Dynamics of Centre-State Financial Relations in India

Imagine a country the size of India, with 28 states and 8 Union Territories, trying to run its finances smoothly. Who collects which tax? Who gets how much? Who decides? These aren’t academic questions – they shape how schools are built in Odisha, how metros run in Bengaluru, and how farmers get subsidies in Punjab. The answers lie in the fascinating, sometimes contentious, world of Centre-State financial relations – a system that is constantly evolving to balance a strong Union with empowered states.

The constitutional foundation of fiscal federalism 🔗

India’s financial architecture is carefully spelled out in Part XII of the Constitution, covering Articles 268 to 293. These provisions aren’t just bureaucratic fine print – they decide who taxes what, who keeps the money, and how resources flow from the Centre to the states. The idea is simple on paper: let the Union handle matters of national scale while giving states enough fiscal room to govern their own affairs. In practice, this balance has always been delicate.

Article 265 lays down the golden rule – no tax can be imposed without legal authority. Beyond this, the Constitution carves out three distinct taxing zones. Parliament enjoys exclusive power over subjects in the Union List, state legislatures have authority over items in the State List, and the residuary power to tax anything not mentioned anywhere rests with Parliament. This residuary clause, though seemingly technical, has historically tilted the fiscal balance toward the Centre.

How taxes are shared 🔗

The Constitution doesn’t just decide who levies a tax – it also decides who collects it and who keeps the proceeds. Some taxes are levied by the Union but collected and appropriated entirely by the states, such as stamp duties on bills of exchange. Others, like taxes on inter-state trade, are levied and collected by the Union but assigned to states. The biggest category, under Article 270, involves taxes levied and collected by the Centre but shared with the states based on Finance Commission recommendations.

This layered design reflects a core truth about Indian federalism: the Centre commands greater revenue-raising capacity, while states shoulder the bulk of expenditure responsibilities in sectors like health, education, agriculture, and law and order. This structural mismatch is known as vertical fiscal imbalance, and correcting it is the very reason transfer mechanisms exist in the first place.

Grants-in-aid: filling the fiscal gaps 🔗

Tax sharing alone cannot meet every state’s needs. Some states are simply poorer, face harsher geography, or carry heavier social burdens. This is where grants-in-aid come in. Under Article 275, Parliament provides statutory grants to states in need of financial assistance, based on Finance Commission recommendations. Special grants are also available for scheduled areas and for the welfare of scheduled tribes.

Article 282, meanwhile, allows both the Union and states to make grants for any public purpose, even outside their usual legislative domain. This has become the constitutional basis for Centrally Sponsored Schemes – a tool that the Centre has used heavily, but one that has also attracted criticism for tying states’ hands.

The Finance Commission as the balancing wheel 🔗

Every five years, a Finance Commission is constituted under Article 280 to recommend how taxes should be divided between the Union and the states, and how grants-in-aid should be distributed among states. The 14th Finance Commission famously recommended raising the states’ share of central taxes from 32% to 42%, a landmark move. The 15th Finance Commission adjusted this to 41% after the reorganisation of Jammu and Kashmir. Successive commissions have also introduced performance-based criteria, rewarding states that control population growth, improve ease of doing business, or strengthen digital governance.

GST: the game-changer 🔗

If one reform has reshaped Centre-State financial relations in the 21st century, it is the Goods and Services Tax. Introduced through the 101st Constitutional Amendment Act of 2016, GST replaced a patchwork of indirect taxes – VAT, service tax, excise, octroi, and others – with a single, unified tax system. For the first time, Parliament and state legislatures were given concurrent powers to legislate on the same tax.

GST is administered jointly. Central GST (CGST) and State GST (SGST) are levied on intra-state transactions, while Integrated GST (IGST) applies to inter-state trade. The GST Council, a joint forum of the Centre and states, decides rates, exemptions, and administrative matters. It is arguably the most powerful example of cooperative federalism in action – or, depending on whom you ask, a cautionary tale about states surrendering too much autonomy.

The double-edged nature of GST 🔗

On one hand, GST eliminated cascading taxes, created a unified domestic market, and improved compliance. On the other hand, states now have far less freedom to tweak indirect tax rates to suit local needs. Delays in GST compensation transfers and the fact that cesses don’t form part of the divisible pool have become chronic irritants, especially for southern and industrialised states. The end of the five-year GST compensation period in 2022 has further intensified debates about revenue-sharing fairness.

NITI Aayog and the new architecture of planning 🔗

The replacement of the Planning Commission by NITI Aayog in January 2015 marked another turning point. The Planning Commission had been criticised for being top-down – handing out plan allocations from Delhi like a headmaster distributing report cards. NITI Aayog was designed differently. Its Governing Council includes all Chief Ministers and Lieutenant Governors, creating a continuing partnership with states rather than a one-way flow of policy from Union to State.

NITI Aayog does not allocate funds the way its predecessor did. Instead, it functions as a policy think-tank, a coordinator, and a platform for competitive federalism. Through initiatives like the Aspirational Districts Programme, state-level performance indices, and sub-groups of Chief Ministers on subjects of national importance, it encourages states to compete on governance outcomes while cooperating on shared goals. The philosophy is captured neatly in the phrase “strong states make a strong nation.”

The Sarkaria and Punchhi Commissions: a long conversation 🔗

The tension between Centre and states is as old as the Republic itself. Two landmark commissions have shaped the modern conversation on federal balance.

The Sarkaria Commission (1983-1988) 🔗

Set up under Justice Ranjit Singh Sarkaria, this commission submitted a 1,600-page report in 1988 containing 247 specific recommendations. On finances, it argued for stronger fiscal federalism and greater state autonomy. It suggested that the Union should not levy surcharges on income tax indefinitely, that such measures must be time-bound and purpose-specific, and that expert bodies similar to the Finance Commission should be created at the state level to channel funds to backward regions. It also proposed a permanent Inter-State Council – an idea that was finally implemented in 1990.

The Punchhi Commission (2007-2010) 🔗

Headed by former Chief Justice Madan Mohan Punchhi, this commission examined federalism two decades after Sarkaria, in a very different economic landscape shaped by liberalisation and globalisation. On financial matters, the Punchhi Commission recommended that states should be actively involved in formulating the Finance Commission’s terms of reference, that the excessive use of cesses and surcharges should be reviewed, and that the Finance Commission division of the Ministry of Finance should be upgraded into a full-fledged permanent secretariat. It also called for synchronising the Finance Commission’s cycle with the five-year plans for better fiscal coherence.

Both commissions agreed on a core principle: India works best when states have meaningful fiscal and administrative autonomy within a strong national framework.

Recent reforms reshaping the fiscal landscape 🔗

Beyond GST and NITI Aayog, several quieter reforms are reshaping how money moves between the Centre and the states.

Rationalising Centrally Sponsored Schemes 🔗

Centrally Sponsored Schemes (CSSs) are programmes funded partly by the Centre and implemented by states. For decades, their proliferation – there were once over 100 of them – locked state finances into predetermined spending patterns. Following recommendations of a Sub-Group of Chief Ministers constituted by NITI Aayog, the number of CSSs has been significantly rationalised and consolidated into fewer umbrella schemes. The aim is to give states greater flexibility in implementation and reduce the pressure of mandatory state matching contributions. Critics argue that despite rationalisation, CSSs still steer state priorities, and that NITI Aayog continues to evaluate and recommend rationalisation of CSSs as a core part of its advisory role.

Direct borrowing from bilateral Official Development Partners 🔗

Historically, external development assistance reached states only through the Union government. If Maharashtra wanted a JICA loan for a metro project, the Centre had to borrow it first and then on-lend. In 2017, the Union Cabinet approved direct borrowing by financially sound state government entities from bilateral ODA partners, backed by state government guarantees and Union government counter-guarantees.

The eligibility is targeted: state entities with annual revenue above Rs 1,000 crore for infrastructure projects exceeding Rs 5,000 crore qualify, and the projects must generate revenue sufficient to repay principal and interest. The first major beneficiary was the Mumbai Metropolitan Region Development Authority, which was cleared to access a JICA loan for the Mumbai Trans-Harbour Link. This reform quietly expands the fiscal toolkit available to capable states while maintaining prudential checks.

Increased tax devolution and performance grants 🔗

The trajectory of Finance Commission awards has been toward greater devolution. Coupled with performance-linked grants for urban governance, power sector reform, and digital delivery, the message is clear: states that reform get rewarded. This shift nudges Indian federalism from purely cooperative to cooperative-competitive.

The challenges that won’t go away 🔗

For all these reforms, stress points remain. The vertical imbalance between Centre’s revenues and states’ expenditure obligations persists. Horizontal inequities – where richer states feel shortchanged because devolution formulas favour poorer, more populous states – generate periodic political friction. Cesses and surcharges, which stay outside the divisible pool, have grown as a share of Union revenues, effectively shrinking the pie that states get to share.

Borrowing powers also remain unequal. Under Article 293, states cannot borrow externally without the Centre’s consent if they have outstanding Union loans. The direct ODA route, while a welcome opening, applies only to select state entities, not to state governments themselves.

Why this balancing act matters 🔗

Centre-State financial relations are not just about accounting. They determine whether a rural health centre in Jharkhand gets funded, whether a metro project in Kerala moves forward, and whether a disaster response in Uttarakhand can be mobilised in time. Every reform – from GST to NITI Aayog to ODA borrowing – is really an attempt to answer one enduring question: how do you keep a diverse, continental nation financially unified without crushing the autonomy that makes its parts distinctive?

The answer is still being written, shaped by Finance Commissions, court rulings, political negotiations, and the everyday demands of governance.

What do you think? Should states be given the power to directly negotiate foreign loans without Centre involvement, or would this weaken India’s federal coherence? And do reforms like GST strengthen cooperative federalism, or do they come at the cost of state fiscal independence?

References

1. https://pwonlyias.com/upsc-instance/centre-state-financial-relations-india/
2. https://www.legalservicesindia.com/article/2312/Central-State-Relation—Legislative,-Administrative-and-Financial.html
3. https://blog.ipleaders.in/centre-state-relations-financial/
4. https://uppcsmagazine.com/financial-relations-between-the-centre-and-states-in-india/
5. https://ecoholics.in/centre-state-financial-relations/
6. https://www.drishtiias.com/pcs-parikshan-answer-writing-practice/papers/UP-PCS-Mains-2024/the-constitutional-provisions-related-to-centre-state-financial-relations-
7. https://www.pmindia.gov.in/en/government_tr_rec/empowering-different-states-equally-with-boost-to-federalism/
8. https://niti.gov.in/cooperative-federalism
9. https://en.wikipedia.org/wiki/Sarkaria_Commission
10. https://www.nammakpsc.com/practices/punchhi-commission-report/
11. https://pwonlyias.com/current-affairs/federalism-in-india/
12. https://www.business-standard.com/article/economy-policy/govt-allows-states-to-seek-direct-external-borrowings-117051801086_1.html
13. https://www.shankariasparliament.com/current-affairs/accessing-oda-by-state-entities