Financial Relations between Center and States

Financial Relations between Center and States

Allocation of Taxing Powers

  • Division of taxing powers is as follows
Parliament Levy taxes on subjects in Union List
State Legislature Subjects enumerated in State List
Both Subjects enumerated in Concurrent List
Residuary Levied by Parliament only
  • There is difference between Power to levy taxes , collect taxes &  appropriate the proceeds of taxes . Eg: CST  is levied & collected by Centre but its proceeds distributed among states

Distribution of Tax Revenues

Article 268 to 293 in Part XII deals with financial relations

Has two parts to ensure adequate finances to states and union

a. Fixed Part Relates to some sources of Finance being entirely given to State 
b. Dynamic Part Making revenue from central taxes and duties divisible between Centre & State by Finance Commission

a. Fixed Part of Finances

Fixed Part of finances of Union and State consist of Direct and Indirect Taxes of Union and State respectively.

1 . Direct Tax of Union & States  

1 . 1 Direct Taxes of Union

These include

  1. Taxes on Income
    • Income tax
    • Corporate Tax (and Minimum Alternate Tax (MAT)
  2. Taxes on assets
    • Wealth Tax (removed now)
    • Securities Transaction Tax (STT)
    • Cash Transaction (CTT)

1 . 2 Direct Taxes of State 

These include

  1. Taxes on income
    • Agriculture income tax – Most of States don’t take this due to vote bank politics.  But in 2017 , Niti Ayog Member Bibek Debroy recommended to levy this tax.
    • Professional tax (constitutional provision : max ₹2500 can be demanded as Professional Tax but 14th Finance Commission proposed to raise it to ₹12,000) (this tax is  levied and collected by state but maximum limit decided by parliament)
  2. Taxes on properties
    • Land Revenue
    • Stamp duty/registration duty
    • Property tax in urban areas

2 . Indirect Tax

It mainly consist of GST.

Union CGST
State SGST

More about GST in Economics

b. Dynamic Part of Finances

  • All the taxes received by Union are shared by it with the States. Percentage of Union taxes to be shared with States is decided by FINANCE COMMISSION.
  • Finance Commission is constituted under Article 280 of Indian Constitution after 5 years or earlier by President
  • According to 14th Finance Commission (latest), 42% of divisible pool of Union Taxes is to be shared with state .

Grants in Aid to States

Center can give money to States via Grant in Aid. These are of two types

1 . Statutory Grants

  • Article 275 –  Parliament can give money to states which are in need of financial assistance  on recommendation of Finance commission 
  • Charged on Consolidated Fund of India

Side Topic : Need of these grants

  • After devolution of divisible taxes if some states still face some revenue deficits, Finance Commission can recommend gap filling grants to such states . These are meant to even out horizontal imbalances
  • They are only Revenue Grants and not Plan Grants and all states don’t receive them equally . These are grants to ameliorate particular problem faced by particular states

2. Discretionary Grants

  • Article 282 – This empowers state & center to make grants even if it is not in their Legislative competence eg Center on Advice of Planning Commission.
  • Discretionary because Center under no obligation
  • There was concept of Special Category States which used to receive more sum through discretionary grants . But after implementation of the recommendations of 14th Finance Commission, these have become insignificant.

3. Other Grants

  • Provided by Constitution but for temporary period
  • For period of 10 years after commencement of Constitution made grant in lieu of export duties on Jute products to states of Assam, Bihar & Orissa & charged on Consolidated Fund

Protection of States Interests

To protect interest of States certain bills can be introduced in Parliament only on the recommendation of President

  • Bill which imposes or varies any Tax in which states are interested
  • Bill which varies the meaning of expression Agriculture income
  • Bill which affects principle on which money is distributed to state
  • Bill which imposes any surcharge on any specified tax or duty for the purpose of center

Borrowing and Loans by Center & States


  • Center can borrow either within India or outside upon security of Consolidated Fund of India within limit fixed by Parliament (no limit fixed yet)
  • State Government can borrow within India (& NOT ABROAD) upon security of Consolidated Fund of State


  • Central Government can make loans to any state or give guarantees in respect of loans
  • State can’t raise loan without consent of Center if there is still outstanding any part of loan made by Center to State or in which Center has guaranteed

Inter Government Tax Immunities

There are certain rules of IMMUNITY FROM MUTUAL TAXATION

  • Property of Center is exempted from all taxes imposed by State or any authority within state like Panchayat, Municipal Corporation etc
  • Property & income of state is exempted from central taxation
  • Property & income of local bodies like panchayat are not exempted from central taxation

Effects of Emergencies on Financial Relations

National Emergency

  • President can modify Constitutional distribution of revenues between Centre & State
  • Modification continue till the end of  financial year  in which emergency cease to operate

Financial Emergency

  • Centre can give direction to states
  • Observe specified canons of financial propriety
  • Reduce the salaries & allowances of all class of persons in states
  • Reserve money bills & financial bills for consideration of President

Analysis :   Center – State  Financial Issues

  1. Vertical Imbalance in Resource Sharing: The States feel that the resource transfers to them have not been commensurate with their growing responsibilities. 
  2. Growing Central Expenditure on Functions in the State List: 12th Finance Commission estimated that a fifth of the expenditure incurred by the Center was on subjects, which were in the domain of the States. (Now addressed to large extent)
  3. Compliance and Enforcement Cost of Central Legislation: There are a number of Central legislations, the compliance and enforcement cost of which are entirely borne by the States . At present, States are not compensated for the cost of compliance and the revenue loss on account of compliance.
  4. Impact of Pay Revision by the Central Government on State Finances: The periodic pay revision by the Central Government gives rise to demand on the part of State government employees for a similar pay hike. States have demanded that the Central Government should bear at least 50 % of increase
  5. Sharing of Off-Shore Royalty and Sale Proceeds of Spectrum:  under the present Constitutional arrangements, offshore royalty accrues entirely to the Center
  6. Profession Tax: it can not exceed Rs. 2,500 per annum. As income and salary levels are increasing, a limit on the profession tax constraints revenue mobilization
  7. FRBM Legislation: At present, the deficit reduction targets are uniform across all States. This ‘one-size fits all’ approach has constrained fiscally strong States to raise more resources. 

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