Fiscal Federalism — How Money Flows in India

Fiscal federalism in India addresses one of the most consequential questions in governance: how financial resources are divided between the central government and 28 states that collectively spend more than the Centre on services that directly affect citizens' lives. The constitutional framework for fiscal federalism has two main pillars. 

First, Articles 264–293 allocate specific tax sources to the Centre (income tax, corporation tax, customs, central excise) and the states (land revenue, stamp duties, excise on alcohol, state GST); they also require mandatory sharing of central taxes with states through the divisible pool mechanism. 

Representational Image: Fiscal Federalism — How Money Flows in India

Second, Article 280 mandates a Finance Commission every five years to recommend the principles governing tax devolution and grants-in-aid from Centre to states — creating a periodic, constitutionally-grounded settlement of the fiscal federal relationship.

The Goods and Services Tax reform of 2017 fundamentally restructured India's indirect tax system and with it the states' own revenue base. Under the 101st Constitutional Amendment's Article 246A, both Centre and states share power to legislate on GST; but states gave up their independent power to levy sales tax, VAT, and entry tax in exchange for state GST (SGST) revenue plus a central guarantee of 14% annual revenue growth compensation for five years. When that guarantee expired in June 2022, states lost the floor protection that had cushioned the GST transition — creating fiscal stress particularly for manufacturing-heavy states like Maharashtra and Kerala whose consumption-based GST collections were lower than their production-based pre-GST tax revenues. Against this background, the 16th Finance Commission (chaired by Arvind Panagariya, report submitted November 2025) retained vertical devolution at 41% of the divisible pool while introducing more performance-based criteria for horizontal distribution among states.

What You Need to Know

• The Finance Commission (Article 280) is a constitutional body constituted every five years by the President; its core function is to recommend the distribution of central taxes between the Centre and states (vertical devolution) and among states (horizontal devolution); Finance Commission recommendations are not legally binding but are politically authoritative and have always been accepted.
• The 16th Finance Commission (2026–31) retained vertical devolution at 41% of the divisible pool — unchanged from the 15th FC; states had sought an increase to 50%; the "divisible pool" is gross tax revenue minus cesses, surcharges, and collection costs — meaning cesses and surcharges, which have grown, reduce the pool on which the 41% is calculated.
• Central government cesses and surcharges — which go directly to the Centre and do not enter the divisible pool — have grown significantly as a share of central tax revenue; the Kerala Finance Commission submission cited in research documents noted that the divisible pool has grown at a slower rate than gross tax revenue, effectively reducing states' share of total central taxes.
• Centrally Sponsored Schemes (CSS) channel central funds to states for specific programmes but with conditions on spending; states must contribute matching funds and comply with central programme guidelines; CSS transfers are not Finance Commission devolution and reduce state fiscal autonomy; their share of total central transfers has grown while untied devolution has stayed stable.
• GST compensation — guaranteed at 14% annual growth from a 2015–16 base — expired in June 2022 after the five-year period; several states including Kerala and Punjab received compensation through the COVID-19 period via back-to-back loans from the Centre; post-June 2022, states assumed the full revenue risk of GST collections without a guaranteed floor.

How It Works in Practice

1. Vertical devolution — what states receive: The 41% vertical devolution means that for every ₹100 in the divisible pool of central taxes, ₹41 goes to all states combined. The remaining ₹59 stays with the Centre. Crucially, cesses and surcharges (like the education cess, health cess, GST compensation cess) do not enter the divisible pool — they are Centre-exclusive revenues. As cesses have grown, the effective share of total central revenue going to states has fallen even as the divisible pool percentage stays at 41%.

2. Horizontal devolution — who gets how much: The Finance Commission distributes the states' 41% share among them using criteria including: population (2011 Census); income distance (how far a state's per capita income is below the three richest states — larger distance means more transfer, as an equalisation tool); area; forest and ecology; demographic performance (fertility rate control); and — newly emphasised in the 16th FC — tax effort and GDP contribution. Poorer states like UP and Bihar receive more per capita due to income distance criteria; richer states like Karnataka and Tamil Nadu argue this penalises good governance.

3. Finance Commission grants: Beyond tax devolution, the Finance Commission recommends grants-in-aid for specific purposes — disaster management, local body strengthening, health and education, post-devolution revenue deficit grants. The 16th FC recommended ₹1.4 lakh crore as Finance Commission grants for FY 2026–27. These grants are more targeted than tax devolution and provide the Centre with some conditionality leverage even within the Finance Commission framework.

4. Centrally Sponsored Schemes (CSS) overlay: On top of Finance Commission devolution, states receive CSS transfers for programmes including MGNREGA, PM Awas Yojana, Ayushman Bharat, Samagra Shiksha, and dozens of others. These transfers come with detailed central guidelines, monitoring requirements, and reporting obligations. States implement the programmes but have limited flexibility to adapt them to local conditions. Total CSS expenditure is comparable in scale to Finance Commission tax devolution.

5. States' own revenue: States raise their own revenue through SGST, stamp duties and registration fees, excise duty on alcohol (one of states' most significant own-revenue sources — kept outside GST at states' insistence), vehicle taxes, electricity duties, and other levies. States that have invested in administrative capacity and economic growth — Gujarat, Maharashtra, Karnataka, Tamil Nadu — have higher own-revenue bases; states with lower economic activity are more dependent on central transfers.

What People Often Misunderstand

• 41% of the divisible pool is not 41% of all central taxes: Cesses and surcharges are excluded from the divisible pool; as cesses have grown, the actual percentage of total central tax revenue going to states has fallen below 41%.
• States argued for 50% devolution; the 16th FC kept it at 41%: The states' collective demand for higher vertical devolution reflects the growing imbalance between their expenditure responsibilities (health, education, agriculture, police) and their revenue receipts; the Commission's retention of 41% is fiscal-prudence driven but contested.
• Finance Commission transfers are not the full story: CSS plus Finance Commission devolution together determine states' fiscal position; the Centre's growing use of conditioned CSS relative to untied devolution has progressively shifted the balance toward central control of how states spend central money.
• Southern states face a specific disadvantage: High-income southern states (Kerala, Tamil Nadu, Karnataka, Andhra Pradesh, Telangana) receive relatively less in per-capita terms from Finance Commission horizontal devolution because their higher per capita incomes mean smaller income-distance adjustment; they argue they contributed more to national tax revenues during their development phase and are being penalised for better governance.
• GST Council recommendations are non-binding: The Supreme Court's 2022 Mohit Minerals judgment confirmed that GST Council decisions are recommendations, not legally binding mandates; this preserves state legislative autonomy in GST but also means fiscal coordination depends on ongoing political consensus in the Council.

What Changes Over Time

The 16th Finance Commission's shift toward performance-based criteria — introducing GDP contribution as a devolution parameter — signals a potential long-run change in India's fiscal federal philosophy, moving from pure equity-based redistribution toward rewarding economic performance. Policy Circle reported in May 2026 that economists are debating whether this shift rewards strong states appropriately or removes the redistributive foundation that poorer states need. The post-GST-compensation era (from July 2022) requires states to manage their fiscal positions without the guaranteed growth floor, producing increased state borrowing and fiscal stress in several states. The 131st Amendment on Lok Sabha expansion does not directly affect fiscal federalism but could affect the political equilibrium within which Finance Commissions operate.

Sources and Further Reading

• PRS Legislative Research — 16th Finance Commission Report: https://prsindia.org/policy/report-summaries/report-of-the-16th-finance-commission-for-2026-31
• Policy Circle — Finance Commission devolution tests fiscal federalism: https://www.policycircle.org/policy/finance-commission-fiscal-federalism/
• The GeoStrata — 16th Finance Commission recommendations: https://www.thegeostrata.com/post/shrinking-fiscal-space-of-indian-states-16th-finance-commission-s-recommendations-that-fail-state-d
• Anantam IAS — Finance Commission: https://anantamias.com/finance-commission/
• GKToday — Article 246A: https://www.gktoday.in/article-246a-2/

(This series is part of a long-term editorial project to explain the structures, institutions, and practical realities of governance in India for a global audience. Designed as a 25-article briefing cluster on Federalism, States & Centre–State Relations, this vertical examines how power, money, and authority are distributed between New Delhi and India's states — from the Seventh Schedule, fiscal federalism, GST, Governors, and central agencies to Centre–state disputes, regional parties, and the evolving balance of the Indian Union. Written in an accessible format for diplomats, investors, researchers, academics, journalists, students, policymakers, civil society organisations, and international observers, the series seeks to explain both the constitutional design of Indian federalism and the political realities through which it operates in practice. This is Vertical 4 of a larger 20-vertical knowledge architecture being developed by IndianRepublic.in under the editorial direction of Saket Suman. All articles are protected under applicable copyright laws. All Rights Reserved.)