Dynamics of India’s Fiscal Federalism

• 21 May 2025

This editorial is based on “A holistic assessment of states' performance across seven pillars” which was published in Business Standard on 19/05/2025. The article highlights that India’s states are ranked holistically on seven pillars using 50 indicators to guide sustainable growth and promote competitive federalism toward Viksit Bharat 2047.

For Prelims: Goods and Services Tax (GST), Finance Commission, Centrally Sponsored Schemes (CSSs), Status of Devolution to Panchayats in States 2024 Report, State Finance Commission (SFC), 6th Finance Commission, Inter-State Council, GST Council, FRBM Acts, Fiscal Health Index. 

For Mains: Significance of Fiscal Federalism for Cooperative Federalism and Competitive Federalism. 

As India charts its course towards becoming Viksit Bharat by 2047, the dynamics of fiscal federalism have become more critical than ever. In a diverse and competitive federal structure, states play a decisive role in driving inclusive development, governance, and economic resilience. With states following varied growth trajectories, assessing their fiscal capacity, autonomy, and spending quality is vital. A robust framework for fiscal federalism not only ensures equitable resource distribution but also empowers states to innovate, invest, and deliver public goods aligned with national goals and local aspirations. 

What are the Constitutional and Policy Provisions Governing Fiscal Federalism in India? 

• Tax Base Division: The Seventh Schedule of the Constitution delineates distinct taxation powers between the Union and the States.  
  • This structured division under Article 246 provides legislative and fiscal clarity to both levels of government. 
• GST and Concurrent Taxation: Inserted by the 101st Constitutional Amendment Act, Article 246A enables concurrent taxation on Goods and Services Tax (GST).  
  • It permits the Union to levy Central Goods and Services Tax (CGST) and Integrated Goods and Services Tax (IGST), while States impose State Goods and Services Tax (SGST). 
• Revenue Devolution: Article 270 mandates the sharing of Union tax revenues with States based on Finance Commission recommendations.  
  • Taxes like income tax, CGST, and corporation tax are shared, ensuring vertical equity and distributive justice. 
• Grants-in-Aid: Article 275 allows the Centre to provide grants-in-aid to States with specific developmental needs.  
  • These grants address fiscal disparities and ensure a minimum level of public services. 
• Finance Commission: Article 280 provides for a periodic Finance Commission to assess and recommend inter-governmental resource sharing.  
  • It addresses both vertical and horizontal fiscal imbalances by suggesting devolution formulae and grants-in-aid. 
• Discretionary Grants: Article 282 allows Union and States to make grants for any public purpose, even beyond legislative authority.  
  • While enabling flexibility, it raises concerns regarding transparency and the potential erosion of State autonomy. 
• Borrowing Powers: Article 293 permits States to borrow domestically, subject to Union consent if previous Union debt exists.  
  • This central control restricts independent fiscal planning and capital mobilization for long-term investments. 
• Local Fiscal Devolution: These empower States to devolve fiscal authority to Panchayats and Municipalities.  
  • State Finance Commissions recommend resource-sharing frameworks to strengthen grassroots governance. 
• Exclusion from Divisible Pool: Cesses and surcharges, though Union taxes, are excluded from the divisible pool under Article 270.  
  • This limits States' access to growing revenue streams, aggravating vertical imbalances and fiscal dependency. 
• CSS Conditionality: Centrally Sponsored Schemes (CSSs), operating in State and Concurrent List domains, are part-funded by States with design control held centrally.  
  • This conditional funding undermines the principle of fiscal subsidiarity and hampers localised development needs. 
• Horizontal Criteria: The Finance Commission allocates horizontal shares using income distance, population, area, forest cover, and tax effort.  
  • This multidimensional formula balances efficiency and equity, though not without inter-State discontent.

What are the Major Challenges Facing Fiscal Federalism in India?  

• Vertical Imbalance: The Union commands 63% of national fiscal resources but bears only 38% of total public expenditure.  
  • States, with only 37% of resources, shoulder 62% of public expenditure, creating a severe fiscal mismatch. 
• Loss of Tax Autonomy: The GST subsumed crucial State taxes like VAT and octroi under a unified regime.  
  • States now rely predominantly on SGST and suffer limited flexibility in fiscal policy innovation. 
• Falling Revenue Share: States' actual share in Union gross tax revenue declined from 35% (2015–16) to 30% (2023–24).  
  • This deviation from the 15th Finance Commission’s 41% recommendation weakens States' fiscal capacity. 
• Cess and Surcharge: Cesses and surcharges rose by 133% from 2017–18 to 2022–23, forming nearly 25% of Union tax revenue.  
  • Being outside the divisible pool, these revenues bypass Finance Commission recommendations and reduce States’ allocations. 
• Borrowing Limits: States’ borrowing limits are capped at 3% of GSDP, including off-budget borrowings and public account liabilities.  
  • This severely hampers counter-cyclical fiscal strategies and large-scale capital investments during economic downturns. 
• GST Compensation: Delayed GST compensation payments post-2017 have caused liquidity crises in States and disrupted fiscal planning.  
  • States reported revenue shortfalls between 19% to 33%, exposing the fragility of cooperative fiscal mechanisms. 
• Dependence on CSS: CSS expenditure increased from ₹5.21 lakh crore (2015–16) to ₹14.68 lakh crore (2023–24), with strict guidelines.  
  • States must often provide matching funds and cannot adapt schemes to local needs, reducing fiscal flexibility. 
• Decline in Grants: Grants-in-aid declined from ₹1.95 lakh crore (2015–16) to ₹1.65 lakh crore (2023–24).  
  • This shift increases reliance on conditional transfers, restricting development autonomy. 
• Horizontal Imbalance: More populous and poorer States receive higher shares due to income distance criteria.  
  • States like Karnataka and Kerala perceive this as penalising efficiency, stoking regional grievances. 
• Uneven Development: States like Bihar and Jharkhand score poorly in infrastructure and financial inclusion in multi-pillar state rankings. 
  • Such disparities weaken economic convergence and challenge the idea of balanced regional development through fiscal mechanisms. 
• Off-Budget Borrowing: Inclusion of off-budget liabilities (e.g., Kerala Infrastructure Investment Fund Board) in Net Borrowing Ceiling limits fiscal manoeuvrability.  
  • Absence of transparent norms complicates intergovernmental fiscal accountability and budgeting integrity. 
• Centralised Expenditure: Tied transfers dominate public spending, with less than 22% devolved as untied funds.  
  • This centralisation restricts States’ ability to respond to region-specific development priorities. 
• Weak Panchayat Devolution: Status of Devolution to Panchayats in States 2024 Report reveals inconsistent transfer of 29 subjects under the Eleventh Schedule.  
  • Most States restrict Panchayats' autonomy, hindering local decision-making and effective implementation of schemes. 
• Institutional Gaps in PRIs: District Planning Committees are dysfunctional, and frequent seat rotation weakens Panchayat leadership continuity.  
  • These institutional flaws reduce accountability and governance efficiency at the grassroots level. 
• Poor Financial Autonomy at Local Level: Non-implementation of State Finance Commission (SFC) recommendations and GST centralisation limit Panchayats’ fiscal independence.  
  • This affects bottom-up planning and deprives Panchayats of meaningful development control. 

How can Fiscal Federalism in India be Strengthened? 

• Increase Devolution: The 16th Finance Commission should raise States’ share beyond 41% to restore fiscal balance.  
  • Enhanced devolution empowers States to independently plan welfare schemes, infrastructure, and governance reforms. 
• Rationalise Cess: The Union must rationalise cesses and surcharges or include them in the divisible pool.  
  • This will ensure equity, transparency, and predictability in fiscal transfers across States. 
• Reform GST: GST Council must guarantee timely compensation and consider expanding GST to include petroleum and alcohol.  
  • This would boost revenue buoyancy and reduce over-dependence on CSS and discretionary transfers. 
• Benchmark States with Composite Indices: Using weighted composite indices across fiscal, social, and environmental pillars enables fair State performance benchmarking. 
  • This approach promotes balanced growth and encourages States to pursue multi-dimensional development strategies. 
• Relax Borrowing Limits: States should receive temporary borrowing leeway during economic downturns and natural disasters.  
  • Flexible borrowing ceilings ensure fiscal space for capital investment and emergency response. 
• Strengthen Local Bodies: States must fully implement Articles 243G, 243H, and 243X by devolving clear functions, funds, and functionaries to PRIs.  
  • As per the Status of Devolution to Panchayats in States 2024 Report, this will enhance local governance and service delivery. 
• Boost Capacity of Panchayats: Schemes like Rashtriya Gram Swaraj Abhiyan must be expanded to train local leaders in governance and planning.  
  • Enhancing digital infrastructure will also improve transparency and Gram Sabha participation. 
• Restructure CSS: CSS should be consolidated into a few impactful umbrella schemes with flexible design frameworks.  
  • This avoids duplication, respects State priorities, and improves developmental outcomes. 
• Institutionalise Dialogue: Revive the Inter-State Council and strengthen NITI Aayog’s consultative role in fiscal planning.  
  • Coordination with the GST Council and Finance Commission will enhance integrated policy responses. 
• Use HDI Criteria: The 16th Finance Commission should include Human Development Index as a parameter for resource sharing.  
  • This would prioritise social outcomes and reduce focus on population alone in tax devolution. 
• Ensure Borrowing Transparency: All off-budget liabilities must be disclosed and managed within transparent fiscal responsibility frameworks.  
  • This avoids hidden debts and enhances financial accountability. 
• Align Fiscal Rules: Synchronise FRBM Acts of Centre and States with flexibility for regional economic diversity.  
  • Uniform fiscal targets aligned with development goals will ensure sustainable public finance. 
• Fiscal Health Index Insights: States should use the Fiscal Health Index to guide reforms in capital expenditure and debt management.  
  • Aspirational States must focus on quality spending and revenue mobilisation for fiscal sustainability. 

Conclusion 

A resilient and equitable fiscal federalism framework is essential to harmonize national priorities with state-specific aspirations. Strengthening devolution, empowering local bodies, and aligning fiscal incentives with development goals will not only deepen cooperative federalism but also accelerate India's journey toward inclusive, sustainable, and competitive growth in the Amrit Kaal. 

Drishti Mains Question:

Critically analyse how fiscal federalism, as the foundation of India’s cooperative and competitive federal structure, confronts structural, institutional, and political challenges.

UPSC Civil Services Examination Previous Year Question (PYQ) 

Prelims:

Q. Which one of the following is not a feature of Indian federalism? (2017)

(a) There is an independent judiciary in India. 

(b) Powers have been clearly divided between the Centre and the States. 

(c) The federating units have been given unequal representation in the Rajya Sabha. 

(d) It is the result of an agreement among the federating units. 

Ans: (d)

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Mains: 

Q. The concept of cooperative federalism has been increasingly emphasized in recent years. Highlight the drawbacks in the existing structure and the extent to which cooperative federalism would answer the shortcomings.(2015)