Fiscal Federalism: How the Constitution Divides Money

Both, under article 246A: goods and services tax.

Three features of the division are examinable.

1. The Union's bases are broad, elastic and grow with the economy: income, corporate profits, imports. The States' remaining exclusive bases are narrow and slow growing: land, liquor, vehicles, stamps.
2. Agricultural income is a State subject and is taxed nowhere. No State levies a general tax on it, so a very large sector of the economy contributes almost nothing in direct tax, which is one reason India's direct tax base is narrow.
3. The residuary power of taxation is with the Union, under entry 97 of List I, so a base nobody anticipated belongs to Parliament.

Who spends on what

The expensive subjects are largely the States'. Public order and police, public health and sanitation, hospitals, agriculture, irrigation, land, local government and roads are in List II. Education, forests and social security are Concurrent. Defence, foreign affairs, railways and communications are the Union's, and are expensive, but the day to day services a citizen encounters are almost all delivered by a State government.

This is the whole problem in one sentence: the Union collects the money and the States do the spending. The imbalance is not an accident or a defect of drafting; the Constituent Assembly designed it, because taxes on income and imports cannot sensibly be levied by each State separately, while a police force or a hospital must be run locally. Having created the gap deliberately, the Constitution then provides the machinery to bridge it.

The two imbalances

Vertical imbalance: between the Union as a whole and the States as a whole. The Union raises more than it needs for its own functions; the States need more than they can raise. This is corrected by devolution, a share of Union taxes transferred as of right.

Horizontal imbalance: among the States themselves. A State with a large industrial base collects far more per head than a poor and largely agricultural State, while the poorer State needs to spend at least as much per head to deliver comparable services. This is corrected by the formula through which the States' share is divided, and by grants.

The four channels

Channel 1: devolution of Union taxes, article 270.

Article 270(1) provides that all taxes and duties referred to in the Union List, except the duties and taxes referred to in articles 268, 269 and 269A, surcharge under article 271, and any cess levied for specific purposes by a law of Parliament, shall be levied and collected by the Government of India and distributed between the Union and the States. What remains after the exclusions is the divisible pool.

Article 270(2): the prescribed percentage of the net proceeds shall not form part of the Consolidated Fund of India but shall be assigned to the States.

Article 270(3): "prescribed" means prescribed by the President by order after considering the recommendations of the Finance Commission.

Article 270(1A) and (1B), inserted in 2016, bring the Union's own goods and services tax and its share of the integrated tax into the same distribution.

Two technical points that carry marks. First, the share is of net proceeds, which article 279 defines as the proceeds reduced by the cost of collection, ascertained and certified by the Comptroller and Auditor General, whose certificate is final. Second, the devolved share does not enter the Consolidated Fund of India at all; it is not a grant from the Union's money but the States' own money passing through the Union's hands, which is why devolution is called a transfer as of right and not an act of generosity.

Channel 2: grants in aid, article 275. Sums as Parliament may by law provide, charged on the Consolidated Fund of India, as grants in aid of the revenues of such States as Parliament may determine to be in need of assistance, and different sums may be fixed for different States. The proviso adds capital and recurring sums for schemes of development for the welfare of Scheduled Tribes and for raising the level of administration of Scheduled Areas. These grants also go on the Finance Commission's recommendation.

Channel 3: discretionary grants, article 282. The Union or a State "may make any grants for any public purpose, notwithstanding that the purpose is not one with respect to which Parliament or the Legislature of the State, as the case may be, may make laws." This is the widest of the four and the most contested, because it is the article under which the Union funds centrally sponsored schemes in subjects that belong to the States, and it requires no Finance Commission recommendation at all.

Channel 4: borrowing, article 293. A State may borrow within India upon the security of its Consolidated Fund within limits fixed by its Legislature. It may not borrow abroad. And under article 293(3), a State indebted to the Union, or in respect of which the Union has given a guarantee, may not raise any loan without the consent of the Government of India, which in practice means every State.

Two smaller channels, which examiners nonetheless name.

• Article 268: stamp duties mentioned in the Union List are levied by the Union but collected and appropriated by the States, and their proceeds do not form part of the Consolidated Fund of India.
• Article 269: taxes on the inter State sale and consignment of goods are levied and collected by the Union but assigned to the States. Article 269A does the corresponding work for the integrated goods and services tax on inter State supply, which is levied and collected by the Government of India and apportioned between the Union and the States.

The surcharge and cess problem

The single most important grievance in Indian fiscal federalism, and it is written into article 270(1) itself.

Article 270(1) excludes from the divisible pool any surcharge under article 271 and any cess levied for specific purposes. Article 271 then provides that Parliament may increase any of the duties or taxes referred to in articles 269 and 270 by a surcharge for purposes of the Union, and that the whole proceeds of any such surcharge shall form part of the Consolidated Fund of India.

The consequence. A rupee raised as a basic rate of income tax is shared with the States. A rupee raised as a surcharge or a cess on the same income is not. The Union can therefore increase its own revenue without increasing what it must devolve, simply by choosing the label under which it levies. The States' complaint is that the practice reduces the effective share of the divisible pool below whatever percentage a Finance Commission has recommended, and the Sixteenth Commission's response is described in [The Finance Commission].

One limit, added in 2016. Article 271 now expressly excludes the goods and services tax under article 246A, so no surcharge may be imposed on the GST. That was the price of the States' agreement to surrender their own indirect taxes.

What the transfers actually amount to

From the Budget Estimates for 2026-27, in crore rupees:

Compare the top line with the Union's own net tax revenue of 28,66,922 crore rupees. The States receive by devolution alone more than half of what the Union keeps for itself, and the total transfer of 25,43,769 crore is close to the Union's entire net tax revenue. Fiscal federalism is not a marginal adjustment to the Indian budget; it is one of its two largest operations, alongside the interest bill.

A worked example: tracing one hundred rupees of income tax

Suppose the Union collects 100 rupees, of which 85 is charged as basic income tax and 15 as a surcharge and a cess.

The States' share is 41 per cent of the divisible pool, which is 34.44 per cent of the gross collection. The gap of about 6.5 rupees is produced entirely by the 15 rupees of surcharge and cess. A student who understands this example understands the entire dispute.

Why the design is defended

The scheme is not merely a Union advantage, and an answer that treats it as one is incomplete.

1. Efficiency. Income, corporate and customs duties cannot be levied State by State without inviting evasion, tax competition and the migration of paper profits.
2. A common market. Part XIII of the Constitution, beginning with article 301, guarantees freedom of trade, commerce and intercourse throughout the territory of India. Independent State taxes on inter State movement would destroy that freedom, and the goods and services tax was designed to complete it.
3. Equalisation. Only a national government can transfer resources from richer States to poorer ones, and article 275 and the Finance Commission's formula exist to do exactly that.
4. Macroeconomic management. Stabilisation policy requires an authority whose reach is the whole economy.

What beginners get wrong

"The States have no taxing powers." They have List II entries, and since 2016 a concurrent power over the goods and services tax under article 246A. What they lack is the large and elastic bases.

"Devolution is a grant from the Union." It is not. Under article 270(2) the States' share does not form part of the Consolidated Fund of India at all. It is theirs as of right, in the percentage prescribed on a Finance Commission's recommendation.

"The Finance Commission decides all transfers." It decides devolution under article 270 and grants under article 275. Centrally sponsored schemes flow under article 282, on which it makes no binding recommendation, and article 282 accounts for a very large share of what reaches the States.

"A State may borrow as it pleases." Only within India, only within limits fixed by its own Legislature, and under article 293(3) not at all without the Union's consent while it remains indebted to the Union, which every State is.

"Cess and surcharge are shared like other taxes." Article 270(1) expressly excludes them, and article 271 gives the whole proceeds of a surcharge to the Union.

"Fiscal federalism means the Union and the States are equals." The Indian Constitution creates a Union with a strong centre. What fiscal federalism supplies is not equality but machinery, and the whole design depends on that machinery being operated fairly.

Limits

The Constitution does not fix the devolution percentage. It is prescribed by the President on a Commission's recommendation and changes every five years, so an answer should give the mechanism and then the current figure.

Local government is the missing third tier. Parts IX and IX-A require State Finance Commissions, and the Union Finance Commission recommends grants to local bodies, but the constitutional machinery for municipal and panchayat finance is far weaker than for the States.

Union budget figures do not show the States' own revenues, which are substantial, so the transfer figures alone overstate the States' dependence.

The GST has changed the picture in ways still being worked out, since the States surrendered independent indirect taxing powers in exchange for a share in a jointly administered tax and a seat on the Council.

Quick revision

1. Fiscal federalism = the division of taxing powers, expenditure responsibilities and resources between Union and States, and the machinery for correcting the resulting imbalances.
2. Article 246 and the Seventh Schedule divide legislative power; taxing entries are separate and specific; article 265, no tax except by authority of law; article 246A, the concurrent power over GST.
3. The Union has the broad and elastic bases, income, corporation tax and customs; the States have land, liquor, stamps, vehicles and professions; agricultural income is a State subject and is effectively untaxed; the residuary taxing power is the Union's.
4. The States carry the expensive services: police, health, agriculture, irrigation, local government, and education concurrently.
5. Vertical imbalance between Union and States; horizontal imbalance among the States.
6. Four channels: article 270 devolution of the divisible pool; article 275 grants in aid charged on the Consolidated Fund; article 282 grants for any public purpose, which fund centrally sponsored schemes; article 293 borrowing, with 293(3) requiring the Union's consent. Also article 268 stamp duties collected and appropriated by the States, and articles 269 and 269A taxes levied by the Union and assigned or apportioned.
7. Net proceeds under article 279 = proceeds less cost of collection, certified by the Comptroller and Auditor General, whose certificate is final.
8. Surcharges under article 271 and cesses are excluded from the divisible pool by article 270(1), so the Union can raise revenue it need not share. Article 271 now excludes GST.
9. 2026-27 BE: States' share of taxes 15,26,255 crore; Finance Commission grants 1,29,397 crore; total transferred to States and Union territories 25,43,769 crore.

Test yourself

1. What is fiscal federalism, and what problem does it exist to solve in India? Fiscal federalism is the division of taxing powers, expenditure responsibilities and financial resources between the Union and the States, together with the machinery for correcting the imbalance that division produces. In India the problem arises because the Constitution deliberately assigns the broad, productive and elastic tax bases to the Union, namely taxes on income other than agricultural income, corporation tax and customs, while the services on which most public money must be spent, such as police and public order, public health and hospitals, agriculture, irrigation, land and local government, fall in the State List, with education and social security in the Concurrent List. The Union therefore raises more than it needs for its own functions and the States need more than they can raise, which is called the vertical imbalance. The States also differ greatly among themselves in capacity, a rich industrial State collecting far more per head than a poor agricultural one while needing to spend no less, which is called the horizontal imbalance. The design was deliberate, since taxes on income and imports cannot sensibly be levied State by State while a hospital must be run locally, and the Constitution accordingly supplies four channels to bridge the gap it has created.

2. Explain the four channels through which resources reach the States. The first is devolution under article 270. All taxes and duties in the Union List, other than those in articles 268, 269 and 269A, surcharges under article 271 and cesses levied for specific purposes, are levied and collected by the Government of India and distributed between the Union and the States in the prescribed percentage; the States' share does not form part of the Consolidated Fund of India at all, and the percentage is prescribed by the President by order after considering the recommendations of the Finance Commission. The second is grants in aid under article 275, being sums provided by Parliament and charged on the Consolidated Fund of India as grants in aid of the revenues of States determined to be in need of assistance, different sums being permissible for different States, with a proviso for the welfare of Scheduled Tribes and the administration of Scheduled Areas.

The third is discretionary grants under article 282, by which the Union or a State may make any grant for any public purpose notwithstanding that the purpose is not one on which it may legislate, which is the basis of centrally sponsored schemes in subjects belonging to the States. The fourth is borrowing under article 293, by which a State may borrow within India upon the security of its Consolidated Fund within limits fixed by its Legislature, but not abroad, and not at all without the consent of the Government of India while it remains indebted to the Union. To these should be added articles 268 and 269, under which certain stamp duties and certain taxes on inter State sale are levied by the Union but collected and appropriated by, or assigned to, the States, and article 269A, which apportions the integrated goods and services tax.

3. What is the divisible pool, and why do the States complain about cesses and surcharges? The divisible pool is what remains of the Union's tax revenue after the exclusions made by article 270(1) itself, namely the duties and taxes referred to in articles 268, 269 and 269A, any surcharge levied under article 271, and any cess levied for a specific purpose by a law of Parliament. From that pool the States receive the prescribed percentage of the net proceeds, net proceeds being defined by article 279 as the proceeds reduced by the cost of collection and certified by the Comptroller and Auditor General, whose certificate is final. The States' complaint follows directly from the exclusion. Article 271 provides that Parliament may increase any of the duties or taxes referred to in articles 269 and 270 by a surcharge for purposes of the Union and that the whole proceeds of such a surcharge shall form part of the Consolidated Fund of India, so a rupee raised as a basic rate is shared while an identical rupee raised as a surcharge or a cess is not. The Union can therefore increase its revenue without increasing what it devolves merely by choosing the label under which it levies, and the effective share of the States falls below the percentage a Finance Commission has recommended. One limit was introduced in 2016, when article 271 was amended to exclude the goods and services tax under article 246A from the surcharge power, which was part of the bargain by which the States surrendered their own indirect taxes.

4. Why is devolution said to be a transfer as of right rather than a grant? Because of the language of article 270(2), which provides that the prescribed percentage of the net proceeds of the shared taxes shall not form part of the Consolidated Fund of India but shall be assigned to the States. The money never becomes the Union's own resource at all; it passes through the Union's collecting machinery and is assigned to the States by force of the Constitution and of the President's order made after considering the Finance Commission's recommendation. It is not appropriated by Parliament as expenditure and it does not depend on the Union's willingness to be generous in a particular year. A grant in aid under article 275, by contrast, is charged on the Consolidated Fund of India and is provided by Parliament by law, and a grant under article 282 is entirely discretionary. The practical importance of the distinction is that devolution is predictable and unconditional, so a State can budget on it, whereas article 282 transfers may carry conditions, matching requirements and changes of policy from year to year.

5. Why did the framers give the Union the more productive tax bases, and what is said in defence of the arrangement? Four reasons are usually given. First, efficiency in collection: taxes on income, corporate profits and imports cannot be levied separately by each State without inviting evasion, competitive rate cutting and the migration of paper profits to whichever State taxes least, and a customs duty is meaningless unless it is levied at the national frontier. Second, the maintenance of a common market: Part XIII of the Constitution, beginning with article 301, guarantees the freedom of trade, commerce and intercourse throughout the territory of India, and independent State taxes on the movement of goods across State boundaries would destroy it, which is precisely the defect the goods and services tax was designed to cure. Third, equalisation: only a national government can transfer resources from richer States to poorer ones so that a citizen's access to public services does not depend entirely on the accident of the State in which they live, and article 275 together with the Finance Commission's formula exists for that purpose. Fourth, macroeconomic management: stabilisation policy, whether in a recession or an inflation, requires an authority whose reach is the whole economy, since a single State that expands its spending confers much of the benefit on its neighbours.

6. What restrictions does the Constitution place on State borrowing, and why? Article 293(1) permits a State to borrow within the territory of India upon the security of its Consolidated Fund, within such limits as its own Legislature may from time to time fix by law. It does not permit a State to borrow outside India, so external commercial borrowing by a State is constitutionally impossible and external assistance reaches it only through the Union. Article 293(3) provides that a State which is indebted to the Government of India in respect of any loan, or in respect of which the Union has given a guarantee, may not raise any loan without the consent of the Government of India, and article 293(4) allows that consent to be given subject to conditions. Since every State is indebted to the Union, the effect is that Union consent is required for State borrowing generally, and the ceiling set under it is the operative constraint on State fiscal policy. The reasons are that a State's default would damage the credit of the country as a whole and would in practice fall to be met by the Union; that unlimited State borrowing would frustrate any national fiscal policy, since the combined deficit and not the Union's alone determines the demand on savings and the level of interest rates; and that borrowing abroad exposes the country to exchange rate risk that no single State could be allowed to create for the others.