Recasting India’s Fiscal Architecture for Viksit Bharat 2047 | Part III
Fiscal Federalism and Intergovernmental Transfers
Constitutional Design of Fiscal Federalism
India’s fiscal federal structure is constitutionally designed to combine a strong Union with financially viable States. The Seventh Schedule assigns taxation and expenditure powers asymmetrically. The Union controls broad-based and elastic taxes, while States bear primary responsibility for expenditure-intensive functions such as health, education, agriculture, and public order. This arrangement creates a structural vertical fiscal imbalance, which the Constitution seeks to address through institutionalised revenue sharing rather than ad hoc transfers.
Articles 268 to 281 govern the assignment and distribution of revenues between the Union and the States. Article 280 establishes the Finance Commission as an independent constitutional body to recommend tax devolution and grants-in-aid. Fiscal federalism in India is therefore designed to operate through rule-based transfers mediated by constitutional institutions, rather than discretionary bargaining.
Scale of Vertical and Horizontal Imbalances
Empirical evidence highlights the magnitude of India’s fiscal imbalances. Data from the Reserve Bank of India’s “State Finances: A Study of Budgets” show that States account for close to 60 per cent of general government expenditure, while their own tax and non-tax revenues constitute roughly 35 to 40 per cent of combined revenues. The resulting gap is bridged through Union transfers and borrowing.
Horizontal imbalances are equally significant. Analyses by successive Finance Commissions and NITI Aayog document wide inter-State disparities in per capita income, fiscal capacity, and development outcomes. Lower-income States face higher expenditure needs relative to their revenue base, reinforcing the continuing importance of equalisation transfers within the federal framework.
Finance Commission Transfers and Their Limits
Finance Commission transfers consist of tax devolution and grants-in-aid, including revenue deficit grants, sector-specific grants, and transfers to local governments. These transfers are formula-based and constitutionally anchored, making them the most predictable component of intergovernmental finance.
The expansion of tax devolution following the Fourteenth Finance Commission, which raised States’ share in the divisible pool to 42 per cent, significantly enhanced State fiscal space. The Fifteenth Finance Commission retained this share while revising horizontal distribution criteria to reflect demographic changes and ecological considerations.
However, recent Finance Commission reports and the Economic Survey have highlighted a growing constraint. The increasing reliance of the Union on cesses and surcharges, which are excluded from the divisible pool, has reduced the effective base for devolution. The Fifteenth Finance Commission noted that cesses and surcharges have accounted for more than one-fifth of gross tax revenues in recent years, weakening the predictability and adequacy of transfers to States.
Centrally Sponsored Schemes and State Autonomy
Alongside Finance Commission transfers, a substantial share of Union resources flows to States through Centrally Sponsored Schemes (CSS). These schemes are designed and largely controlled by the Union, with States required to provide matching contributions and adhere to centrally prescribed guidelines.
Evaluations by the Comptroller and Auditor General of India and policy analyses by the National Institute of Public Finance and Policy indicate that while CSS have supported national priorities, they often constrain State flexibility and fragment expenditure planning. The Economic Survey has observed that the proliferation of schemes and conditionalities complicates budgeting and weakens accountability, as responsibility for outcomes becomes diffused between levels of government.
GST and the Post-Reform Federal Balance
The introduction of the Goods and Services Tax (GST) in 2017 marked a major shift in India’s fiscal federalism. By subsuming multiple Union and State indirect taxes into a harmonised framework, GST altered State-level revenue autonomy while institutionalising cooperative decision-making through the GST Council.
Analyses in the Economic Survey and RBI publications suggest that GST has improved tax harmonisation and compliance, but has also increased States’ dependence on transfers. GST revenues have shown sensitivity to economic cycles, affecting State cash flows. The expiry of the guaranteed compensation period further exposed fiscal vulnerabilities, particularly for States with weaker own-source revenues.
Local Governments and the Third Tier
Local governments remain the weakest link in India’s fiscal federal structure. Despite constitutional recognition under the Seventy-Third and Seventy-Fourth Amendments, fiscal decentralisation has been limited. RBI studies on municipal finances show that Urban Local Bodies generate less than 1 per cent of GDP in own-source revenues, well below international benchmarks. Panchayati Raj Institutions display even lower fiscal capacity.
Although State Finance Commissions are mandated to recommend revenue sharing with local governments, Finance Commission and RBI assessments reveal wide variation in their effectiveness and implementation. Transfers to local bodies often lack predictability, and expenditure responsibilities are not matched by commensurate revenue powers.
Fiscal Federalism and Development Objectives
The Economic Survey and NITI Aayog policy documents increasingly recognise that States and local governments are central to infrastructure development, social sector delivery, and climate adaptation. However, current intergovernmental arrangements often constrain long-term planning and investment at sub-national levels.
Policy research from institutions such as the National Institute of Public Finance and Policy emphasises that sustainable development requires predictable transfers, reduced reliance on non-shareable levies, and stronger State and local revenue bases. Without these reforms, fiscal federalism risks limiting rather than enabling development outcomes.
Sectional Assessment
Evidence from Finance Commission reports, RBI fiscal data, CAG audits, and the Economic Survey indicates that India’s fiscal federal framework remains robust in design but strained in practice. While rule-based transfers have expanded, the growing use of cesses, the prominence of Centrally Sponsored Schemes, and weak local government finances have constrained sub-national autonomy.
Recalibrating fiscal federalism to restore predictability, strengthen State and local fiscal capacity, and align revenue authority with expenditure responsibility is essential for effective service delivery and long-term development.