Introduction
Centre-State financial relations are the bedrock of fiscal federalism in India, determining how financial resources and revenue-raising powers are shared between the Union government and the State governments. These relations are comprehensively defined by the Constitution of India to ensure a balanced distribution of resources, enable states to meet their expenditure responsibilities, and promote equitable development across the country. Key institutions like the Finance Commission play a pivotal role in mediating these relations and recommending resource sharing. The introduction of GST has significantly reshaped this landscape, bringing both opportunities and challenges.
Sources: Constitution of India, M. Laxmikanth - Indian Polity, D.D. Basu - Introduction to the Constitution of India, NCERT Class 11 - Indian Constitution at Work.
Constitutional Provisions: Articles 268 to 281
The Constitution provides an elaborate framework for the distribution of financial resources.
Distribution of Taxing Powers
Union List (List I)
Parliament has exclusive power to levy taxes (e.g., customs duties, corporation tax, income tax (non-agri)).
State List (List II)
State legislatures have exclusive power to levy taxes (e.g., agricultural income, land revenue, excise on liquor, petroleum products sales tax).
Concurrent List (List III)
Both can legislate, but taxation generally not included. Residuary power of taxation (Article 248) lies with Parliament.
Key Articles Governing Financial Relations
Article 268
Duties levied by Union but collected & appropriated by StatesStamp duties on financial instruments, excise duties on medicinal/toilet preparations (alcohol/narcotics).
Article 268A (Omitted)
Service Tax (subsumed under GST)Placeholder for historical context. Omitted by 101st Amendment Act, 2016.
Article 269
Taxes levied & collected by Union but assigned to StatesInter-state sale/purchase of goods (largely IGST now), consignment of goods. Proceeds assigned to states.
Article 269A
Levy & collection of IGSTIntroduced by 101st Amendment. IGST collected by Union, apportioned between Union and States based on GST Council recommendations.
Article 270
Taxes levied & distributed between Union & States (Divisible Pool)Covers most Union List taxes (except 268, 269, 269A, cesses). Distributed as per Finance Commission recommendations.
Article 271
Surcharge on certain duties and taxes for UnionParliament can levy surcharge; proceeds go exclusively to the Union. Point of contention for states.
Article 275
Statutory Grants-in-AidParliament may provide grants to states in need, charged on CFI. Based on Finance Commission recommendations.
Article 282
Discretionary GrantsUnion or State can make grants for any public purpose. Not routed through Finance Commission. Often used for Centrally Sponsored Schemes.
Article 280 & 281
Finance Commission & its RecommendationsArticle 280 constitutes the FC. Article 281 mandates laying its recommendations before Parliament.
The Finance Commission (Article 280)
Constitutional Body
Appointment: Constituted by the President of India every fifth year or earlier.
Composition: Chairman and four other members appointed by the President. Parliament determines their qualifications (Finance Commission (Miscellaneous Provisions) Act, 1951).
Functions (as per Article 280(3)): Makes recommendations to the President regarding:
Distribution of net proceeds of taxes between Union and States, and allocation among States.
Principles governing grants-in-aid of States' revenues from the Consolidated Fund of India.
Measures to augment State Consolidated Fund to supplement resources of Panchayats and Municipalities (based on State Finance Commission recommendations).
Any other matter referred by the President in the interests of sound finance.
Nature of Recommendations: Advisory in nature, not binding, but generally accepted.
Key Recommendations
Vertical Devolution
Share of Union taxes to States (divisible pool).
- 14th FC (Y.V. Reddy, 2015-20): Increased states' share from 32% to an unprecedented 42%.
- 15th FC (N.K. Singh, 2020-26): Recommended 41% (1% adjustment for newly formed UTs of J&K and Ladakh).
Horizontal Devolution Criteria
Principles for distributing states' share among themselves. Aims at equity & efficiency.
| Criterion | Weight (%) - 15th FC (2021-26) |
|---|---|
| Income Distance | 45.0 |
| Population (2011) | 15.0 |
| Area | 15.0 |
| Forest & Ecology | 10.0 |
| Demographic Performance | 12.5 |
| Tax Effort | 2.5 |
| Total | 100.0 |
Grants-in-Aid (Article 275)
Revenue Deficit Grants (PDRDG)
To cover revenue gaps even after tax devolution (15th FC: ₹2,94,514 crore for 17 states).
Sector-Specific Grants
For specific sectors (health, education, judiciary, etc.) - conditional (15th FC: ₹1.3 lakh crore for 8 sectors).
State-Specific Grants
Based on states' proposals for social needs, governance, infrastructure (15th FC: ~₹49,599 crore).
Disaster Risk Management Grants
For SDRF and NDRF (15th FC recommended).
Local Bodies Grants
FCs recommend measures to augment states' consolidated funds for Panchayats and Municipalities (as per 73rd/74th CAA).
15th FC recommended total grants of ₹4,36,361 crore for 2021-26.
- Rural Local Bodies (RLBs): ₹2,36,805 crore.
- Urban Local Bodies (ULBs): ₹1,21,055 crore.
- Health grants through local governments: ₹70,051 crore.
Grants are generally tied to specific basic services and performance-based (e.g., own revenue, audited accounts).
Impact of GST on Centre-State Financial Relations
Subsumption of Taxes
Subsumed many indirect taxes of both Centre (Excise, Service Tax) and States (VAT, Entry Tax), shifting taxation powers.
GST Council (Article 279A)
New federal body: Union FM (Chair), Union MoS Finance, State FMs. Recommends on rates, exemptions. Decisions by 3/4th majority (Centre 1/3rd, States 2/3rd weightage).
Dual GST Structure
CGST (Centre), SGST (States), IGST (Centre on inter-state supplies, apportioned).
GST Compensation Cess
Act, 2017 provided compensation to states for revenue loss (14% growth over 2015-16 base) for 5 years (till June 2022). Levied on luxury/demerit goods.
Note: Cess levy extended till March 2026 to repay COVID-related loans, not for ongoing compensation.
Recent Finance Commissions: Key Recommendations and Implications
14th Finance Commission (Dr. Y.V. Reddy, 2015-2020)
Key Recommendation: Unprecedented increase in vertical devolution to 42%.
Implications:
- Greater untied funds and fiscal autonomy for states.
- Reduced scope for discretionary grants from Centre.
- Led to restructuring/delinking of some Centrally Sponsored Schemes (CSS).
15th Finance Commission (N.K. Singh, 2021-2026)
Context: COVID-19, GST stabilization, J&K reorganisation.
Key Recommendations:
- Maintained vertical devolution at 41%.
- Introduced demographic performance and tax effort in horizontal devolution criteria.
- Extensive grants (PDRDG, sector-specific, local bodies, disaster management).
- Recommended fiscal consolidation roadmap for Centre and States.
- Advocated for a dedicated mechanism to fund defence and internal security (MFDSI).
Implications:
- Framework for resource sharing in challenging environment.
- Emphasis on performance-based grants and fiscal discipline.
- Acknowledged states' efforts in population management.
Local Bodies Finances
The 73rd and 74th Constitutional Amendment Acts mandated the creation of Panchayats and Municipalities as institutions of self-government and endowed them with certain functions and financial powers.
Sources of Revenue for Local Bodies
Tax Revenue
Panchayats: Property tax, professional tax, animal/vehicle taxes. Municipalities: Property tax (major), advertisements, entertainment.
Non-Tax Revenue
Fees for services (water, sanitation), rents, fines, penalties.
Grants-in-Aid
From State Government (SFCs), Central Government (CFCs), specific schemes (e.g., Swachh Bharat).
Loans
From state government or financial institutions (with state approval).
Octroi (Historical)
Levied on goods entering municipal area. Largely abolished/subsumed under GST, leading to revenue shifts.
State Finance Commissions (SFCs)
Constitutional Mandate: Governor constitutes SFC every fifth year (Article 243-I for Panchayats, 243-Y for Municipalities).
Functions: Review financial position of Panchayats/Municipalities; recommend distribution of state taxes to local bodies, assigned taxes, grants-in-aid from State Consolidated Fund; suggest measures to improve financial position.
Challenge: Recommendations often not implemented fully or timely by State Governments.
Challenges in Strengthening Local Government Finances
Inadequate Devolution (Functions, Funds, Functionaries - 3 Fs) by State governments.
Weak Own-Source Revenue Base, over-reliance on grants, poor collection efficiency (e.g., property tax).
Irregular Constitution and Functioning of SFCs; delays in reports and action.
Lack of Financial Autonomy and limited discretion in spending.
Capacity Deficits: Lack of skilled personnel for financial management at local level.
Poor Data and Accounting Systems, hindering planning and transparency.
Limited Access to Borrowing due to weak financial health.
Political Interference undermining financial discipline.
Current Affairs Focus
Latest Finance Commission Report (15th FC) Impact:
- The 41% share provides significant untied funds.
- Performance-based grants for local bodies incentivize reforms.
- Fiscal consolidation roadmap guiding Centre and state policies.
- Health sector grants are crucial post-pandemic.
Debates on Fiscal Federalism:
- Cesses and Surcharges: States' concern over increasing Union reliance on these, as proceeds are not part of divisible pool (CAG reports show rising share).
- GST Compensation: Demands for extension post-June 2022 due to revenue uncertainties, and concerns over reduced state revenue autonomy.
- Centrally Sponsored Schemes (CSS): States seek more flexibility and complain about conditionalities.
- Borrowing Limits for States: Centre's ceiling (Art 293(3)) and conditions during COVID-19 seen as infringement on autonomy.
- Role of NITI Aayog: Debates if it adequately addresses states' financial needs vs. erstwhile Planning Commission.
State Finances:
- Impact of COVID-19: Severe revenue shortfalls and increased expenditure, leading to higher borrowings.
- Fiscal Health: RBI's "State Finances" report notes improvement post-pandemic but cautions on rising committed expenditure (interest, pensions).
- Off-Budget Borrowings: Concerns about states using state-owned enterprises to mask liabilities; Centre includes these in borrowing ceilings.
- Old Pension Scheme (OPS): States reverting to OPS (e.g., Rajasthan, Chhattisgarh) pose long-term fiscal implications due to unfunded liabilities.
- Freebies/Welfare Schemes: Ongoing debate on their impact on state finances.
Prelims-ready Notes
- Const. Provisions: Arts 268-281. Seventh Schedule (Union, State, Concurrent Lists).
- Art 268: Duties levied by Union, collected & appropriated by States (e.g., stamp duties).
- Art 269: Taxes levied & collected by Union, assigned to States (e.g., certain inter-state trade taxes, now largely IGST).
- Art 269A: IGST (inter-state GST) – levied & collected by Union, apportioned.
- Art 270: Taxes levied & distributed between Union & States (divisible pool).
- Art 271: Surcharge on taxes – exclusively for Union (not in divisible pool).
- Grants-in-Aid: Art 275 (Statutory, FC recommends), Art 282 (Discretionary, for any public purpose).
- Quasi-judicial body, appointed by President every 5 years. Chairman + 4 members.
- Recommends: Vertical (Union to States share) & Horizontal (inter-se state share) devolution, grants-in-aid.
- Recommendations are advisory.
- Vertical: 41% to states.
- Horizontal criteria: Income Distance (45%), Population (15%), Area (15%), Forest & Ecology (10%), Demographic Performance (12.5%), Tax Effort (2.5%).
- Recommended Revenue Deficit Grants, Sector-Specific Grants, Local Body Grants.
- Subsumed many indirect taxes.
- GST Council (Art 279A): Federal body for GST recommendations. Centre: 1/3 vote; States: 2/3 vote. Decision: 3/4th majority.
- GST Compensation Cess: For 5 years (till June 2022) for states' revenue loss (14% guaranteed growth). Cess levy extended till March 2026 to repay loans.
- Sources: Property tax, fees, grants. Octroi largely subsumed.
- State Finance Commissions (SFCs - Art 243I, 243Y): Recommend resource sharing between State & Local Bodies.
Summary Table: Key Articles for Financial Relations
| Article | Subject Matter | Key Feature |
|---|---|---|
| 268 | Duties levied by Union, collected & appropriated by States | Stamp duties, excise on medicinal/toilet preps. |
| 269 | Taxes levied & collected by Union, assigned to States | Historically, inter-state sales tax. |
| 269A | Inter-State GST (IGST) | Levied by Union, apportioned based on GST Council recommendations. |
| 270 | Taxes levied by Union, distributed between Union & States (Divisible Pool) | Most major Union taxes (Income Tax, Corp Tax, part of CGST etc.). |
| 271 | Surcharge on certain taxes | Entirely for Union; not part of divisible pool. |
| 275 | Statutory Grants-in-Aid to States | Based on FC recommendations. |
| 280 | Finance Commission | Recommends distribution of taxes & grants. |
| 279A | GST Council | Recommends on GST matters. |
| 243I/Y | State Finance Commissions | Recommends resource sharing with local bodies within the state. |
Mains-ready Analytical Notes
- Centralization vs. Decentralization: Tension from cesses/surcharges, conditional grants.
- Equity vs. Efficiency in Horizontal Devolution: Balancing needs of poorer states with rewarding performance.
- GST: Cooperative Federalism vs. Erosion of State Autonomy: GST Council fosters cooperation, but states lost indirect tax autonomy, end of compensation.
- FRBM and Fiscal Discipline: Balancing consolidation with development, especially during crises.
- Role of Discretionary Grants (Art 282): Criticized for bypassing FC, undermining systematic allocation.
- Continuity: Basic constitutional framework, FC remains primary arbiter.
- Changes: Shift from plan grants (Planning Commission) to formula-based devolution; significant increase in vertical devolution (to 41-42%); GST fundamentally altered indirect tax landscape; growing importance of performance-based incentives; increasing share of cesses/surcharges.
- State Capacity: Financial health crucial for public service delivery and infrastructure.
- Regional Imbalances: Financial relations aim to reduce disparities, but challenges persist.
- Impact of Global Events: Affects revenues, straining federal fiscal relations.
- Political Dimensions: Often at the heart of Centre-State political dynamics.
- Cesses and Surcharges: CAG Report No. 11 of 2023: 25.1% of GTR in FY 2021-22.
- GST Compensation Shortfall (2020-22): Centre facilitated back-to-back loans (₹1.1 lakh cr FY21, ₹1.59 lakh cr FY22). Cess levy extended till March 2026 to repay loans.
- States' Fiscal Deficit: RBI's study projected decline to 3.1% of GDP for 2023-24 (BE) from 4.1% (2020-21).
- Debate on OPS: States like Rajasthan, Chhattisgarh reverting to OPS raise fiscal concerns (RBI cautions).
- Fiscal Responsibility and Budget Management (FRBM) Act: FC recommended specific fiscal glide paths.
- NITI Aayog's Indices: Reflect states' performance, sometimes linked to grants.
- Local Body Finances - 15th FC Focus: Emphasis on property tax reforms, timely audited accounts for grants.
Conclusion & Way Forward
Sound and harmonious Centre-State financial relations are indispensable for India's economic progress, cooperative federalism, and balanced regional development. While the constitutional framework and institutions like the Finance Commission provide a robust basis, continuous dialogue, trust, and adaptation to new economic realities like GST are essential.
Significance
Ensures fiscal autonomy and responsibility for states.
Promotes equitable distribution of resources.
Enables effective public service delivery across the nation.
Underpins the cooperative and competitive federal structure of India.
Way Forward
Greater Transparency in Fiscal Operations: Both at Centre and State levels, including off-budget liabilities.
Review of Cesses and Surcharges: Need for mechanism to share proceeds or limit excessive use.
Strengthening GST Council: Making it a more vibrant forum for resolving fiscal issues and ensuring revenue buoyancy.
Empowering Local Bodies: Ensuring timely SFC recommendations, improving own-source revenue, and capacity building.
Addressing Regional Disparities: FCs to refine criteria for persistent inequalities without disincentivizing performance.
Climate Change Financing: Incorporating climate action funding needs into fiscal transfers.
Regular Fiscal Dialogue: Establishing a permanent platform for Centre-State dialogue beyond FC cycle.
UPSC Previous Year Questions (PYQs)
Prelims MCQs
(UPSC 2017) Consider the following statements:
- The Finance Commission of India is a statutory body.
- The Constitution of India envisages the Finance Commission to be the balancing wheel of fiscal federalism in 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
Answer: (b)
Hint/Explanation: FC is a constitutional body (Art 280), not statutory. Statement 2 is correct for its role in resource distribution.
(UPSC 2010 - Modified) Which of the following is/are not shared by the Central Government with State Governments?
- Corporation Tax
- Customs Duty
- Surcharge on Income Tax
- Integrated Goods and Services Tax (IGST)
Select the correct answer using the code given below:
(a) 3 only (b) 1 and 2 only (c) 2 and 3 only (d) 1, 2, 3 and 4
Answer: (a)
Hint/Explanation: Corporation Tax, Customs Duty, and IGST are part of the divisible pool. Surcharge on Income Tax (Art 271) goes exclusively to the Centre.
Mains Questions
(UPSC 2021) How have the recommendations of the 14th Finance Commission of India enabled the States to improve their fiscal position?
Brief Direction: Highlight 14th FC's key recommendation (42% vertical devolution) and explain how it provided untied funds, enhanced fiscal autonomy, reduced dependence on discretionary grants. Analyze actual impact with data if possible.
(UPSC - Similar themes often asked) Discuss the rationale for the 15th Finance Commission's recommendations on horizontal tax devolution. Do you think they adequately address the concerns of equity and efficiency among Indian states?
Brief Direction: Explain horizontal devolution, list 15th FC criteria (Income Distance, Population, Area, Forest & Ecology, Demographic Performance, Tax Effort) and their rationale. Critically analyze if they balance equity (poorer states) and efficiency (performing states) adequately, noting any controversies.
Original MCQs for Prelims
1. Which of the following statements correctly describes 'Vertical Devolution' as recommended by the Finance Commission of India?
(a) The criteria used for distributing tax revenue among different states.
(b) The share of the net proceeds of Union taxes that is assigned to the States.
(c) Grants provided to states to cover their revenue deficits after tax devolution.
(d) Measures to augment the Consolidated Fund of a State for Panchayats and Municipalities.
Answer: (b)
Explanation: Vertical devolution refers to the division of the divisible pool of taxes between the Union and the States as a whole. Horizontal devolution (a) refers to the inter-se distribution among states. (c) refers to revenue deficit grants. (d) refers to local body grants.
2. Consider the following regarding the Goods and Services Tax (GST) regime in India:
- The GST Council is a constitutional body headed by the Union Home Minister.
- All decisions of the GST Council are taken by a simple majority of the members present and voting.
- The GST Compensation Cess was levied for a period of ten years to compensate states for revenue loss.
Which of the statements given above is/are incorrect?
(a) 1 and 2 only (b) 2 and 3 only (c) 1 and 3 only (d) 1, 2 and 3
Answer: (d)
Explanation: 1. Incorrect: GST Council (Art 279A) is headed by the Union Finance Minister. 2. Incorrect: Decisions require a 3/4th majority. 3. Incorrect: GST Compensation Cess was for five years (July 2017 - June 2022).
3. Which of the following criteria was newly introduced by the 15th Finance Commission for horizontal devolution of taxes among states?
(a) Income Distance
(b) Population (2011)
(c) Demographic Performance
(d) Forest Cover
Answer: (c)
Explanation: 'Demographic Performance' was a distinct criterion introduced by the 15th FC to reward states for efforts in population control. 'Tax Effort' was also new.
Original Descriptive Questions for Mains
1. "The Indian fiscal federalism framework, while robust, faces persistent challenges from issues like the increasing use of cesses and surcharges by the Union and the complexities arising from the GST regime." Critically evaluate this statement and suggest measures to foster greater fiscal harmony between the Centre and the States. (15 marks, 250 words)
Key Points/Structure: Introduction (strengths, tension). Challenges from Cesses/Surcharges (outside divisible pool, increasing share, reduced states' share). Complexities from GST (end of compensation, GST Council functioning, impact of rate changes). Critical Evaluation (acknowledge legitimate needs, GST benefits). Measures for Harmony (share cesses, strengthen GST Council, alternative revenue protection, regular dialogue, transparency). Conclusion.
2. Analyze the role of State Finance Commissions (SFCs) in strengthening the financial health of local bodies in India. What are the primary impediments to their effective functioning, and how can their recommendations be better implemented? (10 marks, 150 words)
Key Points/Structure: Introduction (SFC constitutional mandate). Role of SFCs (review financials, recommend distribution/grants, suggest revenue measures). Impediments (irregular constitution/delays, non-implementation by states, lack of SFC autonomy, poor data, states' reluctance to devolve power). Measures for Implementation (binding recommendations, timely constitution, capacity building, linking CFC grants to SFC implementation, political will). Conclusion.