Fiscal federalism: Finance Commission and GST Council

India's Centre raises most of the tax money, while the states do most of the spending that citizens actually see: schools, hospitals, police, farm support, water. Fiscal federalism is the set of rules that closes that gap. For the RBI it is not an abstract topic. The RBI manages the debt of most state governments, runs their Ways and Means Advances and publishes the annual State Finances: A Study of Budgets. Expect ESI questions on the Finance Commission, GST and state debt, and interview questions if you come from a state with strong views on devolution.

The constitutional scheme

The Seventh Schedule gives the Union the more buoyant taxes (income tax other than on agricultural income, corporation tax, customs duties), and the states narrower bases (land revenue, agricultural income tax, stamp duties, alcohol for human consumption, electricity duty). GST is now a concurrent power under Article 246A.

The 80th Amendment (2000) put all central taxes into the divisible pool, except those under Articles 268, 269 and 269A, surcharges, and cesses levied for a specific purpose.

Two imbalances

• Vertical imbalance: the gap between the Centre's revenue share and the states' spending share. Corrected by tax devolution and grants.
• Horizontal imbalance: differences among states in revenue capacity and needs. Corrected by the formula that divides the states' share, which favours poorer states.

The Finance Commission

Constituted by the President under Article 280 every five years or earlier, with a chairperson and four members (qualifications under the Finance Commission (Miscellaneous Provisions) Act, 1951). It recommends:

1. the share of the divisible pool to go to states (vertical devolution);
2. the formula for dividing it among states (horizontal devolution);
3. grants-in-aid under Article 275, including revenue deficit grants, grants to panchayats and municipalities, and disaster-management grants;
4. anything else the President refers to it.

Recent Commissions for reference:

The 15th Commission's horizontal criteria for 2021–26:

Why cesses matter: a worked example

Suppose (illustratively) the Centre's gross tax revenue is 100. Cesses and surcharges are 15, and the cost of collection is 1.

1. Divisible pool = 100 − 15 − 1 = 84.
2. States' share at 41% = 0.41 × 84 = 34.4.
3. As a share of gross tax revenue, states get 34.4%, not 41%.

If cesses and surcharges rise to 20, the pool falls to 79 and the states get 32.4 even though the Commission's percentage has not changed. This is the heart of the states' complaint.

GST and the GST Council

• 101st Constitutional Amendment (2016); rollout 1 July 2017. GST replaced central excise, service tax, VAT, entry tax and several other levies. Both levels tax the same transaction: CGST and SGST on intra-state supply, IGST on inter-state supply.
• Council (Article 279A): the Union Finance Minister (chair), the Union Minister of State for Finance and a minister from each state.
• Voting: a decision needs at least three-fourths of the weighted votes of members present and voting. The Centre's vote counts for one-third and all states together for two-thirds, so neither side can push a decision alone.
• Legal status: in Union of India v. Mohit Minerals (2022), the Supreme Court held that the Council's recommendations are persuasive, not binding on Parliament and state legislatures.
• Compensation: the GST (Compensation to States) Act, 2017 guaranteed states 14% annual revenue growth over the 2015–16 base for five years, to June 2022, funded by a compensation cess. The cess was extended beyond that to repay loans taken to pay compensation during the pandemic.

State borrowing and debt

States borrow mainly through State Development Loans auctioned by the RBI. Under Article 293(3), a state that owes money to the Centre needs its consent to borrow, and the Centre sets an annual net borrowing ceiling, usually a percentage of the state's GSDP, sometimes with extra room tied to reforms (for example in the power sector). Off-budget borrowing by state entities has been counted against these limits in recent years, which some states have contested.

Concerns the RBI has flagged in its state finance studies include high debt in some states, rising committed spending (salaries, pensions, interest), a return to old pension schemes in some states, and unconditional cash transfers and power subsidies crowding out capital spending.

The debates

Model answer outline (15 marks)

Question: Discuss the role of the Finance Commission in addressing vertical and horizontal fiscal imbalances in India. What are the emerging challenges?

1. Opening: Article 280; define the two imbalances.
2. Vertical: share of divisible pool (14th: 42%, 15th: 41%); grants.
3. Horizontal: criteria and their logic; equity versus efficiency.
4. Challenges: cesses and surcharges; population criteria; GST's effect on state autonomy; state debt and freebies; weak local finances.
5. Way forward: limit cesses or bring them into the pool; performance-based grants; GST Council as a forum for dispute resolution; stronger municipal finances; transparent borrowing rules.
6. Conclusion: cooperative federalism depends on predictable, rule-based transfers.

Short model answer (10 marks)

Question: Why is the GST Council described as an example of cooperative federalism?

The GST Council, set up under Article 279A by the 101st Amendment, brings the Union Finance Minister and state finance ministers into one body that recommends GST rates, exemptions, thresholds and rules. Because GST is a concurrent tax under Article 246A, neither level can run it alone.

Its voting design forces cooperation. Decisions need three-fourths of the weighted votes present and voting, with the Centre holding one-third and the states two-thirds. The Centre cannot impose a decision without broad state support, and states cannot act without the Centre.

The Council also pools sovereignty: states gave up taxes such as VAT and entry tax in exchange for a share of a larger, common base and, for five years, guaranteed compensation. The Supreme Court's 2022 ruling that its recommendations are persuasive, not binding, keeps the legislatures sovereign while the Council works by consensus. Tensions over compensation and rates show that cooperation needs continued trust.

Practice questions

1. Under which article is the Finance Commission constituted?
   • Article 280.
2. What share of the divisible pool did the 15th Finance Commission recommend for states for 2021–26?
   • 41%.
3. Which criterion carried the highest weight in the 15th Commission's horizontal formula?
   • Income distance (45%).
4. What fraction of the weighted votes in the GST Council does the Centre hold?
   • One-third.
5. In which case did the Supreme Court hold that GST Council recommendations are not binding?
   • Union of India v. Mohit Minerals (2022).
6. Are cesses part of the divisible pool?
   • No, cesses levied for specific purposes and surcharges are excluded.

Common mistakes

• Confusing NITI Aayog with the Finance Commission. NITI Aayog has no role in distributing funds.
• Treating the Council's recommendations as binding. After 2022, they are persuasive.

What to do next

• Read the latest Finance Commission report summary and note its vertical share and criteria.
• Redo the cess example with the latest Budget figures.
• Revise fiscal policy alongside this guide; state debt links the two.