Financial Relations and the Finance Commission

Article 270: the divisible pool. All taxes and duties in the Union List, except the duties and taxes in articles 268 and 269, surcharges under article 271 and cesses levied 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.

Article 271: surcharges belong wholly to the Union. Parliament may at any time increase any of the duties or taxes in articles 269 and 270 by a surcharge, and the whole proceeds form part of the Consolidated Fund of India.

That last provision is the most important sentence in this chapter for a modern answer. A surcharge or a cess is outside the divisible pool, so a Union that raises revenue through surcharges and cesses rather than through the basic rate keeps all of it, whatever the Finance Commission has recommended about the share. The share of gross tax revenue actually transferred is therefore smaller than the headline percentage, and this is the principal State grievance in fiscal federalism today.

Grants

Article 275: statutory grants in aid. Such sums as Parliament may by law provide shall be charged on the Consolidated Fund of India as grants in aid of the revenues of such States as Parliament determines to be in need of assistance, and different sums may be fixed for different States. The proviso provides for grants for schemes of development to raise the level of administration of Scheduled Areas and for the welfare of Scheduled Tribes.

Article 282: discretionary grants. The Union or a State may make any grants for any public purpose, notwithstanding that the purpose is not one with respect to which the Parliament or the State Legislature may make laws.

Article 282 is short and it has carried an enormous weight. Centrally sponsored schemes in education, health, rural employment and housing, on subjects in List II, are made under it. A State is not obliged to join; a State that does not join loses the money. That is why the article is at the centre of the coercive federalism argument in [The Inter-State Council, and Cooperative Federalism].

The Finance Commission

Article 280(1) requires the President to constitute a Finance Commission within two years of the commencement of the Constitution and thereafter at the expiration of every fifth year or earlier if he considers it necessary. It consists of a Chairman and four other members.

Clause (3) sets the terms of reference. It is the duty of the Commission to make recommendations as to the distribution between the Union and the States of the net proceeds of taxes which are to be, or may be, divided between them and the allocation between the States of the respective shares of such proceeds; the principles which should govern the grants in aid of the revenues of the States out of the Consolidated Fund of India; the measures needed to augment the Consolidated Fund of a State to supplement the resources of the panchayats and municipalities in the State on the basis of the recommendations of the State Finance Commission; and any other matter referred to the Commission by the President in the interests of sound finance.

Article 281 requires the President to cause every recommendation of the Commission, together with an explanatory memorandum as to the action taken on it, to be laid before each House of Parliament.

The recommendations are not legally binding, and that is the point students should notice. Their force is conventional: no government has rejected the core recommendation on the vertical share, and the memorandum under article 281 makes any departure public.

And there is a State-level counterpart. Articles 243-I and 243Y require the Governor to constitute a State Finance Commission every fifth year to review the finances of panchayats and municipalities, which is the third tier's version of the same machinery.

Borrowing, and the rest of Part XII

Article 292: the Union may borrow upon the security of the Consolidated Fund of India within such limits as Parliament may fix.

Article 293: a State may borrow within India upon the security of its Consolidated Fund, subject to limits fixed by its Legislature; but a State may not raise a loan without the Union's consent if there is still outstanding any part of a loan made to it by the Union or in respect of which the Union has given a guarantee. That is a significant and much-used lever.

Articles 285 to 289 exempt each government's property and income from the other's taxation, with exceptions, which is the ordinary immunity of instrumentalities found in every federation.

A worked example

A State complains that although the Fifteenth Finance Commission recommended that forty-one per cent of the divisible pool go to the States, it receives far less than forty-one per cent of what the Union actually collects. Is the complaint constitutionally sound?

The arithmetic is sound and the constitutional answer is that nothing has been breached. Article 270 defines the divisible pool as the taxes in the Union List EXCEPT surcharges under article 271 and cesses levied for specific purposes. A rupee collected as a cess is not in the pool at all, so the forty-one per cent is forty-one per cent of a smaller number.

So the State's remedy is not a court. There is no provision limiting how much revenue the Union may raise through surcharges and cesses, and article 271 says in terms that the whole proceeds form part of the Consolidated Fund of India.

The remedies that exist are political and institutional. The Finance Commission may be asked, under the "any other matter" limb of article 280(3), to consider the treatment of cesses; the Inter-State Council under article 263 may discuss it; and the memorandum under article 281 makes the Union's action on the recommendation public.

And the example makes the general point. In fiscal federalism the constitutional text settles less than students expect, and the practice is governed by an independent recommending body whose recommendations do not bind.

The case

The newest institution in this field is the one whose recommendations were said to bind. In Union of India v. Mohit Minerals Pvt Ltd, (2022) 10 SCC 700. Facts. A challenge to integrated goods and services tax on ocean freight, and the question whether the recommendations of the Goods and Services Tax Council bind the Union and the States. Held. The levy was bad as double taxation, and that the Council's recommendations are not binding but have persuasive value, because article 246A confers simultaneous legislative power on the Union and the States and article 279A does not create a body whose recommendations displace that power; Indian federalism is a dialogue in which both are equal participants. Why it matters here is that the same reasoning explains the Finance Commission: a recommending body in a federation is powerful because both governments accept its recommendations, not because they must.

Distinctions

What it does NOT mean

It does not mean the States are financially helpless. Entries 45 to 63 of List II give them land revenue, stamp duty, taxes on vehicles, on professions, on entertainments and on electricity, and article 246A gives them the goods and services tax on intra-State supply.

It does not mean the Finance Commission's recommendations bind. They do not, and article 281 provides for a memorandum on the action taken precisely because a government may depart from them.

It does not mean article 282 is unconstitutional. It is in the Constitution and has been used since 1950; the criticism is about its use to enter the State List by conditional funding, not about its validity.

And it does not mean a State may borrow freely. Article 293(3) requires the Union's consent while any Union loan or guarantee is outstanding, which in practice is always.

Quick revision

Vertical imbalance: elastic taxes to the Union, expensive services to the States, corrected by machinery. Article 268: levied by the Union, collected and appropriated by the States. Article 269: levied and collected by the Union, assigned to the States. Article 269A: integrated goods and services tax, apportioned. Article 270: the divisible pool, excluding surcharges under article 271 and cesses, distributed on the Finance Commission's recommendation. Article 271: surcharges belong wholly to the Union, which is the principal State grievance. Article 275: statutory grants in aid to States in need, with a proviso for Scheduled Areas and Scheduled Tribes. Article 282: discretionary grants for any public purpose, the basis of centrally sponsored schemes. Article 280: the Finance Commission every fifth year, a Chairman and four members, recommending the division of taxes, the principles of grants, and measures to supplement panchayat and municipal resources. Article 281: the recommendation and an explanatory memorandum laid before each House. Article 292 and 293: borrowing, with the Union's consent required for a State while a Union loan or guarantee is outstanding.

Test yourself

1. What is the vertical imbalance, and is it accidental? That the Union holds the taxes that grow with the economy while the States carry most of the expenditure responsibilities. It is deliberate, inherited from the Government of India Act 1935, and the Constitution provides machinery to correct it.

2. Why does a State receive less than the percentage the Finance Commission recommends? Because article 270 excludes surcharges under article 271 and cesses levied for specific purposes from the divisible pool, and article 271 gives the whole proceeds of a surcharge to the Union. The percentage is a share of a smaller sum.

3. Distinguish articles 275 and 282. Article 275 provides statutory grants in aid, charged on the Consolidated Fund of India, to States Parliament determines to be in need. Article 282 permits either government to make a grant for any public purpose even outside its legislative competence, and is the basis of centrally sponsored schemes on State subjects.

4. State the four terms of reference of the Finance Commission. The distribution between the Union and the States of the net proceeds of divisible taxes and the allocation between the States; the principles governing grants in aid out of the Consolidated Fund of India; the measures needed to augment a State's Consolidated Fund to supplement the resources of panchayats and municipalities on the State Finance Commission's recommendations; and any other matter referred by the President in the interests of sound finance.

5. Are the Commission's recommendations binding, and what follows? No. Article 281 requires the President to lay every recommendation before each House with an explanatory memorandum on the action taken, so a departure is made public. Their force is conventional rather than legal.

6. What limits a State's power to borrow? Article 293: a State may borrow within India on the security of its Consolidated Fund within limits fixed by its Legislature, but may not raise a loan without the Union's consent while any part of a Union loan to it, or a loan guaranteed by the Union, remains outstanding.