SCHOLARS' CORNER

  CBS LINE

Volume 4(10)

Sharing the Pie: Who Gets What in India's Fiscal Federalism?  

Jisha Judson

PhD Scholar 

Centre for Budget Studies, CUSAT

"States seek a greater share of central taxes."

"States demand more funds from the Centre."

"Cesses and surcharges become a point of contention."

These are the kinds of headlines we often come across, especially around the Union Budget, state budgets and the Finance Commission. We see states asking for a greater share of tax revenues, more transfers from the Centre, or greater freedom over how they use the money they receive. But what do all these headlines actually mean? Why do states need money from the Centre in the first place? Why doesn't every state get the same amount? Who decides how much each state gets? And why do terms like tax devolution, cesses, surcharges, grants and the Finance Commission keep coming up in these discussions? 

These questions become particularly interesting in a diverse country like India. The Constitution describes India as a "Union of States", where both the Union and state governments have important responsibilities. While these responsibilities are divided between the two levels of government, their sources of revenue are not distributed in the same way. The Union government collects a large share of the country's major taxes. Income tax, for instance, is collected by the Union government, while the GST system involves both the Union and state governments. States also have their own sources of revenue, but they are responsible for a substantial share of public expenditure, including areas such as health, education, agriculture and infrastructure. This creates a basic imbalance: the level of government that has greater revenue-raising capacity is not necessarily the level that has greater spending responsibilities. 

So, if states have their own sources of revenue, why do they still need transfers from the Centre? The reason is that the revenues available to a state may not always be enough to meet its expenditure needs. This gap is one of the reasons why intergovernmental transfers become important. In simple terms, these are transfers of financial resources between different levels of government. In India, states receive resources from the Union through mechanisms such as their share of Union taxes and various grants. But this raises an even more interesting question: when taxes are collected, how is the tax revenue actually divided between the Union and the states? And why doesn't every state receive the same amount? 

If we look at the major sources of tax revenue, the Union government has a much greater revenue-raising capacity than the states. Taxes such as income tax and corporation tax are collected by the Union government and form important sources of its revenue. States also have their own sources of revenue, including state GST, excise duties on certain products, taxes on vehicles and other state-level taxes. But the important issue is not simply who collects more. The Union and the states also have different expenditure responsibilities. States are responsible for many of the public services that people experience directly, which creates a need for adequate financial resources. 

One way transfers happen is through tax devolution. A share of certain Union tax revenues is transferred to the states. The other major channel is grants, through which the Union provides financial resources to states for different purposes. 

India's states differ greatly in their economic size, income levels, geography, population, resources and ability to raise their own revenue. As a result, some states have a much stronger revenue base than others, while their expenditure needs can also differ. This creates an important question: if states start from very different financial positions, should they all receive the same share of the tax revenue? The answer built into India's transfer system is no. The distribution of resources among states takes into account differences between them, with the broader aim of enabling states with weaker fiscal capacity to provide public services without having to rely entirely on their own limited revenues. This idea is often described in terms of equity or equalisation. In simple terms, the objective is not necessarily to give every state the same amount of money, but to take differences in their circumstances into account. 

So, how is this share actually decided? There is a formula behind it, and an important institution responsible for recommending this formula is the Finance Commission. The Finance Commission is a constitutional body established under Article 280 of the Indian Constitution. It is normally constituted every five years, or earlier if necessary, by the President of India. Its main responsibilities include recommending how the shareable Union tax revenue should be divided between the Union and the states, how the states' share should be distributed among the different states, and the principles that should govern certain grants-in-aid to the states. 

For the period 2021-26, the 15th Finance Commission recommended that 41% of the divisible pool of Union taxes be devolved to the states. The Commission reduced the share from the 42% recommended by the 14th Finance Commission by one percentage point to account for the share assigned to the Union Territories of Jammu and Kashmir and Ladakh. The Finance Commission therefore plays an important role in deciding how the tax pie is divided among the states.

The Finance Commission therefore considers different criteria and assigns weights to them when recommending how the states' share of Union taxes should be distributed. The criteria can reflect both equity, taking account of differences between states, and performance on certain fiscal and demographic indicators. For the 15th Finance Commission, these included income distance, population, area, forest and ecology, demographic performance and tax effort. Income distance had the largest weight at 45%. This means that the available resources are distributed by taking the different circumstances of the states into account, rather than simply giving every state an equal-sized piece. 

But there is another part of the tax-sharing debate that often appears in the news: cesses and surcharges. The share of Union taxes given to states is calculated from what is known as the divisible pool. But not every tax collected by the Union becomes part of this pool. In particular, cesses and surcharges are excluded. In simple terms, a cess is an additional charge collected for a particular purpose, while a surcharge is an additional charge imposed on an existing tax. This has become a major point of discussion because the increasing share of cesses and surcharges can reduce the proportion of the Union's gross tax revenue that forms part of the divisible pool. The 16th Finance Commission recorded demands from several states to include cesses and surcharges in the divisible pool, cap their share, or compensate states in some other way. 

But tax devolution is not the only way in which states receive money from the Union. There is another important part of the story: grants. You may have noticed that many government programmes have names such as Pradhan Mantri followed by the name of a particular programme. Many of them are implemented through what are called Centrally Sponsored Schemes (CSS). These involve financial contributions from both the Union and state governments, although the exact sharing pattern can differ. For many major programmes, the common pattern for general states has been 60% from the Centre and 40% from the state, while some states and programmes have different arrangements. Two familiar examples are Pradhan Mantri Poshan Shakti Nirman (PM POSHAN), which provides meals to children in government and government-aided schools, and the Jal Jeevan Mission, which aims to provide tap-water connections to rural households. 

Apart from such programmes, grants can also be provided for other purposes. Some grants are recommended by the Finance Commission, while others are provided through Union ministries under particular programmes. Broadly, these grants can be conditional or unconditional. Unconditional grants give states greater flexibility in deciding how to use the money, while conditional grants are linked to a particular purpose or come with conditions that the state has to meet. 

This is where an important debate begins. A programme designed at the national level may have a common structure across many states. But India's states are very different from one another. Their needs, priorities and financial capacities are not the same. If the Centre provides part of the funding but the state has to contribute the remaining amount, the programme also creates an expenditure commitment for the state. So, grants can be useful in supporting important public programmes, but they also raise a difficult question: how much should the Union government decide about what states spend, and how much freedom should states have to decide their own priorities? This is one of the central debates surrounding India's system of intergovernmental transfers. 

So why does equalisation matter in the first place? They differ not only in their income and economic size, but also in their ability to raise revenue and in the cost of providing public services. Some states have a stronger revenue base, while others face geographical or economic constraints that make raising sufficient revenue more difficult. But the people living in these states are all citizens of the same country. They need schools, hospitals, roads, water and other public services, regardless of where they live. This creates a basic idea behind equalisation: people should have access to a reasonable level of public services even when the state they live in has a weaker capacity to raise revenue. 

But this raises another question: if states receive additional resources, does that automatically mean that the differences between them will disappear? Not necessarily. A transfer can help a state spend more, but what matters is also how those additional resources are used. Some expenditure is necessary for the day-to-day functioning of government, such as salaries, pensions, subsidies and other recurring commitments. Other expenditure creates assets that can support future economic activity, such as roads, irrigation, schools, hospitals and other infrastructure.

This creates an important challenge for the transfer system. If a state receives additional resources but continues to face weak revenue capacity and growing expenditure commitments, the transfer may help meet its immediate needs without necessarily changing the underlying fiscal disadvantage. The question, therefore, is not simply how much money a state receives, but also what happens to that money after it reaches the state. 

There is also a concern that if states come to rely heavily on transfers from the Union to meet their expenditure needs, they may have less incentive to strengthen their own revenue sources. Over time, this can create a difficult situation where transfers become an expected part of the state's finances rather than a means of strengthening its fiscal position. 

Then there is another question: how much freedom should states have over the money they receive? Tax devolution is largely untied, meaning states have greater freedom to decide how to use it. Grants, on the other hand, can be tied to particular purposes and conditions. Some states have therefore argued for greater flexibility and fewer conditions, particularly where centrally designed programmes overlap with areas that fall largely within state responsibilities. The 16th Finance Commission records such demands, including proposals to rationalise Centrally Sponsored Schemes and replace some specific-purpose transfers with more flexible grants. 

But there is another side to this argument. Conditional transfers can also serve a purpose. They allow the Union government to support priorities that may have national importance, such as health, nutrition, education or drinking water, even when states might otherwise give these areas different levels of priority. So the question is not simply whether transfers should be conditional or unconditional. It is about finding the right balance between national priorities and state-level flexibility. 

There is also the question of what happens after the money reaches the states. All of this shows why there is no single formula that can solve every problem. A transfer system has to balance several objectives at the same time: reducing disparities between states, giving states enough resources to meet their responsibilities, encouraging sound fiscal behaviour, and allowing the Union to pursue certain national priorities. 

Sharing the pie is not simply about dividing it into equal pieces. It is about deciding how the pieces should be divided when the states themselves have very different needs and capacities.