After eight years, GST is at a turning point — recent reforms bring efficiency and consumer benefits, but ongoing revenue issues and reduced state powers challenge India’s cooperative federalism.

Fiscal Federalism

• About: Fiscal Federalism refers to the division of financial responsibilities, revenue-raising powers, and expenditure functions between multiple tiers of government. 
  • It is the economic dimension of political federalism, aimed at ensuring both fiscal efficiency and democratic accountability.
• Balancing Wheel: The Finance Commission (FC), constituted under Article 280 of the Constitution, is regarded as the “balancing wheel of fiscal federalism.” It recommends:
  • The share of the divisible pool of Union taxes to be devolved to States,
  • Grants-in-aid to cover revenue deficits, and
  • Special-purpose grants to strengthen local governments.

Broad Principles Underlying Fiscal Federalism

• Fiscal Equivalency: The jurisdiction that provides a public good should correspond to the population benefiting from it.
• Decentralisation Theorem: Public services should be provided by the lowest level of government capable of internalising costs and benefits.
• Principle of Subsidiarity: Functions should be performed at the lowest appropriate level — Central, State, or Local — promoting efficiency, responsiveness, and participation.
  • India’s Constitution, however, establishes a centralised federal structure, where the Union retains most revenue-raising powers, while States bear greater expenditure responsibilities, making intergovernmental fiscal transfers essential to sustain balanced regional development.

Evolution of India’s Tax Federalism

• Pre-GST Framework: Before 2017, the fiscal domain was clearly divided:
  • The Centre levied excise, customs, and service tax.
  • The States collected sales tax, VAT, octroi, and entry tax.
  • This system provided fiscal autonomy to States, allowing them to design taxes suited to their developmental priorities.
• Constitutional and Legal Developments: The 92nd Amendment empowered Parliament to levy service tax, while the 101st Constitutional Amendment (2016) introduced Article 246A, enabling both Centre and States to levy GST on a common tax base.
  • GST replaced an origin-based system with a destination-based regime, reducing cascading effects but also eroding States’ independent taxing authority. 
  • Decisions on rates and exemptions are now made by the GST Council, where the Centre holds dominant voting power, altering India’s federal fiscal balance.

• The Post-Compensation Era: Emerging Challenges: The expiry of the GST (Compensation to States) Act, 2017, which guaranteed States 14% annual revenue growth for five years, and the merger of the compensation cess into regular GST, have created deep fiscal uncertainty.
  • Key Concerns of the States:
    • Revenue Loss: States contend that the Centre has underestimated actual revenue losses, particularly in consumption-heavy States.
    • Erosion of Fiscal Autonomy: With no power to alter GST rates independently, States face greater dependence on Central transfers.
    • Cesses and Surcharges: The Centre’s growing use of non-divisible revenue sources has reduced the divisible pool—its share in gross tax revenue declined from 88.6% (2011–12) to 78.9% (2021–22) (RBI, State Finances Report 2023–24).
    • Falling Devolution: Despite the 14th Finance Commission’s 42% (now 41%) tax devolution mandate, effective transfers remain lower due to rising cesses and discretionary grants.
      • This widening vertical fiscal imbalance leaves States responsible for health, education, and agriculture without adequate revenue control, challenging the federal balance envisioned under GST.

Constitutional and Institutional Framework

• Article 280 – Finance Commission: Establishes the Finance Commission to recommend the devolution of taxes between the Centre and States.
• Article 282 – Discretionary Grants: Allows both the Centre and States to provide grants for any public purpose, leading to expanded use of Centrally Sponsored Schemes (CSS) beyond their original intent.
• Article 293 – State Borrowing: Regulates State borrowing powers, requiring Central approval for new loans if previous dues remain unpaid.
• Centralisation Concerns: Though intended to promote coordination, these provisions have led to discretionary centralisation, as Article 282 is often invoked to justify central schemes in State List areas.
• Seventh Schedule and 42nd Amendment: The 42nd Amendment (1976) shifted key subjects like education and forests to the Concurrent List, further reducing the fiscal and policy autonomy of States.

Finance Commission and Cooperative Federalism

• Finance Commission (FC): The Constitution envisages the FC as the balancing wheel of fiscal federalism in India. 
  • Article 280 of the Constitution of India provides for a Finance Commission as a quasi judicial body. It is constituted by the president of India every fifth year or at such an earlier time as he considers necessary.
  • The FC was formed to define the financial relations between the central government of India and the individual state governments.
  • It makes recommendations on three areas:
    • The share of the divisible pool of the Union government’s taxes that is to be devolved to the States.
    • Grants made by the Union government to the States to meet their revenue deficits. 
    • Certain other grants to States and local governments. 
• Parallel Grant Channels: Post the abolition of the Planning Commission (2014), grants are routed through the Finance Commission and Centrally Sponsored Schemes (CSS). States view this as opaque and politically influenced, undermining cooperative federalism.
• Dependence on Central Transfers: On average, 44% of State revenue comes from Central transfers — rising to 72% for Bihar and falling to 20–34% for industrialised States like Haryana, Tamil Nadu, and Kerala. This dependence limits fiscal autonomy and planning flexibility.

Towards Fiscal Autonomy

• New Models of Devolution: Some economists propose sharing the personal income tax base with States (like GST), allowing a 50:50 split or State-level top-ups. This could reward tax-performing States and reduce dependence on Central transfers.
• Comparative Example: In Canada, the federal government collects 46% and spends 40%, while provinces collect 54% and spend 60%, ensuring a more balanced fiscal federalism.
• Dynamic Resource Sharing: Periodic re-assessment of revenue responsibilities and dynamic devolution formulas can ensure fiscal alignment with public expectations and expenditure growth.

Challenges Confronting India’s Fiscal Federalism

• Shrinking Divisible Pool- Rise of Cesses and Declining Devolution: The rising cesses and surcharges (₹4.23 lakh crore, 18% of tax receipts) excluded from the divisible pool have lowered States’ share in Gross Tax Revenue below 33%.
  • It leads to undermining fiscal transparency, cooperative federalism, and trust between Centre and States.
• Dependence on Central Transfers and Horizontal Inequity: With Central transfers making up 44% of State revenues, poorer States like Bihar (72%), Uttar Pradesh (61%), and Madhya Pradesh (58%) remain highly dependent, while advanced States like Tamil Nadu (31%) and Maharashtra (28%) receive less, creating horizontal inequity and limiting fiscal autonomy.
• Politicisation of Grants and Centralised Control through Schemes: Post-2014, Centrally Sponsored Schemes (CSS) dominate fiscal transfers, often overlapping with State List subjects and operating under fixed cost-sharing ratios, limiting State discretion. 
  • Alleged political bias has turned CSS into tools of centralised financial control.
• GST and Fiscal Centralisation: The Goods and Services Tax (GST, 2017) unified indirect taxes but restricted States’ rate-setting power. 
  • Centre-dominated GST Council and delayed ₹78,000 crore compensation have eroded State flexibility, centralising fiscal control at the expense of federal autonomy.
• Vertical Fiscal Imbalance and Borrowing Constraints: The RBI State Finances Report 2025 highlights persistent vertical fiscal imbalance: 
  • The Centre collects 67% of taxes while States handle 52% of expenditure, face borrowing limits, and rising debt (31.2% of GSDP), revealing centralised taxation but decentralised spending.
• Macroeconomic Stability and Fiscal Coordination: Rising State debt (31.2% of GSDP) threatens national fiscal stability. 
  • A statutory Loan Council under Article 293, along with coordinated borrowing rules, can curb competitive populism, enable counter-cyclical policies, and strengthen State fiscal autonomy.
• Weak Finances of Local Governments: Despite 73rd and 74th Amendments, Panchayats and Municipalities remain fiscally weak, relying on transfers. Managing nearly half of public services yet receiving <5% of spending, they face structural fragility that undermines subsidiarity and grassroots governance.
• Structural and Ethical Consequences for Federalism: The cumulative effect of these trends is a progressive weakening of cooperative federalism:
  • Tax devolution imbalances penalise high-performing States.
  • Scheme-based centralisation limits local innovation.
  • Borrowing restrictions and political discretion reduce fiscal accountability.
  • Underfunded local governments weaken the base of democratic governance.

Check Out UPSC CSE Books

Visit PW Store

Fiscal Imbalance and the GST Paradox

• Despite centralisation of taxation, expenditure responsibilities of States — in health, education, agriculture, and local governance — continue to rise.
• This mismatch has intensified vertical fiscal imbalance, with States demanding greater resource autonomy and flexible taxation powers.

Way Forward

• Strengthening the Finance Commission’s Mandate: The 16th Finance Commission (2025–30) offers a chance to revise fiscal devolution post-GST. 
  • Key priorities include raising vertical devolution, integrating IGST and input credits, introducing performance-based incentives, and adopting a dynamic, equitable formula reflecting demographics, ecology, and revenue effort.
• Expanding and Diversifying the Tax Base: Expanding GST to cover electricity, petroleum, diesel, real estate, and agriculture, along with 50:50 sharing of Personal Income Tax or State-level PIT top-ups, can boost State revenues, enhance fiscal stability, and reduce reliance on Central transfers.
• Merging Cesses and Ensuring Transparency: Merging cesses and surcharges (₹4.23 lakh crore) into the divisible pool could provide States ₹1.5 lakh crore annually. 
  • Real-time data disclosure on collection and use would boost transparency, trust, and accountability in intergovernmental finance.
• Rationalising Centrally Sponsored Schemes (CSS): The proliferation of over 200 CSS has created duplication and constrained State flexibility.
  • Central schemes should be consolidated and jointly managed via a Federal Fiscal Council. Emphasizing shared accountability over top-down control ensures alignment with State priorities and limits politicisation of transfers.
• Empowering States and Local Governments: True fiscal federalism requires predictable, untied funds for subnational governments. 
  • Restructuring Article 275 grants, creating a Local List, and linking Finance Commission allocations to SFC implementation can bridge the 3F deficit, strengthen subsidiarity, and empower Panchayats and Municipalities.
• Revisiting the Constitutional and Institutional Framework: Reforms in Article 246 and the Seventh Schedule, including rationalising the Concurrent List and establishing an Intergovernmental Fiscal Council, can clarify legislative powers, reduce overlap, and strengthen cooperative federalism.
• Lessons from Global Models: Global examples show that fiscal autonomy and cohesion can coexist. Australia’s Horizontal Fiscal Equalisation (HFE) ensures equitable service delivery, Germany’s Cooperative Tax Administration enhances compliance, and Canada’s Personal Income Tax (PIT) Top-Ups provide provincial fiscal flexibility within a unified framework.

Conclusion

GST, a milestone in economic integration, has also tested India’s federal balance. As compensation ends, GST 2.0 must uphold cooperative federalism, ensuring efficiency, equity, and fiscal inclusion for all States.

DOWNLOAD PDF