India's governance model rests on a delicate balance of power and resources between the Union government and the states. At the heart of this relationship lies fiscal federalism, the system that determines how financial resources are collected and shared. This complex compact, often debated and sometimes contested, defines the economic autonomy of states and the redistributive role of the Centre.
The Pillars of the Financial Compact: Key Constitutional Provisions
The Indian Constitution provides the foundational framework for fiscal relations. The Seventh Schedule clearly demarcates taxation powers through the Union List, State List, and Concurrent List. The Union government holds the exclusive power to levy taxes on income (except agricultural income), customs duties, and corporation tax. States, on the other hand, can impose taxes on land, agricultural income, and goods sold within their territory, like State GST.
However, the collection of major revenue generators like income tax and central excise (now subsumed under GST) rests with the Centre. This creates a vertical imbalance, where the Centre collects more than it needs for its own functions, while states have responsibilities that often outstrip their revenue-raising capacity. To bridge this gap, the Constitution mandates a mechanism for sharing these pooled resources.
The Role of the Finance Commission: The Arbitrator of Fair Share
Article 280 of the Constitution establishes a crucial institution: the Finance Commission. Appointed every five years, this body is tasked with recommending the formula for distributing the net proceeds of taxes between the Union and the States. The 15th Finance Commission, chaired by N.K. Singh, served from 2020 to 2026.
The Commission's recommendations are not merely mathematical; they embody principles of equity, efficiency, and need. Its formula considers a state's population (as per the 2011 census), area, forest and ecology, income distance (to help poorer states), and demographic performance. For the period 2021-26, the Commission recommended that states receive 41% of the divisible tax pool, a slight reduction from the 42% recommended by the 14th Finance Commission.
Beyond Tax Devolution: Grants and the Cess Conundrum
Tax devolution is the primary channel for resource transfer, but it's not the only one. The Finance Commission also recommends grants-in-aid to states from the Consolidated Fund of India. These are often targeted at specific needs, such as strengthening local bodies or addressing revenue deficits in post-devolution scenarios.
A significant point of contention in recent years has been the Union government's increasing reliance on cesses and surcharges. Unlike taxes, the proceeds from these levies are not part of the divisible pool and are retained entirely by the Centre. Examples include the Health and Education Cess or the GST Compensation Cess. Critics argue that this trend reduces the effective share of resources available for states, potentially undermining the spirit of cooperative federalism.
Eight Defining Questions on India's Fiscal Federalism
To fully grasp the dynamics at play, one must address several pivotal questions that shape the debate.
1. What constitutes the divisible pool of taxes? This pool includes all taxes levied by the Centre, except for cesses, surcharges, and taxes earmarked for specific purposes like the GST Compensation Cess.
2. How does the Finance Commission determine each state's share? As mentioned, it uses a multi-dimensional formula weighing factors like population, area, and fiscal capacity to ensure a fair and needs-based distribution.
3. What is the difference between tax devolution and grants-in-aid? Devolution is a state's rightful share of central taxes, determined by a formula. Grants-in-aid are discretionary or recommended transfers for specific purposes or to assist states in financial difficulty.
4. Why are cess and surcharge a point of friction? Their non-sharable nature means that as the Centre raises more revenue through these instruments, the actual size of the divisible pool shrinks in relative terms, affecting state revenues.
5. How has the Goods and Services Tax (GST) changed the landscape? GST, a landmark reform, subsumed many central and state taxes, creating a unified national market. While it simplified the tax structure, its success hinges on robust revenue collection and timely compensation to states for any shortfall, a guarantee that lasted until June 2022.
6. What is the impact of centrally sponsored schemes (CSS)? These are schemes conceived by the Centre where states are required to contribute a share of the cost. They allow the Centre to drive policy in state subjects but can strain state finances and limit their autonomy in prioritizing local needs.
7. How do fiscal deficits and borrowing limits interact? States' power to borrow is regulated by the Centre under Article 293. Their fiscal deficit limits are often set in consultation with the Centre, especially for states that have availed financial assistance, ensuring macroeconomic stability.
8. What is the future of fiscal federalism in India? The future will be shaped by evolving challenges: ensuring stable GST revenues, managing the post-compensation era, balancing state autonomy with national priorities, and revisiting the discourse on cess and surcharges to maintain trust in the federal compact.
In conclusion, India's fiscal federalism is a living, evolving system. It strives to balance the Union's need for macroeconomic management and national development with the states' requirement for adequate resources and autonomy to address regional aspirations. The continuous dialogue around the eight questions above ensures this compact remains relevant, responsive, and resilient in steering India's cooperative federal journey.
