Essay on the Centre-State Financial Relations in India


Essay on the Centre-State Financial Relations in India


The distribution of powers in countries adopting the federal system of government defines the financial relations between the Central and State governments.


However, there are some special problems that have to be solved within the federal financial system in determining the basis of division and the amount that should he divided between the Centre and the State.

Development of Thought:

The Indian Constitution provides for the appointment of a Finance Commission every five years to determine the criteria and amount of finance to be divided between the Centre and the States. Transfer of resources takes places in the following three ways: share in taxes and duties, grants and loans.

However transfers through the Finance Commission contribute only about one-third of the total transfers from the Centre to the States. The rest are channeled through the Planning Commission and discretionary grants from the Centre to the States.


This has led to arbitrary distribution with backward states suffering a disadvantage and has led to an erosion of state autonomy. The revenue raising capacity of the states is also restricted because of the nature of the taxes assigned to them.

The scope of the Finance Commission should therefore be enlarged to reduce the interference of the Centre in the financial management of the States. In the context of raising revenues the recommendation of the Tenth Finance Commission to increase the role of industry, needs to be seriously considered.


Ultimately the basic issue is efficiency in fiscal management and self restraint. In the context of resources mobilization, the tax structure needs to be rationalized and tax evasion and other loopholes need to be plugged.


Before the question of division of finances between Centre and State arises, it is necessary to determine the basis of division and the amount that should be divided.

The Indian Constitution recognizes that due to changing needs and circumstances it might become necessary to change the criteria and amount of vision between the two levels of government (Centre and State) from time to time. Hence it did not lay down any hard and fast rules in this regard.

Instead it provided for the appointment of a Finance Commission at the expiry of every year or earlier, if necessary, to investigate these questions.

The Commission appointed under Article 280 of the Constitution and is entrusted with the task of recommending;


(i) The distribution between the Union and the States of the net proceeds of taxes which are to be, or may be, divided between them and the location between the States of the respective shares of such proceeds;

(ii) The principles which should govern the grants-in-aid of the revenue of the States out of the Consolidated Fund of India; and

(iii) Any other matter referred to the Commission by the President in the interests of sound finance.

The Ninth Finance Commission was appointed with N.P.K. Salve as deputy chairman in June 1987. It submitted its Second Report in December 1989. The Tenth Finance Commission was constituted with the deputy chairmanship of K.C. Pant.


The Finance Commissions have concerned themselves with allocating net proceeds from income tax, Union excise duties, additional duties of excise, estate duty in respect of property other than agricultural land, grants in-aid in lieu of jute export duty (issue that concerned the first two Commissions only), taxes railway fares and freights (levied for the first time in 1957), and grants-in-aid to fill in the budgetary gaps of the States.

In addition, some Finance Commissions gave grants for up gradation of standards of administration. The Sixth and Seventh Finance Commissions were also asked to undertake a general review of the State’s indebtedness to the Centre and examine the policy and arrangements in regard to the financing of relief expenditure.

The Twelfth finance commission with Mr. M.S. Ahluwalia as Deputy Chairman is moving ahead with economic reforms.

The main taxes shared between the Centre and the State governments are the income tax and the Union excise duties though recommendations regarding some other taxes (e.g. estate duty) are also generally made.

The principle that has been followed in deciding this division is that taxes likely to have an effect upon the economic life of the country as a whole are leaved by the levied by the Centre while taxes which have no effect in States other than the known ones from which they are collected are levied by the States.

However, since 10 per resources of the Central government yield a substantial surplus, while State governments experience heavy deficits, a mechanism of transfer of resource from the Centre to the States has been provided. In addition to this, Article 275 those of the Constitution provides for grants-in-aid to the States in need of assistance.

Different sums can be fixed for different States, so that the weaker States can be given specific assistance to meet the necessary expenditure in the proper discharge of their duties to the people.

Article 282 provides for grants by the Union government to the State governments for any public purpose. Under Article 275 grants-in-aid are fixed on the advice of the Finance Commission, while under Article 282 grants can be fixed by the Central government on its own discretion.

The States governments also borrow from the Centre to carry out the various developmental and rehabilitation programmes. Thus transfer of resources from the Centre to the State government takes place in the following three ways-(i) share in taxes and duties, (ii) grants, and (iii) loans.

In addition to transfer of resources from the Centre to the States according to the recommendations of the Finance Commission, there are two other sources of transfer- (i) assistance for Plan purposes from the Planning Commission, and (ii) discretionary grants from the Centre to the States.

These sources of transfer have contributed substantially more resources than statutory transfers (which are transfers through the Finance Commission) and reflect the considerable power that the Central government enjoys in influencing the decision-making process at the State level.

For most of the period of planning, statutory transfers have remained less than one-third of total transfers, the remaining two-thirds having been contributed by the Planning Commission as assistance for Plan purpose or by the Central Government under the head of ‘discretionary grants’.

There were no objective criteria to decide the distribution of non-statutory transfers and this introduced an element of arbitrariness in the whole scheme. Everything depended on what the Centre thought about the needs of the States. Basically, Plan assistance was meant to enable the State to undertake certain schemes according to Plan priorities.

In actual practice, however, the States were presented with a choice of schemes-each with pre-determined proportions of loans and grants assistance.

Though the Planning Commission had no statutory basis (as against the Finance Commission which is an ad quennial body statutorily set up to recommend devolution of resources from the Centre to the States), it tended to take up the functions of the Finance Commission and for a considerable period of planning, has remained the more important source of transfer.

Since it was not guided by any objective criteria, the whole scheme introduced arbitrariness in the determination of resource transfers.

It was only from 1969-70 onwards that objective criteria were adopted for the Plan assistance among the States. The formula used for the purpose was known as the Gadgil formula which gave 60 per cent weight age to population, percent to per capita income if below national average, 10 per cent of tax effort in relation to per capita income, 10 percent to continuing major and medium irrigation projects, and 10 per cent to special problems of individual States (like relating to metropolitan areas, floods, chronically drought affected areas tribal areas).

Under the new formula, it is stated that 30 per cent of total Plan assistance would be given in the form of grants and 70 per cent in the form of This provision did not apply to Jammu and Kashmir, Assam and North- Eastern States in whose case 10 percent was to be given in the form of loans and rest 90 per cent in the form of grants.

In its meeting held in August 1980, the National Development Council accepted a modified Gadgil formula raising the percentage of resources to be transferred to the States whose per capita income was less than the national average from 10 per cent to 20 per cent.

Under the modified Gadgil formula 60 percent of the assistance is to be given on basis of population, 20 per cent the States having per capita income below the national average, per cent on basis of per capita tax effort and 10 per cent for special problems.

The Constitution provides for division of financial powers between the Centers the States. However the revenue-raising capacity of the States is restricted use of the nature of taxes assigned to them. Since land is limited, the scope increasing land revenue is also limited.

Similarly, taxes on agricultural income, excise duties on intoxicants, taxes on motor vehicles, entertainments, etc., are comparatively less elastic than the taxes assigned to the Centre. Sales Tax the only tax levied by the States which has substantial elasticity.

Because of economic progress registered by the country in the last three decades, the base of income tax, Union excise duties, customs duties and other important central taxes has expanded considerably. This has given immense powers to the central government to increase its resources with the passage of time.

This lure of financial relations between the Centre and the State governments elastic sources of revenue for the States and more elastic sources of revenue the Centre places the States at a distinct disadvantage.

While demands on States’ resources are increasing rapidly because of the pressure of development ices, especially in the field of social welfare, their income has failed to ease correspondingly.

Accordingly, vertical imbalances have accentuated over years and the dependence of the State governments on the Centre has considerably increased. This has made them vulnerable to increasing pressure in the Central government to its lines.

Where the State government belongs a different political party these pressures give rise to open conflict seriously jeopardizing the effectiveness of the policy measures introduced by the concerned State government.

This “strong Centre and the weak States” arrangement was introduced intentionally by the framers of the Constitution in a bid to stall the divisive fore operating in the economy. The partition and its after effects created a strong public opinion in favour of such an arrangement.

The one-party rule at the Centre and the States further cemented this relationship arid the role of the Stat became more and more secondary. As pointed out in the Document on Cent State Relations’ adopted by the West Bengal government in December 19791 structure of the Indian Constitution is more unitary than federal.

By vesting residuary powers in the Centre and by keeping 47 items in the concurrent list strengthened the base of Central control and vested the Central government with practically unlimited powers to interfere in the governance of States.

Though and order is a State subject, the Centre has not hesitated in interfering in this field through the establishment of the Central Reserve Police, the Border Security Force, the Industrial Security Force, etc. Education, which was till recently State subject, has been transferred to the concurrent list by the 42nd amendment to the Constitution.

All these processes in the political field have considerably eroded independence of the States and their political and economic powers.

Therefore quite recently, demands for increase in State autonomy have been raised various quarters. While no one denies the importance of a strong Centre for preserving the integrity of the nation, it is necessary to give a serious thought these demands.

Grant of a certain amount of autonomy, at least in the sphere originally contemplated by the Constitution, is necessary to fulfill the democratic ambitions of the people. A ‘strong Centre’ without ‘strong States’ is not conceivable.

Transfers through the Finance Commission (which is a statutory body) contribute only about one-third of total transfers from the Centre to the Stat this means that about two-thirds of the transfers are channeled through the Planning Commission or the Central Government directly.

For a consider period of planning, the Planning Commission was not guided by any object criteria to determine the share of different States in its assistance and this introduced an aura of arbitrariness in the whole transfer mechanism.

Since the Centre contributed a large amount of resources in the form of discretion- grants to the States, it acquired considerable powers to affect the decision making process at the State level. This led to a further erosion of autonomy of the Stat.

The process of resource transfers through the Planning Commission and the Finance Commission has failed in correcting the “horizontal imbalance” among the federating units and disparities in their per capita incomes are growing. Plan assistance is provided 70 per cent in the form of loans and 30 per cent in the form of grants.

Since the ratio is a fixed one and does not discriminate between advanced and backward States, it amounts to discrimination against backward States.

Since advanced States have a relatively better economic position the; should be granted a greater percentage of resources in the form of loans while backward States should receive a larger percentage in the form of grants.

Non­compliance to this common sense logic has resulted in a paradoxical situation where the comparatively richer States received a higher per capita grant than poorer States.

For example, during 1969-70, rich States like Punjab and Haryana received a higher per capita grant than the poor States like Uttar Pradesh. Madhya Pradesh, Bihar and Andhra Pradesh. Bihar with lowest per capita income also received the lowest per capita grant.

As far as transfers through the Finance Commission are concerned, all Finance Commissions sought to give due importance to backward States. However, there was no clear-cut bias in favour of backward States. The ultimate result was that advanced States cornered a major share of the actual devolution of resources from the Centre to the States.

For example, the four advanced industrial States of Maharashtra, Gujarat, Tamil Nadu and West Bengal have consistently obtained more than one-third of total income tax transfers. However, the distribution of proceeds from Union excise duties was more judicious.

All Finance Commissions gave undue importance to budgetary needs while deciding the allocation of grants-in-aid. They did not realize that advanced States could also incur large budgetary deficits (even deliberately at times) and qualify for larger grants-in-aid. This led to a paradoxical situation in some instances as richer States got more grants-in-aid compared to poorer States:

The third constituent of resource transfer, viz., discretionary grants is not guided by any distinct philosophy of helping the poorer States to a greater extent. It is guided more by political consideration than by anything else. In any case, discretionary grants also do not seem to have helped the backward States more m-a-vis the advanced States.

In suggesting any reforms in the federal finance structure, the above problems should be constantly kept in mind. It is also imperative to remember that the Centre-State financial relations form a part of Centre-State relations in general whose character is to a larger extent, political.

It is unfortunate that in this country, the question of State autonomy is raised mostly to gain political advantages and is not guided by sound economic logic as it should be. Excepting the two communist parties which have argued for State autonomy on clear economic grounds, all other parties clamoring for State autonomy have narrow sectarian outlook.

This is the basic reason why in this country ‘regional’ is viewed as something ‘anti-national’. Selfish and corrupt politicians have stalled the process of true federalism. Therefore, a smooth and truly beneficial federal financing stem in this country can evolve only when a true federal spirit develops.

Since is not foreseeable in the immediate future, a compromise has to be struck between a ‘strong Centre’ policy and ‘State autonomy’ demand. Politically the centre should remain strong but it should reduce its interference in the financial sphere of the States. To accomplish this, some of the steps that can be initiated in the first instance are:

The scope of the Finance Commission should be enlarged considerable since it is a statutory body. This would reduce the interference of the Centre in the financial management of the States and the ‘arbitrariness of discretionary grants’ that accompanies such interference.

In addition, it would reduce the atmosphere of suspicion and distrust in the States over the role of the Centre in federal finance system.

Some States have demanded the setting up of a permanent Finance Commission instead of one constituted in five years. This is sought to be justified on the following considerations: (i) a permanent Finance Commission would reduce the scope for the Central government to make discretionary transfers in an ad hoc manner to the States.

Since under the existing provision. Finance Commissions are appointed once in about five years; the scope for making discretionary grants by the Centre automatically grew. This introduced an element of arbitrariness in the transfer mechanism.

The Finance Commission, being an impartial body, would be able to ensure that Central transfers were not made to particular States on considerations which may not be fair or acceptable to the rest of the States; and (ii) when a Finance Commission is appointed, it has to start on a clean slate, collect the material required for its work from the State governments and the Central government, and then initiate such studies and analysis as it requires.

A permanent Finance Commission (as the Australian Grants Commission in Australia) would be able to keep under review various aspects of the finances of the Centre and the state governments, special features of particular States, and the factors which affect heir finances.

This suggestion did not find favour with the Seventh Finance Commission since it felt that if a permanent Commission is set up, there might well be a tendency for members to be regarded as full time employees of the Central government. This would be unhealthy from the point of view of the Commission’s function vis-a-vis the State governments.

Besides, under the present arrangement, new persons with a fresh approach and unbiased opinions can be inducted into the Finance Commission. On these grounds, the Seventh Finance Commission did not support the idea of a permanent Commission.

However, it called for the establishment of an expert non-political agency by the Central government to perform such functions as the Secretariat of the Commission is expected to perform. In addition, it can be entrusted to play a watching and advisory role with regard to Centre-State financial relations generally.

This is a sound suggestion and should be implemented. The expert non-political agency can collect vital information regarding Centre-State finances to enable the Finance Commission (whenever appointed) to start work without loss of time. It can also oversee the implementation of the recommendations of the Finance Commission as accepted by the Central government.

In addition to these measures, adequate steps should be undertaken to narrow down inter-State disparities by adopting a set of criteria distinctly biased in favour of backward States.

This can be ensured by giving more weight age to backwardness reflected through various economic and social indicators like per capita income, level of literacy, road length, administrative services, hospital I beds, etc.

Further it is necessary to enlarge the very quantum of resources transferred from the Centre to the States. In this context, the proposal of the Rajamannar Committee to widen the base of devolution of resources to the States by including

Corporation tax, customs duties and all excise duties in the divisible pool, needs consideration. These taxes and duties are highly elastic and can help inconsiderably enlarging the revenue base of the States which are in dire need of more finance to fulfill the social and economic responsibilities which the development process is forcing them to shoulder.

The Tenth Finance Commission established under the chairmanship of K.C. I Pant recommended a major role for industry in the field of public finance.

Looking at both vertical and horizontal equity i.e. sharing of resources between the Union and the states and again, among the states, the nexus between industry, trade and the public finance can hardly be over emphasized.

The programme for removing the distortions in the industrial policy in the context of the changing global economic scene was set in motion in the Eighties but it gathered greater momentum in the last few years. Major changes have taken place in the industrial policy.

As the economy opens up and becomes more and more outward looking, greater challenges and opportunities will come our way. These have to be carefully and comprehensively assessed and the emerging possibilities fully exploited.

The major tasks of the Finance Commission are to assess the resource position and the needs of the Central and the state governments, and to consider issues like reduction of fiscal deficit, striking a balance between revenue receipts and expenditure and creating surplus for capital investment, and the efficiency of fiscal management of governments.

What is of crucial concern at this stage is not only what the state can do to promote industry but also as to how industry would be able to help governments in raising resources in a sustainable manner?

A question which is being posed by some knowledgeable people is regarding the fate of the weaker states which have comparatively fewer logistical advantages. In this regime, with foreign investment playing a more meaningful role, the choice of location would obviously be greatly influenced by the availability of social and economic infrastructure.

If industry goes where infrastructure is, as it perhaps would, how would the weaker states compete unless the quality and spread of their infrastructure is improved to an acceptable level?

And this is where the states may look to the captains of industry for a helping hand especially in areas of physical infrastructure like power, roads and communication and also the human infrastructure i.e., professionally and technically trained manpower which would meet the emerging requirements of industry and industry related services.

In their anxiety to woo industry, the states have been following for many years the policy of offering packages of incentives, including tax concessions. This has sometimes resulted in unhealthy competition among the states, abandonment of revenues, and even destabilization of industry.

On the subject of consignment tax many states have, favored the imposition of consignment tax which, it was stated, would curb evasion of sales tax presently taking place in the garb of branch transfers and consignment dispatches while often such transactions are, in effect, inter-state sales.

It has also been urged that far from distorting the present pattern of trade, imposition of consignment tax would lead to smoother flow of trade and better tax compliance.

Sales tax barriers, or octroi barriers, or barriers against the movement of food grain etc., lead to wastage of man-hours through idle time, wastage of fall and reduction in the efficiency of the capital employed through lower turnaround of vehicles.

The industry’s views on the matter would be welcome particularly on how to replace the fiscal and physical barriers through more sophisticated ways of compliance with the law.

Another basic question which needs to be considered by the Centre and the state governments is whether the ever increasing demand on the governments, Central or state, can continue to be satisfied without reordering priorities, without insisting upon greater efficiency in fiscal management and without exercising some measure of self restraint.

The industry must offer suggestions and also cooperation to the Central and the State governments in the matter of resources mobilization which includes not only rationalization of tax structure but also timely payment of tax, plugging of loopholes and eschewing tax evasion.

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