Fiscal Federalism

Fiscal federalism refers to the division of financial responsibilities, taxing powers, and revenue-sharing mechanisms between the central government and the state governments. In India, this structure is designed to balance the financial autonomy of states with the economic stability and unity of the nation. It is primarily governed by Constitutional provisions under Part XII, statutory bodies like the Finance Commission, and executive mechanisms.

Constitutional Framework of Centre-State Financial Relations

The Constitution of India distributes taxing powers and financial resources to ensure clear demarcation, though it maintains a strong central bias to handle national economic challenges.

Distribution of Legislative Powers to Levy Taxes

The Seventh Schedule of the Constitution divides the taxation powers between the Centre and the States through three distinct lists:

• Union List (List I): The Central Government has exclusive power to levy taxes on subjects of national importance. Key examples include Income Tax (except agricultural income), Corporation Tax, Customs Duties, and Central Excise Duties (on tobacco and manufactured goods except alcohol and narcotics).
• State List (List II): State Governments hold exclusive power to levy taxes on localized subjects. Key examples include Land Revenue, Agricultural Income Tax, Duties of Excise on alcoholic liquors for human consumption, Stamp Duty (except those in Union List), State Excise Duty, and Taxes on vehicles, professions, and entertainment.
• Concurrent List (List III): This list generally does not contain specific taxation powers to avoid double taxation, except for the shared framework introduced by the 101st Constitutional Amendment Act for the Goods and Services Tax (GST).

Classification of Tax Revenues (Articles 268 to 271)

The Constitution outlines specific arrangements for the collection and appropriation of Union taxes to manage the financial requirements of both tiers of government:

Mechanisms for Financial Adjustment: Grants-in-Aid

To correct structural imbalances where states’ expenditure responsibilities exceed their revenue-raising capacities (vertical imbalance), the Constitution provides for Grants-in-Aid from the Centre to the States.

Statutory Grants (Article 275)

• Nature: Charged on the Consolidated Fund of India every year.
• Authority: Provided on the recommendation of the Finance Commission.
• Purpose: Given to specific states in need of financial assistance, particularly for promoting the welfare of Scheduled Tribes or raising the administration level of Scheduled Areas. It varies from state to state.

Discretionary Grants (Article 282)

• Nature: Both the Centre and the States can make grants for any public purpose, even if the subject does not fall within their respective legislative competence.
• Authority: Purely executive discretion, not bound by Finance Commission recommendations.
• Historical Context: Previously used extensively by the Central Government to allocate funds under Central Sector Schemes and Centrally Sponsored Schemes.

Institutional Pillars of Indian Fiscal Federalism

The Finance Commission (Article 280)

The Finance Commission is a quasi-judicial statutory body constituted by the President of India every five years (or earlier) to institutionalize the financial transfers from the Centre to the States.

Core Mandate and Duties

• Recommending the distribution of net proceeds of taxes between the Centre and States (Vertical Devolution).
• Recommending the allocation of these tax shares among the states themselves (Horizontal Devolution).
• Specifying principles governing Grants-in-Aid to states under Article 275.
• Recommending measures to augment the Consolidated Fund of a State to supplement resources of local bodies (Panchayats and Municipalities) based on State Finance Commission recommendations.

Horizontal Devolution Criteria Comparison

The criteria used by the recent Finance Commissions reflect balancing equity (helping poorer states) and efficiency (rewarding fiscal performance):

Trivia for Prelims: The 14th Finance Commission significantly increased the vertical devolution share from 32% to 42%. The 15th Finance Commission adjusted this to 41% for the period 2021–2026, keeping 1% aside for the newly formed Union Territories of Jammu & Kashmir and Ladakh.

The Goods and Services Tax (GST) Council (Article 279A)

Introduced via the 101st Constitutional Amendment Act, the GST Council is a joint forum of the Centre and the States.

• Composition: Chaired by the Union Finance Minister, with the Union Minister of State for Revenue/Finance and State Finance Ministers as members.
• Voting Pattern: The Central Government holds one-third (33.3%) of the total voting power, while all State Governments combined hold two-thirds (66.6%) of the voting power.
• Decision-Making: Decisions require a three-fourths (75%) majority of the weighted votes of members present and voting, forcing consensus between Centre and States.

Borrowing Powers and Financial Emergencies

Borrowing Powers (Articles 292 and 293)

• Centre (Article 292): The executive power of the Union extends to borrowing money both within India and from abroad upon the security of the Consolidated Fund of India, within limits set by Parliament.
• States (Article 293): State governments can borrow money only domestically within India upon the security of the Consolidated Fund of the State.
• Key Restriction: A State cannot raise any fresh loan without the consent of the Centre if there is still outstanding any part of a previous loan given to the State by the Centre or in respect of which the Centre has given a guarantee.

Financial Emergency (Article 360)

During the operation of a Financial Emergency declared by the President of India:

• The executive authority of the Centre extends to giving directions to any State to observe specified canons of financial propriety.
• The President can issue directions for the reduction of salaries and allowances of all or any class of persons serving the State, including Judges of the High Courts.
• The Centre can require all Money Bills or Financial Bills passed by State Legislatures to be reserved for the consideration of the President.

Key Challenges in Contemporary Fiscal Federalism

Proliferation of Cess and Surcharges

The Central government has increasingly relied on Cesses (taxes levied for specific purposes like education or health) and Surcharges. Under Article 271, these proceeds do not enter the divisible pool shared with states. This reduces the effective share of revenue states receive compared to the headline Finance Commission devolution target.

Centrally Sponsored Schemes (CSS)

CSS are programs where funding is split between the Centre and States (e.g., 60:40 or 90:10 for North-Eastern states), but the implementation terms are designed by central ministries. States argue this limits their flexibility to tailor schemes to local geographic and economic realities.

Fiscal Discipline vs. Welfare Autonomy

Under the Fiscal Responsibility and Budget Management (FRBM) frameworks, the Centre sets limits on state net borrowing requirements. Tensions arise when states demand relaxed borrowing ceilings to handle economic downturns, disasters, or localized welfare priorities.