Financial relations in outline

Detail

1. NCERT's diagnosis: money power sits with the Centre

• Centralised economic and financial powers. NCERT (Class 11, Federalism) says the Union keeps the main economic and financial powers.
• States have "immense responsibilities but very meagre revenue sources".

• So states depend on grants (money given by the Centre) and loans from the Union.

• Vertical fiscal imbalance is the gap between what a level of government earns and what it must spend.

• The Union holds the best taxes, such as income tax, corporation tax and customs.
• The states do the costly work: police, health, schools, farming and local roads.

• So money has to flow from the Centre to the states. That flow gives the Centre power over them.

• Planning centralised decisions. In NCERT's account, the Planning Commission decided how much plan money each state got and what it was spent on.

• Charges of discrimination. The Union's discretionary grants and loans were often said to favour states ruled by the party in power at the Centre and to hurt opposition-ruled states.
• NCERT's "husband and wife" margin note uses a household picture to show this unequal money relationship. One partner controls the money and the other must ask for it.

2. NCERT is outdated: what has changed

Point	NCERT's version	Current position
Body controlling plan funds	Planning Commission	NITI Aayog replaced it on 1 January 2015. NITI is a think tank and does not give out funds.
Budget classification	Plan and non-plan spending	The plan/non-plan split ended in 2017-18.
Indirect taxes	Separate Union and state sales and excise taxes	GST from 1 July 2017 (101st Amendment, 2016)
Rules for sharing plan aid	Gadgil and Gadgil-Mukherjee formulas	These ended with planning. Money now flows through the Finance Commission, centrally sponsored schemes and other transfers.

3. The constitutional outline (Part XII)

(a) Separate tax lists (Seventh Schedule)

• Union List entries 82-92C cover taxes only Parliament can levy, such as income tax, customs and corporation tax.
• State List entries 45-63 cover taxes only state legislatures can levy, such as land revenue, stamp duty on some documents, and taxes on alcohol.
• The Concurrent List contains no taxes. Before GST, no tax could be levied by both the Union and the states.

(b) Sharing of Union taxes (Arts. 268-272)

Article	What it does
268	Union levies the duty. States collect and keep it. Example: stamp duties on bills of exchange.
269	Union levies and collects the tax and gives it to the states. Example: taxes on inter-state sale or consignment of goods.
269A	IGST (Integrated GST) on inter-state supplies. The Union levies and collects it, then splits it with the states by a law Parliament makes on the GST Council's advice [2]
270	Most Union taxes are shared between the Union and the states. The split follows the Finance Commission's advice.
271	Parliament may add a surcharge (an extra tax on top of a tax) only for the Union. Surcharges are not shared.
272	Omitted by the 80th Amendment, 2000. After that, the Art. 270 pool covers almost all Union taxes.

• Divisible pool is the part of central taxes that is shared with states. It is gross tax revenue minus the cost of collection and minus cesses and surcharges [7].

• A cess is a tax raised for one stated purpose, such as education or roads.

• The 16th Finance Commission (2026-31) kept the states' share of the divisible pool at 41%. This is the same as the 15th Finance Commission [7].

(c) Finance Commission (Art. 280)

• The President sets it up every five years.
• It advises on two things:
• how Union taxes are split between the Union and the states, and among the states;

• the rules for grants-in-aid.

• Its full structure is in the constitutional-bodies note.

• The 16th Finance Commission recommended ₹9.47 lakh crore in grants for 2026-31 [7]:
• ₹4.35 lakh crore for rural local bodies;
• ₹3.56 lakh crore for urban local bodies;
• ₹1.56 lakh crore for disaster management.

(d) Grants

• Grants-in-aid (Art. 275). Parliament fixes these grants by law for states that need help, based on the Finance Commission's advice.
• They are statutory grants, which means they come from a law and are not a favour.

• The proviso to Art. 275(1) adds grants for the welfare of Scheduled Tribes and for raising the level of administration in Scheduled Areas.

• Discretionary grants (Art. 282). The Union or a state may make grants for any public purpose, even on a subject outside its own lists.

• These grants are the legal base for centrally sponsored schemes. These are schemes the Centre designs and partly funds, and the states run.
• Examples: MGNREGA and Samagra Shiksha.
• The Centre decides who gets the money and on what conditions. So these grants draw the strongest charges of bias against opposition-ruled states.

(e) Borrowing

• Art. 292: the Union borrows on the security of the Consolidated Fund of India.
• Art. 293: a state may borrow only within India, on the security of its own Consolidated Fund, within limits its legislature sets.
• If a state still owes the Union money on a past loan, it needs the Union's consent to borrow again (Art. 293(3)).

• In practice, almost every state owes the Union money, so the Union controls state borrowing.

• In 2023-24, Kerala filed an original suit under Art. 131 (a dispute between the Centre and a state that goes straight to the Supreme Court). Kerala said the Union had gone beyond its powers under Art. 293 by capping its borrowing [6].

• On 1 April 2024, the Supreme Court referred the case to a five-judge Constitution Bench. Art. 293 had never been authoritatively interpreted [6].

• One question referred: does Art. 293 let the Union regulate state borrowing, and if so, how far? [6]

• The 16th Finance Commission asked states to stop off-budget borrowing (loans taken by state companies or bodies that do not show in the state budget). All such borrowing should come onto the budget [7].

4. Planning-era sharing rules: Gadgil formulas

• Gadgil formula (1969, Fourth Plan). It was a rule for sharing central plan assistance among states. It used:
• population;
• per capita income;
• tax effort (how hard a state tries to raise its own taxes);

• special problems.

• Special category states (hill and border states) got a fixed share first. The rest was shared by the formula.

• Gadgil-Mukherjee formula (1991) revised the weights. Roughly:
• population 55%;
• per capita income 25%;
• fiscal management 15%;

• special problems 5%.

• Both formulas ended with planning (Planning Commission abolished in 2015, plan/non-plan split ended in 2017-18).

5. The 101st Amendment, 2016 (GST)

What GST is: the Goods and Services Tax is one tax on the supply of goods and services. It replaced many separate Union and state taxes. It came into force on 1 July 2017.

New articles inserted [2]

Article	Content
246A	Concurrent taxing power for GST. Parliament and every state legislature can make GST laws at the same time. Parliament alone can tax supplies in inter-state trade or commerce [2].
269A	IGST on inter-state supplies. The Union levies and collects it, and it is split between the Union and the states [2].
279A	GST Council. The President sets it up. The Union Finance Minister is chairperson. Members are the Union Minister of State for Revenue and a minister nominated by each state, usually the state finance minister [2].

• GST Council decisions need a three-fourths majority of weighted votes of members present and voting [2].
• The Centre's vote counts for one-third.
• All the states together count for two-thirds.

• So neither the Centre nor the states acting alone can pass a decision.

• The detailed working of the GST Council and IGST is in the constitutional-bodies and fiscal-federalism notes.

Taxes subsumed (merged into GST):

• Union taxes: central excise (except on tobacco and petroleum), service tax, additional customs duties.
• State taxes: VAT and sales tax, entry tax, entertainment tax (except when local bodies levy it), luxury tax, and taxes on advertisements.

List entries deleted or narrowed [2]:

• Union List:
• Entry 92 (newspaper sales and advertisements) deleted.
• Entry 92C (service tax) deleted.

• Entry 84 (excise) narrowed to tobacco and petroleum products.

• State List:

• Entry 52 (entry tax) deleted.
• Entry 55 (advertisements) deleted.
• Entry 62 limited to taxes on entertainment levied by local bodies.
• Entry 54 limited to petroleum crude, diesel, petrol, natural gas, aviation fuel and alcoholic liquor for human consumption.

Kept outside GST:

• Alcohol for human consumption stays fully outside GST.
• Five petroleum products (crude, diesel, petrol, natural gas, aviation fuel) are legally inside GST. But the GST Council must recommend a date before GST applies to them (Art. 279A(5)) [2].
• Until then, states and the Centre keep taxing them as before.

Compensation guarantee

• The 101st Amendment required Parliament to compensate states for revenue lost because of GST, for five years [3].
• The GST (Compensation to States) Act, 2017 worked this out:
• 2015-16 was the base year;
• state revenue was assumed to grow by 14% a year [3];

• the money came from a GST compensation cess.

• The five-year guarantee ran from July 2017 to June 2022.

Union of India v. Mohit Minerals (19 May 2022)

• The Supreme Court held that GST Council recommendations are persuasive, not binding, on Parliament and state legislatures [4][5].
• Reasoning:
• Art. 279A only says the Council "recommends" [4].
• Art. 246A gives Parliament and the states simultaneous power (power at the same time) to make GST laws [4].

• Making Council advice binding would go against fiscal federalism (each level of government's right to raise and spend its own money) [5].

• Background: the case arose from a Gujarat High Court ruling of 2020. That ruling struck down IGST on ocean freight charged to importers under reverse charge (where the buyer, not the seller, pays the tax) [5].

6. Present points of friction

These are named here only. The details are in the economy note on fiscal federalism.

• Cesses and surcharges outside the divisible pool. This money goes only to the Centre [7]. So the 41% share applies to a smaller pool than total central taxes.
• Withheld scheme funds under centrally sponsored schemes (verify current status):
• MGNREGA funds to West Bengal;

• Samagra Shiksha funds to Tamil Nadu, tied to signing the PM SHRI school agreement.

• Borrowing ceilings. See Kerala's Art. 131 suit above [6].

• Devolution formulas, the detail of grants and borrowing ceilings are covered in the economy subject's fiscal-federalism note.

Prelims Hooks

• Art. 246A gives Parliament and state legislatures simultaneous power to tax supplies of goods and services. It was inserted by the 101st Amendment, 2016 [2].
• Art. 269A covers IGST on inter-state supplies. Art. 279A covers the GST Council. The Union Finance Minister chairs the Council [2].
• GST Council voting needs a 3/4 weighted majority. The Centre has 1/3 of the weight and the states together have 2/3 [2].
• Mohit Minerals (2022): GST Council recommendations are persuasive, not binding [4].
• Art. 282 (discretionary grants for "any public purpose") is the base for centrally sponsored schemes. Art. 275 covers statutory grants-in-aid on the Finance Commission's advice.
• Art. 293(3): a state that owes the Union money on a loan needs the Union's consent to borrow. Kerala's challenge was referred to a five-judge bench on 1 April 2024 [6].
• Trap: cesses and surcharges are not part of the divisible pool. The states' share of the pool stays 41% under the 16th Finance Commission (2026-31) [7].
• Trap: alcohol for human consumption is outside GST. The five petroleum products are inside GST on paper but are taxed only from a date the Council recommends.
• Gadgil formula (1969) shared central plan assistance. It was revised to Gadgil-Mukherjee (1991) and ended with the Planning Commission (replaced by NITI Aayog on 1 January 2015).
• GST compensation: five years, 2015-16 base, 14% assumed yearly growth [3].

Mains Points

• Vertical fiscal imbalance and dependence. The Union has the stronger taxes and the states carry the heavier duties. So states depend on transfers.
• The more transfers come through Art. 282 schemes instead of Finance Commission devolution, the more the Centre controls state priorities.

• Withheld scheme funds show this risk.

• GST: shared sovereignty, two sides.

• Gain: one national market, and states have a real voice through weighted voting.
• Loss: states gave up their own power to set indirect tax rates.

• Mohit Minerals (2022) protects state legislatures by keeping Council advice non-binding [4]. But it also makes the Council work by agreement among partners, not by orders.

• Shrinking divisible pool. Rising cesses and surcharges reduce the states' real share below the 41% headline [7].

• Reform ideas: cap cesses, bring them into the divisible pool after a fixed period, or need the Finance Commission to review them.

• Borrowing autonomy. Kerala's suit asks how far Art. 293 lets the Centre cap state borrowing, including off-budget loans [6][7]. The answer will set the line between fiscal discipline and state autonomy in cooperative federalism.