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Fiscal Federalism: Distribution of funds from Centre to States

GS Paper 2

 Syllabus: Government Policies and Interventions, Relations Between Centre and State


Source: TH, Hindu Business Line


Context: The recent disagreement between the central and Tamil Nadu governments over flood relief following heavy rainfall sparked a debate on the criteria for awarding central grants to states.

Also, Uttar Pradesh (UP) has received the highest allocation of funds under the ‘Scheme for Special Assistance to States for Capital Expenditure/Investment’, while some other states such as Andhra Pradesh, Kerala, Manipur, and Punjab have received no allocation in 2023-24


What is Fiscal Federalism?

Fiscal federalism deals with the division of financial powers as well as the functions between multiple levels of the government in a country. It has within its ambit the imposition of taxes as well as the division of different taxes between the Centre and the constituent units.


Tools for Fiscal Federalism:

Constitutional Assignment of PowersThe Constitution of India delineates taxation and expenditure powers for different government levels, ensuring clear demarcation between the central and state governments.
Finance CommissionA constitutional body (Art 280) is responsible for recommending tax revenue distribution, suggesting ways to enhance state financial resources, and promoting fiscal discipline.
Goods and Services Tax (GST)A comprehensive indirect tax replacing multiple central and state taxes on goods and services, administered by a GST Council with representatives from the central and state governments.
Grants-in-Aid SystemInvolves the discretionary transfer of funds (Art 275) from the central government to state governments for specific purposes or schemes, addressing regional disparities and developmental gaps.


Issues in the Fiscal Federalism in India:

Central Assistance for DisastersThe Tamil Nadu government requested ₹21,692 crore in relief funds from the Union government due to the disaster caused by Cyclone Michaung. The central government allocated only ₹450 crore to the State Disaster Response Fund (SDRF) and ₹500 crore for a Chennai flood mitigation project.
Scheme for Special Assistance to States for Capital Expenditure/InvestmentUP and Bihar lead in meeting criteria for Capital Expenditure, securing the highest allocation in the last four years. However, Uttarakhand, Haryana, Kerala, and Punjab receive 1-2% of the total released amount. Andhra Pradesh, Kerala, Manipur, and Punjab have not received any allocation in 2023-24, as they didn’t meet the criteria.
The Scheme for Special Assistance to States for Capital Expenditure, initiated in FY 2020-21 during the Covid-19 pandemic, is extended as the ‘Scheme for Special Assistance to States for Capital Investment 2023-24’ with an allocation of over Rs 1lakh crore.
FRBM ActFiscal Responsibility and Budget Management (FRBM) Act, 2003 is applicable to all states. However, many of the states have missed its targets.
Issues w.r.t GSTFinancial Autonomy of the State: The GST has taken away much of the autonomy available to states, making the country’s indirect tax regime unitary in nature.
GST Compensation: The Centre missed the compensation amount, becoming a major point of contention.
GST Council: The GST Council’s voting structure gives a virtual veto to the central government, sidelining the principle of consensus.


Role of the 15th Finance Commission in fostering fiscal federalism:

  1. Increased tax devolution to states from 32% to 41%: This enhances states’ fiscal capacity and autonomy on spending, allocating more resources to states for economic development and governance roles. States’ fiscal buffer has widened.
  2. Emphasis on sector-specific purpose-based grants: The commission has provisioned Rs 4.36 lakh crore performance-based grants to states in areas like health, education, rural connectivity, and water conservation that address development gaps.
  3. Boosts local government finance: The commission mandates a 31% share of the divisible pool for local governments. Over Rs 2 lakh crore, grants to urban and rural local bodies strengthen decentralization.



  1. Centre retains larger revenue-raising powers and control over citizens’ vital personal finances & expenditures through GST, corporate taxes etc. constraining states’ capacity. RBI’s monetary powers also lie with the central government. This severely skews fiscal imbalance against states.
  2. Rigid fiscal consolidation goals overlook economic constraints: Mandating 4% fiscal deficit limits for states could curb their capital spending abilities and reduce fiscal legroom, posing risks amid the economic revival phase.
  3. Limited sectoral grants in a few specialized domains: The absence of performance incentives for states in many areas like environmental management, digital governance, and social security benefits leaves critical sectors underfunded hampering states’ capacity to uplift them.


Key principles that guided 15th Finance Commission recommendations:

  1. Equity: Balanced distribution of resources between the Centre and states based on sound criteria like demographics, development levels etc. to bridge inequality.
  2. Efficiency: Results-based incentives were introduced for the first time across sectors like agriculture, education, and health to boost effective governance.
  3. Conditionality: Certain sector grants are tied to state-level reforms to enable the realization of national priorities like power sector viability and ease of doing business.
  4. Inclusiveness: Enhanced funds allocation to deprived groups and backward regions to ensure even development. Also empowered local governments by allotting them a share of central taxes.
  5. Responsiveness: Sector-specific grants responsive to emerging priorities like improving air quality, water conservation and metro connectivity made growth more sustainable.
  6. Cooperative Federalism: Constant consultation between the Centre and states throughout the Commission’s five-year award period to better reconcile national and sub-national priorities.


Suggested measures for improving centre-state fiscal relations:

SuggestionsProposed Solutions
Equity-Oriented Intergovernmental TransfersIntergovernmental transfers, like funds from the central government to states, should be designed to promote equity.
Horizontal and Vertical Fiscal ImbalancesAddressing both horizontal imbalances (disparities among states) and vertical imbalances (between central and state governments) is crucial.
The devolution formula should be designed to account for both sets of imbalances to ensure that resources are allocated fairly.
Constitutional ReformsRevisit Articles 246 and the Seventh Schedule to redefine the division of powers and responsibilities between the central and state governments. This can help clarify which functions should be carried out at each level, reducing confusion and enhancing efficiency.
Empowering Local GovernmentsStrengthen the third tier of government by providing them with adequate resources, functions, and autonomy.
Fiscal Responsibility and Budget Management (FRBM) ActAlign the FRBM Act provisions for both central and state governments to maintain fiscal discipline while accommodating their unique fiscal situations.
Promote the implementation of FRBM Acts at the state level, as suggested by the Fourteenth Finance Commission.
Devolving Tax PowersProvide states with more flexibility and control over taxation, enabling them to generate revenue according to their local economic conditions and priorities.
Cooperative FederalismFoster a spirit of cooperative federalism where the central and state governments collaborate to design and implement policies that benefit the nation as a whole.
Regularization of Appointments of FC


Implement the recommendations of the Punchhi Commission, which suggested that the Finance Commission’s appointment should be regularized to ensure its autonomy and periodic review.
Clear Guidelines for Disaster ReliefThere is a need for clear guidelines for disaster relief and debates about the exclusion of long-term restoration works from SDRF/NDRF funding.
Scheme Funds for Disaster ReliefA parliamentary committee recommended in 2021 that states should be allowed to use more than the allocated 25% flexi-fund of centrally sponsored schemes for post-disaster restoration.



A careful re-evaluation of fiscal arrangements, prioritization of central expenditure, and discussions on a new grant framework are crucial for fostering effective fiscal federalism in India. The government has given the Terms of Reference of the 16th Finance Commission in order to better prioritise government finances.


Insta Links:


Prelims Links:

Which of the following is/are included in the capital budget of the Government of India? (UPSC 2016)


  1. Expenditure on acquisition of assets like roads, buildings, machinery, etc.
  2. Loans received from foreign governments
  3. Loans and advances granted to the States and Union Territories


Select the correct answer using the code given below:

(a) 1 only
(b) 2 and 3 only
(c) 1 and 3 only
(d) 1, 2 and 3


Ans: D