The time has come for revisiting the entire gamut of issues concerning the Centre-State financial relationship.


Several recent developments have brought out the inherent asymmetry in Centre-State financial relationships. These include funding the state efforts to mitigate the ongoing Covid-19 pandemic, a virtual somersault by Finance Minister Nirmala Sitharaman in fulfilling the promised GST compensation to the states, and the inordinate delays by the Centre in passing on the entitled funds under the extant arrangements for central schemes under implementation in states. Laying blame aside, those getting the short-end of stick are the citizens, particularly the indigent and sick who are dependent on state- assistance for their well–being. In addition, the tenets of federalism, which have been central to the country’s diversity, are getting undermined.

Right from 1950, the Constitutional mechanisms in India to ensure adequate funding of states have been lop-sided. Even for the limited responsibilities assigned to states under the 7th Schedule by way of the State and Concurrent Lists, states are not adequately empowered to raise requisite finances themselves or entitled to secure them from the Centre. Ab initio, the Centre was trusted with greater powers to impose and collect taxes, particularly the growth-elastic ones—these include taxes on personal incomes and corporates, excise duties on manufactures and most other goods and all services and customs duties (both on imports and exports of goods and services). In aggregate, for 2019-20 the states’ “own revenue” was 52.5% of their total revenue, with them relying on Central transfers for the remaining amount.

Over the years, the Centre has been able to prevail over the states to “cede” more ground with regard to their limited powers to levy sales tax (a kind of VAT), excise duties they could impose on agricultural and other specified products, and entry taxes in favour of establishing a nationally common Goods and Service Tax (GST) regime. This has virtually amounted to surrendering 70% of their tax domain, and led provincial governments to collect only stamp duties, registration fees on transfer of property, motor vehicle taxes cum road user charges and three items not yet included in GST viz electricity, petrol and alcohol. An explicit outcome has been the inability of states—whose aggregate expenditure amounts to 60% of the national spend to meet their expected obligations of rendering basic and essential services to residents.

Potentially wary that the Constitution may tip the fiscal scale in favour of the Centre, the drafters had provided for a Finance Commission being set up every five years to assess likely revenues and expenditures of states and the Union government, and suggest a fair apportionment of Central revenues. The body recognises criteria ranging from population, differences in income, taxation efficiency, and reforms and development efforts of states to develop a principle for fiscal federalism for the ensuing five years.

The Fifteenth Finance Commission is expected to make its recommendations by end October for the duration of 2021-26. Almost from the beginning, the Finance Commissions, who have broadly grouped their proposals into the proportion of Central taxes to be annually devolved to the states, have made incremental changes. They have not fully reckoned with the gradual erosion of autonomy and functions of states—one, first caused by the Planning Commission in 1951 which suo motu oversaw the development and investments across the entire country, and subsequently by successive Central Governments, who acting under Article 282 which permits taking on schemes, projects and grants in public interest, devised scores of nation-wide schemes that fall squarely in the State List. More recently, the Centre has doubled down on standalone pan-India entitlement-driven schemes to fulfil new obligations under Central legislations ensuring Right to Education, Right to Food and Right to Employment. Such developments have only further obfuscated the fragile rubicon of our young federalism.

Despite the 14th Finance Commission in 2014 recommending an increase of the tax share of states from 32% to 42% (partly because of a reduction in the number of centrally sponsored schemes), there has been an escalating squeeze in the states’ share. It had peaked at 36.6% by 2018-19, but then last year declined again sharply to 32.4%. On the other hand, the share of surcharges and cesses in Central taxes, which is not shared with states, has grown from under 10% (Rs 91,700cr) in 2014-15 to 15% (Rs 3,69,111cr) by 2019-20.

In its recent report on state finances, the RBI disclosed that in 2019-20, states received 14.5% of excise duties of Central collections, 34.5% for corporate taxes, 40.3% of income tax and 37.5% of customs duties. The sharpest decline in collections was in corporate taxes on account of tax rates being slashed from 30% to 22% for domestic manufacturing companies, and from 25% to 15% for new manufacturing entities, provided they did not claim any exemptions. This single step caused a revenue reduction of Rs 2.09 trillion (instead of the anticipated loss of Rs 1.45 trillion) and its incidence fell on the states as well.

At the same time, the Centre has been “smart” in hugely augmenting its own revenue through hiking up the additional duties (which are not shareable with states) on petrol and diesel and whose global prices have declined perceptibly. Such “management” shrinks the divisible pool, similar to what would also happen if the FFC were to concede to the Central proposal of making defence expenditure non-lapsable and charge the entire expenditure to this pool. In a like manner, the Central government has also asked the Commission to re-look at the impact on its fiscal situation if it followed the recommendation from the 14th Commission to substantially enhance tax devolution to states, when coupled with its own continuing imperative of funding national development. Such direct hints have been given by the Union Government when the divisible pool is already becoming smaller—overall tax revenues rose 2.4 times in the 7 years from 2012-13, while the divisible pool rose by a lower figure of 2.2.

The time has come for revisiting the entire gamut of issues concerning the Centre-State financial relationship, and effecting the required amendments to the Constitution to reflect the new reality. In many ways, it is demeaning to a state’s autonomy to constantly be begging the Centre for funds. Rather than the Centre always playing big brother, states must be assigned additional sources of taxation from the pool currently vested in the Centre.

There is a strong case for each state levying and collecting corporate taxes in their respective jurisdiction. After all, states have a direct responsibility for fostering business development, be it by way of provision of land, electricity, labour or the maintenance of law and order. With licencing long gone, the role of the Centre has been greatly reduced in this regard except in regulating foreign capital and trade flows associated with businesses. Given this, why retain the power of taxing corporate profits at the Union Government level? In addition to being incentivised to enhance facilities in their state for such entities, corporate taxation rates would become a tool for attracting investment. This source of income would also enable provincial governments to more meaningfully look after the justified needs of “industry” in their state. True federal co-operativism does not mean altogether doing away with healthy competitiveness.

Apart from greater access to taxation avenues, Indian states need leeway in their borrowing ability, especially from domestic markets. In the name of maintaining financial stability, states are currently being too rigidly controlled with a prescribed annual ceiling on loans up to 3% of state GDP (while the Centre can go about borrowing quite freely both within and outside the country, with the only restriction on such profligate behaviour being changes in market borrowing rates). As long as the RBI finds capital is being properly raised and utilised, states should be permitted to borrow funds as per their capacity to meet their genuine needs without having to comply with Central Government imposed arbitrary and uniform nationwide norms.

In fact, a step even further would be exploring the benefits of allowing states to be freed from Central “over control” in matters related to receiving foreign aid and foreign capital flows. As long as there is no sovereign guarantee involved in such borrowings, it should be left to the RBI and the newly set up International Financial Services Regulatory Authority to ensure compliance with applicable regulations. The Union Ministry of Finance would then focus on macro policy making while leaving individual transactions, whether of private corporates or state governments, to self-certification and oversight of the already established institutions.

Ultimately, mutual respect, rather than suspicion has to be the building block of effective federalism. This is all the more relevant in matters of finance, particularly when the new India, represented by a Union of States, needs to work judiciously and at all levels of governance in expediting welfare cum development.

Dr Ajay Dua, a public policy specialist and a development economist by training, is a former Union Secretary.