From Finance Commission to GST: Understanding Centre-State Relations in India’s Fiscal Federalism

One of the reasons India’s democracy remains strong is because of the balanced sharing of powers and duties between various levels of government. Fiscal federalism is the quiet machinery that keeps this vast arrangement functioning, defining the financial relations between the various levels of government.

Illustration by The Geostrata

India has a quasi-federal system because the framers of the constitution believed a powerful Centre was essential to prevent disintegration. However, they also knew that a strong Centre, unchecked, could become overbearing. The Government of India Act, 1935, significantly influenced this design, introducing the idea of dividing powers into Union, State, and Concurrent Lists — a feature that continues to this day.

WHY DOES FISCAL FEDERALISM MATTER?

In India, taxes ensure that public services are provided, and they lead towards economic growth. Every State has a varied perspective on development shaped by its geographical location, population and cultural factors. Therefore, States contribute different proportions of taxes to the centre and in return, receive different proportions of tax revenue according to its needs. 

An orderly government helps maintain economic and political stability. If States borrow recklessly, the national economy suffers and if the centre hoards revenue, the State development slows. Fiscal federalism ensures a balance in fiscal equity.  

Indian fiscal federalism directly affects citizens because it determines how money is raised and shared between the Centre and the States. As a result, it influences the quality of public services like healthcare, education, and infrastructure. It also allows flexibility in policy implementation. Sikkim’s organic farming push and Gujarat’s industrial policy, 2020, are examples of this.

FINANCE COMMISSION

States often have limitations for revenue generation due to centralisation of resources. The Finance Commission was created to address this imbalance. The commission is appointed every five years to make recommendations on how taxes should be shared. It focuses on the division of financial resources between the Centre and the States in both vertical and horizontal devolution.

Articles 268 to 293 of the Indian Constitution define this fiscal commission, fiscal distribution, grants, taxes and borrowings. The responsibilities are divided among the Union and the States as mentioned in the Seventh Schedule. The Union List includes taxes like income tax, corporate tax, customs duties, and GST. On the other hand, States have access to land revenue, state excise and GST on intra-state transactions. After the implementation of the Goods and Services Tax (GST), the Finance Commission’s role has become even more significant.

The Sixteenth Finance Commission is chaired by Dr. Arvind Panagariya. It is currently working and was constituted on December 31, 2023. The Commission will make recommendations for the five years commencing on April 1, 2026.

NITI AAYOG AND COOPERATIVE FEDERALISM

Cooperative federalism emphasises the cooperation between the Centre and State governments working together to solve common problems and work towards shared goals. Rather than a strict separation of powers, it promotes collaboration between different levels of government.

In India, the origin of cooperative federalism was rooted in the Regulating Act of 1773, where the Crown rule of England supervised the East India Company while leaving governing power to the local government.

In 2015, NITI Aayog replaced the Planning Commission. The NITI Aayog is a policy think tank that promotes federalism, gives policy inputs and encourages states to compete for performance-based incentives and rankings. Moreover, it shifted the focus from ‘top-down planning’ to ‘cooperative federalism’, treating States as equal partners.

GOODS AND SERVICES TAX (GST)

In 2017, the Indian Constitution established a unified taxation called ‘Goods and Services Tax’ (GST). It is a direct tax that is imposed directly on the consumers and replaces multiple other indirect taxes like VAT, excise duty, service taxes and others. The aim is to achieve a “one nation, one tax” goal. Due to this, the Indian tax regime has become more unitary in nature, taking away most of the autonomy available to states.

CHALLENGES

A few factors like falling state revenue shares, increasing reliance on Centrally Sponsored Schemes (CSS), and problems related to GST, put pressure on state finances and reduces States freedom to frame policies suited to local needs.

Richer States like Maharashtra or Gujarat contribute more to central revenues but may receive less in return, while poorer States rely heavily on central revenues. This creates inequality amongst States.

Moreover, the central government has enforced a borrowing cap of around 3% of the State Domestic Product (SDP). This limitation makes it difficult for the States to raise funds, especially during financial crises.

The Union government has increased cess and surcharge collections, which are not shared with States, shrinking the divisible pool of taxes and leading to concerns about transparency and fairness.

There have been allegations that fiscal transfers are politically motivated, favouring States governed by the ruling party at the Centre. This weakens trust and undermines the principles of cooperative federalism.

CONCLUSION

Fiscal federalism is one of the pillars holding up India’s democracy. It has continuously evolved, adapting to economic changes, political shifts, and governance. If the governance system favours the Centre, States lose the ability to respond to their people, and if it favours the States, national priorities may suffer. The government should work in a manner where it can be held accountable, and it should also be transparent to the citizens. 

Indian fiscal federalism represents a balancing act between central authority and regional power, between unity and diversity, between efficiency and equity. A strong, accountable and cooperative governance system is the foundation for an inclusive India.

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BY ALINA JACOB

COVERING PRIME MINISTER'S OFFICE

TEAM GEOSTRATA

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