Lesson 29 of 76 7 min Premium

Financial Relations, the Finance Commission and the GST Council

GS2 · Federalism and Centre–State Relations

Vertical fiscal imbalance

The Constitution gives the Centre the most buoyant taxes (income tax on non-agricultural income, corporation tax, customs), while states carry most of the spending responsibilities (police, health, agriculture, school education). This mismatch – vertical fiscal imbalance – is corrected by transfers from the Centre: tax devolution, grants-in-aid and scheme funds. Differences among states in capacity and needs – horizontal imbalance – are addressed through formula-based sharing. Part XII (Articles 264–293) deals with finance.

Allocation of taxing powers

Parliament has exclusive power over Union List taxes (e.g. corporation tax, customs, income tax other than on agricultural income); states over State List taxes (e.g. land revenue, tax on agricultural income, taxes on alcohol for human consumption, stamp duty except on certain instruments, taxes on electricity consumption, tolls); the Concurrent List has no taxes, except the GST power under Article 246A.
Residuary taxing power is with Parliament – gift tax, wealth tax and expenditure tax were levied under it.
Article 265: no tax shall be levied or collected except by authority of law.

Distribution of tax revenues

After the 80th Amendment (2000) (based on the 10th Finance Commission's "alternative scheme"), all central taxes – except those specifically excluded – form a divisible pool shared with the states under Article 270. Excluded from the divisible pool are surcharges and cesses (Article 271 allows surcharges for Union purposes; cesses are levied for specific purposes), and collection costs. The growing share of cesses and surcharges in central revenue, which states do not share, is a major grievance of states.

After the 101st Amendment (2016): Article 269A – GST on inter-state supply (IGST) is levied and collected by the Centre and apportioned between the Centre and states on GST Council recommendations; Article 279A – the GST Council. Entry 92C and Article 268A (service tax) were removed.

Grants-in-aid

Statutory grants (Article 275) – charged on the Consolidated Fund of India each year for states in need of assistance, on Finance Commission recommendations; also specific grants for tribal welfare and administration of Scheduled Areas.
Discretionary grants (Article 282) – the Centre and states can make grants for any public purpose, even outside their legislative competence. Most central sector and centrally sponsored scheme funding flows under this Article. The Finance Commission's role in such grants is limited, which some states see as eroding fiscal autonomy.

The Finance Commission (Article 280)

A quasi-judicial body constituted by the President every fifth year or earlier. It has a chairman and four members. Parliament determined qualifications by the Finance Commission (Miscellaneous Provisions) Act, 1951: the chairman must have experience in public affairs; members are drawn from High Court judges (or those qualified), experts in government finance and accounts, persons with administrative and financial experience, and economists.

Donut chart of the 15th Finance Commission criteria: income distance 45%, population 15%, area 15%, forest and ecology 10%, demographic performance 12.5%, tax effort 2.5% — Income distance rewards poorer states; demographic performance rewards states that controlled population growth.

Functions: recommend (1) the distribution of net proceeds of shared taxes between the Centre and states (vertical devolution) and among states (horizontal distribution); (2) the principles governing grants-in-aid under Article 275; (3) measures to augment the Consolidated Fund of a state to supplement the resources of panchayats and municipalities, based on State Finance Commission recommendations (added by the 73rd and 74th Amendments); and (4) any other matter referred by the President. Its recommendations are advisory, but are generally accepted. The report is laid before Parliament with an explanatory memorandum.

Recent Finance Commissions:

14th FC (Y.V. Reddy, 2015–20): raised the states' share of the divisible pool from 32% to 42% – a landmark increase.
15th FC (N.K. Singh, 2020–26): 41% (after Jammu and Kashmir became a UT). Criteria for horizontal distribution: income distance 45%, population (2011) 15%, area 15%, forest and ecology 10%, demographic performance 12.5% and tax and fiscal effort 2.5%. Also recommended revenue deficit grants, grants to local bodies, health grants and disaster management grants.
16th FC (Arvind Panagariya) was constituted on 31 December 2023 for the award period 2026–31; its report was submitted to the President in 2025 and its recommendations apply from 1 April 2026.

Bar chart showing the states' share of central taxes rising from 30.5% under the 12th Finance Commission to 42% under the 14th and 41% under the 15th — The 14th Finance Commission's jump to 42% was the largest increase in vertical devolution.

The use of the 2011 Census for population led southern states to argue that they were penalised for controlling population – hence the demographic performance criterion.

GST and the GST Council

GST, launched on 1 July 2017, subsumed central taxes (central excise, service tax, additional customs duties) and state taxes (VAT, entry tax, luxury tax, entertainment tax except by local bodies, and others). It has CGST and SGST on intra-state supply and IGST on inter-state supply. Petroleum products (crude, diesel, petrol, ATF and natural gas) are within the constitutional scope of GST but not yet taxed under it until the Council recommends; alcohol for human consumption is outside GST.

GST Council (Article 279A): chaired by the Union Finance Minister; members are the Union Minister of State for Finance and the finance (or other nominated) ministers of all states and UTs with legislatures. Voting: decisions need three-fourths of the weighted votes of members present and voting; the Centre has one-third of the weight and all states together two-thirds – so neither can push a decision alone. Quorum is half the members. In Mohit Minerals (2022) the Supreme Court held that the Council's recommendations are persuasive, not binding, on Parliament and state legislatures – reflecting cooperative federalism. The GST compensation to states for revenue shortfall (guaranteed 14% annual growth over 2015–16 base) ended in June 2022; the compensation cess was continued to repay loans taken during the pandemic. In September 2025 the Council approved a major rationalisation, moving most goods to two main slabs of 5% and 18%, with a higher rate of 40% on a small set of luxury and "sin" goods.

Borrowing (Articles 292–293)

The Centre can borrow within India and abroad within limits fixed by Parliament. States can borrow only within India, and if a state owes money to the Centre (as all do), it needs the Centre's consent to borrow (Article 293(3)). Kerala's challenge to borrowing limits (2023–24) was referred to a Constitution Bench – an example of fiscal federalism disputes.

Common traps

The Finance Commission is constituted by the President every five years; its advice is not binding.
The divisible pool excludes cesses and surcharges.
GST Council: Centre 1/3, states 2/3 weight; decisions by 3/4 majority; recommendations not binding (Mohit Minerals).
Discretionary grants are under Article 282; statutory grants under Article 275.

Practice: Mains question

*"Fiscal federalism in India is marked by growing dependence of states on central transfers." Examine. (150 words)* Points: states raise about one-third of total revenue but spend about 60% of general government expenditure; rising share of cesses and surcharges outside the divisible pool; conditional scheme funds under Article 282; GST reduced states' independent tax room; on the other hand, higher devolution after the 14th FC and interest-free capital expenditure loans to states (Special Assistance for Capital Investment since 2020–21). Suggest: capping cesses, a larger role for the Finance Commission in grants, and strengthening the GST Council as a forum of equals.

⚡ Quick revision

Vertical and horizontal imbalances; Part XII (Arts 264–293); Art 265 no tax without law
80th Amdt 2000: all central taxes in divisible pool (Art 270), except cesses & surcharges
Grants: Art 275 statutory (FC); Art 282 discretionary
FC (Art 280): President, every 5 years, chairman + 4; 14th 42%; 15th 41% (income distance 45%, population 15%, area 15%, forest 10%, demographic 12.5%, tax effort 2.5%); 16th Panagariya (2026–31)
GST 1 July 2017; Art 246A, 269A, 279A; Council: FM chairs, 3/4 majority, Centre 1/3 weight; Mohit Minerals 2022
States need Centre's consent to borrow if indebted (Art 293(3))

The schedule of the Constitution that divides law-making subjects between Parliament and the state legislatures through three lists (Union, State and Concurrent), read with Article 246.A comprehensive, destination-based indirect tax on the supply of goods and services, introduced in India on 1 July 2017, that replaced most central and state levies with a single system in which tax paid on inputs is credited against tax on outputs.The article inserted by the 101st Amendment of 2016 that gives Parliament and every state legislature simultaneous power to make laws on goods and services tax, while reserving to Parliament the exclusive power over GST on inter-state supply.A quasi-judicial body that the President must set up under Article 280 at least once every five years to recommend how central tax revenue is shared with the states and how grants-in-aid are given.The constitutional provision, added by the 101st Amendment in 2016, that creates the Goods and Services Tax Council—a joint forum of the Union and state finance ministers that recommends GST rates, exemptions and rules.The article that empowers Parliament to provide grants-in-aid from the Consolidated Fund of India to states in need of assistance, including special grants for the welfare of Scheduled Tribes and the development of Scheduled Areas, usually on Finance Commission recommendations.Two schedules under Article 244 that provide special administration for tribal regions: the Fifth for Scheduled Areas in most states, and the Sixth for autonomous tribal areas in Assam, Meghalaya, Tripura and Mizoram.The highest courts of the states (Articles 214–231), with writ jurisdiction under Article 226. Full coverage: High Courts and Subordinate Courts.The study of the size, structure, distribution and change of human populations through births, deaths and migration, central to planning for India, now the world's most populous country.Planning and action to prevent, prepare for, respond to and recover from disasters. Full coverage: Disaster Management (module).India's apex court under Articles 124–147; guardian of the Constitution and final court of appeal. Full coverage: The Supreme Court: Composition, Appointment and Jurisdiction.Model where the Centre and states work together through shared institutions. Full coverage: Inter-State Relations and Cooperative Federalism.The article that allows states to borrow within India on the security of their Consolidated Funds, within limits set by state law, and requires a state to obtain the Union's consent for fresh borrowing while it owes the Union money or any loan guaranteed by it.A system of government in which power is constitutionally divided between a central government and regional governments, each supreme in its own sphere. This hub page connects the many forms of Indian federalism; see the linked lessons for depth.

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