/business by a State is incidental to ordinary functions of government, in which case its income would be exempt.
Conclusion & Way Forward
India's financial relations represent a dynamic and evolving aspect of its federal structure. From a pre-GST framework characterized by a clear division of taxing powers and complex revenue-sharing mechanisms, the country has moved towards a more integrated indirect tax regime with GST, fostering cooperative federalism through the GST Council. The Finance Commission remains the cornerstone for vertical and horizontal fiscal transfers, addressing regional disparities and ensuring equitable distribution of resources.
The journey continues to involve balancing the need for a strong Centre to manage macro-economic stability and national priorities with the imperative of enhancing states' fiscal autonomy and capacity. Debates around GST compensation, the use of cesses/surcharges by the Centre, and the recommendations of the Finance Commission highlight the ongoing challenges and the need for continuous dialogue and institutional reforms to strengthen India's fiscal federalism and promote balanced regional development. The increasing fiscal strain on states, especially post-pandemic, necessitates innovative solutions and greater trust between the Centre and states for sustainable and inclusive growth.
Prelims-ready Notes & Key Articles Summary
Key Prelims Points
- Part XII, Articles 268-293 deal with Financial Relations.
- Seventh Schedule lists taxing powers. No taxing power in Concurrent List.
- Art 248: Residuary power of taxation with Parliament.
- Art 276: State profession tax limit Rs. 2500 p.a.
- Art 286: State cannot tax inter-state, import/export, outside state sale/purchase.
- Art 287/288: State cannot tax Central/specified authority's electricity/water.
- Art 268: Union levies, States collect/appropriate (e.g., Stamp duties on financial instruments).
- Art 269: Union levies/collects, assigned to States (Pre-GST: CST; Post-GST: IGST under 269A).
- Art 270: Union levies/collects, distributed between Union & States (main sharing pool, excl. 268, 269, 269A, 271, cesses). Finance Commission recommends distribution.
- Art 271: Surcharge by Parliament on Art 270 taxes, proceeds exclusively for Centre.
- 101st Amendment Act, 2016 introduced GST.
- Art 246A: Concurrent power for Centre & States to tax GST.
- Art 269A: IGST on inter-state supply, levied/collected by Centre, apportioned b/w Centre & States.
- Art 279A: GST Council. Chairperson: Union FM. Decision: 3/4th majority (Centre 1/3, States 2/3 weightage). Recommendations non-binding (SC Mohit Minerals case, 2022).
- GST Compensation: 5 years (2017-2022), 14% growth protection, cess funded. Extended till March 2026 for repayment.
- Art 275: Statutory Grants. To states in need. Charged on CFI. Based on FC recommendations. For ST welfare/Scheduled Areas.
- Art 282: Discretionary Grants. For any public purpose, even outside legislative competence. Union/State can give.
- Art 280: Finance Commission. Quasi-judicial. President constitutes every 5 years. Recommends vertical/horizontal devolution, grants-in-aid, state FC augmentation. Recommendations advisory.
- 14th FC: States' share 42%.
- 15th FC: States' share 41% (due to J&K/Ladakh UTs). Criteria shifts: Demographic Performance, Tax & Fiscal Effort, Forest & Ecology got more weight.
- Art 274: Bills affecting states' interest in taxation need President's prior recommendation.
- Art 292: Centre's borrowing. Within/outside India. Parliament sets limits (not yet).
- Art 293: State's borrowing. Within India only. State Legislature sets limits. Needs Centre's consent if outstanding loan from Centre/guarantee. State cannot borrow abroad directly.
- Art 285: Union property exempt from State tax.
- Art 289: State property/income exempt from Union tax (except state income from trade/business not incidental to govt. functions).
Summary Table: Key Articles
| Article | Subject |
|---|---|
| 268 | Taxes levied by Union but collected and appropriated by States |
| 269 | Taxes levied and collected by Union but assigned to States (Pre-GST) |
| 269A | Goods and Services Tax on Inter-State Supply (IGST) |
| 270 | Taxes levied and collected by Union and Distributed |
| 271 | Surcharge on certain duties and taxes for Union purposes |
| 274 | Prior recommendation of President for Bills affecting taxation in which States are interested |
| 275 | Grants from the Union to certain States (Statutory) |
| 276 | Taxes on professions, trades, callings and employments |
| 279A | GST Council |
| 280 | Finance Commission |
| 282 | Discretionary Grants |
| 285 | Exemption of property of the Union from State taxation |
| 286 | Restrictions as to imposition of tax on the sale or purchase of goods |
| 289 | Exemption of property and income of a State from Union taxation |
| 292 | Borrowing by the Government of India |
| 293 | Borrowing by States |
Mains-ready Analytical Notes
Major Debates/Discussions
- Centralisation vs. Fiscal Autonomy: GST reduced states' independent revenue powers, increasing dependence on central transfers.
- Role of Finance Commission vs. NITI Aayog: FC's role paramount post-Planning Commission abolition, but Centre's discretionary allocations (CSS) remain substantial.
- Cesses and Surcharges: Union's increasing reliance on non-shareable cesses/surcharges (Art 271) reduces states' share, contentious point.
- GST Council's Recommendations: SC's Mohit Minerals judgment (2022) clarified recommendations are not binding, impacting future consensus-building.
Historical/Long-term Trends, Continuity & Changes
- Shift from Shared-Taxes to Divisible Pool: Evolution from specific tax sharing to a broader "divisible pool" under Art 270 (FC recommendations) providing untied funds.
- Evolution of Transfers: From needs-based discretionary grants to more formula-based statutory transfers, now a hybrid with GST compensation and conditional schemes.
- Increasing Centralisation of Revenue Powers: States' revenue-raising capacity lags expenditure, especially post-GST.
- Increased Focus on Horizontal Equity: Recent FCs refined criteria (demographic performance, tax effort, ecological contributions) to address inter-state disparities.
Contemporary Relevance/Significance/Impact
- Fiscal Federalism under Strain: Post-COVID fiscal impacts on both Centre and states, leading to increased borrowing and demands for support.
- Role of Supreme Court: SC's Mohit Minerals ruling reinforces legislative sovereignty and recommendatory nature of GST Council.
- Debt Sustainability: Rising debt-to-GSDP ratios for states are concerns, Centre's oversight (Art 293) is critical.
- Centrally Sponsored Schemes (CSS): Major chunk of central transfers, design and conditionalities continue to be debated.
Real-world/Data-backed Recent Examples (India)
- 15th Finance Commission Recommendations (2020-2026): Reduction of states' share to 41%, new horizontal devolution criteria (demographic performance, tax effort, ecology).
- GST Compensation Cess Extension Debate (2022-2023): States lobbied for extension beyond June 2022; cess extended till March 2026 for repaying past loans.
- Supreme Court Ruling on GST Council (Mohit Minerals case, May 2022): Clarified recommendations are not binding, reinforcing legislative autonomy.
- States' Mounting Debt: Post-COVID, RBI reports (July 2023) highlighted elevated debt levels for many states, impacting fiscal space.
Current Affairs and Recent Developments
- 15th Finance Commission's implementation: Recommendations are currently being implemented, performance-based grants driving specific policy changes.
- Extension of GST Compensation Cess (July 2022 onwards): Levy extended until March 31, 2026, solely for repayment of loans, not future compensation. Continues to be contentious.
- Supreme Court's Ruling on GST Council (Mohit Minerals Pvt. Ltd. v. Union of India, May 2022): Emphasizes recommendatory nature and legislative autonomy.
- Debates on inclusion of petroleum products and electricity under GST: Ongoing discussions, though not immediately imminent, would further integrate tax structure but impact state revenues.
UPSC Previous Year Questions (PYQs)
Prelims MCQs
UPSC Prelims 2019 Question
With reference to the Constitution of India, consider the following statements:
- No High Court shall have the jurisdiction to declare any Central law to be constitutionally invalid.
- An amendment to the Constitution of India cannot be called into question by the Supreme Court of India.
Which of the statements given above is/are correct?
- (a) 1 only
- (b) 2 only
- (c) Both 1 and 2
- (d) Neither 1 nor 2
UPSC Prelims 2017 Question
Local self-government can be best explained as an exercise in:
- (a) Federalism
- (b) Democratic decentralisation
- (c) Administrative delegation
- (d) Direct democracy
UPSC Prelims 2013 Question
The provisions in Fifth Schedule and Sixth Schedule in the Constitution of India are made in order to
- (a) protect the interests of Scheduled Tribes
- (b) determine the boundaries of States
- (c) determine the powers, authority and responsibilities of Panchayats
- (d) protect the interests of all the border States
Mains Questions
UPSC Mains 2018 (GS Paper 2)
"The 14th Finance Commission (FC) has recommended a nearly 10% increase in the devolution of the divisible pool of taxes to States. How far do you think this change will affect the States' ability to draw upon discretionary grants from the Centre?"
UPSC Mains 2015 (GS Paper 2)
"The concept of 'cooperative federalism' has been increasingly emphasized in recent years. Highlight the challenges in its implementation in India."
Practice Questions
Original MCQs for Prelims
Original MCQ 1
Consider the following statements regarding the Goods and Services Tax (GST) regime in India:
- Both Parliament and State Legislatures have concurrent power to make laws with respect to Goods and Services Tax.
- The Integrated Goods and Services Tax (IGST) is levied and collected by the Union but its proceeds are exclusively retained by the Union.
- The Goods and Services Tax Council's recommendations are binding on the Union and State Legislatures.
Which of the statements given above is/are correct?
- (a) 1 only
- (b) 1 and 2 only
- (c) 2 and 3 only
- (d) 1, 2 and 3
Original MCQ 2
Which of the following statements correctly describes the powers of the Centre and States regarding borrowing in India?
- The Union Government can borrow within India or outside, subject to limits fixed by Parliament.
- State Governments can borrow within India and abroad, subject to limits fixed by their respective State Legislatures.
- A State Government requires the consent of the Union Government if it has any outstanding loan from the Centre.
Select the correct answer using the code given below:
- (a) 1 only
- (b) 1 and 2 only
- (c) 1 and 3 only
- (d) 1, 2 and 3
Original Descriptive Questions for Mains
Original Mains Question 1 (15 marks, 250 words)
"The Finance Commission is the fulcrum of fiscal federalism in India, but its effectiveness is often challenged by extra-constitutional bodies and the Centre's fiscal choices." Elaborate with suitable examples.
Original Mains Question 2 (10 marks, 150 words)
Analyze the impact of the Goods and Services Tax (GST) regime on India's fiscal federalism, highlighting both its achievements and the ongoing challenges from the perspective of states.