Financial Autonomy in Centre-State Relations: Challenges and Opportunities

Money is at the heart of every federal relationship. In India, the Union government collects the bulk of the country’s revenue, while the states are expected to deliver the services people use every day, including schools, hospitals, roads, and policing. This mismatch between who raises the money and who spends it is the central tension in Centre-State financial relations. Understanding how funds are divided, why states feel short-changed, and what reforms have been attempted tells us a great deal about how Indian federalism actually works in practice.

The constitutional design of financial relations 🔗

The Constitution deals with the division of financial powers in Part XII, which covers Articles 268 to 293. These provisions decide who can levy which taxes, who collects the proceeds, and how revenue is shared. The framers wanted both the Centre to have enough resources for national priorities and the states to retain a degree of fiscal independence.

Taxing powers are split through the legislative lists in the Seventh Schedule. Parliament has exclusive authority over subjects in the Union List, while state legislatures handle subjects in the State List. The catch is that the most lucrative tax bases, such as income tax, corporation tax, and customs duties, sit with the Centre. The residuary power to tax also rests with Parliament. States are left with comparatively narrower and slower-growing sources of revenue.

This is why India is often described as a quasi-federal system. The structure is federal in form, but the financial balance tilts decisively toward the Centre. The result is a structural gap: states carry heavy spending responsibilities but lack matching revenue powers, forcing them to rely on transfers from the Union.

How taxes are collected and shared 🔗

The Constitution sets up several categories of taxes with different sharing arrangements. Some taxes, such as stamp duties, are levied by the Union but collected and kept by the states under Article 268. Most major central taxes, however, go into a common pool that is then divided between the Centre and the states. Article 275 allows the Centre to give grants-in-aid to states that need extra support, and Article 280 establishes the body that decides how the shared pool is split.

The role of the Finance Commission 🔗

The Finance Commission is the constitutional body at the centre of revenue sharing. Appointed by the President every five years under Article 280, it recommends two key things: how much of the central tax pool should go to states as a whole (vertical devolution), and how that amount should be divided among individual states (horizontal devolution).

Its recommendations are not legally binding, but they carry enormous political weight and have always been accepted by the Union government. This makes the Commission a periodic settlement of the fiscal relationship, a moment when the terms of the Centre-State financial bargain are renegotiated.

Vertical devolution and the divisible pool 🔗

Vertical devolution is the share of the central tax pool that goes to the states collectively. This figure has risen over the decades. A major jump came when the 14th Finance Commission raised the states’ share from 32% to 42%, widely seen as a big step toward stronger fiscal federalism. The 15th Finance Commission set it at 41%, and the 16th Finance Commission, chaired by Arvind Panagariya, retained the 41% share for the 2026-31 period in the Union Budget for 2026-27.

States had pushed for an increase to 50%, so the decision to hold the figure steady disappointed many of them. But the headline number hides a deeper problem, which we will turn to shortly.

Horizontal distribution among states 🔗

The harder question is how to split the states’ collective share among individual states. The Finance Commission uses a formula that weighs factors like income distance, population, area, and demographic performance, with the goal of reducing disparities so that poorer states can still fund basic services. The 16th Finance Commission added a new criterion based on a state’s contribution to GDP, signalling a modest shift toward rewarding economic performance. As a result, southern and western states saw a small rise in their share, while large northern and central states saw a marginal decline.

Why states feel financially squeezed 🔗

Even with a 41% devolution figure on paper, many states argue that they are not getting their fair share. The biggest reason is the growing use of cesses and surcharges by the Union government. These are special levies imposed for specific purposes, and crucially, they are excluded from the divisible pool. That means none of the money raised through them is shared with states.

The numbers show how significant this has become. The share of cesses and surcharges in the Centre’s gross tax revenue rose sharply over the last decade, peaking at over 20% in 2020-21 before settling around 14.8% in 2023-24. Because so much revenue sits outside the shareable pool, the effective transfer to states has been estimated at only around 29-30% of gross tax revenue, far below the 41% promise. This gap between the formal figure and the real transfer is the heart of the dispute.

Tied transfers and centrally sponsored schemes 🔗

A second issue is the rise of tied transfers. Beyond their guaranteed share of taxes, states receive money through centrally sponsored schemes. But unlike untied devolution, these funds come with conditions attached. States must often spend in ways the Centre dictates and contribute matching funds of their own. This limits a state’s freedom to set its own priorities and effectively shifts spending decisions back toward the Union, even when the money is meant for the states.

The GST and the loss of tax autonomy 🔗

The introduction of the Goods and Services Tax in 2017 reshaped financial relations in a fundamental way. By merging many indirect taxes into a single system run through the GST Council, it reduced states’ control over their own indirect taxes. States gave up the power to set many of their own tax rates in exchange for a share of GST revenue and a promise of compensation for any losses during the first five years.

That compensation guarantee expired in June 2022. When it ended, states lost the floor protection that had cushioned the transition, creating particular stress for manufacturing-heavy states whose consumption-based GST collections fell short of what they earned under the older production-based system. Delays in releasing compensation during the pandemic added to the friction.

The regional dimension of the dispute 🔗

Financial tensions are not spread evenly. Richer southern and western states feel a specific grievance. Because the horizontal formula gives weight to income distance, high-income states such as Kerala, Tamil Nadu, and Karnataka receive relatively less per capita than poorer states. They argue that they contribute more to national tax revenue yet are effectively penalised for better economic performance and governance.

These frustrations spilled into the open with public protests by the governments of Kerala and Karnataka, which drew support from several other states. The agitations highlighted both vertical inequality, meaning too little going to states overall, and horizontal inequality, meaning the way the limited pot is divided. These were exactly the complaints the 16th Finance Commission was expected to address.

Committees and commissions that tried to fix it 🔗

The demand for greater state autonomy is not new, and several official bodies have examined it. The Sarkaria Commission, set up in 1983 under Justice R.S. Sarkaria, reviewed the entire working of Centre-State relations. On finance, it recommended giving states more financial autonomy by increasing their share in central taxes and reducing reliance on discretionary grants. Although not all of its recommendations were implemented, its report became a lasting reference point, and it led directly to the creation of the Inter-State Council in 1990.

The Punchhi Commission, established in 2007 under Justice Madan Mohan Punchhi, revisited these questions in a changed economic landscape. It made over 310 recommendations, including involving states more directly in framing the Finance Commission’s terms of reference. Significantly, it expressed concern about the growing use of cesses and surcharges, the very issue that dominates the debate today. This shows that the structural problem was identified long before it reached its current scale.

Why progress has been slow 🔗

The recommendations of these commissions were advisory, not binding. That allowed governments to accept the suggestions they found convenient and quietly set aside the rest. Bodies like the Inter-State Council, meant to provide a forum for dialogue, have met irregularly. As a result, the deeper imbalance in financial relations has persisted, even as the formal devolution percentage has improved on paper.

The case for greater financial autonomy 🔗

The argument for empowering states financially rests on a simple idea. States are closer to the people and better placed to understand local needs in health, education, and agriculture. If they have stable, untied resources, they can plan for the long term and tailor spending to their own circumstances rather than waiting on conditional central funds.

Reform proposals that experts and state governments have raised include bringing cesses and surcharges gradually into the divisible pool so the headline devolution figure reflects reality, reducing the conditions attached to centrally sponsored schemes, and strengthening the GST Council as a genuine forum of cooperative bargaining. Some have also suggested a comprehensive review of the fiscal federalism framework to close the gaps that current mechanisms leave open.

At the same time, the Centre’s position is that it needs substantial resources for defence, macroeconomic stability, and large infrastructure, and that much of its spending already flows to states through schemes. The challenge, then, is not to weaken the Union but to design a settlement that gives states predictable resources and real decision-making space while preserving national priorities. That balance, struck and re-struck every five years, will continue to define Indian federalism.

What do you think? Should cesses and surcharges be included in the divisible pool so that states receive their full promised share, even if it reduces the Centre’s flexibility on national projects? And is it fair for richer states to receive less per capita in the name of equity, or does this discourage strong economic performance?

References

1. https://www.apnilaw.com/upsc/indian-constitution/financial-relations-between-centre-and-states-articles-268-293/
2. https://blog.ipleaders.in/centre-state-relations-financial/
3. https://www.drishtiias.com/daily-updates/daily-news-analysis/financial-devolution-in-india
4. https://vajiramandravi.com/upsc-exam/fiscal-federalism/
5. https://www.policycircle.org/policy/finance-commission-fiscal-federalism/
6. https://vajiramandravi.com/current-affairs/16th-finance-commission/
7. https://www.iasgyan.in/daily-current-affairs/vertical-devolution-to-states
8. https://superkalam.com/upsc-mains/topics/centre-state-relations
9. https://www.indianrepublic.in/2026/05/fiscal-federalism-how-money-flows-india.html
10. https://vajiramandravi.com/upsc-exam/sarkaria-commission/
11. https://www.nammakpsc.com/practices/punchhi-commission-report/