Fiscal federalism

The first principle

The Constitution gives the Union the taxes that are easy to collect and grow fast, such as income tax, corporation tax and customs, because a national market is best taxed at the national level. It gives the states most of the work that touches citizens, such as police, health, agriculture and schools, because those are best done close to the people. The result is a built in gap between what states must spend and what they can raise, called vertical fiscal imbalance, and every institution in this note, from the Finance Commission to the Goods and Services Tax (GST) Council, exists to close that gap without taking away the states' freedom to decide how to spend.

The core

Who taxes what

• The lists. Taxing powers sit in the Union and State Lists rather than the Concurrent List, so before GST the two levels taxed separate bases. The Union takes income other than agricultural income, corporation tax, customs and excise on tobacco; the states take land revenue, agricultural income, stamp duty on most documents, alcohol, and electricity and vehicle taxes.
• The imbalance. States carry out roughly three fifths of general government spending but raise much less than that share of revenue, so transfers from the Union are a permanent feature, not a favour.
• The divisible pool. Since the Eightieth Amendment (2000), all central taxes go into one pool shared with states under Article 270, but cesses and surcharges are kept out of it. When their share in central revenue rises, the states' real share of central taxes falls, even if the Finance Commission's percentage stays the same.

The Finance Commission

• Constitution under Article 280. The President constitutes a Finance Commission (FC) every five years, or earlier, with a chairperson and four other members. The Finance Commission (Miscellaneous Provisions) Act, 1951 lays down the qualifications: the chairperson must have experience in public affairs, and the members are drawn from those qualified to be High Court judges, those with special knowledge of government finance and accounts, those with wide experience of financial administration, and those with special knowledge of economics.
• Duties. The FC recommends how the net proceeds of shared taxes are divided between the Union and the states (vertical devolution) and among states (horizontal devolution); the principles for grants in aid under Article 275; and, since the Seventy third and Seventy fourth Amendments (1992), measures to augment state funds for panchayats and municipalities on the basis of State Finance Commission reports. The President may refer any other matter in its terms of reference.
• Status. Its report goes to the President and is laid before Parliament with an explanatory memorandum (Article 281). The recommendations are advisory in law, but devolution shares have been accepted in practice.

Grants and borrowing

• Article 275 and Article 282. Statutory grants under Article 275 go to states in need on the FC's advice. Discretionary grants under Article 282, for any public purpose, carry the centrally sponsored schemes and were the channel for Planning Commission assistance.
• Article 293. A state may borrow only within India, and if it owes money to the Union, it needs the Union's consent for fresh loans. The Fiscal Responsibility and Budget Management (FRBM) Act, 2003 and state laws modelled on it cap deficits, usually around 3 per cent of Gross State Domestic Product (GSDP) for states, with extra room tied to reforms. In State of Kerala v Union of India (2024), Kerala's suit against the counting of borrowings by state entities in its limit was referred by the Supreme Court to a Constitution Bench, the first time Article 293 is to be authoritatively interpreted.

Dimensions

From planned development to the present

• The planning era. The Planning Commission (1950), set up by an executive resolution, controlled plan transfers outside the FC. The Gadgil formula (1969) shared central plan assistance mainly by population and per capita income, with a portion set aside for special category states, and later versions changed the weights. The result was two parallel channels, one constitutional and one administrative, and states complained that the second came with conditions.
• NITI Aayog (2015). The National Institution for Transforming India (NITI) Aayog replaced the Planning Commission on 1 January 2015 as a think tank without power to allocate funds. The plan and non plan distinction was ended from 2017 to 2018, so the FC became the main channel of untied transfers.
• Fourteenth Finance Commission (Y. V. Reddy, award 2015 to 2020). It raised the states' share of the divisible pool to 42 per cent from 32 per cent, the largest increase ever. This gave states more untied money to spend on their own priorities, and it led to a restructuring of centrally sponsored schemes, with a higher state share in many of them. Part of the gain was offset by the growth of cesses and surcharges, which fall outside the pool, and by the states' larger contribution to shared schemes.
• Fifteenth Finance Commission (N. K. Singh, 2020 to 2026). It set the share at 41 per cent, one point lower to account for the conversion of Jammu and Kashmir into Union territories. Its terms of reference used the 2011 population, which southern states feared would penalise them for having controlled population growth; the FC responded with a demographic performance criterion. It retained income distance as the main equalising criterion and added tax effort.
• Sixteenth Finance Commission (Arvind Panagariya). Constituted in December 2023, it covers the five years from 2026 to 2031, and its terms of reference include a review of how disaster management is financed.

Source: Reports of the Eleventh to Fifteenth Finance Commissions.

Source: Reports of the Fourteenth and Fifteenth Finance Commissions.

In practice

The Goods and Services Tax

• The One hundred and first Amendment (2016). Article 246A gives Parliament and state legislatures a simultaneous power to make GST laws, with Parliament alone covering inter state supply. Article 269A provides for Integrated GST on inter state trade, collected by the Union and shared with states. The amendment needed ratification by half the states because it changed taxing powers.
• What it subsumed. Union excise, service tax and additional customs duties, and state value added tax, entry tax, luxury and entertainment taxes and central sales tax were merged into one tax. Alcohol for human consumption is outside GST, and five petroleum products stay outside until the Council recommends otherwise.
• The GST Council (Article 279A). The Union Finance Minister chairs it, with the Union Minister of State for Finance and the finance ministers of all states as members. The Union vote carries one third of the weight and all states together two thirds, and a decision needs three fourths of the weighted votes, so neither side can act alone.
• Union of India v Mohit Minerals (2022). The Supreme Court held that the Council's recommendations are persuasive, not binding, because Parliament and states hold simultaneous power and the Council is a forum for dialogue, not a superior legislature.
• Compensation and reform. The GST (Compensation to States) Act, 2017 guaranteed states 14 per cent annual growth over 2015 to 2016 revenue for five years; the guarantee ended in June 2022, and the cess was continued to repay loans taken to cover the pandemic shortfall. In September 2025 the Council rationalised rates mainly into slabs of 5 and 18 per cent, with 40 per cent on a few luxury and harmful goods.

Does GST reflect accommodative federalism?

• Yes, in design. It is a case of pooled sovereignty: both levels gave up separate taxing powers to create one national market and a joint body in which neither can impose its will. The Council has taken almost all its decisions by consensus.
• Less so in effect. States lost the freedom to set their own rates on most goods, and became dependent on compensation; the 2020 shortfall and the end of compensation in 2022 strained trust. The dispute resolution mechanism that Article 279A(11) provides for has not been set up.

Local bodies

• Third tier. State Finance Commissions under Articles 243I and 243Y recommend how state revenues are shared with panchayats and municipalities; their delays and weak acceptance are covered in the notes on panchayats and urban local bodies.

Issues and way forward

• Cesses and surcharges. Their growth shrinks the pool shared with states. Capping their share in gross tax revenue, or bringing them into the pool after a period, would protect the spirit of Article 270.
• Conditional transfers. Centrally sponsored schemes and incentive grants pull state budgets towards Union priorities. Fewer, larger schemes with flexible funds would restore choice to states.
• Borrowing limits. Disputes over net borrowing ceilings, now before the Constitution Bench, call for transparent rules agreed with states, possibly through an independent fiscal council.
• Equity against efficiency. Southern and western states argue that equalising transfers penalise good performance. Weighting criteria such as demographic performance and tax effort, as the Fifteenth FC began to do, balances the two aims.
• GST institutions. A standing dispute resolution body and a secretariat with state representation would make the Council the federal forum it was meant to be.

Common confusions

• Finance Commission and NITI Aayog. The FC is a constitutional body that recommends tax shares and grants; NITI Aayog is an executive think tank with no power to allocate funds.
• Divisible pool and gross tax revenue. The pool excludes cesses, surcharges and collection costs, so 41 per cent of the pool is a smaller share of gross tax revenue.
• Article 275 and Article 282. The first gives statutory grants on the FC's advice; the second gives discretionary grants for any public purpose.

For the exam

• Keyword bank: vertical fiscal imbalance, divisible pool, cesses and surcharges, Article 280, Finance Commission (Miscellaneous Provisions) Act, 1951, terms of reference, income distance, demographic performance, Article 246A, GST Council, pooled sovereignty, Mohit Minerals, Article 293, Gadgil formula, State Finance Commission.
• Practise the previous year questions on this topic →
• Use in an answer:
  • Introduction with data: "The Fourteenth Finance Commission raised the states' share of the divisible pool from 32 to 42 per cent, the largest single increase in the history of fiscal transfers."
  • Introduction with a judgement: "In Mohit Minerals (2022) the Supreme Court held that GST Council recommendations are persuasive, not binding, describing the Council as a forum for dialogue between the Union and the states."
  • Conclusion: "Fiscal federalism in India has moved from planning to rules, but its health will depend on keeping the divisible pool from shrinking through cesses and on giving states real choice over the money they receive."
  • Conclusion: "A Finance Commission that rewards performance as well as need, and a GST Council that settles disputes within itself, would make transfers a source of trust between the Union and the states."