Fiscal Federalism

Article 265, and the rule of law in taxation

"No tax shall be levied or collected except by authority of law."

Three points make this more than a formality. Law means a statute, not an executive order, so a tax imposed by a government resolution is void. The whole of the levy must be authorised: the taxable event, the person liable, the rate and the measure must all be found in the law, and a tax cannot be saved by an authority's assurance that it is reasonable. And "levied or collected" covers both imposition and recovery, so money collected without authority is recoverable.

Article 265 is the taxation limb of the rule of law and belongs with [The Rule of Law] as well as here.

The three funds

The Consolidated Fund of India, and of each State, under article 266(1). All revenues received, all loans raised and all money received in repayment of loans go into it. No money may be appropriated out of it except in accordance with law and for the purposes and in the manner provided in the Constitution. This is the fund that the annual budget and the appropriation Act operate on.

The Public Account under article 266(2). Money received by or on behalf of the government that is not revenue: provident funds, small savings, deposits. The government holds it as a banker, and payments out of it do not need an appropriation by the legislature.

The Contingency Fund under article 267. Placed at the disposal of the President, or the Governor, to meet unforeseen expenditure pending authorisation by the legislature. It is an imprest and must be recouped.

Where the tax money goes

The pre-2016 scheme distinguished several categories, and the goods and services tax has since absorbed a great deal of it. The categories still in the text, and still examinable, are these.

Article 268. Duties levied by the Union but collected and appropriated by the States: stamp duties on the instruments listed in the Union List. The Union sets the rate; the State collects and keeps it.

Article 269. Taxes on the sale or purchase of goods and on the consignment of goods in the course of inter-State trade, levied and collected by the Union but assigned to the States. The proceeds do not form part of the Consolidated Fund of India.

Article 269A. The goods and services tax on inter-State supply, levied and collected by the Union and apportioned between the Union and the States. See [The Goods and Services Tax and Its Council].

Article 270. The general rule. All taxes and duties in the Union List, except those in articles 268, 269 and 269A, surcharges under article 271 and cesses for a specific purpose, are levied and collected by the Union and distributed between the Union and the States in the manner the Finance Commission recommends. This is the divisible pool, and it is the main channel.

Article 271. Parliament may at any time increase any of the duties or taxes in articles 269 and 270 by a surcharge for the purposes of the Union, and the whole proceeds of such a surcharge form part of the Consolidated Fund of India.

That last sentence is the most contested provision in the whole chapter. A surcharge, and equally a cess levied for a specific purpose, is outside the divisible pool, so none of it is shared with the States. A Union that raises revenue through surcharges and cesses rather than through the base rate of a shared tax increases its own resources without increasing anybody's share. That is the single most frequently made criticism of Indian fiscal federalism in the last decade, and an answer should make it in those terms.

Grants

Article 275. Statutory grants in aid of the revenues of States which Parliament determines to be in need of assistance, charged on the Consolidated Fund of India. Different sums may be fixed for different States. There are also specific grants for schemes of development for the Scheduled Tribes and Scheduled Areas.

Article 282. Discretionary grants. The Union or a State may make any grant for any public purpose, notwithstanding that the purpose is not one with respect to which the legislature concerned may make laws. This is a striking provision: it lets the Union spend on State subjects.

Article 282 is the constitutional basis of the centrally sponsored schemes, which is how a very large part of the Union's transfer to the States is actually made, and it is why the Union has effective influence over policy in fields the Seventh Schedule gives to the States. A State that wants the money accepts the scheme's design. Whether an article intended for occasional grants should have become a principal channel of transfer is a fair question to raise.

The Finance Commission

Article 280 requires the President to constitute a Finance Commission within two years of the commencement of the Constitution and every fifth year thereafter, or earlier if he considers it necessary.

Composition. A chairman and four other members, with qualifications determined by Parliament.

Duties. To make recommendations to the President on the distribution between the Union and the States of the net proceeds of taxes which are to be divided between them, and the allocation of the respective shares between the States; on the principles which should govern grants in aid of the revenues of the States out of the Consolidated Fund of India; on measures needed to augment the Consolidated Fund of a State to supplement the resources of the panchayats and municipalities on the basis of the recommendations of the State Finance Commission; and on any other matter referred to it by the President in the interests of sound finance.

Status of its recommendations. They are advisory. Article 281 requires the President to cause every recommendation, together with an explanatory memorandum as to the action taken on it, to be laid before each House of Parliament. The convention has been that the core recommendations on tax devolution are accepted, and the strength of the Commission rests on that convention rather than on any legal obligation.

Two features worth naming. The terms of reference are set by the Union, which shapes what the Commission can recommend. And the Commission's recommendations operate on the divisible pool, so revenue raised outside that pool by surcharge or cess is beyond its reach whatever it recommends.

The Planning Commission and NITI Aayog

Alongside the constitutional machinery there was, from 1950 to 2014, a parallel and entirely extra-constitutional channel. The Planning Commission was created by a Cabinet resolution, not by the Constitution or by statute, and it allocated plan assistance to the States. For much of that period the plan channel was comparable in size to the Finance Commission channel, and it operated on criteria the Union set.

It was replaced in 2015 by NITI Aayog, also created by a Cabinet resolution, which does not allocate funds at all. Its function is advisory and co-ordinating. The consequence is that the Finance Commission is now the principal formula-based channel, which strengthens the constitutional machinery, while the discretionary channel under article 282 remains.

The federalism argument

Bring the chapter together in one paragraph, which is what an examiner is looking for.

Fiscal federalism is where the formal division of powers meets the practical question of who can actually govern. A State with exclusive legislative competence over public health cannot deliver public health without money, and if the money comes from the Union on the Union's terms, the exclusivity in article 246 is worth less than it reads. The Constitution recognised the problem and answered it with an independent Finance Commission whose formula the Union has by convention accepted. The pressure on that answer comes from three directions: revenue raised outside the divisible pool by surcharge and cess, the growth of conditional transfers under article 282, and the fact that the Commission's terms of reference are written by one of the two parties whose shares it is dividing. All three are live and all three are proper material for an answer on whether India is a federation.

A worked example

The Union raises the rate of a cess levied for a specified purpose on a tax in the Union List, and reduces the base rate of the same tax by an equivalent amount. Total collections are unchanged. A State complains that its revenue has fallen sharply.

Why the State's revenue falls. Article 270 provides that taxes in the Union List are levied and collected by the Union and DISTRIBUTED between the Union and the States in the manner the Finance Commission recommends. That is the divisible pool. But article 270 expressly excludes surcharges under article 271 and cesses levied for a specific purpose. A rupee moved from the base rate to a cess leaves the divisible pool entirely.

Is it unconstitutional? No. Article 271 permits Parliament at any time to increase any of the duties or taxes referred to in articles 269 and 270 by a surcharge for the purposes of the Union, and the whole proceeds form part of the Consolidated Fund of India. A cess for a specified purpose is likewise outside the pool. The Union is exercising powers it plainly has.

What the State can and cannot do. It cannot challenge the levy for want of competence. It may argue that a cess collected for a specified purpose must actually be spent on that purpose, which is a real limit, and that a levy called a cess but functioning as general revenue is a colourable exercise. Whether that succeeds depends on the facts.

What the Finance Commission can do. Nothing directly: it operates on the divisible pool, so revenue raised outside the pool is beyond its reach whatever it recommends. It may comment, and Commissions have.

The point for an essay. This is the sharpest current criticism of Indian fiscal federalism, and it needs no allegation of bad faith: the structure permits it.

Quick revision

• Vertical imbalance is deliberate: the States spend, the Union collects, and Part XII moves the money.
• Article 265: no tax except by authority of law, and law means a statute.
• Consolidated Fund, Public Account, Contingency Fund: articles 266 and 267.
• Article 270 is the divisible pool; article 271 surcharges and specific-purpose cesses sit outside it and are not shared.
• Article 275 is statutory grants; article 282 is discretionary grants and is the basis of centrally sponsored schemes on State subjects.
• Article 280: a Finance Commission every fifth year, advisory, with terms of reference set by the Union, its recommendations laid before Parliament under article 281.
• The Planning Commission was never constitutional; NITI Aayog replaced it in 2015 and allocates nothing.

Test yourself

1. Explain the vertical imbalance and why it is deliberate.

2. What is the divisible pool, and what falls outside it? Why does that matter?

3. Distinguish articles 275 and 282, and explain why article 282 has become a principal channel of transfer.

4. How often must a Finance Commission be constituted, what must it recommend, and what is the status of its recommendations?

5. Was the Planning Commission a constitutional body? What replaced it, and what does the replacement do?