Financial Federalism in India

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1. Pre-Independence Financial Relations

  • Government of India Act, 1919 (Montague-Chelmsford Reforms):

    • Introduced dyarchy in provinces.

    • Revenue sources divided but provinces had limited autonomy (land revenue, excise on liquor, agriculture).

  • Government of India Act, 1935:

    • Clear division of powers between Centre and Provinces.

    • Federal structure was visualized but financial dependence of provinces continued.

    • Key revenues (customs, income tax, railways) remained with Centre → provinces dependent on grants-in-aid.

2. Post-Independence & Constitutional Arrangement

  • Seventh Schedule (Art. 246):

    • Union List → Taxes on income (except agricultural), customs, excise (except on alcohol), corporate tax.

    • State List → Land revenue, taxes on agriculture, sales tax, excise on alcohol.

    • Concurrent List → Sharing in social/economic policy but Centre dominates.

  • Art. 268–281: Define distribution of revenues between Centre and States.

  • Finance Commission (Art. 280): Constitutionally mandated body for recommending tax devolution and grants.

3. Executive Mechanisms: Planning & Distribution

  • Planning Commission (1950–2014):

    • Allocated plan funds to states, creating Centre-driven financial control.

  • NITI Aayog (2015–present): Advisory, not fund-allocating; reduces central discretion.

4. Committees & Reports

  • Sarkaria Commission (1983): Recommended strengthening Inter-State Council, more autonomy in tax revenues.

  • Punchhi Commission (2007): Emphasized fiscal autonomy of states, rational grants, cooperative federalism.

  • Finance Commissions (esp. 14th & 15th):

    • 14th FC (2015–20): Increased states’ share in central taxes from 32% → 42%.

    • 15th FC (2021–26): Retained 41% but introduced performance-linked grants (health, agriculture, reforms).

5. Statutes & Policies

  • Goods and Services Tax (GST) 2017:

    • Subsumed many state taxes into one indirect tax.

    • GST Council (Art. 279A) → joint decision-making body.

    • Challenge: States dependent on compensation from Centre.



  • FRBM Act 2003: Restricted states’ borrowing limits.

6. Post-1991 Liberalization Arrangement

  • Economic reforms shifted power to Centre (customs, corporate taxes rose).

  • States sought autonomy in FDI clearances, industrial policy.

  • Growing regional imbalance as industrialized states (Maharashtra, Gujarat, Tamil Nadu) benefitted more.

7. Safeguards & Promotion Mechanisms

  • Finance Commission recommendations.

  • Inter-State Council (Art. 263).

  • Zonal Councils: Promote coordination.

  • CAG & Fiscal Responsibility Laws: Ensure accountability.

8. Present Scenario

  • Revenue imbalance: States raise ~38% of total revenues but spend ~60% of expenditure responsibilities.

  • GST Compensation Issue: Delays have caused Centre–State tension.

  • Post-Covid fiscal stress: States demanded higher borrowing limits and larger devolution.

  • ADR (Association for Democratic Reforms, 2023–24): Highlighted political bias in fund allocation (e.g., MPLADS, centrally sponsored schemes).

9. Significance of Balance / Imbalance

  • Balanced fiscal federalism → ensures regional equity, welfare delivery, and cooperative federalism.

  • Imbalance leads to vertical imbalance (Centre vs States) and horizontal imbalance (rich vs poor states).

10. Challenges

  • Vertical imbalance: Centre controls buoyant taxes (corporate, income tax), states rely on transfers.

  • Horizontal imbalance:

    • Richer states (Maharashtra, Gujarat, Tamil Nadu, Karnataka) contribute more but poorer states (Bihar, UP, Odisha, NE states) receive more transfers.

  • Political bias: Centrally Sponsored Schemes often aligned with ruling party states.

  • GST dependency: States lost fiscal autonomy; delay in compensation created strain.

  • Third-tier (Panchayats & Municipalities):

    • 73rd & 74th Amendments mandate financial devolution.

    • Reality: Local bodies heavily dependent on state governments, weak tax base.

11. Global Best Practices

  • USA: States levy income & sales taxes independently.

  • Canada: Equalization payments ensure equity among provinces.

  • Australia: Horizontal Fiscal Equalization system (GST revenue distributed to balance states).

12. Way Forward

  • Strengthen Finance Commission autonomy (formula-driven, not political).

  • Rationalize Centrally Sponsored Schemes.

  • Strengthen GST Council with dispute resolution mechanism.

  • Empower local bodies with real taxation powers (property tax, service fees).

  • Promote cooperative federalism → consensus-driven policy, not coercion.

  • Learn from global equalization mechanisms for fairer devolution.

  • Use technology-enabled fiscal monitoring for transparency.

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