Centre-State Financial Relations & Fiscal Federalism in India

Centre-State financial relations form the fiscal backbone of Indian federalism. Part XII of the Constitution (Articles 268–293) defines how financial powers, revenues, and grants are distributed between the Union and States. Understanding this framework is essential for GS2, as it explains both how India is governed financially and why disputes between the Centre and states regularly arise.

Constitutional Basis: Division of Financial Powers

The Constitution distributes taxing powers across three lists:

Taxes levied by the Centre but shared with States:

• Article 270 — Taxes on income (other than agricultural income) are distributed between Centre and States per the Finance Commission's formula.
• Article 268 — Certain duties (stamp duties on bills of exchange, cheques, etc.) are levied by the Centre but collected and retained by States.
• Article 269 — Taxes on consignment of goods and inter-state trade taxes are levied and collected by the Centre but assigned to the States.
• Article 269A — GST on supplies in the course of inter-state trade is levied and collected by the Centre and distributed to States.

The Consolidated Fund of India (Article 266) is the central pool from which the divisible pool of taxes is shared. States have their own Consolidated Fund under Article 266(1).

Finance Commission (Article 280)

The Finance Commission is a constitutional body constituted by the President every five years (or earlier if needed) under Article 280. It is a quasi-judicial body whose recommendations, while technically advisory, are treated as binding by convention.

Mandate:

1. Distribution of net proceeds of Union taxes between Centre and States (vertical devolution)
2. Principles for grants-in-aid to States from the Consolidated Fund of India
3. Any other matter in the interest of sound finance referred by the President

15th Finance Commission (2020–25)

Horizontal Distribution Criteria (how 41% is divided among States):

The income distance criterion (45%) ensures that poorer states receive a larger share — the farther a state's per capita income is from the richest state, the higher its allocation. The demographic performance criterion (12.5%) rewards states that controlled population growth — this addresses the "south India grievance" that states which invested in family planning should not be penalised under population-based criteria.

16th Finance Commission (2026–31)

The 16th FC will determine tax devolution and grants for the period beginning April 2026. Key issues before it include the north-south equity debate, sub-national fiscal consolidation, and local body financing.

Grants-in-Aid (Articles 275, 282)

Beyond tax devolution, the Centre transfers resources to States through grants:

Vertical and Horizontal Devolution: The Core Debate

Vertical devolution asks: what percentage goes to the States collectively? The trend has been upward — from around 30% in earlier FCs to 42% (14th FC) and 41% (15th FC). States argue for higher devolution to reduce dependence on CSS with Central conditions.

Horizontal devolution asks: how is the States' share divided among 28 states and 8 UTs? This is where the north-south equity debate intensifies:

• Southern states (Tamil Nadu, Kerala, Karnataka, Telangana, Andhra Pradesh) argue they are penalised for:
  • Achieving demographic transition (low population growth reduces their share when population weight is high)
  • Higher per capita income (which reduces their income-distance share)
  • Better tax collection (which slightly rewards them via tax effort but not enough)
• The 15th FC's inclusion of demographic performance (12.5%) was specifically designed to address this — states that controlled population get a bonus rather than a penalty.

Centrally Sponsored Schemes (CSS)

CSS are schemes funded partly by the Centre and partly by States, implemented by State governments. They are a major channel of resource transfer but have been criticised for rigidity.

Criticism of CSS: States must bear matching expenditure even when their priorities differ; CSS proliferation (40+ major schemes) fragments state budgets; conditionalities limit state autonomy. The NITI Aayog replaced the Planning Commission in 2015, shifting some planning functions but the CSS architecture persisted largely intact.

Special Category Status (SCS)

Historically, some states received Special Category Status — a higher Centre:State ratio (90:10) for CSS and special Central assistance. The 14th Finance Commission (2015) effectively discontinued new SCS grants for general purpose, arguing that higher tax devolution (42%) should compensate. However, North-Eastern states and three hill states (J&K now UTs, Himachal Pradesh, Uttarakhand) continue to receive 90:10 ratio for most CSS.

State Finance Commissions (SFCs)

The 73rd and 74th Constitutional Amendments (1992) mandated that each State constitute a State Finance Commission every five years to recommend devolution of funds from the State to:

• Panchayati Raj Institutions (Article 243-I)
• Urban Local Bodies (Article 243-Y)

The 15th FC also linked some grants to States providing adequate funding to local bodies based on SFC recommendations. In practice, most States underfund local bodies — SFC recommendations are often not implemented or delayed, leaving India's third tier financially weak.

GST and Cooperative Federalism

Goods and Services Tax (GST), implemented from 1 July 2017, restructured indirect taxation comprehensively. Under GST:

• CGST (Central GST) goes to the Centre
• SGST (State GST) goes to the State
• IGST (Integrated GST on inter-state supplies) is collected by Centre and distributed based on destination principle

The GST Council (Article 279A) — comprising the Union Finance Minister and State Finance Ministers — is considered a landmark in cooperative federalism: Centre and States have equal stakes in decisions, though the Centre has a one-third vote and States together have two-thirds.

GST Compensation issue: Under the GST (Compensation to States) Act, 2017, States were guaranteed 14% annual revenue growth (base year 2015–16) for a transition period of five years (July 2017 – June 2022). When the pandemic caused revenue shortfall, the Centre borrowed funds to compensate States rather than paying directly — creating tensions. The compensation period ended June 2022, and States reliant on compensation revenues faced a revenue gap thereafter.

FRBM and State Fiscal Discipline

The Fiscal Responsibility and Budget Management (FRBM) Act, 2003 mandates fiscal consolidation. States are required to keep their fiscal deficit within 3% of GSDP (with some flexibility — during FY2023-24, states were allowed 3.5% of GSDP, with 0.5% linked to power sector reforms).

Key concerns: Off-budget borrowings through state public sector enterprises; state guarantees not captured in fiscal deficit figures; populist freebies debate (Supreme Court has flagged this); debt sustainability of high-deficit states.

Challenges in Centre-State Financial Relations

Recent Developments (2024–2026)

16th Finance Commission — Constituted, Report Submitted (2024–2025)

The 16th Finance Commission was constituted in late 2023 with Dr. Arvind Panagariya (former first Vice Chairman of NITI Aayog, Columbia University) as Chairman. The Commission held extensive consultations with states, state finance commissions, and the RBI. It submitted its report to President Droupadi Murmu on 17 November 2025 — covering the period 2026-27 to 2030-31.

Southern states argued for increasing devolution from 41% (15th FC level) to 45–50%, citing their demographic management efforts being penalised under population-based criteria. The states also urged inclusion of Union cesses and surcharges (approximately 23% of gross tax revenue in 2024-25) in the divisible pool — a long-standing grievance since these are not shared with states.

UPSC angle: Prelims — 16th FC; Arvind Panagariya; report November 2025; covers 2026-31. Mains — critically evaluate the demands of southern states on horizontal devolution; should cess and surcharges be included in the divisible pool? What are the fiscal implications?

GST Compensation Cess — Extended Beyond 2026 Transition (2024–2025)

When GST was launched on 1 July 2017, states were promised 14% revenue growth compensation for 5 years (until June 2022). The compensation cess on luxury, sin, and demerit goods was extended to March 2026 to repay the back-to-back loans taken by the Centre during COVID to compensate states. Between July 2017 and July 2024, net GST Compensation Cess collection amounted to ₹7.61 lakh crore. The Union Budget 2025-26 proposes to rebrand and continue the cess for loan repayment purposes beyond March 2026.

States continue to press for the GST compensation period to be extended further (at least 5 more years from 2026), arguing that their revenue buoyancy from GST has not reached the original projected levels.

UPSC angle: Prelims — GST compensation cess extended to March 2026; cess collected ₹7.61 lakh crore (July 2017–July 2024). Mains — should the GST compensation framework be made permanent or is it time for states to accept revenue risk from the GST structure? Discuss the implications for fiscal federalism.

States' Power to Tax Minerals — Nine-Judge Bench Ruling (July 2024)

In Mineral Area Development Authority v. M/S Steel Authority of India (25 July 2024), the nine-judge Constitution Bench (8:1) ruled that states can levy tax on mineral-bearing land in addition to the royalty collected under the central MMDR Act. The ruling — which allows retrospective application from 1 April 2005 — will significantly boost the revenues of mineral-rich states (Jharkhand, Odisha, Chhattisgarh, Rajasthan, Goa) through enhanced cess and tax on mining activities.

UPSC angle: Prelims — MADA v. SAIL (July 2024); Entry 50 State List; states can levy mineral tax; retrospective from 1 April 2005. Mains — analyse how this ruling alters the Centre-State fiscal balance in mineral-rich states; is there a risk of double taxation discouraging mining investment?

Union Budget 2025-26 — Fiscal Devolution and State Borrowing Limits

The Union Budget 2025-26 (presented 1 February 2025, Finance Minister Nirmala Sitharaman) set the fiscal deficit target at 4.4% of GDP (down from 4.8% in 2024-25). State borrowing limits under Article 293 remained at 3% of GSDP, with additional 0.5% conditional on power sector reforms. Total tax devolution to states in 2025-26 was estimated at ₹12.47 lakh crore — an increase over 2024-25's ₹12.19 lakh crore actual devolution. The Budget also reaffirmed the government's intent to maintain timely GST devolution transfers to states.

UPSC angle: Prelims — Budget 2025-26; fiscal deficit 4.4% GDP; state borrowing 3% GSDP; devolution ₹12.47 lakh crore. Mains — evaluate the Union Budget 2025-26 from the perspective of fiscal federalism; are states adequately resourced to meet their constitutional obligations?

16th Finance Commission Report Accepted — Key Decisions for 2026-31

The 16th Finance Commission (Chairman: Arvind Panagariya) submitted its report on 17 November 2025; the Union Budget 2026-27 (1 February 2026) accepted the recommendations and tabled the report in Parliament on the same day. The central government accepted the framework for 2026-27 to 2030-31. Key decisions affecting Centre-State financial relations:

• 41% devolution maintained — States' share in the divisible pool unchanged at 41% (same as 15th FC); southern states' demand for 45-50% was not accepted.
• New GDP-contribution criterion in horizontal distribution formula — rewards economically productive states; partially offsets the south's loss from population-based criteria.
• DISCOM privatisation — States recommended to privatise electricity distribution companies; SPV for legacy debt warehousing.
• Subsidy rationalisation — States advised to tighten targeting mechanisms for direct benefit schemes.
• Combined debt path — Centre + State combined debt to fall from 77.3% GDP (2026-27) to 73.1% GDP (2030-31).

The 16th FC's refusal to include Union cesses and surcharges (~23% of gross tax revenue) in the divisible pool remains a major grievance for southern states.

UPSC angle: Prelims — 16th FC: 41% devolution maintained; new GDP-contribution criterion; DISCOM privatisation recommendation; report tabled February 1, 2026. Mains — evaluate whether the 16th FC's horizontal distribution formula adequately addresses the north-south fiscal equity debate; should cesses and surcharges be included in the divisible pool as a constitutional imperative or merely a policy choice?

Exam Strategy

For Prelims:

• Article 280 — Finance Commission; constituted every 5 years by President
• 15th FC: Chairman N.K. Singh, 41% devolution to States (not 42% — due to J&K bifurcation)
• 15th FC horizontal criteria: income distance 45%, population (2011) 15%, area 15%, forest & ecology 10%, demographic performance 12.5%, tax effort 2.5%
• 16th FC: Chairman Arvind Panagariya, constituted December 2023, covers 2026–31
• Article 243-I (SFC for Panchayats), Article 243-Y (SFC for Municipalities)
• GST compensation period: July 2017–June 2022; 14% annual growth guarantee
• FRBM target for states: 3% of GSDP (with flexibility)

For Mains (GS2):

• The north-south divide in fiscal devolution: argue both sides — equity vs efficiency
• Is the Finance Commission adequately independent? Can it truly mediate Centre-State tensions?
• CSS vs untied devolution: which model better serves cooperative federalism?
• GST Council as a model of cooperative federalism — successes and limitations
• SFC weakness and underfunded local bodies — systemic governance failure

Previous Year Questions (PYQs)

Prelims

1. With reference to the Finance Commission of India, which of the following statements is/are correct? It is constituted under Article 280 of the Constitution. (UPSC 2011)
2. The 15th Finance Commission recommended what percentage of divisible pool taxes to States? — 41%
3. The State Finance Commission for urban local bodies is mandated under which Article? — Article 243-Y
4. Which Article deals with grants-in-aid from the Centre to States? — Article 275

Mains

1. "The Finance Commission plays a crucial role in maintaining fiscal balance between the Centre and States, yet structural tensions persist in Indian fiscal federalism." Critically examine. (GS2, 250 words)
2. Discuss the criteria used by the 15th Finance Commission for horizontal devolution of taxes among States. How does the 'demographic performance' criterion address the concerns of southern states? (GS2, 150 words)
3. "Centrally Sponsored Schemes, while serving national objectives, undermine fiscal federalism by reducing state autonomy." Do you agree? Suggest reforms. (GS2, 250 words)
4. What is the GST Council? How does it embody the principle of cooperative federalism? What challenges has it faced since 2017? (GS2, 150 words)