The Indian Constitution provides a detailed framework for the distribution of financial resources between the Union and the States, primarily structured to address the inherent vertical and horizontal fiscal imbalances.
Key Constitutional Provisions
- Article 268: Duties levied by the Union but collected and appropriated by the States (e.g., stamp duties on certain financial instruments).
- Article 269: Taxes levied and collected by the Union but assigned to the States (e.g., taxes on the inter-state sale of goods, prior to GST framework modifications).
- Article 269A: Insertion via the 101st Constitutional Amendment Act; mandates that Goods and Services Tax (GST) on supplies in the course of inter-state trade or commerce shall be levied and collected by the Government of India and apportioned between the Union and the States on the recommendations of the GST Council.
- Article 270: Taxes levied and distributed between the Union and the States. This forms the “Divisible Pool” of central taxes, which excludes specific cesses and surcharges.
- Article 271: Empowers Parliament to levy surcharges on certain taxes for Union purposes, which do not form part of the divisible pool shared with states.
- Article 275: Statutory Grants-in-Aid provided to specific states in need of assistance, charged on the Consolidated Fund of India, based on Finance Commission recommendations.
- Article 280: Mandates the constitution of a Finance Commission every five years by the President of India to recommend the distribution of tax proceeds.
- Article 282: Autonomy given to both the Union and States to make grants for any public purpose, widely utilized for Centrally Sponsored Schemes (CSS).
- Article 293: Regulates the borrowing powers of the States, requiring central consent if a state has outstanding central loans.
Core Vectors of Inter-State Fiscal Friction
The structural dynamics of Indian fiscal federalism feature a high degree of centralization of tax powers (vertical imbalance) alongside sharp variations in the economic and demographic capacities of individual states (horizontal imbalance).
The Problem of Surcharges and Cesses
The Union government has increasingly relied on cesses and surcharges to raise revenue. Under Article 271, these collections are kept entirely by the Centre and are not shared with the states through the divisible pool. This practice effectively reduces the states’ actual share in gross central tax revenues below the headline percentage recommended by the Finance Commission.
Centrally Sponsored Schemes (CSS) and Fiscal Autonomy
The proliferation of Centrally Sponsored Schemes introduces rigid expenditure structures for states. CSS require states to match a specific percentage of funding (typically 40% for general category states and 10% for North-Eastern and Himalayan states). This shifts state budgetary resources away from local priorities toward federally determined schemes, reducing state-level fiscal autonomy.
Off-Budget Borrowings and Article 293(3) Strictures
The Union Ministry of Finance enforces strict borrowing limits under Article 293(3). State off-budget borrowings—loans raised by state-owned public sector undertakings or special purpose vehicles backed by state guarantees—are counted against the state’s net borrowing ceiling. This policy aims to maintain macro-fiscal stability but limits the capacity of states to fund infrastructure developments.
Horizontal Equity and the Finance Commission Dilemma
The primary mechanism to resolve inter-state fiscal disparity is the Finance Commission’s horizontal devolution formula. However, balancing historical structural backwardness against administrative performance remains a source of political and fiscal debate.
Evolution of Devolution Criteria
| Criteria | 14th Finance Commission | 15th Finance Commission | Focus Area |
| Income Distance | 50.0% | 45.0% | Equity based on distance from the highest-income state. |
| Population (1971) | 17.5% | — | Discontinued to reward demographic stabilization. |
| Population (2011) | 10.0% | 15.0% | Measures the absolute need for public services. |
| Area | 15.0% | 15.0% | Accounts for administrative costs over larger territories. |
| Forest & Ecology | 7.5% (Forest Cover) | 10.0% (Forest & Ecology) | Incentivizes environmental conservation and carbon sinks. |
| Demographic Performance | — | 12.5% | Rewards states that reduced Total Fertility Rates (TFR). |
| Tax & Fiscal Efforts | — | 2.5% | Rewards revenue mobilization and efficiency. |
The Southern vs. Northern States Demographic Divide
The adoption of the 2011 Census population data by the 15th Finance Commission replaced the dual usage of 1971 and 2011 data seen in previous commissions. Southern states (such as Kerala, Tamil Nadu, and Karnataka) argued that this penalized them for successfully implementing national population control policies over four decades. To balance this effect, the Commission introduced the “Demographic Performance” criterion, which rewards states with lower fertility rates.
The GST Regime and Inter-State Compensation
The implementation of the Goods and Services Tax (GST) transformed India from a production-based taxation model to a destination-based consumption taxation model, fundamentally rewriting inter-state economic dynamics.
Transition from Origin to Destination-Based Taxation
Prior to GST, manufacturing states (such as Gujarat, Maharashtra, and Tamil Nadu) collected Central Sales Tax (CST) on inter-state sales, retaining revenues at the point of origin. Under GST, the revenue accrues to the consuming state (such as Bihar, Uttar Pradesh, and West Bengal). This structural shift benefited consuming states while creating revenue anxieties for manufacturing hubs.
The Compensation Cess Conundrum
To secure state consensus for the 101st Constitutional Amendment, the Union guaranteed a 14% compound annual revenue growth rate to states, promising to make up any shortfalls for the first five years (2017–2022) through a dedicated GST Compensation Cess. The economic disruption during the 2020–2021 pandemic slowed collections, leading to disputes over the definition of revenue shortfalls and forcing the Union to borrow on behalf of states to bridge the gap.
Institutional Mechanisms and Reform Pathways
Resolving inter-state fiscal issues requires balanced, institutionalized platforms where both tiers of government can address emerging macroeconomic challenges.
The Role of the GST Council
The GST Council established under Article 279A is a notable example of cooperative federalism. It provides a formal vote-share mechanism where the Union holds one-third of the voting power and all states combined hold two-thirds. A three-fourths majority is required to pass any resolution, giving the states collective leverage over tax rates, exemptions, and administrative rules.
Revitalizing the Inter-State Council
Unlike the GST Council, the Inter-State Council (Article 263) lacks a standing mandate for binding fiscal decisions. Analysts and state governments frequently call for the institutional revitalization of this body to resolve non-GST fiscal frictions, such as the design of Centrally Sponsored Schemes and the expanding scope of Article 271 surcharges.
Fact Sheet: Core Terminology for UPSC Prelims
- Vertical Imbalance: The structural mismatch where the expenditure responsibilities of states are disproportionate to their independent tax-raising powers.
- Horizontal Imbalance: The fiscal disparity among different states, driven by variations in industrialization, resource endowments, and demographic factors.
- Divisible Pool: The total collection of central taxes that can be shared with states under Article 270, specifically excluding Union cesses, surcharges, and administrative costs of collection.
- Net Borrowing Ceiling (NBC): The total limit on borrowings imposed annually on states by the Centre under Article 293(3), typically pegged as a percentage of the State Gross Domestic Product (SGDP).