Financial relations

1. Constitutional architecture and fiscal imbalance

Financial federalism concerns the assignment of taxation powers, expenditure responsibilities, transfers and borrowing authority across governments. Article 265 establishes the basic safeguard: no tax shall be levied or collected except by authority of law. Taxation powers are allocated mainly through Article 246 and separate entries in the Union and State Lists of the Seventh Schedule. There is no general taxation entry in the Concurrent List; GST rests on the special arrangement under Article 246A.

The Union controls broad and buoyant bases such as corporation tax, non-agricultural income tax and customs duties. States retain important powers over agricultural income, land revenue, taxes on vehicles, electricity consumption or sale, and alcoholic liquor for human consumption. Taxes on the sale of specified petroleum products also remain outside the operative GST levy. Agricultural income is constitutionally within State taxing competence, even though its actual taxation varies across States.

Two imbalances explain intergovernmental transfers. Vertical imbalance arises because States have substantial responsibilities for health, education, agriculture and local infrastructure but comparatively limited revenue capacity. Horizontal imbalance arises from differences among States in income, population, geography, infrastructure and service-delivery costs. Transfers therefore support both adequate State financing and equalisation, without implying identical expenditure outcomes everywhere.

• Distinguish legislative competence to impose a tax from responsibility for collecting it and entitlement to its proceeds.
• Under Articles 248 and Union List Entry 97, residuary taxation power belongs to Parliament, subject to the constitutional GST framework.

2. Tax assignment, sharing and the divisible pool

Article 268 covers specified stamp duties levied by the Union but collected and appropriated by States, except in Union territories. Article 269 deals with Union-levied and collected taxes assigned to States, notably specified inter-State sale or purchase taxes outside Article 269A. Article 269A separately governs GST on inter-State supplies: it is levied and collected by the Union and apportioned between the Union and States according to parliamentary law.

Article 270 provides the principal framework for distributing shareable Union tax proceeds between the Union and States. The divisible pool excludes constitutionally specified categories, including Article 271 surcharges and cesses levied for specific purposes. Consequently, a rise in the share of cesses and surcharges within gross Union tax revenue can reduce the proportion available for ordinary tax devolution, even without changing the States’ recommended devolution percentage.

Under Article 279, net proceeds mean proceeds reduced by collection costs. The Comptroller and Auditor General ascertains and certifies these proceeds, and that certificate is final. Vertical devolution determines the collective State share of the divisible pool; horizontal devolution distributes that share among individual States. A frequently tested distinction is that a percentage of the divisible pool is not the same as that percentage of all Union receipts.

• Article 271 permits Union surcharges on certain taxes, but expressly excludes GST under Article 246A.
• The Constitution (80th Amendment) Act, 2000 broadened the tax-sharing arrangement, with effect from 1 April 1996.

3. Finance Commission, grants and local governments

Under Article 280, the President constitutes a Finance Commission every five years or earlier. It comprises a chairperson and four other members; Parliament prescribes their qualifications and manner of selection. Its core functions include recommending Union–State tax distribution, allocation among States and principles governing grants-in-aid under Article 275. It also recommends measures to augment State Consolidated Funds to supplement panchayat and municipal resources, based on State Finance Commission recommendations.

The Fifteenth Finance Commission, chaired by N. K. Singh, recommended 41% tax devolution for 2021–26. The reduction from the Fourteenth Commission’s 42% reflected the reorganisation of Jammu and Kashmir into Union territories. Its horizontal formula assigned weights to income distance, population, area, forest and ecology, demographic performance, and tax and fiscal efforts. These recommendations are period-specific, not permanent constitutional percentages.

Article 275 provides grants-in-aid, including constitutionally specified support for Scheduled Tribe welfare and administration of Scheduled Areas. Article 282 allows the Union or a State to make grants for any public purpose even beyond its ordinary legislative competence. It supports discretionary transfers, including many scheme-based transfers. Unlike generally untied tax devolution, scheme grants may impose matching contributions and spending conditions.

Finance Commission recommendations are advisory, not automatically enforceable awards. Article 281 requires the President to lay them, together with an explanatory memorandum on action taken, before both Houses of Parliament. State Finance Commissions under Articles 243I and 243Y address State–local fiscal relations; delayed constitution or weak implementation can undermine decentralisation.

4. GST and cooperative fiscal federalism

The 101st Amendment created a shared GST framework. Article 246A empowers Parliament and State legislatures to legislate on GST, while Parliament has exclusive power over inter-State supplies. Intra-State supplies ordinarily attract Central GST and State GST; inter-State supplies and imports attract Integrated GST. GST is destination-based, so revenue broadly follows the place of consumption rather than production.

Article 279A establishes the GST Council, chaired by the Union Finance Minister. Its membership includes the Union Minister of State in charge of Revenue or Finance and the nominated minister from each State. Formal decisions require at least three-fourths of weighted votes of members present and voting. The Union carries one-third and the States collectively two-thirds; neither side can independently secure the required majority.

In Union of India v. Mohit Minerals Pvt. Ltd. (2022), the Supreme Court held that GST Council recommendations are not binding on the Union and States. They nevertheless have significant persuasive value within cooperative federalism. The original statutory GST compensation arrangement protected States against specified revenue shortfalls for five years ending June 2022. Subsequent compensation-cess collection for servicing pandemic-era borrowing should not be confused with an extension of that original compensation entitlement.

5. Borrowing, accountability and contemporary concerns

Article 292 authorises Union borrowing on the security of the Consolidated Fund of India, subject to limits Parliament may fix. Article 293 permits States to borrow within India on the security of their Consolidated Funds, subject to limits imposed by their legislatures. Where a Union loan or Union-guaranteed loan remains outstanding, a State requires Union consent to raise further loans; consent may carry conditions.

Fiscal responsibility legislation complements these constitutional rules but does not create identical permanent deficit limits for every government. Contemporary disputes concern borrowing ceilings, off-budget liabilities, conditional grants and the fiscal implications of cesses. Sound reform requires predictable transfers, transparent accounting of guarantees and debt, strengthened own-source revenues and timely State Finance Commissions. Equalisation must be balanced with incentives for tax effort, responsible borrowing and expenditure quality.

• A Union Budget transfer is not necessarily Finance Commission tax devolution.
• Tax devolution, grants, loans and GST settlement are distinct fiscal channels.

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