Fiscal Federalism in India: The Constitutional Roadmap to Inclusive Growth

Rethinking Fiscal Federalism for Viksit Bharat 2047

A Constitutional Blueprint for Strengthening State Capacities

As India sets its vision for Viksit Bharat by 2047, the foundation of fiscal federalism becomes central to achieving balanced, inclusive, and resilient economic growth. In a complex and competitive federal structure, state governments act as the primary engines of local development, economic innovation, and social welfare. With uneven regional development and varied fiscal capabilities, assessing and refining the architecture of fiscal federalism is imperative for aligning national priorities with local aspirations.

Constitutional Framework of Fiscal Federalism in India

Tax Base Division
The Seventh Schedule of the Constitution, under Article 246, defines legislative powers by dividing taxation authority into the Union List, State List, and Concurrent List.

This ensures clear fiscal demarcation and minimizes legislative overlaps.
States are empowered to levy taxes on goods like alcohol, land revenue, and vehicles, while the Centre retains high-revenue sources such as income tax and customs duty.

GST and Concurrent Taxation
The 101st Constitutional Amendment introduced Article 246A, enabling both Centre and States to impose GST concurrently.

The Centre levies CGST and IGST, and States impose SGST, fostering cooperative fiscal federalism.
However, GST Council decisions, although consensus-based, often lead to reduced fiscal discretion for States.

Revenue Devolution
Under Article 270, a portion of Union taxes is devolved to States based on Finance Commission recommendations.

Taxes like income tax, CGST, and corporate tax are shared.
This mechanism promotes vertical equity by ensuring that States receive a fair share of central resources.

Grants-in-Aid
Article 275 authorizes the Centre to give targeted grants-in-aid for promoting development in backward regions and addressing fiscal disparities.

These grants are crucial for States with weaker revenue bases to maintain essential public services.
However, their allocation often lacks transparency and long-term predictability.

Finance Commission Role
Article 280 mandates the appointment of a Finance Commission every five years.

It advises on tax devolution, grants, and fiscal discipline, ensuring both vertical and horizontal balance.
Recent Commissions have added performance-based criteria to reward reform-oriented States.

Policy Provisions Influencing State Finances

Discretionary Grants under Article 282
Both Union and States can provide grants for public purposes, even beyond their legislative domain.

While this provides policy flexibility, it raises concerns about State dependency and autonomy erosion, especially when tied to politically motivated conditions.

Borrowing Constraints under Article 293
States can borrow within India, but prior Union consent is needed if they have outstanding Central debt.

This mechanism limits States’ fiscal independence and delays infrastructure investment, particularly in high-growth States.

Local Fiscal Devolution
Through State Finance Commissions, States are expected to devolve funds and functions to Panchayats and Municipalities.

While constitutionally mandated, the devolution often remains partial and irregular, weakening grassroots governance.
Strengthening these institutions is vital for delivering services tailored to local needs.

Exclusion of Cesses and Surcharges
Although they are part of Union taxes, cesses and surcharges are excluded from the divisible pool as per Article 270.

This reduces the effective share of States in growing tax revenues, contributing to vertical fiscal imbalance.

Centrally Sponsored Schemes (CSSs)
CSSs operate in State and Concurrent List subjects but are often centrally designed and partially funded by States.

This structure restricts States’ fiscal freedom, misaligns with local development priorities, and burdens State budgets.

Horizontal Devolution Criteria
The Finance Commission employs a multi-variable formula to distribute funds among States.

Key factors include income distance, population, area, forest cover, and tax effort.
While aimed at equity, the formula has led to discontent among high-performing States, who feel penalized for their efficiency.

Towards a Stronger Fiscal Union for Viksit Bharat

To realize the goal of Viksit Bharat by 2047, a recalibrated approach to fiscal federalism is necessary.

Greater autonomy in tax design and borrowing will empower States to plan strategically.
Transparent and predictable grants and devolution mechanisms can reduce friction and foster cooperation.
Enhancing the capacity and accountability of local bodies will enable more citizen-centric development.

India’s constitutional architecture provides a robust base, but responsive and evolving fiscal policies are essential for ensuring that States are equal partners in India’s transformation journey.

Key Challenges Undermining Fiscal Federalism in India

Structural and Policy Barriers to Cooperative Governance

Despite a strong constitutional framework, fiscal federalism in India faces deep-rooted challenges that hinder effective resource sharing, equitable development, and responsive governance. These challenges, both structural and institutional, underscore the growing strain on State autonomy, local governance, and federal cooperation.

Vertical Fiscal Imbalance

The Union controls 63% of national fiscal resources but is responsible for only 38% of total public expenditure.

In contrast, States manage 62% of expenditure with just 37% of fiscal resources, creating a persistent fiscal mismatch.
This misalignment restricts States’ ability to fund crucial public services and infrastructure.

Loss of Tax Autonomy

The implementation of GST subsumed key State-level taxes like VAT and octroi.

As a result, States now depend largely on SGST with limited ability to design independent fiscal policies.
The uniform structure reduces scope for revenue innovation or addressing regional economic diversity.

States’ share in gross Union tax revenue declined from 35% (2015–16) to 30% (2023–24).

This drop contrasts sharply with the 15th Finance Commission’s recommended 41%, eroding States’ fiscal strength.
The shortfall exacerbates budget constraints, particularly in social sectors.

Rising Cess and Surcharge Collections

Cess and surcharge revenues grew by 133% from 2017–18 to 2022–23, now forming 25% of Union tax income.

Since they fall outside the divisible pool, these earnings bypass States and Finance Commission oversight.
This trend further aggravates vertical imbalance and weakens cooperative federalism.

Restrictive Borrowing Limits

States are restricted to borrowing 3% of GSDP, inclusive of off-budget borrowings and public account liabilities.

These tight limits impair counter-cyclical spending during crises and constrain capital investment in infrastructure.
Even well-performing States face limitations despite stronger fiscal credentials.

GST Compensation Delays

Following GST rollout, delayed compensation payments have triggered liquidity crises in several States.

Revenue shortfalls ranging from 19% to 33% disrupted fiscal planning and highlighted flaws in cooperative fiscal mechanisms.
Compensation cessation post-2022 left many States financially vulnerable.

Dependence on Centrally Sponsored Schemes (CSSs)

CSS funding grew from ₹5.21 lakh crore in 2015–16 to ₹14.68 lakh crore in 2023–24, with stringent guidelines.

States are often required to provide matching funds and have limited discretion in scheme design.
This reduces fiscal flexibility and impedes alignment with local development priorities.

Decline in Unconditional Grants

Grants-in-aid fell from ₹1.95 lakh crore to ₹1.65 lakh crore between 2015–16 and 2023–24.

This shift increases reliance on conditional transfers, reducing developmental autonomy.
States are left with fewer resources for discretionary spending or region-specific interventions.

Horizontal Imbalances Among States

The devolution formula rewards poorer and more populous States based on income distance.

States like Karnataka and Kerala feel penalized for fiscal prudence, raising concerns about equity versus efficiency.
This creates regional tensions and undermines cooperative spirit.

Regional Disparities and Uneven Development

States like Bihar and Jharkhand continue to lag in infrastructure and financial inclusion, as shown in multi-pillar rankings.

This stifles economic convergence and widens developmental gaps, challenging the objective of balanced growth.

Off-Budget Borrowings and Transparency Issues

Inclusion of off-budget liabilities (e.g., KIIFB in Kerala) in Net Borrowing Ceilings constrains States further.

The lack of clear norms erodes fiscal accountability and undermines long-term planning.
It complicates the assessment of true fiscal health of States.

Centralised Control over Public Spending

Only 22% of Union transfers to States are untied, with the rest being tied or conditional.

This centralisation of expenditure limits States’ responsiveness to region-specific needs.
It also weakens the spirit of fiscal subsidiarity enshrined in the Constitution.

Weak Panchayat-Level Devolution

The 2024 Devolution Status Report shows inconsistent transfer of 29 subjects under the Eleventh Schedule to Panchayats.

Most States retain control, restricting local self-governance and participatory planning.
This curtails effective grassroots delivery and public accountability.

Institutional Weaknesses in PRIs

Dysfunctional District Planning Committees and frequent rotation of seats hinder leadership continuity at the Panchayat level.

These gaps impair planning efficiency, weaken institutional memory, and reduce grassroots governance impact.

Limited Fiscal Autonomy for Local Bodies

Many States have not implemented recommendations of State Finance Commissions, undermining local fiscal strength.

Centralisation under GST has also curtailed Panchayats’ access to stable revenue sources.
The result is reduced capacity for bottom-up planning and need-based development.

These challenges, if unaddressed, threaten to dilute the foundations of cooperative federalism and hinder India’s journey towards inclusive development and Viksit Bharat 2047.

Strengthening Fiscal Federalism for a Resilient India

Reforms to Empower States and Foster Balanced Growth

To realize the vision of Viksit Bharat by 2047, India must build a stronger, more equitable fiscal federal structure. This demands not just constitutional compliance but progressive reforms, ensuring fiscal autonomy, transparent resource sharing, and local empowerment.

Increase Devolution to States

The upcoming 16th Finance Commission must consider increasing the States’ share of central taxes beyond the current 41%.

Greater devolution empowers States to independently fund social welfare, infrastructure, and administrative reforms.
It also restores fiscal parity, bridging the growing mismatch between responsibilities and resources.

Rationalise Cesses and Surcharges

Cesses and surcharges should be either reduced or included in the divisible pool under Article 270.

This would ensure equity and transparency in fiscal transfers.
States will gain access to a more predictable revenue stream, improving fiscal planning.

Reform the GST Framework

The GST Council must ensure timely compensation and deliberate the inclusion of petroleum and alcohol under the GST umbrella.

This expansion would enhance revenue buoyancy and reduce States’ dependency on CSSs and tied grants.
It also promotes uniform taxation and reduces compliance burden.

Benchmark State Performance with Composite Indices

Using weighted indices across fiscal, social, and environmental parameters provides a holistic tool for performance assessment.

Such benchmarking encourages States to pursue multi-dimensional development goals.
It fosters competitive federalism through evidence-based policy formulation.

Relax Borrowing Limits During Emergencies

States should be granted temporary borrowing flexibility during economic shocks or natural disasters.

A responsive framework allows for counter-cyclical investments and infrastructure resilience.
Flexibility must be paired with accountability norms to maintain fiscal discipline.

Strengthen Local Bodies with Full Devolution

States must implement Articles 243G, 243H, and 243X in letter and spirit, ensuring clear devolution of funds, functions, and functionaries to Panchayati Raj Institutions (PRIs).

This move, supported by the 2024 Devolution Status Report, will boost grassroots governance.
Local bodies will be empowered to deliver region-specific services effectively.

Build Capacity of Panchayats

Expanding schemes like the Rashtriya Gram Swaraj Abhiyan can train local leaders in planning, budgeting, and service delivery.

Investing in digital infrastructure enhances transparency and community participation through Gram Sabhas.
This approach ensures that development is participatory and accountable.

Restructure Centrally Sponsored Schemes (CSSs)

CSSs should be consolidated into umbrella schemes with flexible, locally adaptable frameworks.

This avoids duplication and inefficiencies while respecting State-specific priorities.
It enables targeted implementation and better developmental outcomes.

Institutionalise Intergovernmental Dialogue

Reinvigorating platforms like the Inter-State Council and strengthening NITI Aayog’s consultative role can improve policy synergy.

Integration with Finance Commission and GST Council ensures a cohesive fiscal vision.
Such coordination builds trust-based federalism.

Use Human Development Index in Resource Allocation

The 16th Finance Commission should adopt HDI as a criterion for horizontal devolution.

Prioritising social outcomes promotes human-centric development.
It moves beyond population-centric allocations, addressing deeper inequalities.

Ensure Borrowing Transparency

All off-budget liabilities must be disclosed and managed under transparent fiscal frameworks.

This prevents fiscal opacity and strengthens public trust.
Adhering to FRBM norms will ensure sustainability.

Align Fiscal Rules across Governments

Harmonising Fiscal Responsibility and Budget Management (FRBM) Acts of the Centre and States will ensure coherent fiscal targets.

Flexibility for regional diversity should be embedded to support context-sensitive growth.
Such alignment promotes stable and sustainable public finance.

Leverage Fiscal Health Index

States must actively use the Fiscal Health Index to guide reforms in debt, capital spending, and revenue efficiency.

Aspirational States can benchmark progress, improve resource mobilisation, and ensure fiscal sustainability.

By adopting these reforms, India can transform its fiscal federalism into a catalyst for inclusive growth, regional equity, and effective governance, aligning every tier of government toward the collective ambition of Viksit Bharat by 2047.