Fiscal Federalism in India – Significance & Challenges – Explained Pointwise

Fiscal federalism in India balances resource distribution between the Union and states to ensure cooperative governance. The 16th Finance Commission, chaired by Dr. Arvind Panagariya, retained vertical tax devolution at 41% while introducing performance-driven criteria like GDP contribution. This framework aims to harmonize regional equity, fiscal discipline, and sub-national autonomy for 2026-31.

What is Fiscal Federalism? What are the constitutional provisions which provide for Fiscal Federalism in India?

• Fiscal Federalism: Fiscal federalism refers to the division of financial powers and responsibilities between the central government and state governments in India.
• Constitutional Provisions: The Indian Constitution defines the taxation and expenditure powers of the central and state governments through various provisions:
  1. Seventh Schedule: The Constitution assigns specific tax bases to the central and state governments, listed in the Union List and State List respectively.
  2. Article 270: Article 270 of the Indian Constitution provides for the distribution of net tax proceeds collected by the Union government between the Centre and the States.
  3. Article 280: The Finance Commission which is a constitutional body under Article 280, recommends the sharing of tax revenues and grants-in-aid to the states.
  4. Article 275: It provides for the grants-in-aid system which involves discretionary transfers from the Centre to states for specific purposes.
• Examples of Cooperative Fiscal Federalism:
  1. Introduction of GST: The introduction of Goods and Services Tax (GST) through the 101st Constitutional Amendment is a historic example of cooperative fiscal federalism in India. The GST act has transformed India’s indirect tax landscape, and fostered Centre-State cooperation.
  2. Passage of FRBM Act: The Fiscal Responsibility and Budget Management (FRBM) Act 2003 aims to promote fiscal discipline at the central and state levels. 21 states enacted their own FRBM Acts, incentivized by debt and interest rate relief provided by the 12th Finance Commission. This is a historic example of centre-state cooperation in maintenance of Fiscal prudence.
  3. Introduction of performance based grants: Performance-based grants are being used to incentivize states to achieve developmental targets. This has led to competitive and cooperative federalism between the Centre and States in the sphere of finances and public expenditure.

What are the Challenges to Fiscal Federalism in India?

1. Vertical Fiscal Imbalance: States bear a disproportionate share of expenditure responsibilities (agriculture, health, education, law and order, rural development) relative to their revenue-raising powers. The Centre collects a larger share of aggregate revenue but has comparatively fewer expenditure obligations, making states dependent on transfers.
2. Reduced Financial Transfers to the States: The share of states in the gross tax revenue (total tax revenue collected, which includes cess and surcharges) has decreased from 35% in 2015-16 to 30% in 2023-24.
3. Disproportionate Growth between Union Govt’s & State Govt’s Revenue: From 2015-16 to 2023-24, while the Union government’s tax revenue has increased by 2.3 times from ₹14.6 lakh crore to ₹33.6 lakh crore, the states’ share in the tax revenue has only doubled from ₹5.1 lakh crore to ₹10.2 lakh crore. This indicates a disproportionate growth between Union Govt’s and State Govt’s Revenues.
4. Decrease in Grants-in-Aid to the states: Direct financial support to states, in the form of grants-in-aid, has declined from ₹1.95 lakh crore in 2015-16 to ₹1.65 lakh crore in 2023-24.
5. Increase in the share of non-devolvable cess and surcharge: The increasing reliance on cesses and surcharges, which are not shareable with States under Article 270, has reduced the effective divisible pool. The share of cesses and surcharges in the Union’s gross tax revenue has risen from around 10% (2011–12) to about 20% in recent years, reducing States’ share.
6. Centralisation of Public Expenditure: Out of the combined allocation of ₹19.4 lakh crore for Centrally Sponsored Schemes (CSS) and Central Sector Schemes (CSec Schemes) in 2023-24, only ₹4.25 lakh crore was devolved to States. These are tied grants and the states have no autonomy to plan their expenditure.
7. Interstate Inequality in public Finances through CSS schemes: The Union government compels the State to commit more or less an equivalent quantum of financial resources in the implementation of CSS schemes. Wealthy States can afford to commit equivalent finances and leverage Union finances inwards through the implementation of CSS. However, less wealthy States will have to commit their borrowed finances in these CSS, thus increasing their own liabilities. It has created inter-state inequality in public finances.
8. Increase in Conditional Transfers: Several grants to states are contingent on fulfilling certain conditions, including the insistence on specific labelling, which imposes Union government preferences over state priorities.
9. Erosion of State Taxation Autonomy on account of implementation of GST: The ability of states to set tax rates on their own revenue sources has been significantly diminished due to the implementation of GST. For ex- State VAT have been subsumed under GST.
10. Issues with GST: States surrendered the power to independently set rates for major indirect taxes (VAT, sales tax, entry tax) in favor of a unified GST regime. The GST Compensation Cess (guaranteeing 14% annual revenue growth to states) expired in 2022, and its extension has been used mainly to service compensation loan repayments, thus, leaving the states more exposed to GST revenue volatility.

What is the Significance of Fiscal Federalism?

1. Ensures Balanced Distribution of Resources: Fiscal federalism allows the central and state governments to address the regional imbalances through mechanisms like tax sharing, grants-in-aid, and performance-based incentives. Thus, it enables states with lower revenue capacity to still deliver comparable public services through equalizing transfers.
2. Strengthens Cooperative Federalism: Fiscal federalism encourages cooperation and coordination between the Centre and states, as they negotiate the sharing of resources and responsibilities. For e.g. The GST Council brings together the Centre and states to jointly administer the Goods and Services Tax.
3. Promotes Equitable Regional Development: Devolution formulas (income distance, area, population, forest cover, demographic performance) aim to channel more resources to less-developed states, helping bridge regional disparities. Special provisions for hill states, North-East, and island territories address geographic and historical disadvantages.
4. Ensuring Fiscal Discipline: Fiscal federalism frameworks like the Fiscal Responsibility and Budget Management (FRBM) Act promote fiscal discipline at both the central and state levels. This helps maintain macroeconomic stability and sustainability.
5. Enabling Decentralized Governance: Fiscal federalism supports decentralization by empowering state and local governments with financial autonomy and resources. This strengthens grassroots democracy and responsive governance closer to the people. Local bodies with adequate finances can respond faster to local needs (sanitation, primary education, local infrastructure) than a distant central authority.
6. Undertaking Economic Reforms: Fiscal federalism helps to adapt to changes like the shift towards a market-oriented economy (1991 economic reforms), and undertake taxation reforms like the introduction of GST.

What are the finance commission recommendations for Fiscal federalism?

The Finance Commissions have made several important recommendations over the years to promote fiscal federalism in India:

1. Vertical Tax Devolution: The 14th Finance Commission radically increased the share of states in the central divisible pool of taxes from 32% to 42%, the biggest ever increase in vertical tax devolution. This enhances the fiscal autonomy and resources of state governments. The 15th Finance Commission reduced it to 41% & the 16th Finance Commission retained it at 41%.
2. Horizontal Distribution Formula: The 16th FC recommended distribution among States based on the following criteria: Income Distance (42.5%), Population 2011 (17.5%), Demographic Performance (10%), Area (10%), Forest & Ecology (10%), and Contribution to GSDP (10%), balancing equity with incentives for economic performance.
3. Grants-in-Aid: The Finance Commissions provide grants-in-aid to specific states or sectors that are in need of assistance or reform. This promotes the spirit of competitive and cooperative fiscal federalism.
4. Fiscal Consolidation: The finance commissions have suggested maintenance of fiscal prudence by the states. The 12th FC recommended a multi-dimensional restructuring aimed at both qualitative and quantitative aspects of managing government finances. The 16th FC recommended a medium-term fiscal path targeting Union fiscal deficit of 3.5% of GDP and State fiscal deficit of 3% of GSDP by 2030–31, ensuring debt sustainability.
5. Strengthening State Finance Commissions (SFCs): Various FC over the years recommended closer integration of Central Finance Commission transfers with timely SFC recommendations and suggested constitutional changes to improve the functioning of SFCs.

What should be the way Forward to strengthen Fiscal Federalism in India?

1. Reform Horizontal Devolution Criteria: Move toward a more balanced formula that doesn’t penalize demographic and developmental success for e.g. using a rolling/updated population base rather than freezing it at 1971 or 2011, or giving greater weight to “demographic performance” alongside “need-based” criteria.
2. Rationalisation of Public Expenditure by Central Govt: A mechanism must be instituted for thorough financial rationalisation of the Central Sector and Centrally Sponsored schemes, in collaboration with state governments. Centrally Sponsored Schemes should be consolidated and pruned to cover only core national priorities (e.g. primary health, basic education, rural employment).
3. Addressing the GST related Concerns: The anomalies in GST like the Integrated GST which favours the consuming states like UP and Bihar, rather than the producing states of TN, Gujarat must be corrected. Also, efforts must be undertaken to open more avenues for revenue generation by broadening the scope of GST to include petrol, diesel etc.
4. Revisiting Article 246 and the Seventh Schedule: The taxation powers listed in the seventh schedule must be relooked in the context of fiscal federalism.
5. List of Taxation for Third Tier of Govt: Specific taxation powers must be devolved to the local self governments to help them raise their own resources and reduce their dependence on grant-in-aids. This will help in achieving fiscal federalism in its true sense.
6. Reduction of Borrowing Constraints on States: The Union government should revisit the borrowing constraints placed on state investment funds, as suggested by Kerala.
7. Address the Issue of Cesses and Surcharges: Bring cesses and surcharges into the divisible pool, or at minimum cap their share of gross tax revenue, since their rising share bypasses the Finance Commission’s constitutional mandate (Article 270).
8. Minimisation of the discretionary aspect of transfers to states: Some of these transfers can be made automatic. For other transfers, clear and non-discriminatory methods should be followed.
9. Mandatory State Finance Commission (SFC) Implementation: Mandate that state governments accept and implement SFC recommendations within a strict statutory timeframe, or tie a portion of central transfers to SFC compliance.