Fiscal Federalism in India

Fiscal Federalism in India


Fiscal federalism in India operates through a complex interplay of principles and mechanisms aimed at ensuring balanced development and cooperative governance between central and state authorities.

The Finance Commission serves as a linchpin in this framework, facilitating equitable distribution of resources and fostering cooperative federalism.

What is Fiscal Federalism?

  • Fiscal federalism refers to the distribution of financial powers and responsibilities among different levels of government within a country.
  •  It encompasses decisions about which government level provides specific services, how revenues are generated and shared, and the allocation of transfers or grants to ensure effectiveness and fairness.
  • It involves dividing responsibilities and resources between central and state governments, with the Finance Commission crucial for recommending tax proceeds distribution.

Tools for Achieving Fiscal Federalism

  • Constitutional Assignment of Taxation and Expenditure Powers: The Constitution of India delineates taxation and expenditure powers between the central government and state governments, establishing clear boundaries.
  • Finance Commission: Mandated by Article 280 of the Constitution, the Finance Commission recommends the distribution of tax revenues between the central and state governments. It also proposes measures to enhance states' financial resources, promote fiscal discipline, and ensure stability.
  • Goods and Services Tax (GST): GST is a unified indirect tax replacing multiple central and state taxes on goods and services. Administered by the GST Council comprising representatives from both levels of government, it streamlines tax administration and fosters fiscal cooperation.
  • Grants-in-Aid System: Articulated in Article 275, the grants-in-aid system involves discretionary fund transfers from the central government to state governments for specific purposes or schemes. These grants aim to bolster state resources, mitigate regional disparities, and address developmental gaps.


  • Fiscal Equivalency: Public goods provision order determined by the jurisdiction should encompass individuals consuming them, often requiring multiple overlapping jurisdictions.
  • Decentralisation Theorem: Each public service should be provided by the jurisdiction controlling the minimum geographic area internalizing benefits and costs.
  • Principle of Subsidiarity: Functions performed at the lowest government level, implying a hierarchical structure.

Finance Commission

  • Serves as the balancing wheel of fiscal federalism.
  • Constitutional Provision: Article 280 establishes the Finance Commission as a quasi-judicial body, constituted every fifth year or earlier by the President of India.
  • Functions: Recommends financial relations between the central government and state governments, covering:
    • Share of Union government's taxes to be devolved to states.
    • Grants to states to address revenue deficits.
    • Other grants to states and local governments. 

Equitable Intergovernmental Transfers

    • Purpose: Vital for balanced regional development, reducing fiscal imbalances, and promoting cooperative federalism.
    • Federalism: Combines general and regional governments within a single political system, dividing powers between the two.
  • Constitutional Structure:
    • Centralization: Constitution leans towards a significantly centralized federal structure, with most revenue-raising powers vested in the Union government.
    • Importance of Transfers: Union government transfers to states crucial for their fiscal space.

Perspectives of Previous Commissions and Committees on Centre-State Relations in India

  • First Administrative Reforms Commission (1966)
    • The Union Government's Role: Should primarily serve as a pioneer, guide, disseminator of information, overall planner, and evaluator in areas delineated in the State List of subjects in the Constitution.
  • Rajamannar Committee (1969)
    • Consultation Protocol with Inter-State Council: Proposes that the Union government refrain from making decisions impacting states' interests without prior consultation with the Inter-State Council.
    • Residual Taxation Power: Suggests that residual taxation authority be vested with the states.
  • Sarkaria Commission (1988)
    • Streamlining Centrally Sponsored Schemes: Advocates for a reduction in the number of centrally sponsored schemes and stresses the importance of involving state governments in determining their content and coverage to accommodate local nuances.
  • Punchhi Commission (2010)
    • Reviewing Transfer Mechanisms: Recommends a thorough review of transfers to states, especially through centrally sponsored schemes, aiming to minimize discretionary transfers.
  • Report of the Sub-Group of Chief Ministers on Rationalisation of Centrally Sponsored Schemes (2015)
    • Restructuring of Schemes: Suggests downsizing the existing centrally sponsored schemes to a maximum of 30, transforming each scheme into an umbrella framework comprising multiple components with uniform funding patterns.

Challenges in India's Fiscal Federalism

Tax Devolution Disparities

  • Less populous southern states with stronger fiscal positions receive lower tax devolution shares compared to weaker northern states.
  • Despite a 10-percentage point increase in tax devolution recommended by the 15th Finance Commission, the divisible pool has shrunk due to increased cesses and surcharges.

Issues with the Seventh Schedule

  • The Concurrent List's expansion encroaches on the domains of subnational governments, leading to overlapping responsibilities.
  • Acts like the Mahatma Gandhi National Rural Employment Guarantee Act and the Right to Education Act impose additional financial burdens on states.
  • States incur a significant portion of expenditure (62.4%) but have access to a smaller share of resources (37.3%).

Incongruence of Article 282

  • Article 282 allows discretionary grants by the Union and states for 'public purposes', but it's being used extensively, exceeding legislative competences.
  • Numerous centrally sponsored schemes add to the financial burden of both Union and state governments.

Issues with GST

  • While GST streamlines indirect taxes, states lose autonomy over tax rates, leading to dependence on the center for funds.

Finances of the Third Tier of Government

  • Inadequate integration of panchayat raj institutions and municipalities into fiscal federalism.

Limits on State Borrowings

  • Net Borrowing Ceiling (NBC) restricts states' borrowing capacity, affecting their ability to meet financial requirements.
  • Imposition of NBC by the Centre on states like Kerala is contested, citing violations of constitutional provisions.

Determining State Finances

  • State borrowing requires consent from the Centre if any previous loans from the Center are outstanding, limiting states' financial autonomy.
  • Parliament lacks authority to legislate on 'Public Debt of the State', as per the State List of the Constitution.

Strategies to Strengthen India's Fiscal Federalism

  • Equity-Oriented Intergovernmental Transfers: Design transfers to promote equity, addressing both horizontal (among states) and vertical (between central and state governments) fiscal imbalances.
  • Performance-Based Grants: Introduce grants rewarding states for achieving developmental targets, encouraging effective governance and results-oriented policies.
  • Constitutional Reforms: Revisit Articles 246 and the Seventh Schedule to redefine powers and responsibilities, clarifying functions at each level and enhancing efficiency.
  • Empowering Local Governments: Strengthen local governments by providing resources, functions, and autonomy, ensuring they can make decisions impacting their communities.
  • Uniform Financial Reporting System: Implement standardized financial reporting across all government levels to maintain transparency, accountability, and efficient fiscal management.
  • Review Off-Budget Borrowing: Address off-budget borrowings to prevent hidden liabilities, ensuring transparency in fiscal management.
  • Convergence of Development Indicators: Allocate funds based on a combination of economic and social indicators, promoting overall well-being alongside economic development.
  • Fiscal Responsibility and Budget Management (FRBM) Act: Align FRBM Act provisions for central and state governments to maintain fiscal discipline while accommodating unique fiscal situations.
  • Devolving Tax Powers: Provide states with more control over taxation to generate revenue according to local conditions and priorities.
  • Cooperative Federalism: Foster cooperation between central and state governments to design and implement policies benefiting the nation as a whole.
  • Regular Review and Dialogue: Establish mechanisms for ongoing review and dialogue between central and state governments to address fiscal challenges and improve the fiscal federalism framework.

Steps Forward for India’s Fiscal Federalism

  • 16th Finance Commission Directives
    • Review Tax-Sharing Principles: Align tax-sharing mechanisms with India’s evolving fiscal federalism, focusing on consolidating the indirect tax base between the Union and states.
    • Revamp Statutory: Sharing of Indirect Taxes Reevaluate and redesign the statutory sharing of indirect taxes, both vertically and horizontally, to adapt to the changing landscape.
    • Vertical Devolution: Redefine the divisible pool and procedures for integrating Integrated GST (IGST), including unsettled IGST with input tax credit.
    • Horizontal Devolution: Revisit criteria for distributing the divisible pool among states, especially concerning equalizing grants, to reflect the shift to a consumption-based tax system.
  • Revisiting Article 246 and the Seventh Schedule
    • Reform the division of power between the Union and the States to accommodate India's transition from one-party governance to a multi-party system, ensuring cooperative federalism.
  • Rationalizing Central Spending
    • Establish a credible approach to rationalize Central Sector Schemes (CSS) and Central outlays, ideally in collaboration with state governments.
    • Explore mechanisms for financial rationalization of CSS, considering NITI Aayog’s role primarily as a Think Tank.
  • New List for Third Tier Governance
    • Develop a comprehensive local list delineating the functional and financial responsibilities of panchayat raj institutions and municipalities.
    • Transfer irrelevant items from the State list to this new local list to streamline governance at the grassroots level.
  • Expanding Scope of GST to Boost Revenue
    • Broaden the scope of GST to include electricity, petrol, diesel, real estate, and agriculture, establishing a broader taxation base to address revenue shortages and foster economic growth.