Fiscal Federalism in India — Finance Commission, GST & UPSC Notes

When state Finance Ministers meet the Union every year to negotiate devolution, disaster relief and GST compensation, they are playing out a constitutional choreography that dates back to 1950. Fiscal federalism is the architecture that allocates taxation powers, spending responsibilities and financial resources between the Union and the States. It determines whether welfare schemes run or stall, whether states can build infrastructure, and whether India's federation feels cooperative or confrontational.

For UPSC GS II and GS III, fiscal federalism is one of the most frequently tested themes — in Prelims through constitutional details, in Mains through questions on the Finance Commission, GST Council, and the Centre-state fiscal balance.

Constitutional framework

Articles 268 to 293 in Part XII of the Constitution deal with Centre-State financial relations. Key provisions:

Finance Commission and tax devolution

The Finance Commission under Article 280 is appointed every five years by the President. Its functions include:

• Determining the distribution of net proceeds of taxes between Centre and states.
• Principles governing grants-in-aid to states.
• Transfer of resources to local bodies (since 73rd and 74th Amendments).

Evolution of the devolution formula

The devolution formula has evolved significantly:

15th Finance Commission (2021-26)

• Vertical devolution: 41% of central divisible pool to states (reduced from 42% under 14th FC to accommodate J&K UT).
• Horizontal devolution criteria and weightage:

Issues with the Finance Commission's approach

Population weight shifted

• The combined weight of population and area has increased since 2005.
• Population weight moved from 10 percent (11th FC) to 15 percent (15th FC) using 2011 census.
• Area weight doubled from 7.5 percent (11th FC) to 15 percent (14th and 15th FCs).
• This tilts devolution towards large states with high population.

Income distance tilts toward poorer states

• Income distance is calculated by deducting a state's GSDP per capita from the highest-scoring state.
• Carries 45 percent weight under 15th FC.
• Based on the federal principle that wealthier states share with less wealthy states.
• Has benefited North Indian states disproportionately.

Demographic performance

• Introduced by 15th FC to address the concerns of southern states which have controlled population growth.
• Formula inverses the TFR and multiplies by 1971 population — results in higher weight going to more populous states, partially diluting the intended reward.

Tax and fiscal effort

• 15th FC reintroduced this with only 2.5 percent weight.
• 13th FC had 17.5 percent weight for fiscal discipline.

Disproportionate devolution outcomes

• Budget estimates for FY24 showed Bihar receiving Rs 1.02 lakh crore as Centre's tax share — about 67.4 percent of the state's total tax revenue.
• UP's share was around Rs 1.83 lakh crore (42 percent of total tax revenue).
• Haryana received just Rs 11,164 crore (13 percent).
• Southern states received less than 30 percent of total tax revenue from the divisible pool.
• Per rupee contribution: Bihar received Rs 7.26 while Maharashtra received 8 paise, Haryana 14 paise, Karnataka 17 paise, Gujarat 26 paise, Tamil Nadu 28 paise.

Shrinking divisible pool — cess and surcharge

• Though the FC mandated higher devolution share, actual devolution has not risen proportionately.
• The Centre has reduced tax rates but increased cess and surcharges which are not shareable with states.
• Share of cess and surcharge as a percentage of Centre's Gross Tax Revenue has risen sharply — from around 2.3 percent in 1980-81 to over 15 percent in 2019-20.

Borrowing restrictions

• The Union Budget has kept state borrowing at around 3.5 percent of GSDP for FY24, restricting state fiscal space.
• Article 293 requires states with outstanding central loans or guarantees to obtain Centre's consent for new borrowings.

Loss of taxation rights under GST

• With GST (101st Amendment), states lost the right to unilaterally increase tax revenues by changing rates on goods and services.
• GST rates and slabs are decided by the GST Council with a 3/4th majority (weighted voting).

Restrictions on off-budget borrowings

• The Centre has ruled that off-budget borrowings by states are to be treated as state debt — reducing fiscal creativity.

GST Council

• Under Article 279A, the GST Council comprises:
• Union Finance Minister (Chair).
• Union Minister of State for Finance.
• Finance/Taxation Minister from each state.
• Voting weight: Centre has 1/3; states collectively have 2/3. Decisions require 3/4th of weighted votes.
• Despite this formula, the Council has functioned largely by consensus — until the GST compensation sunset debate exposed frictions.

Way forward — reform suggestions

• Taxation autonomy for states with sound fiscal performance or high disaster exposure (e.g., Kerala).
• Include states in deciding the Terms of Reference of the Finance Commission.
• Raise weight of demographic performance to 15-20 percent.
• Reduce weight of income distance to help southern states.
• Rationalise cess and surcharges — shareable share of gross tax revenue.
• Review Article 293 to grant states fiscal room during downturns.
• Strengthen State Finance Commissions for local body transfers.

Sixth Schedule and Ladakh's demand

Separately, the people of Ladakh have advocated for recognition under the Sixth Schedule. The Sixth Schedule is distinct from the Fifth Schedule in several ways.

Fifth Schedule vs Sixth Schedule

Additional powers under the Sixth Schedule

If different Scheduled Tribes live in an autonomous district, the Governor may divide the area into autonomous regions.

• Legislative power: Rules on land management, forests (other than Reserved Forests), shifting cultivation, chief/headman appointment, inheritance, marriage/divorce, social practice, moneylending by non-STs.
• Executive power: Establish and manage primary schools, dispensaries, markets, cattle pounds, fisheries, roads, road transport, waterways; prescribe language and manner of instruction in primary schools.
• Judicial power: Constitute Village and District Council Courts. Only High Courts and Supreme Court have appellate jurisdiction. Cannot decide cases involving offences punishable with death or 5+ years imprisonment.
• Financial power: Prepare budgets; assess and collect land revenue; impose taxes on professions, trades; grant licenses/leases for mineral extraction.

Advantages of inclusion under Sixth Schedule

• Autonomous District Councils — legislative laws with Governor's approval.
• Autonomous regions within districts for different tribal groups.
• Limitation of Parliament's / state legislature's laws — Acts may not apply unless President/Governor assents.
• Village courts for trials involving tribes.
• Regulatory power on primary schools, markets, moneylending.
• Tax revenue collection — land revenue, specified taxes, grants from Consolidated Fund of India.

Issues with Sixth Schedule

• No decentralisation of powers below the district level in many areas (e.g., Bodo Territorial Council has only a district council).
• Laws require Governor's assent with no time limit — delays persist.
• Conflict between discretionary powers of Governor and the council of ministers.
• Customary laws not codified; ambiguity in application.
• Lack of skilled professionals for council planning.
• Financial dependency on state government; no State Finance Commission for ADCs.
• Lack of development despite autonomy; no panchayat-level structures with MGNREGA-like schemes.
• Corruption and financial mismanagement in some ADCs.

Way forward for Sixth Schedule

• Create elected village councils below the ADC; accountability to Gram Sabha.
• Regular elections by the State Election Commission.
• Recognise Gram Sabha under law with specified powers.
• Ensure women and ethnic minorities are represented.
• Transparency in planning, implementation and monitoring.

Latest developments (2024-26)

• The 16th Finance Commission (2026-2031) has been constituted under Arvind Panagariya; its recommendations will shape fiscal federalism for the next half-decade.
• GST Council continues to deliberate on rationalising slabs; the GST compensation cess has been extended to repay borrowings during the pandemic.
• Ladakh's demands for Sixth Schedule inclusion and statehood remain active with a committee set up by the Union government.
• Updated context: Southern states have formed informal groupings to advocate for population-adjusted devolution formulas ahead of 16th FC recommendations. States like Karnataka, Tamil Nadu and Kerala have publicly raised the issue of imbalanced devolution.

UPSC relevance

For Prelims, remember:

• Articles 268-293 — Centre-State financial relations.
• Article 280 — Finance Commission; constituted every 5 years.
• Article 279A — GST Council.
• Article 293(3) — Centre's consent for state borrowing.
• 15th FC vertical devolution — 41%.
• Sixth Schedule — Assam, Meghalaya, Tripura, Mizoram.

For Mains (GS II and GS III):

• Critically examine the issues in India's fiscal federalism.
• Discuss the challenges facing the 16th Finance Commission.
• Evaluate the GST Council's role in cooperative federalism.
• Examine the demand for Sixth Schedule inclusion of Ladakh.

In essays, fiscal federalism is a fertile theme that connects to cooperative federalism, redistributive justice, and the fiscal foundations of democracy — all enduring UPSC preoccupations.