India’s Fiscal Federalism

India needs to ensure equitable fiscal federalism by strengthening states’ financial autonomy and restoring balance in tax devolution and grants. A healthy fiscal federal structure is essential for cooperative governance, balanced regional development, and effective public service delivery.

What is Fiscal Federalism?

Fiscal federalism refers to the division of financial powers, responsibilities, and resources among different levels of government in a federal system.

In India, fiscal federalism operates through the following mechanisms:

1. Vertical Devolution

• It refers to the sharing of central tax revenues between the Union and the States.

• The Finance Commission determines the proportion of taxes to be devolved to states.

2. Horizontal Devolution

• It involves the distribution of resources among states.

• Allocation is based on criteria such as population, income distance, area, forest cover, and fiscal discipline.

3. Grants-in-Aid

• These are targeted financial transfers provided to states.

• They aim to correct regional imbalances, support specific sectors, or assist fiscally weaker states.

Constitutional Provisions Related to Fiscal Federalism

Division of Taxing Powers

• The Seventh Schedule (Article 246) of the Constitution divides taxation powers between:

  • Union List – taxes levied by the Centre

  • State List – taxes levied by the States

• No taxation powers were originally provided in the Concurrent List.

GST and Article 246A

• To introduce the Goods and Services Tax (GST), a concurrent taxation base was required.

• The 101st Constitutional Amendment Act inserted Article 246A, which:

  • Empowers the Union to levy CGST and IGST

  • Allows States to levy SGST

Article 270

• Article 270 provides the framework for distribution of net tax proceeds collected by the Union between the Centre and the States, based on Finance Commission recommendations.

Evolution of Fiscal Federalism in India

Pre-2015 Period

• The Planning Commission played a central role in resource allocation through plan and non-plan transfers.

• States had limited fiscal autonomy, with greater central control.

Post-2015 Reforms

• The Planning Commission was replaced by NITI Aayog, signalling a move towards cooperative federalism.

• The 14th Finance Commission significantly enhanced states’ autonomy by increasing their share in central taxes to 42%.

Post-GST Era

• With the introduction of GST, states surrendered many independent taxation powers.

• This was done with the expectation of:

  • Timely GST compensation

  • Predictable revenue flows

  • Cooperative fiscal management

• However, delays in compensation and reduced flexibility have raised concerns over fiscal imbalance.

Changing Dynamics of Fiscal Transfers in India

The dynamics of fiscal transfers between the Centre and the States in India have undergone significant changes across successive Finance Commission (FC) periods. While the 14th Finance Commission strengthened states’ fiscal autonomy, the 15th Finance Commission period witnessed a relative decline in states’ fiscal space.

14th Finance Commission (2015–2020): Expansion of States’ Fiscal Space

The 14th Finance Commission increased the states’ share in the divisible pool of central taxes from 32% to 42%, significantly enhancing states’ financial autonomy.

• During this period, the share of states in central taxes rose from 15% (13th FC) to 19.2% of combined revenue receipts, marking a 4.25 percentage point increase.

• As a result, the post-transfer fiscal share of states increased from 63.85% to 68.08%, effectively reversing the earlier fiscal balance in favour of the Centre.

• Both Finance Commission grants and non-FC grants remained broadly stable, ensuring continuity in the composition of fiscal transfers.

15th Finance Commission (2020–2025): Contraction in States’ Fiscal Space

In contrast, the 15th Finance Commission period saw a decline in states’ aggregate revenue receipts.

• States’ share fell from 68.08% to 67.39% of combined revenue receipts, a reduction of 0.70 percentage points.

• The share of tax devolution declined by 1.05 percentage points, from 19.2% to 18.2%, though this was partially offset by marginally higher FC and non-FC grants.

• Additionally, states’ own revenue receipts declined slightly, from 37.72% to 37.35%.

Structural Factors Behind the Decline

Several structural changes contributed to the reduced fiscal space for states during the 15th FC period:

• The number of states reduced to 28 following the bifurcation of Jammu and Kashmir, altering aggregate fiscal calculations.

• The increased reliance on cesses and surcharges by the Centre, which are non-sharable with states, reduced the divisible pool of taxes.

Impact on High-Income States

The changing dynamics have been more adverse for high-income states such as Haryana, Karnataka, Kerala, Maharashtra, and Tamil Nadu.

• Between the 13th and 14th FC periods, these states experienced no net expansion in fiscal space, as higher transfers were offset by declines in own revenues.

• From the 14th to the 15th FC period, their fiscal space declined by 0.38 percentage points of combined revenue receipts, indicating growing fiscal stress.

Underlying Causes of Changing Fiscal Transfer Dynamics

• The rising share of non-sharable cesses and surcharges has constrained the divisible pool available for devolution.

• The horizontal devolution formula, with greater weight assigned to equity-based criteria, may have disadvantaged high-income states.

• GST 2.0 reforms, including extensive rate rationalisation and the phasing out of the GST compensation cess, pose further risks to states’ fiscal capacity.

Way Forward

Need for Balanced Fiscal Federalism

The experience since the 14th Finance Commission highlights the need to strike a balance between equity and fiscal autonomy. While redistribution is essential, states must have adequate untied resources to effectively discharge their constitutional responsibilities in key sectors such as health, education, and infrastructure.

Rethinking the Use of Cesses and Surcharges

The Centre’s increasing dependence on cesses and surcharges, which are non-divisible with states, has weakened the spirit of cooperative federalism.
Reining in these non-sharable revenue instruments would restore fiscal trust, expand the divisible pool, and ensure greater predictability of transfers to states.

Enhancing Tax Buoyancy

Both the Centre and the States must focus on improving tax efficiency, broadening the tax base, and enhancing compliance.

• Stronger GST collections, supported by better administration and fewer exemptions, can boost revenues.

• Rationalisation of direct taxes can further expand the overall fiscal pie, reducing zero-sum conflicts over revenue sharing.

Role of the 16th Finance Commission

The 16th Finance Commission, which has recently submitted its report, faces the critical task of correcting emerging fiscal imbalances.

It is expected to:

• Revisit the ‘distance criterion’ in horizontal devolution to ensure fairer treatment of high-income states.

• Safeguard states’ fiscal space through a more balanced and equitable sharing framework.

Conclusion

India’s fiscal federal architecture has evolved towards greater state empowerment since the 14th Finance Commission. However, the 15th Finance Commission period reveals growing strains, especially for high-income states experiencing erosion of fiscal autonomy.

As the recommendations of the 16th Finance Commission await implementation, the future of fiscal federalism will depend on ensuring that both the Centre and the States possess adequate resources, flexibility, and trust to pursue shared developmental objectives effectively