Centre-State Financial Relations & Fiscal Federalism in India

Cross-paper relevance

• GS2 — Core domain: Finance Commission, vertical/horizontal devolution, grants-in-aid, GST Council, CSS fiscal federalism, State Finance Commissions
• GS3 — Economic dimension: Tax devolution vs CSS debate, FRBM fiscal discipline, GST revenue, MADA v. SAIL mineral taxation, state borrowing limits, cess/surcharge exclusion from divisible pool
• Essay — Recurring themes: "Fiscal federalism — aspirations and reality", "Cooperative federalism in India — the GST experiment"

Centre-State financial relations form the fiscal backbone of Indian federalism. Part XII of the Constitution (Articles 268–293) defines how financial powers, revenues, and grants are distributed between the Union and States. Understanding this framework is essential for GS2, as it explains both how India is governed financially and why disputes between the Centre and states regularly arise.

Constitutional Basis: Division of Financial Powers

The Constitution distributes taxing powers across three lists:

Taxes levied by the Centre but shared with States:

• Article 270 — Taxes on income (other than agricultural income) are distributed between Centre and States per the Finance Commission's formula.
• Article 268 — Certain duties (stamp duties on bills of exchange, cheques, etc.) are levied by the Centre but collected and retained by States.
• Article 269 — Taxes on consignment of goods and inter-state trade taxes are levied and collected by the Centre but assigned to the States.
• Article 269A — GST on supplies in the course of inter-state trade is levied and collected by the Centre and distributed to States.

The Consolidated Fund of India (Article 266) is the central pool from which the divisible pool of taxes is shared. States have their own Consolidated Fund under Article 266(1).

Finance Commission (Article 280)

The Finance Commission is a constitutional advisory body constituted by the President every five years (or earlier if needed) under Article 280. Its recommendations are technically advisory but are treated as binding by convention — unlike a quasi-judicial body, the FC does not adjudicate disputes but recommends fiscal policy.

Mandate:

1. Distribution of net proceeds of Union taxes between Centre and States (vertical devolution)
2. Principles for grants-in-aid to States from the Consolidated Fund of India
3. Any other matter in the interest of sound finance referred by the President

15th Finance Commission (2020–25)

Horizontal Distribution Criteria (how 41% is divided among States):

The income distance criterion (45%) ensures that poorer states receive a larger share. The demographic performance criterion (12.5%) rewards states that controlled population growth — addressing the south India grievance that good demographic management should not be penalised.

UPSC Trap: The 15th FC and 16th FC use different horizontal formula weights. UPSC Prelims 2025-26 may ask the 16th FC formula specifically — know both.

16th Finance Commission (2026–31)

16th FC Horizontal Distribution Criteria (how 41% is divided among states):

Key change: The new GDP contribution criterion (10%) benefits economically productive states (Gujarat, Maharashtra, Karnataka, Tamil Nadu, Andhra Pradesh) — partially offsetting the south's concern about population-based criteria. Tax effort removed to avoid complexity. Combined debt path: Centre + States to fall from 77.3% GDP (2026-27) to 73.1% GDP (2030-31).

Grants-in-Aid (Articles 275, 282)

Beyond tax devolution, the Centre transfers resources to States through grants:

Vertical and Horizontal Devolution: The Core Debate

Vertical devolution asks: what percentage goes to the States collectively? The trend has been upward — from around 30% in earlier FCs to 42% (14th FC) and 41% (15th FC). States argue for higher devolution to reduce dependence on CSS with Central conditions.

Horizontal devolution asks: how is the States' share divided among 28 states and 8 UTs? This is where the north-south equity debate intensifies:

• Southern states (Tamil Nadu, Kerala, Karnataka, Telangana, Andhra Pradesh) argue they are penalised for:
  • Achieving demographic transition (low population growth reduces their share when population weight is high)
  • Higher per capita income (which reduces their income-distance share)
  • Better tax collection (which slightly rewards them via tax effort but not enough)
• The 15th FC's inclusion of demographic performance (12.5%) was specifically designed to address this — states that controlled population get a bonus rather than a penalty.

Centrally Sponsored Schemes (CSS)

CSS are schemes funded partly by the Centre and partly by States, implemented by State governments. They are a major channel of resource transfer but have been criticised for rigidity.

Criticism of CSS: States must bear matching expenditure even when their priorities differ; CSS proliferation (40+ major schemes) fragments state budgets; conditionalities limit state autonomy. The NITI Aayog replaced the Planning Commission in 2015, shifting some planning functions but the CSS architecture persisted largely intact.

Special Category Status (SCS)

Historically, some states received Special Category Status — a higher Centre:State ratio (90:10) for CSS and special Central assistance. The 14th Finance Commission (2015) effectively discontinued new SCS grants for general purpose, arguing that higher tax devolution (42%) should compensate. However, North-Eastern states and three hill states (J&K now UTs, Himachal Pradesh, Uttarakhand) continue to receive 90:10 ratio for most CSS.

State Finance Commissions (SFCs)

The 73rd and 74th Constitutional Amendments (1992) mandated that each State constitute a State Finance Commission every five years to recommend devolution of funds from the State to:

• Panchayati Raj Institutions (Article 243-I)
• Urban Local Bodies (Article 243-Y)

The 15th FC also linked some grants to States providing adequate funding to local bodies based on SFC recommendations. In practice, most States underfund local bodies — SFC recommendations are often not implemented or delayed, leaving India's third tier financially weak.

GST and Cooperative Federalism

Goods and Services Tax (GST), implemented from 1 July 2017, restructured indirect taxation comprehensively. Under GST:

• CGST (Central GST) goes to the Centre
• SGST (State GST) goes to the State
• IGST (Integrated GST on inter-state supplies) is collected by Centre and distributed based on destination principle

The GST Council (Article 279A, inserted by the 101st Constitutional Amendment Act, 2016) — comprising the Union Finance Minister and State Finance Ministers — is considered a landmark in cooperative federalism: Centre and States have equal stakes in decisions, though the Centre has a one-third vote and States together have two-thirds. Decisions require 3/4 majority of weighted votes.

Key SC ruling: Union of India v. Mohit Minerals Pvt. Ltd. (19 May 2022) — the Supreme Court held that GST Council recommendations are not binding on Parliament or State legislatures; they carry only persuasive value. Legislative power on GST rests with Parliament and States under Article 246A.

GST Compensation issue: Under the GST (Compensation to States) Act, 2017, States were guaranteed 14% annual revenue growth (base year 2015–16) for a transition period of five years (July 2017 – June 2022). When the pandemic caused revenue shortfall, the Centre borrowed funds to compensate States rather than paying directly — creating tensions. The compensation period ended June 2022, and States reliant on compensation revenues faced a revenue gap thereafter.

FRBM and State Fiscal Discipline

The Fiscal Responsibility and Budget Management (FRBM) Act, 2003 mandates fiscal consolidation. States are required to keep their fiscal deficit within 3% of GSDP (with some flexibility — during FY2023-24, states were allowed 3.5% of GSDP, with 0.5% linked to power sector reforms).

Key concerns: Off-budget borrowings through state public sector enterprises; state guarantees not captured in fiscal deficit figures; populist freebies debate (Supreme Court has flagged this); debt sustainability of high-deficit states.

Challenges in Centre-State Financial Relations

Recent Developments (2024–2026)

16th Finance Commission — Constituted, Report Submitted (2024–2025)

The 16th Finance Commission was constituted in late 2023 with Dr. Arvind Panagariya (former first Vice Chairman of NITI Aayog, Columbia University) as Chairman. The Commission held extensive consultations with states, state finance commissions, and the RBI. It submitted its report to President Droupadi Murmu on 17 November 2025 — covering the period 2026-27 to 2030-31.

Southern states argued for increasing devolution from 41% (15th FC level) to 45–50%, citing demographic management efforts being penalised under population-based criteria. States also urged inclusion of Union cesses and surcharges in the divisible pool — their share fell from a peak of 20.2% of gross tax revenue (2020-21) to 14.5% (2023-24 actuals, FACTLY/CGA data) — still a significant exclusion from states' share.

UPSC angle: Prelims — 16th FC; Arvind Panagariya; report November 2025; covers 2026-31. Mains — critically evaluate the demands of southern states on horizontal devolution; should cess and surcharges be included in the divisible pool? What are the fiscal implications?

GST Compensation Cess — Ended March 2026 (Final Update)

When GST was launched on 1 July 2017, states were promised 14% annual revenue growth compensation for 5 years (July 2017 – June 2022). The compensation period ended June 2022, but the compensation cess levy was extended to March 2026 to repay back-to-back COVID loans taken by the Centre to compensate states. Between July 2017 and July 2024, net cess collection amounted to ₹7.61 lakh crore.

Post-March 2026 (current position as of May 2026): The GST Compensation Cess ended on 31 March 2026 — it was not extended further. Key transition:

• Tobacco products moved to a new excise + health cess framework from 1 February 2026 (Union Budget 2026-27 announcement)
• Most other goods under the cess merged into consolidated GST rates under GST Reform 2.0 from 22 September 2025
• The GST Council is examining whether some cess-type levy should continue for environmental or health externalities, but no formal decision as of May 2026

States continue to press for the GST architecture to provide them equivalent revenue buoyancy, arguing that post-GST own-tax revenues have not reached original projections.

UPSC angle: Prelims — GST compensation cess ended 31 March 2026 (not extended); total cess collected ₹7.61 lakh crore (2017–2024); tobacco moved to excise+health cess from Feb 2026. Mains — should the GST compensation framework be made permanent or is it time for states to accept revenue risk? Discuss the implications for cooperative federalism when states lose a guaranteed revenue buffer.

States' Power to Tax Minerals — Nine-Judge Bench Ruling (July 2024)

In Mineral Area Development Authority v. M/S Steel Authority of India (25 July 2024), the nine-judge Constitution Bench (8:1) ruled that states can levy tax on mineral-bearing land in addition to the royalty collected under the central MMDR Act. The ruling — which allows retrospective application from 1 April 2005 — will significantly boost the revenues of mineral-rich states (Jharkhand, Odisha, Chhattisgarh, Rajasthan, Goa) through enhanced cess and tax on mining activities.

UPSC angle: Prelims — MADA v. SAIL (July 2024); Entry 50 State List; states can levy mineral tax; retrospective from 1 April 2005. Mains — analyse how this ruling alters the Centre-State fiscal balance in mineral-rich states; is there a risk of double taxation discouraging mining investment?

Union Budget 2025-26 — Fiscal Devolution and State Borrowing Limits

The Union Budget 2025-26 (presented 1 February 2025, Finance Minister Nirmala Sitharaman) set the fiscal deficit target at 4.4% of GDP (down from 4.8% in 2024-25). State borrowing limits under Article 293 remained at 3% of GSDP, with additional 0.5% conditional on power sector reforms. Total tax devolution to states in 2025-26 (BE) was ₹14,22,444 crore (₹14.22 lakh crore) — an increase of 10.5% over the 2024-25 revised estimate (Source: PRS India Union Budget Analysis 2025-26). The Budget also maintained state borrowing limits at 3% of GSDP with 0.5% conditional on power sector reforms.

UPSC angle: Prelims — Budget 2025-26; fiscal deficit 4.4% GDP; state borrowing 3% GSDP; devolution ₹14.22 lakh crore (BE 2025-26; up 10.5% over 2024-25 RE of ₹12.87 lakh crore — Source: PRS India). Mains — evaluate the Union Budget 2025-26 from the perspective of fiscal federalism; are states adequately resourced to meet their constitutional obligations?

Union Budget 2026-27 — First Year Under 16th Finance Commission Framework

The Union Budget 2026-27 (presented 1 February 2026, Finance Minister Nirmala Sitharaman) is the first to implement the 16th Finance Commission's recommendations. Key fiscal federalism data points:

• Fiscal deficit target — 4.3% of GDP for 2026-27 (down from revised estimate of 4.4% in 2025-26)
• Tax devolution to states — ₹15,26,255 crore (₹15.26 lakh crore) (BE 2026-27); an increase of 9.6% over the 2025-26 revised estimate (Source: PRS India Union Budget Analysis 2026-27)
• Finance Commission grants — ₹1.4 lakh crore to states for FY 2026-27 (local body + disaster management grants under 16th FC framework)
• Total resource transfer to states — ₹16.56 lakh crore (tax devolution + FC grants + other transfers)
• State borrowing limits — retained at 3% of GSDP under Article 293, with 0.5% conditional on power sector reforms

UPSC angle: Prelims — Budget 2026-27; fiscal deficit 4.3% GDP; tax devolution ₹15.26 lakh crore (9.6% increase over 2025-26 RE; source: PRS India). Mains — compare the 2025-26 and 2026-27 fiscal federalism postures; does the first year of 16th FC implementation show greater state fiscal empowerment or tighter Centre control?

16th Finance Commission Report Accepted — Key Decisions for 2026-31

(The 16th Finance Commission's vertical devolution maintained at 41%, Dr. Arvind Panagariya as Chairman, and the report covering 2026-31 are in the "16th Finance Commission — Constituted, Report Submitted" section above. This section analyses the full set of accepted recommendations and what the 16th FC's departures from 15th FC practice mean for Centre-State fiscal dynamics.)

The 16th Finance Commission submitted its report on 17 November 2025; the Union Budget 2026-27 (1 February 2026) accepted the recommendations and tabled the report in Parliament on the same day. Key decisions affecting Centre-State financial relations:

• 41% devolution maintained — States' share in the divisible pool unchanged at 41% (same as 15th FC); southern states' demand for 45-50% was not accepted.
• New GDP-contribution criterion in horizontal distribution formula — rewards economically productive states; partially offsets the south's loss from population-based criteria.
• Revenue-deficit grants, sector-specific grants, and state-specific grants all DISCONTINUED — a major departure from 15th FC practice. Total grants of ₹9.47 lakh crore (2026-31) consist only of: (a) Local body grants — ₹7.91 lakh crore (rural local bodies ₹4.4 lakh crore; urban local bodies ₹3.56 lakh crore; basic:performance split of 80:20); (b) Disaster management grants — ₹2.04 lakh crore (SDRF ₹1.63 lakh crore + SDMF ₹0.41 lakh crore; cost-sharing 90:10 for NE/Himalayan states, 75:25 for others; Centre's total share ₹1.56 lakh crore); (c) Special Infrastructure Grants — ₹56,100 crore (new; for wastewater management systems in cities with population 10–40 lakh per 2011 Census); (d) Urbanisation Premium Grants — ₹10,000 crore (new; one-time grant for merger of peri-urban villages into urban local bodies + Rural-Urban Transition Policy). Impact: Thirteen states that received revenue-deficit grants under the 15th FC lose a significant unconditional transfer; this effectively forces fiscal adjustment without a gradual transition mechanism, disproportionately affecting states with structurally low own-tax revenues (Source: PRS India 16th FC Report Summary, Policy Circle, February 2026).
• DISCOM privatisation — States recommended to privatise electricity distribution companies; SPV for legacy debt warehousing
• Subsidy rationalisation — States advised to tighten targeting mechanisms for direct benefit schemes
• Combined debt path — Centre + State combined debt to fall from 77.3% GDP (2026-27) to 73.1% GDP (2030-31)

UPSC Mains angle: The discontinuation of revenue-deficit grants by the 16th FC is a significant fiscal federalism development — it removes a safety net for deficit states and forces fiscal discipline, but critics argue it penalises states with genuine structural deficits. Connect to the NK Singh Committee's debt-as-anchor recommendation (FRBM 2017).

The 16th FC's refusal to include Union cesses and surcharges (~14.5% of gross tax revenue as of 2023-24) in the divisible pool remains a major grievance. The 80th Constitutional Amendment (2000) amended Article 270 to formally exclude cesses levied for specific purposes from the divisible pool — the constitutional basis for this exclusion.

UPSC angle: Prelims — 16th FC: 41% devolution maintained; new GDP-contribution criterion; DISCOM privatisation recommendation; report tabled February 1, 2026. Mains — evaluate whether the 16th FC's horizontal distribution formula adequately addresses the north-south fiscal equity debate; should cesses and surcharges be included in the divisible pool as a constitutional imperative or merely a policy choice?

Commonly Confused Pairs — UPSC Alert

UPSC Mains PYQs — Verified Deep Links

Finance Commission & Fiscal Federalism:

• GS2 2018 Q14 — How is the Finance Commission constituted? What do you know about the terms of reference of the recently constituted Finance Commission? What, in your view, should be the key recommendations? (15M)
• GS2 2021 Q5 — How have the recommendations of the 14th Finance Commission enabled the states to improve their fiscal position? (15M)
• GS2 2013 Q19 — Discuss the recommendations of the 13th Finance Commission which have been a departure from the previous commissions for strengthening the local government finances. (10M)
• GS2 2015 Q2 — The concept of cooperative federalism has been increasingly emphasised in recent years. Highlight the drawbacks in the existing structure and suggest measures to strengthen it. (12.5M)

GST & Constitutional Amendments:

• GS2 2017 Q11 — Explain the salient features of the Constitution (101st Amendment) Act, 2016. Do you think it is efficacious enough to remove cascading effect of taxes and encourage 'Make in India'? (15M)
• GS2 2023 Q4 — Explain the significance of the 101st Constitutional Amendment Act. To what extent does it reflect the accommodative spirit of cooperative federalism? (15M)
• GS2 2024 Q2 — What changes has the Union Government recently introduced in the domain of Centre-State relations? Suggest what could be done to strengthen cooperative federalism in India. (15M)

Financial Emergency & Fiscal Accountability:

• GS2 2018 Q3 — Under what circumstances can the Financial Emergency be proclaimed by the President? What consequences follow such a proclamation? (15M)
• GS2 2020 Q1 — How far do you think cooperation, competition and confrontation have shaped the nature of federation in India? Cite recent examples. (15M)

Exam Strategy

For Prelims:

• Article 280 — Finance Commission; constituted every 5 years by President
• 15th FC: Chairman N.K. Singh, 41% devolution (not 42% — due to J&K bifurcation); horizontal: income distance 45%, pop 15%, area 15%, forest 10%, demographic performance 12.5%, tax effort 2.5%
• 16th FC: Chairman Arvind Panagariya; constituted 31 Dec 2023; 41% maintained; new GDP contribution 10%; tax effort removed; horizontal: income distance 42.5%, pop 17.5%, area 10%, forest 10%, demographic performance 10%, GDP contribution 10%; report tabled 1 Feb 2026; grants ₹9.47 lakh crore (local bodies + disaster only; revenue-deficit grants discontinued)
• Article 243-I (SFC for Panchayats), Article 243-Y (SFC for Municipalities)
• GST compensation cess: ended 31 March 2026 (not extended); guarantee period was July 2017 – June 2022 (14% annual growth)
• FRBM target for states: 3% of GSDP (with 0.5% flexibility for power sector reforms)
• Mohit Minerals (May 2022): GST Council recommendations = persuasive only, not binding
• Budget 2026-27: fiscal deficit 4.3% GDP; tax devolution to states ₹15.26 lakh crore BE (9.6% increase over 2025-26 RE)

For Mains (GS2):

• The north-south divide in fiscal devolution: argue both sides — equity vs efficiency
• Is the Finance Commission adequately independent? Can it truly mediate Centre-State tensions?
• CSS vs untied devolution: which model better serves cooperative federalism?
• GST Council as a model of cooperative federalism — successes and limitations
• SFC weakness and underfunded local bodies — systemic governance failure

Prelims Quick-Fire Facts

• Article 280 — Finance Commission; constituted every 5 years by President
• 15th FC (2021–26): Chairman N.K. Singh; 41% (reduced from 42% due to J&K bifurcation); horizontal: income distance 45%, pop 15%, area 15%, forest 10%, demographic performance 12.5%, tax effort 2.5%
• 16th FC (2026–31): Chairman Arvind Panagariya; constituted 31 December 2023; 41% maintained; new GDP contribution 10%; tax effort removed; tabled Parliament 1 February 2026
• Article 243-I — State Finance Commission for Panchayats; Article 243-Y — SFC for Municipalities
• Article 275 — statutory grants (FC-recommended, needs-based); Article 282 — discretionary grants (CSS basis)
• GST compensation cess — ended 31 March 2026 (not extended); total collected ₹7.61 lakh crore (2017–2024); tobacco → excise + health cess from 1 Feb 2026
• FRBM — 3% GSDP fiscal deficit target for states (with 0.5% flexibility for power sector reforms)
• Mohit Minerals (19 May 2022) — SC: GST Council recommendations not binding on Parliament/State legislatures; only persuasive
• MADA v. SAIL (25 Jul 2024) — 9-judge bench (8:1): states can levy mineral tax under Entry 50 State List; overruled India Cement (1989)
• Tax devolution 2025-26 — ₹14.22 lakh crore BE (10.5% increase over 2024-25 RE; source: PRS India)
• Tax devolution 2026-27 — ₹15.26 lakh crore BE (9.6% increase over 2025-26 RE; first year of 16th FC framework; source: PRS India Union Budget Analysis 2026-27)
• Budget 2026-27 fiscal deficit — 4.3% of GDP (down from 4.4% in 2025-26 RE)
• 16th FC grants total — ₹9.47 lakh crore (2026-31); breakdown: local bodies ₹7.91 lakh crore (rural ₹4.4L cr + urban ₹3.56L cr), disaster management ₹2.04 lakh crore (SDRF ₹1.63L cr + SDMF ₹0.41L cr), special infrastructure grants ₹56,100 crore (NEW), urbanisation premium grants ₹10,000 crore (NEW); revenue-deficit, sector-specific, and state-specific grants all discontinued
• Cess/surcharge share — 14.5% of gross tax revenue (2023-24 actuals); peak was 20.2% (2020-21); excluded from divisible pool under Art 270 as amended by 80th Amendment (2000)