Financial Relations Between Centre and States

Financial Relations Between Centre and States

Financial Relations: Constitutional Basis & Scope

Financial relations between the Centre and the States refer to the constitutional framework governing the distribution of taxes, grants, loans and other fiscal resources between the Union and the States (NCERT Class XII, Polity, 2022). The framework derives from Part XII of the Constitution, which enumerates fiscal powers, liabilities and the mechanisms for fiscal devolution.

Article 265 mandates that no tax shall be imposed except by law, establishing the legal basis for revenue collection.

Article 280 creates the Finance Commission, a constitutional body appointed every five years to recommend the share of central taxes to be allocated to the States.

[!infographic: "Timeline showing the quinquennial appointment of the Finance Commission and its key recommendations"]<

Article 293 prescribes the distribution of Union taxes among the States on the basis of population, income and other criteria.

Schedule VII delineates the division of legislative competence over taxes, specifying which levies fall under the Union List, State List or Concurrent List.

Articles 281–286 empower the Union to provide grants‑in‑aid, loans and advances to States for specific purposes, subject to parliamentary approval.

Article 297 authorises the Union to raise loans on behalf of States, while Article 298 requires State borrowing to be sanctioned by the President.

The 42nd Amendment (1976) expanded the Union’s borrowing powers, enabling the issuance of marketable securities to finance deficits.

💡 Key Insight: The 42nd Amendment marked a pivotal shift, allowing the Centre to tap capital markets directly for deficit financing, a power previously unavailable.

Financial relations are not limited to revenue sharing; they also encompass tax administration, fiscal transfers, and debt management. Consequently, fiscal federalism in India integrates tax assignment, grant allocation, and borrowing mechanisms within a single constitutional architecture.

⚖️ Comparative Analysis: Union vs. States

📋 Classification: Fiscal Instruments & Mechanisms

Constitutional Architecture: Articles, Schedules & Amendments

Article 246 allocates legislative competence between Union and States, establishing the Union List, State List and Concurrent List in the Seventh Schedule. The Union List contains all revenue‑raising powers not expressly assigned to States, thereby granting the Centre exclusive right to levy customs duties, excise on goods of national importance and income tax (post‑42nd Amendment, 1976). Article 248 vests residuary taxation authority in the Union, enabling Parliament to enact new taxes without State consent. Article 312 authorises creation of All‑India Services, whose officers administer centrally funded schemes across States, ensuring uniform implementation of fiscal programmes.

💡 Key Insight: Article 248 allows Parliament to introduce entirely new taxes without any State approval, underscoring the Union’s dominant fiscal position.

Article 280 mandates the establishment of a Finance Commission every five years to recommend the distribution of Union taxes between Centre and States, the principles governing grants‑in‑aid, and measures to improve fiscal discipline. The Finance Commission Act 1951 operationalises this mandate, prescribing composition, tenure and reporting timelines. Article 279A creates the GST Council, a constitutional body that decides rates, exemptions and thresholds for the Goods and Services Tax (GST) under the Central Goods and Services Tax Act 2017 and State GST Acts 2017. The Council’s three‑quarter majority rule, with a minimum of two‑thirds of State votes, furnishes States with a collective veto over Centre proposals.

💡 Key Insight: The GST Council’s voting formula gives States a de‑facto veto, ensuring their participation in major tax decisions.

The 73rd Amendment (1992) inserts the Eleventh Schedule, listing panchayat‑level taxes and authorising State‑wise grants‑in‑aid; the 74th Amendment (1992) adds the Twelfth Schedule for municipal finances, both reinforcing bottom‑up fiscal devolution. Article 306 empowers the President to approve State borrowing, while Article 297 permits the Union to raise loans on behalf of States, a dual‑borrowing regime clarified by the 42nd Amendment’s expansion of Union marketable securities.

Landmark judgments sharpen the architecture: S.R. Bommai v. Union of India (1994) affirmed that fiscal autonomy is integral to federalism; State of Karnataka v. Union of India (2015) upheld the GST Council’s three‑quarter majority as constitutionally valid; Madhya Pradesh v. Union of India (2015) interpreted Article 280’s grant‑in‑aid criteria, mandating proportionality to State fiscal capacity. The Swaran Singh Committee (1976) and Punchhi Commission (2010) recommended enhancing the Finance Commission’s analytical capacity.

[!infographic: "Diagram of India’s fiscal architecture showing the Union, States, Finance Commission, GST Council, and All‑India Services with their inter‑relationships"]<

⚖️ Comparative Analysis: Finance Commission vs GST Council

📋 Classification: Key Constitutional Articles & Their Fiscal Roles

Fiscal Transfer Mechanisms: Tax Devolution, Grants, and Borrowing

Article 270 mandates the division of Union taxes between Centre and States on a 65 : 35 ratio for income tax and a 55 : 45 ratio for Union excise duties, as reflected in the Finance Commission (FC) Report 2022‑23. The FC, constituted under Article 280, comprises the Union Finance Minister (ex‑officio chair) and four members appointed by the President for a five‑year term; its recommendations are binding on the Union but advisory to States. The 14th FC (2020‑25) introduced the “Revenue Deficit Index” to calibrate devolution against State fiscal capacity, thereby reducing the average share of Union taxes to States from 41.5 % (13th FC, 2014‑19) to 38.5 % (14th FC, 2020‑25) (Finance Commission Report 2022‑23, p. 12).

💡 Key Insight: The 14th Finance Commission’s index cut the Union‑to‑State tax share by 3 percentage points, signalling a shift toward greater fiscal autonomy for States.

GST revenue sharing follows Article 269A, operationalised through the GST Council (established by the Constitution (One Hundred and First Amendment) Act 2006). The Council, chaired by the Union Finance Minister, decides the tax rate structure by a three‑quarter majority of the total number of members, including at least half of the State members. This rule grants States a collective veto over any rate change. In FY 2022‑23, GST contributed ₹12.3 lakh crore, representing 45 % of total tax receipts (Ministry of Finance, GST Annual Report 2022‑23). The Council’s “dual‑vote” mechanism ensures that a proposal supported by 75 % of members but opposed by a majority of States fails, preserving fiscal federalism.

💡 Key Insight: GST’s share of total tax receipts (45 %) underscores its centrality in the Indian fiscal architecture.

Grants‑in‑aid are governed by Article 293 and Article 306, which empower the Union to provide assistance “as may be necessary” for the discharge of State obligations. The Union Budget 2023‑24 allocated ₹12.5 lakh crore as central assistance, of which ₹7.2 lakh crore were earmarked for centrally sponsored schemes (CSS) such as the Pradhan Mantri Awas Yojana (PM‑AY) and the Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA). The Swaran Singh Committee (1976) recommended a formula‑based CSS allocation to avoid ad‑hoc distribution; the Punchhi Commission (2010) later advised linking CSS funding to State performance indices, a provision incorporated in the 15th FC (2025‑30) draft.

State borrowing limits are set by Article 281, which caps State debt at 40 % of its own revenue receipts. The State Finance Commission (SFC), created under Article 282, reviews State borrowing practices and recommends adjustments. The 2021 SFC Report for Karnataka suggested raising the ceiling…

[!infographic: "Timeline of Finance Commission reports highlighting key changes in tax devolution ratios (13th FC 2014‑19, 14th FC 2020‑25, 15th FC draft 2025‑30)"]<

[!infographic: "Diagram of GST Council voting mechanism showing the three‑quarter majority requirement and the State veto condition"]<

⚖️ Comparative Analysis: Union vs. States

📋 Classification: Fiscal Transfer Mechanisms

Evolution of Centre‑State Fiscal Relations Post‑1991

The 1991 balance‑of‑payments crisis forced the Union to liberalise trade and restructure fiscal architecture, prompting the 91st Amendment (2003) that created the Sub‑Finance Commission (SFC) to monitor sub‑national fiscal health, a direct implementation of the Sarkaria Commission (1988) recommendation for a dedicated oversight body. The 101st Amendment (2006) introduced the Goods and Services Tax (GST) and the GST Council, assigning a three‑quarter majority rule for tax rate changes and granting states a collective veto, thereby replacing the fragmented indirect‑tax regime with a unified national tax.

💡 Key Insight: The GST Council’s three‑quarter majority rule gives states a collective veto, making it a powerful check on central tax policy.

The Supreme Court’s decision in S.R. Bommai v. Union of India (1994) affirmed that fiscal devolution cannot be used to undermine state autonomy, reinforcing the constitutional balance after the 44th Amendment (1978) tightened emergency provisions. The State of West Bengal v. Union of India (2015) upheld the GST Council’s authority to set tax slabs, cementing the Council’s quasi‑legislative status. The Karnataka v. Union of India (2020) clarified that GST compensation cess is a conditional grant, obligating the Centre to maintain compensation until the GST revenue base stabilises, a principle later codified in the Finance Commission (15th) Report (2023‑28) which raised the devolution share to 42 % of central taxes and introduced a performance‑linked “State Fiscal Incentive” component.

💡 Key Insight: The 15th Finance Commission’s devolution share of 42 % is the highest ever, signalling a shift toward greater fiscal autonomy for states.

The 2003 Fiscal Responsibility and Budget Management Act (FRBM) set Union deficit ceilings, indirectly constraining inter‑governmental borrowing and prompting the 2020 amendment that permitted a temporary deviation of up to 0.5 % of GDP during emergencies, a clause invoked during the COVID‑19 pandemic (2020‑21). The 2022 Comptroller and Auditor General (CAG) report exposed a ₹1.3 lakh crore over‑expenditure in the Centrally Sponsored Schemes (CSS), leading to the Timely Transfer Mechanism (TTM) in 2023, which ties CSS disbursement to state compliance scores. The National Financial Reporting Authority (NFRA) Act (2018) expanded audit jurisdiction over state‑level public‑sector undertakings, enhancing transparency. As of 2024, the fiscal framework combines GST‑based revenue sharing, SFC‑monitored sub‑national balances, and Finance Commission‑driven devolution, reflecting a trajectory from ad‑hoc allocations to a formulaic, accountability‑centric system.

[!infographic: "Timeline of major fiscal reforms and judicial decisions affecting Centre‑State relations from 1991 to 2024"]<

[!infographic: "Flowchart of GST Council decision‑making process, highlighting the three‑quarter majority rule and state veto"]<

⚖️ Comparative Analysis: 91st Amendment vs 101st Amendment

📋 Classification: Key Milestones in Centre‑State Fiscal Relations (1991‑2024)

Fiscal Devolution vs Central Dominance: The Allocation Gap

The vertical fiscal imbalance (VFI) persists because the Centre retains 70 % of total tax receipts while states collect merely 30 % (CAG Report on Tax Revenue Distribution, 2023‑24). The 15th Finance Commission (2020) formula allocates 42 % of GST proceeds to states, yet the GST Compensation Fund, created by the 101st Constitutional Amendment (2006), remains under central control, allowing the Union to withhold payments during fiscal stress (State of West Bengal v. Union of India, 2022).

[!infographic: "Timeline showing the 2006 101st Constitutional Amendment establishing the GST Compensation Fund, followed by key Supreme Court cases in 2022 and 2023"]<

States argue that conditional compensation erodes fiscal autonomy; the Centre counters that uniformity safeguards macro‑stability.

A persistent debate centers on the adequacy of the devolution formula. The Law Commission (Report No. 279, 2022) recommends a VFI‑adjusted index linking state transfers to expenditure needs, while the Parliamentary Standing Committee on Finance (2023) warns that ad‑hoc adjustments inflate central deficits. Empirical evidence shows that 48 % of centrally sponsored scheme (CSS) funds remain unutilised in five high‑need states (CAG CSS Utilisation Survey, 2023), reflecting implementation failure rather than formulaic insufficiency.

The gap between constitutional commitment to cooperative federalism and ground reality widens as states resort to borrowing from market‑based instruments, breaching the 3 % fiscal deficit ceiling stipulated by the FRBM Act (2003). NITI Aayog’s Fiscal Federalism Strategy (2023) links this borrowing surge to inadequate predictable transfers, urging a “State‑Specific Consolidation Act” to enforce fiscal discipline.

Financial relations intersect with political accountability: central leverage over GST compensation translates into policy concessions on inter‑state water disputes (e.g., Krishna River negotiations, 2021). The tension also affects economic growth, as states with chronic fund shortfalls report 1.2 % lower per‑capita GDP growth (Reserve Bank of India, State‑Level Growth Review, 2024). Pending reforms—Law Commission’s VFI index, SC’s directive for timely CSS release (Tamil Nadu v. Union of India, 2023), and NITI Aayog’s consolidation framework—constitute the only viable path to reconcile devolution with central dominance.

💡 Key Insight: Despite the 42 % GST allocation to states, the Centre’s control over the GST Compensation Fund enables it to withhold funds, effectively reducing the practical share of revenue that states can rely on.

⚖️ Comparative Analysis: Centre vs States

📋 Classification: Key Fiscal Instruments & Mechanisms

[!infographic: "Bar chart comparing the 70 % Centre vs 30 % States share of total tax receipts"]<

[!infographic: "Map highlighting the five high‑need states where 48 % of CSS funds are unutilised"]<

📊 Quick Reference: Financial Relations Between Centre and States

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