Fiscal Federalism in India: Tax Devolution, Finance Commission and GST

Fiscal federalism is central to the functioning of India’s federal system because the responsibilities of government are divided across different levels, but the resources required to fulfil those responsibilities are not distributed equally. State governments are responsible for important public services such as healthcare, education, agriculture, policing and local infrastructure. However, the Union government controls several major sources of tax revenue. This creates a need for a constitutional mechanism through which financial resources can be shared fairly between the Centre and the States.

India addresses this challenge through tax devolution, Finance Commission recommendations, grants-in-aid and the Goods and Services Tax (GST) framework. Together, these mechanisms determine how governments raise revenue, distribute resources and finance development. Understanding fiscal federalism is therefore essential for analysing Centre-State relations, regional inequalities and the financial autonomy of States.

What Is Fiscal Federalism?

Fiscal federalism refers to the division of taxation powers, expenditure responsibilities and financial resources among different levels of government in a federal system. It establishes how the Union, State and local governments collect revenue, allocate expenditure and manage fiscal responsibilities. In India, fiscal federalism is shaped by the Constitution, particularly Part XII, which deals with finance, property, contracts and suits.

The distribution of legislative and administrative responsibilities determines which level of government provides a service and which level can raise the resources required to finance it. A central challenge is the mismatch between revenue-raising capacity and expenditure responsibilities. The Union government has access to major tax sources, including corporation tax and customs duties, while States must finance many essential public services.

Fiscal transfers help bridge this gap and allow States with different economic capacities to deliver public services. Fiscal federalism is closely connected to three principles: fiscal autonomy, which enables governments to make financial decisions within their constitutional powers; equity, which seeks to reduce disparities in fiscal capacity; and accountability, which links revenue collection and public expenditure to transparent governance.

Constitutional Framework of Fiscal Federalism in India

The Constitution provides the legal foundation for financial relations between the Union and the States. Article 265 establishes that no tax can be levied or collected except by authority of law. Articles 268 to 281 contain important provisions relating to the distribution of revenues, grants and the Finance Commission. Article 270 provides for the distribution of specified Union taxes between the Union and the States. Article 275 provides for grants-in-aid to eligible States, while Article 280 mandates the constitution of a Finance Commission. Article 281 requires the recommendations of the Finance Commission, together with an explanatory memorandum on action taken, to be laid before Parliament.

The Constitution also provides for GST through Articles 246A, 269A and 279A. Article 246A gives Parliament and State legislatures legislative powers over GST, subject to the special arrangements for inter-State supplies. Article 269A deals with GST on inter-State trade or commerce, while Article 279A establishes the GST Council. These provisions create a system in which financial relations are governed by constitutional rules rather than being left entirely to the discretion of the Union government.

Tax Devolution in India: How Are Central Taxes Shared?

Tax devolution refers to the transfer of a specified share of the Union government’s shareable tax revenue to the States. It is one of the most important instruments of fiscal federalism because it provides States with resources that are not tied to a particular centrally designed scheme. The divisible pool generally comprises the net proceeds of shareable Union taxes after deducting the cost of collection, excluding cesses and surcharges. Article 270 provides the constitutional basis for distributing eligible taxes between the Union and the States.

Two distinct questions arise in this process. Vertical devolution determines the share of the divisible pool allocated collectively to the States. Horizontal devolution determines how that States’ share is distributed among individual States. The distinction matters because States differ in population, income levels, geographical size, development needs and revenue-generating capacity. A formula based only on population or economic contribution could overlook important differences in expenditure needs and fiscal capacity. Finance Commissions therefore use multiple criteria to balance equity, need and other policy considerations.

Vertical Devolution: The Union-State Share

The share of States in the divisible pool is determined through Finance Commission recommendations. The Fifteenth Finance Commission recommended a 41% share for States for its award period, which ran through 2025-26. The Sixteenth Finance Commission has also recommended that States receive 41% of the divisible pool for 2026-27 to 2030-31. The recommendation is unchanged, although the criteria for distributing the States’ share among individual States have been revised.

The 41% figure refers to the States’ collective share of the divisible pool, not 41% of the Union government’s entire gross tax revenue. Cesses and surcharges are excluded from the divisible pool, which is a significant point in discussions about the adequacy of fiscal transfers.

Horizontal Devolution: Distribution Among States

Horizontal devolution determines the share of each State in the amount allocated collectively to the States. Finance Commissions consider indicators designed to reflect differences in development, population, geography and other relevant factors. For the 2026-31 period, the Sixteenth Finance Commission recommended the following criteria:

Income distance gives greater weight to States with lower per capita income relative to more prosperous States, helping address differences in fiscal capacity. Population reflects the scale of public-service requirements, while area and forest-related criteria recognise geographical and environmental considerations. Demographic performance rewards differences in population growth, and the contribution-to-GDP criterion recognises the role of States in national economic output.

The inclusion of contribution to GDP and the revised weights illustrate a continuing policy debate: how should the system balance the needs of less-developed States with the economic contribution and performance of other States?

The Role of the Finance Commission in Fiscal Federalism

The Finance Commission is a constitutional body established under Article 280. The President constitutes it every five years or earlier when considered necessary. It recommends how the net proceeds of shareable Union taxes should be divided between the Union and the States, how the States’ share should be distributed among them, and the principles governing certain grants-in-aid.

It also recommends measures to augment the resources of Panchayats and Municipalities, based on the recommendations of State Finance Commissions, and considers other matters referred to it by the President in the interests of sound finance. The Finance Commission is important because it provides a periodic, rule-based framework for fiscal transfers. Rather than relying exclusively on negotiations between governments, it assesses fiscal conditions and recommends a formula for sharing resources.

Sixteenth Finance Commission: Recommendations for 2026–31

The Sixteenth Finance Commission, chaired by Dr Arvind Panagariya, covers the award period from 2026-27 to 2030-31. Its report was tabled in Parliament on 1 February 2026. Alongside retaining the States’ share of the divisible pool at 41%, it recommended grants amounting to approximately ₹9.47 lakh crore for rural and urban local bodies and disaster management over the five-year period. It discontinued the revenue-deficit, sector-specific and State-specific grants recommended by the previous Commission.

These recommendations matter because fiscal transfers affect the ability of State governments to finance public services, infrastructure and local development. The distribution formula also influences the relationship between economic performance and the principle of equitable development.

The Commission’s recommendations do not eliminate the need for sound fiscal management at the State level. States must still improve their own revenue mobilisation, control inefficient expenditure and maintain transparent budgets. The effectiveness of fiscal federalism depends on both the design of transfers and the capacity of governments to use resources responsibly.

Grants-in-Aid and Their Importance

Tax devolution is not the only way in which the Union transfers financial resources to States. Grants-in-aid provide another channel, particularly where constitutional provisions or specific fiscal needs justify additional support. Article 275 provides for grants-in-aid from the Union to eligible States. These grants can help address gaps in resources and support expenditure that may not be adequately financed through a State’s own revenue and tax devolution.

Finance Commission grants also support local governments. Panchayats and Municipalities are responsible for essential functions such as sanitation, drinking water, local roads and urban services, but their ability to raise sufficient revenue is often limited. Transfers recommended through the Finance Commission can strengthen their financial capacity. However, grants must be designed carefully. Conditions that are too restrictive may reduce flexibility, while poorly designed transfers can weaken incentives to improve revenue collection. A sound grant system should balance accountability with the freedom of States and local bodies to respond to their own needs.

GST and Fiscal Federalism in India

The introduction of the Goods and Services Tax on 1 July 2017 was a major change in India’s indirect taxation system. GST brought several central and State indirect taxes into a common framework, reducing the fragmentation of the domestic market and changing how the Union and States exercise their taxation powers.

The constitutional foundation for GST was created by the Constitution (One Hundred and First Amendment) Act, 2016. Under Article 246A, Parliament and State legislatures have the power to make laws on GST, subject to the special provisions governing inter-State supplies. Article 269A provides for the levy and collection of GST on inter-State trade or commerce and its apportionment between the Union and the States.

GST is administered through a dual structure. Intra-State supplies generally attract Central GST (CGST) and State GST (SGST), while inter-State supplies generally attract Integrated GST (IGST). This arrangement allows both levels of government to participate in the tax system while supporting a common national market.

GST Council: An Institution of Cooperative Fiscal Federalism

Article 279A provides for the GST Council, a joint forum involving the Union and the States. The Union Finance Minister serves as its Chairperson, and State finance or taxation ministers represent their respective governments. The Council makes recommendations on matters including GST rates, exemptions, model laws, threshold limits and special provisions for certain States.

Its purpose is to promote coordination and a more harmonised structure of indirect taxation. Under Article 279A, the Union government’s vote carries one-third of the total weighted votes cast, while the votes of all State governments together carry two-thirds. A decision requires a majority of at least three-fourths of the weighted votes of members present and voting.

The GST Council illustrates how fiscal federalism operates through consultation and negotiation. It gives States a formal role in shaping a tax that is central to their revenue systems. At the same time, differences between the Union and States over tax rates, compensation, revenue forecasts and policy changes demonstrate that institutional cooperation does not remove all fiscal tensions.

GST and the Question of State Autonomy

GST has helped create a more integrated indirect tax system, but it has also changed the nature of State taxation powers. States now make many important GST decisions within a shared constitutional and institutional framework rather than exercising complete independent discretion over the taxes subsumed into GST. This creates a central question for fiscal federalism: how can tax harmonisation be maintained without weakening the financial autonomy of States?

The Supreme Court addressed an important aspect of this issue in Union of India v. Mohit Minerals Pvt. Ltd. (2022). The Court held that GST Council recommendations are not binding on Parliament and State legislatures when they exercise their legislative powers. It also highlighted the importance of cooperative federalism and dialogue between the Union and the States. The judgment underlines that the GST Council is a significant forum for coordination, but its recommendations must be understood within the constitutional distribution of legislative powers.

Major Challenges in India’s Fiscal Federalism

One major challenge is the imbalance between the revenue available to governments and the responsibilities they must discharge. States finance many essential services, but their capacity to raise revenue varies significantly. Tax devolution and grants help address this imbalance, although differences in fiscal needs and economic capacity remain. A second concern is the composition of the divisible pool. Cesses and surcharges levied by the Union are generally excluded from the pool shared with States.

As a result, the proportion of gross Union tax revenue that reaches States through tax devolution can differ from the headline devolution percentage. States may therefore seek greater predictability and transparency in the overall transfer of resources. A third challenge is the tension between equity and performance. States with lower per capita income often require greater support to provide comparable public services, while States that contribute significantly to national output may argue that their economic contribution should receive greater recognition. A fair formula must balance these concerns without undermining national cohesion.

GST creates another set of challenges. States participate in a common tax framework, but they may have different revenue needs and policy priorities. Achieving consensus on rates, exemptions and administrative changes requires sustained consultation. Delays or disagreements can affect budget planning and revenue certainty. Finally, local governments often lack sufficient financial autonomy. Although constitutional amendments recognise Panchayats and Municipalities, their actual revenue powers and fiscal capacity vary across States. Strengthening local finances is essential if fiscal federalism is to extend beyond the Union-State relationship.

How Can Fiscal Federalism Be Strengthened?

Fiscal federalism can be strengthened by making intergovernmental transfers more predictable, transparent and responsive to genuine expenditure needs. Finance Commission recommendations should be accompanied by clear explanations of the criteria used, while the Union and States should maintain regular consultation on emerging fiscal pressures. States also need to improve their own revenue mobilisation, expenditure quality and fiscal reporting. Better tax administration, wider compliance and transparent accounting can reduce excessive dependence on transfers.

Fiscal responsibility should not, however, become a reason to overlook the different development needs and revenue capacities of States. The GST Council can contribute by maintaining a consultative approach to tax changes, giving States adequate time to assess their fiscal implications and improving the transparency of its decision-making. A predictable GST framework benefits businesses, consumers and governments alike. At the local level, State Finance Commissions should be constituted and their recommendations acted upon in a timely manner.

Panchayats and Municipalities need clearer revenue assignments, stronger administrative capacity and more reliable transfers to carry out their responsibilities. Ultimately, fiscal federalism works best when the Union and the States see revenue-sharing not merely as a contest over money, but as a constitutional arrangement for financing shared national development.

Conclusion

Fiscal federalism is a practical expression of India’s federal structure. Tax devolution distributes resources from the Union to the States, the Finance Commission provides a constitutional framework for determining shares and grants, and GST creates a joint institutional structure for indirect taxation.

The Sixteenth Finance Commission’s recommendations for 2026-31 and the continuing evolution of GST highlight the importance of balancing equity, economic contribution, fiscal discipline and State autonomy. India’s long-term development depends not only on how much revenue governments collect, but also on whether financial resources are distributed fairly and used effectively.

A stronger fiscal federal system requires transparent transfers, meaningful consultation, responsible public expenditure and financially empowered local governments. These measures can help ensure that fiscal federalism supports both national economic integration and the diverse development priorities of India’s States.

Frequently Asked Questions (FAQs)

1. What is fiscal federalism in India?

Fiscal federalism refers to the distribution of taxation powers, expenditure responsibilities and financial resources among the Union, State and local governments. In India, it operates through constitutional provisions, tax devolution, Finance Commission grants and the GST framework.

2. Which Article of the Indian Constitution deals with the Finance Commission?

Article 280 provides for the constitution of the Finance Commission by the President every five years or earlier when necessary. The Commission recommends the distribution of shareable Union taxes between the Union and States, the allocation among States and principles governing certain grants-in-aid.

3. What is tax devolution?

Tax devolution is the transfer of a specified share of the divisible pool of Union taxes to the States. Vertical devolution determines the collective share of States, while horizontal devolution determines how that share is distributed among individual States.

4. What is the States’ share in the divisible pool under the Sixteenth Finance Commission?

The Sixteenth Finance Commission has recommended that States receive 41% of the divisible pool of Union taxes for the 2026-27 to 2030-31 period, retaining the share recommended by the Fifteenth Finance Commission.

5. Which Article provides for the GST Council?

Article 279A provides for the GST Council. It is a joint forum of the Union and the States that recommends GST rates, exemptions and other important aspects of the indirect taxation framework.

6. How does GST affect fiscal federalism in India?

GST has created a common framework for indirect taxation and institutionalised Union-State coordination through the GST Council. However, it has also made consultation and consensus important for State revenue planning and the exercise of taxation powers.

7. What is the significance of the Mohit Minerals judgment?

In Union of India v. Mohit Minerals Pvt. Ltd. (2022), the Supreme Court held that GST Council recommendations are not binding on Parliament and State legislatures when exercising their legislative powers. The judgment is important for understanding cooperative federalism and the constitutional autonomy of legislatures.

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