Centre-State Financial Relations in India: Devolution, Grants and Fiscal Federalism

Centre-State financial relations in India form the economic core of Indian fiscal federalism. The Constitution of India divides tax powers and expenditure responsibilities between the Union and the States to balance regional development and maintain fiscal stability. Part XII of the Constitution (Articles 264 to 293) sets the legal framework governing revenue distribution, grants-in-aid, borrowing powers, and financial mechanisms across tiers of government.

Constitutional Allocation of Tax Powers

The Seventh Schedule of the Constitution divides taxation powers between the Union List (List I) and the State List (List II). The Concurrent List (List III) contains no major tax entries, ensuring clear taxing jurisdictions between central and state governments.

Distribution of Taxation Capabilities

• Union List (List I): Includes taxes with an inter-state or national base, such as Income Tax (excluding agricultural income), Corporation Tax, Customs Duties, and Goods and Services Tax (GST) on inter-state supplies.
• State List (List II): Covers local tax bases, including Land Revenue, Stamp Duty, Agricultural Income Tax, State Excise on alcoholic liquors, and Taxes on Professions.
• Residuary Powers (Article 248): Rest with Parliament, giving the Union government exclusive authority to levy taxes not mentioned in any list.

Categories of Union Taxes and Their Distribution

Articles 268 to 271 define how taxes levied by the Union are collected, retained, or shared with the States.

The Finance Commission of India

Article 280 mandates the President of India to constitute a Finance Commission every five years (or earlier) as a quasi-judicial statutory body to recommend revenue distribution.

Key Constitutional Functions

• Vertical Devolution: Recommends the percentage share of net proceeds of Union taxes given to the States.
• Horizontal Devolution: Formulates criteria and weighting formulas to divide the state share among individual States.
• Grants-in-Aid Principles: Lays down principles governing revenue deficit grants, local body grants, and disaster relief grants under Article 275.
• Local Body Resources: Recommends measures to augment the Consolidated Fund of a State to supplement resources of Panchayats and Municipalities.

Grants-in-Aid under the Constitution

The Constitution provides two main types of grants to address horizontal fiscal imbalances across States.

Statutory Grants (Article 275)

Parliament provides statutory grants out of the Consolidated Fund of India to States requiring financial assistance. The Finance Commission recommends these grants, which can target specific state needs, promote welfare of Scheduled Tribes, or raise administrative standards in tribal areas.

Discretionary Grants (Article 282)

The Union or a State can make grants for any public purpose, even if the target falls outside its legislative domain. Historically, central ministries used these grants to fund Centrally Sponsored Schemes (CSS) and Central Sector Schemes.

Goods and Services Tax (GST) and the GST Council

The 101st Constitutional Amendment Act, 2016 introduced a dual GST system (CGST and SGST) alongside an integrated tax (IGST) to streamline indirect taxation.

Statutory Architecture

• Article 246A: Grants simultaneous power to Parliament and State Legislatures to make laws regarding Goods and Services Tax.
• Article 279A: Establishes the GST Council as a joint forum chaired by the Union Finance Minister, with State Finance Ministers as members.
• Voting Mechanics: The Union Government holds one-third of total votes cast, while all State Governments combined hold two-thirds. Decisions require a three-fourths majority of weighted votes present.

Borrowing Powers and Financial Emergencies

Articles 292 and 293 regulate borrowing limits for the Union and State governments to preserve fiscal stability.

Borrowing Restrictions (Article 293)

States can borrow within India using the security of the Consolidated Fund of the State. A State cannot raise a fresh loan without Union consent if any part of a previous Union loan remains outstanding.

Financial Emergency (Article 360)

When the President proclaims a Financial Emergency, the Union executive can issue directives to States regarding financial propriety. The Union can order the reduction of salaries of state public servants and require all money bills to be reserved for Presidential consideration.

Important Facts and Trivia for Exams

• The 80th Constitutional Amendment Act, 2000 implemented an alternative scheme of devolution, pooling all central taxes (except cesses and surcharges) into a single divisible pool.
• Under Article 270, cesses and surcharges collected by the Union stay outside the divisible pool shared with States.
• K.C. Neogy chaired the First Finance Commission of India, constituted in 1951.
• The 101st Constitutional Amendment inserted Article 246A, Article 269A, and Article 279A into the Constitution.
• The Fiscal Responsibility and Budget Management (FRBM) Act sets targets for central and state deficit limits.
• Article 282 allows the Union government to transfer discretionary funds to States outside Finance Commission recommendations.
• State excise duty applies to alcoholic liquors for human consumption, opium, Indian hemp, and other narcotic drugs, but excludes medicinal and toilet preparations containing alcohol.