Strengthening Fiscal Federalism in India (UPSC Economy)

Fiscal federalism is the economic counterpart of political federalism. It concerns how revenue-raising powers and spending responsibilities are assigned across tiers of government, and how imbalances between them are corrected through transfers. India's fiscal federalism is anchored in Articles 268 to 293 of the Constitution and built around two pillars: the Finance Commission for statutory transfers, and a looser set of institutions for discretionary grants and cooperative policy-making. The last decade has seen significant shifts – abolition of the Planning Commission, introduction of GST, larger vertical devolution, and rising Centre-state tensions over cesses, surcharges and borrowing limits.

The Two Aspects of Fiscal Federalism

• Assignment of functions to different levels of government – Union List, State List, Concurrent List.
• Allocation of financial powers through Articles 268-293.

The asymmetry between Union taxing powers and state spending responsibilities creates vertical fiscal imbalance, necessitating transfers.

The Finance Commission System

Article 280 creates the Finance Commission every five years to recommend:

• Vertical devolution of the divisible pool of taxes between Centre and states.
• Horizontal distribution among states using a formula of population, area, income distance, forest cover, demographic performance and tax effort.
• Grants-in-aid to states under Article 275 for revenue deficits, sector-specific needs and local bodies.

Evolution

• 13th FC: Vertical devolution at 32 per cent.
• 14th FC (2015-20): Raised devolution to 42 per cent, the single biggest structural shift; used 2011 census, forest cover and demographic change.
• 15th FC (2021-26): Reduced to 41 per cent after J&K reorganisation; introduced demographic performance (2011 census) parameter; retained forest and ecology, income distance, population and tax effort. Included performance grants linked to power sector reforms, health sector outlays and civic services.
• 16th FC: Arvind Panagariya-led Commission covering 2026-31, expected to report in October 2025.

Need for Continuity Between Commissions

Each Commission has freedom to innovate, but broad consistency matters so states can plan. Sharp parameter changes between Commissions can disrupt state finances. For instance:

• 14th FC introduced forest cover (7.5 per cent weight) and demographic change (2011 census, 10 per cent).
• 14th FC dropped 13th FC's fiscal discipline parameter.
• 15th FC rebalanced weights and brought in demographic performance to reward fertility moderation.

The Role of NITI Aayog

The 2015 replacement of the Planning Commission with NITI Aayog stripped the discretionary transfer function. NITI Aayog acts as a think tank, not a finance-transferring institution. This weakened the second pillar of fiscal federalism that had historically corrected regional imbalances through Plan transfers.

Vijay Kelkar's View

Former Finance Commission chair Vijay Kelkar argues India's fiscal federalism now rests on one pillar – the Finance Commission. This is structurally weak. He calls for:

• Strengthening NITI Aayog with transfer-of-funds powers.
• Vice Chair as a permanent invitee to the Cabinet Committee on Economic Affairs.
• Long-term perspective on policy proposals.

Conditional Convergence

India has experienced conditional convergence where poorer states grow faster than richer ones. Kelkar attributes much of this to Plan transfers by the erstwhile Planning Commission. Without that channel, inter-state inequality could widen. The concern is particularly acute for UP, Bihar, Jharkhand, Odisha and North-East states.

The GST Council

Article 279A created the GST Council as a constitutional body for tax harmonisation. It is a pioneering experiment in cooperative federalism, with the Centre holding one-third and states together holding two-thirds of the votes. The Council decides rates, exemptions, thresholds and the operation of the IGST mechanism. The Supreme Court clarified in 2022 that Council recommendations are not binding, recognising states' autonomy.

Pressure Points in Indian Fiscal Federalism

Cesses and surcharges

The divisible pool excludes cesses and surcharges. Their share in Union gross tax revenue rose from 10.4 per cent in 2011-12 to nearly 20 per cent in recent years. Every rupee collected as cess reduces the pool shared with states.

GST compensation

The five-year compensation period ended in June 2022. States have sought extension, citing shortfalls, but the Centre has declined. Compensation cess-backed loans (Rs 2.69 lakh crore) are being repaid through extended levy until March 2026.

Centrally Sponsored Schemes

CSS funds compete with untied devolution. Excessive use of CSS erodes state autonomy, since spending is tied to Centre's priorities.

Borrowing limits

Article 293(3) requires states to seek Centre's consent for fresh borrowing while outstanding Centre loans exist. The Kerala case before the Supreme Court challenges the Centre's unilateral curtailment of state borrowings, including off-budget vehicles.

Special Category Status demands

Andhra Pradesh, Bihar and Odisha have sought Special Category Status; the 14th FC effectively abolished the category but the political demand persists.

State fiscal stress

Punjab, Kerala, Himachal Pradesh, West Bengal and several North-East states face serious fiscal strain, heightening the Centre-state fiscal contest.

Strengthening the System

Institutional reforms

• Permanent Finance Commission secretariat to maintain analytical continuity.
• Fiscal Council to monitor Centre-state fiscal performance independently.
• Strengthened GST Council with better dispute resolution.
• NITI Aayog with limited fund-transfer role for outcome-based grants.

Revenue-side reforms

• Rationalise cesses and surcharges by periodic review.
• Include petroleum under GST to widen the divisible base.
• Plug GST compensation gaps through more buoyant design.

Expenditure-side reforms

• Reduce the number and granularity of CSS, as recommended by the 15th FC.
• Expand untied Finance Commission grants.
• Strengthen local-body transfers under Article 275.

Latest developments (2024-26)

• 16th Finance Commission: ToR include reviewing Centre-state tax sharing, grants, fiscal consolidation path, and measures to improve quality of expenditure. Report due October 2025 for 2026-31.
• Budget 2025-26: Rs 11.2 lakh crore capex with significant state pass-through via the Rs 1.5 lakh crore interest-free 50-year loan to states for capex.
• GST Council reforms: Council in 2024-25 worked on rate rationalisation (collapsing 12 and 18 per cent slabs), inclusion of natural gas and ATF under discussion.
• PLI allocations: Distributed across states based on industrial geography – Gujarat, Maharashtra, Tamil Nadu, Karnataka lead; concerns about spatial concentration of benefits.
• MPI 2024: Wide inter-state variation in multidimensional poverty reinforces the case for equity-sensitive devolution.
• Kerala case: The Supreme Court Constitution Bench reference on Article 293 could fundamentally redraw the contours of state borrowing autonomy.
• Regional rail and metro: Centre-state cost-sharing models for urban transport expanding across states, testing cooperative fiscal arrangements.

UPSC Relevance

Fiscal federalism is a core GS II and GS III theme linking Polity and Economy. Mains prompts test candidates on Finance Commission devolution, NITI Aayog's limited fiscal role, GST Council federalism and cess-surcharge issues. Prelims can ask about Article 280, 279A, 293, devolution percentages, and Commission chairpersons. Candidates should memorise vertical devolution trajectory (32 per cent to 42 per cent to 41 per cent), the 16th FC ToR, and the Budget 2025-26 transfer architecture. Linking current-affairs (Kerala case, GST rate rationalisation, 16th FC) with constitutional provisions produces high-scoring answers.

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