Mains Article

Reforming India’s architecture of fiscal federalism [Mains Article]

The benefit of the federal financial system is an even and equitable development of all regions of the country. But, this is lacking in the policies of Government of India as the investment of the central government is not evenly and equally distributed in the country.
By IT's Mains Articles Team
September 24, 2019


  • Introduction
  • What is Fiscal Deficit?
  • Federal finance system of India
  • Current scenario of Fiscal management of various states
  • Issues in India’s federal finance system
  • How is state’s fiscal autonomy is eroded by center?
  • Suggestions
  • Conclusion

Reforming India’s architecture of fiscal federalism

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  • In July 2019, the government amended the mandate of the 15th Finance Commission (FC), asking it to examine whether a separate mechanism for funding of defence and internal security ought to be set up.
  • The amendment has been interpreted as an attempt by the Centre to encroach on the fiscal autonomy of states and pre-empt a part of states’ resources to fund defence and internal security.

Reforming-India’s-architecture-of-fiscal-federalismIASToppersWhat is Fiscal Deficit?

  • Fiscal Deficit is the difference between the total income of the government (total taxes and non-debt capital receipts) and its total expenditure.
  • A fiscal deficit situation occurs when the government’s expenditure exceeds its income.
  • This difference is calculated both in absolute terms and also as a percentage of the Gross Domestic Product (GDP) of the country.


  • The government meets fiscal deficit by borrowing money.
  • A high fiscal deficit can also be good for the economy if the money spent goes into the creation of productive assets like highways, roads, ports etc.

Federal finance system of India

  • Federal finance refers to the system of assigning the source of revenue to the Central as well as State Governments for the efficient discharge of their respective functions.
  • The Constitution of India, in the Seventh Schedule (Article 246), made a clear distinction between the financial jurisdiction of the various governments. The various functions of each government have been delineated into three lists: (i) Union List, (ii) State List, and (iii) Concurrent List.



  • Taxes to be levied by the Centre, such as taxes on income (other than agricultural income), wealth tax, estate duty, excise duties etc. are enumerated in the Union List.
  • Taxes to be collected by the states, such as land revenue, tax on agricultural income, taxes on sales or purchase of goods etc. are listed in State list. The Concurrent List, which does not include any important taxes, falls within the jurisdiction of both the Centre and the states.

Mechanism of Federal Transfers

There are three sources of transfers from the union to states in the Indian federal system.

  1. Statutory transfers made on the recommendation of the Finance Commission appointed by the President every five years.

14th FC has undertaken only a marginal shift in the total transfers to states. The share of low-income states has reduced gradually from 48 % during the 11th Finance Commission to 42 % in respect of the central divisible pool of taxes. For the average-income states too, the share has declined from 26 % during FC11 to 24 % during FC14.

  1. Assistance given for plan purposes.

All developed states like Punjab, Haryana and Gujarat always had a higher share of the plan outlay compared to the population share, whereas poor states like Bihar, Odisha and Jharkhand received a much lower share of the plan outlay compared to their share of population.

  1. Individual central ministries provide grants for specified services in the states as desired by them.

The per capita transfer in the health sector was the least to Bihar (₹186) among all the major states, whereas it was the highest to Odisha (₹363). In the case of social security and the Backward Regions Grant Fund (BRGF), poor states were receiving more funds as compared to developed states.

Central Direct Investment

  • Central Direct Investment could lead to a higher growth rate in a state. Regarding investment in Central public sector enterprises (CPSE), only four rich states (Maharashtra, TN, AP, and Gujarat) had nearly 40% CPSEs while poor states had a negligible share.
  • A low level of central sector investments in poorer states made them more poor. Therefore, poor states should build a consensus for creating an investment-friendly environment and also bargain from the union government for direct central investment in these states.
  • Externally aided projects are important potential sources for augmenting the states’ resources. A poor state like Jharkhand has got barely 0.8% of the total fund while only three southern states of TN, AP, and Karnataka received about 30% of the funds.

Current scenario of Fiscal management of various states

  • Backward states are generally not able to attract investments due to lack of infrastructure on their own due to lack of investible funds. Backward states have a limited own resource due to a small economy and a weak market structure. Therefore, they rely heavily on funding and tax sharing support from central government.
  • For example, West Bengal and Jharkhand have low tax– Gross State Domestic Product (GSDP) ratio, while Karnataka and Kerala have a higher tax–GSDP ratio as a result of the better tax administration of their state governments.
  • In the light of revenue deficit grants provided by the FC14, eight states have shown revenue deficit in their budgets for 2015–16. All these states are high-income or average-income states.
  • On the other side, Low-income states have been generating revenue surplus, especially after the Twelfth Finance Commission’s (FC12) recommendation for implementing the Fiscal Resources of Budgetary Management Act (FRBMA), by compromising on their social and economic needs by compromising on their social and economic needs.
  • However, they should spend more on better human and economic development outcomes. Further, they should utilise their full debt potential for creation of adequate infrastructure.
  • Contrary to this, developed states utilise and sometimes cross limit of the FRBMA (states are allowed to borrow loan till 3.5% GSDP) for more development outcomes. Instead of rewarding them, FC14 has penalised the revenue-surplus states for maintaining the fiscal discipline.
  • Against this backdrop, it can be seen that the states that have not followed FRBMA norms are awarded with revenue deficit grants, whereas states that have a high population pressure are being penalised since 1971 for not following the desired development trend.

Issues in India’s federal finance system

India faces vertical and horizontal imbalances in fiscal federalism.

Vertical imbalance

  • A vertical imbalance arises because the tax systems are designed in a manner that yields much greater tax revenues to the Central government compared to the State governments.
  • For example, in India, post the advent of Goods and Services Tax (GST), the share of States in the public expenditure is 60% while it is 40% for the Centre to perform their constitutionally mandated duties.

Horizontal imbalance

  • The horizontal imbalances arise because of differing levels of attainment by the States due to differential growth rates and their developmental status in terms of the social or infrastructure capital.
  • The horizontal imbalances involve two types of imbalances. Type I is to do with the adequate provision of basic public goods and services, while the second type is due to growth accelerating infrastructure or the capital deficits.

Other issues

  • In the past, the Planning Commission used to give grants to the States as conditional transfers using the Gadgil-Mukherjee formula. However, now with the Planning Commission disbanded, the current NITI Aayog have no resources to dispense, which renders it toothless to undertake a transformational intervention.

How is state’s fiscal autonomy is eroded by center?

  • The 14th finance commission provided that the sharing of tax revenue between state and center will be 63% with state while 37 % with center.
  • The 15th FC recommends to create a defence and internal security fund by setting aside money from gross tax revenues of the central government. The money from these fund will be set aside before the tax sharing between state and center.
  • Now, internal security is the joint responsibility of the Centre and the states. This means that the money for fund will be cut in advance from what would otherwise have been resources of states, without their approval. This will affect the fiscal autonomy of state.
  • This decision of center to amend the mandate of 15th FC is seen in the backdrop of a sharp economic deceleration of growth and large shortfall in revenue. It is against this background that the 15th FC amendment is being seen as an attempt to pre-empt some resources of the states for funding defence and internal security.

Centrally sponsored schemes (CSS)

  • There is a similar erosion of fiscal autonomy with centrally sponsored schemes (CSS). CSS schemes are funded on a cost sharing basis between state and center. Hence, center took out a large share of the states’ expenditure.
  • Moreover, CSS allocations are entirely ad hoc decisions of central ministries, favouring some states at the cost of others.

These issues call for reform of the overall architecture of fiscal federalism.


  • Only allow transfers through untied tax devolution. However, this option is unrealistic for several reasons as there may be issues of national importance such as basic education which cannot be left entirely to states. Further, strong states may have the resources and capacity to design, finance and manage schemes on their own, but the weaker ones may not.
  • One can think of reviving the Inter-State Council as an effective federal decision-making body. Inter-State Council can be restructured as a federal institution outside the home ministry and it should be supported by a secretariat of experts to design programmes and lay out the principles for their allocation among the states.
  • One can also think of making the Finance commission (FC) a permanent body and expand its mandate to undertake the resource allocation role of the erstwhile Planning Commission. However, this option would not preserve the fiscal autonomy of states as the FC would decide what programmes should be allocated to which states.
  • NITI Aayog should be mandated to create an independent evaluation office which will monitor the efficacy of the utilisation of grants given to states. In doing so, it should not commit the mistake of micro-management or conflicts with line departments.
  • Given the significant importance of intra-State regional imbalances, seriousness has to be accorded to the 73rd and 74th constitutional amendments. For this, the local public finance should be created through the creation of an urban local body/panchayati raj institutions consolidated fund.
  • The State Finance Commissions should be accorded the same status as the Finance Commission and the 3Fs of democratic decentralisation (funds, functions and functionaries) should be vigorously implemented.
  • GST needs further simplification and extended coverage. To quickly achieve the goal of a single rate GST with suitable surcharges on sin goods, zero rating of exports and reforming the Integrated Goods and Services Tax (IGST) and the e-way bill.


  • With two major institutional transformations—implementation of the recommendations of the Fourteenth Finance Commission (FC14) and replacement of the Planning Commission by the NITI (National Institution for Transforming India) Aayog—the financial architecture of India has been redefined.
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