Transforming Financial Relations in Indian Federalism: GST and Beyond

Money is at the heart of every federal arrangement. A state government can frame ambitious welfare schemes, but without a steady flow of revenue, those plans remain on paper. This is why the financial relationship between the Centre and the States is one of the most contested areas of our federal structure. The Constitution carefully divides taxing powers, but the real story lies in how that division has been reshaped, most dramatically by the arrival of the Goods and Services Tax.

The constitutional framework of financial relations
How taxes are levied and shared
Grants, loans, and the safety net
The Finance Commission as the balancing wheel
The Sixteenth Finance Commission
GST: the biggest shift in fiscal federalism
How GST actually works
The GST Council and cooperative federalism
The voting design
When cooperation was tested: the COVID-19 compensation crisis
GST 2.0 and the road ahead

The constitutional framework of financial relations

The financial relationship between the Union and the States is governed by Articles 268 to 293 in Part XII of the Constitution. This part, titled “Finance, Property, Contracts and Suits,” lays out who can tax what, how revenues are shared, and how the Centre can support States that fall short.

The basic logic is straightforward. The Constitution gives the Union and the States independent sources of revenue so that neither is wholly dependent on the other. Parliament has exclusive power to levy taxes on subjects in the Union List, while State legislatures hold exclusive power over subjects in the State List. The Concurrent List, notably, contains very few major taxes, which was a deliberate design choice to avoid both levels of government chasing the same revenue source.

How taxes are levied and shared

Not every tax follows the same path from collection to spending. The Constitution actually creates several distinct categories. Some taxes are levied by the Union but collected and kept by the States, such as the stamp duties covered under Article 268. Others are levied and collected by the Centre but assigned entirely to the States. A large group of taxes is levied and collected by the Centre but shared between both levels of government.

This careful sorting reflects a deeper principle. The framers wanted to prevent overlapping tax jurisdictions while still ensuring that resources could flow to where they were most needed. The system is often described as quasi-federal because, in practice, the Union enjoys greater financial strength than the States, a point that fuels recurring debates about state autonomy.

Grants, loans, and the safety net

Beyond shared taxes, the Centre transfers money to States through grants. Statutory grants under Article 275 are given to States in need of assistance, made on the recommendation of the Finance Commission, and include special provisions for the welfare of tribal areas. Discretionary grants under Article 282 allow both the Centre and States to fund any public purpose. The Union can also extend loans to States or guarantee their borrowings, while States face constitutional restrictions on borrowing from abroad. Together, these mechanisms form a safety net that keeps weaker States financially viable.

The Finance Commission as the balancing wheel

If the constitutional articles set the rules, the Finance Commission keeps the system fair over time. Constituted by the President under Article 280 every five years, it recommends how the net proceeds of taxes should be distributed between the Union and the States, and how that pool should be divided among the States themselves.

The framers made a clever choice here. Instead of fixing a permanent state share in the constitutional text, Article 280 created a periodic expert mechanism that can respond to shifting demographics, widening income gaps between States, and changing fiscal pressures. This is the Constitution’s built-in corrective for fiscal federalism.

The Sixteenth Finance Commission

The most recent body, the Sixteenth Finance Commission chaired by economist Arvind Panagariya, submitted its report in November 2025 for the award period covering 2026-27 to 2030-31. The government accepted its recommendation to retain the vertical share of devolution, meaning the States’ collective share in the divisible pool of central taxes, at 41 percent.

A long-standing grievance surfaced again in this process. Many States argued for a higher share, pointing out that cesses and surcharges collected by the Centre lie outside the divisible pool and are therefore not shared at all. The Commission declined to cap these levies, holding that the Constitution does not permit it, though it floated the idea of a future “grand bargain” in which the Centre might fold cesses into regular taxes in exchange for a smaller state share of a larger pool.

GST: the biggest shift in fiscal federalism

For decades, the framework above operated within a messy reality. India’s indirect tax system was a tangle of central excise duty, service tax, customs duty, state VAT, sales tax, entry tax, and a host of local levies. Goods crossing state borders were taxed repeatedly, raising prices and creating barriers to a single national market.

The Goods and Services Tax, introduced through the 101st Constitution Amendment Act, 2016, set out to fix this. The Constitution Amendment Bill received the President’s assent on 8 September 2016 after being ratified by more than 15 States. GST replaced the patchwork of indirect taxes with a unified structure under the slogan “One Nation, One Tax,” and went live on 1 July 2017.

How GST actually works

The amendment did something constitutionally unusual. Through the new Article 246A, it gave both Parliament and State legislatures concurrent power to make laws on GST. This is a significant departure from the older model where taxes were neatly slotted into separate lists.

In practice, GST operates through three components. Central GST (CGST) subsumes central levies like excise duty and service tax. State GST (SGST) covers state taxes such as VAT and luxury tax. For transactions that cross state lines, the Centre levies Integrated GST (IGST), which is not really a separate tax but a mechanism to coordinate revenue sharing between the Centre and the States. Importantly, States receive 100 percent of the SGST they collect and roughly half of the IGST pool.

The GST Council and cooperative federalism

The institutional heart of the GST system is the GST Council, created under Article 279A. The amendment required the President to constitute the Council within sixty days, and it came into existence on 12 September 2016. It is chaired by the Union Finance Minister, with the Union Minister of State for Finance or Revenue and the finance or taxation minister of every State as members.

The Council is the first constitutional body of its kind empowered to make decisions jointly on a shared tax. It recommends the rates, the goods and services to be taxed or exempted, the model GST laws, and the threshold limits. This is why it is often called a working model of cooperative federalism, a framework where both levels of government collaborate on economic policy rather than acting in isolation.

The voting design

What makes the Council interesting is its voting structure. Decisions require a three-fourths majority of the weighted votes cast. The Centre holds one-third of the total votes, while all the States together hold two-thirds. On paper, this means neither side can push a decision through unilaterally, forcing cooperation.

Yet critics point to a structural imbalance. Because the Centre’s one-third bloc votes as a single unit while the States must coordinate among themselves, the Centre wields disproportionate influence. Opposition-ruled States in particular have argued that the Council can resemble a centralised model rather than a genuinely cooperative one.

When cooperation was tested: the COVID-19 compensation crisis

The strongest test of this arrangement came during the pandemic. To convince States to surrender their largest independent revenue sources, the Centre had offered a crucial guarantee. States were promised compensation for any revenue shortfall below 14 percent annual growth, calculated from a 2015-16 base, for the first five years running from July 2017 to June 2022. This compensation was to be funded through a separate cess on certain goods.

By the end of 2019, compensation payments to States had already begun to fall behind schedule. Then the pandemic struck. With the economy contracting sharply, the cess pool could not cover the promised amounts. The Centre suggested that States borrow to meet the shortfall, a move that triggered sharp protests.

The political reaction was intense. The West Bengal Chief Minister, for instance, wrote to the Prime Minister arguing that withholding compensation violated the spirit of cooperative federalism, reminding the Centre that States had given up roughly 70 percent of their taxing powers to make GST possible. Eventually the Centre borrowed on behalf of the States and passed on the funds, but the episode exposed how fragile the trust underlying the system could be.

Interestingly, some economists read the same events more favourably. They argue that the 14 percent guarantee functioned as a powerful counter-cyclical transfer, cushioning States during a common economic shock that hit every region at once. The compensation arrangement, in this view, was an unplanned but effective example of the Centre absorbing risk on behalf of the States.

GST 2.0 and the road ahead

The GST system continues to evolve. In its 56th meeting on 3 September 2025, the GST Council approved a major rationalisation of the rate structure. The earlier four-tier system was replaced with a simpler two-slab structure of 5 percent and 18 percent, along with a special 40 percent rate reserved for luxury and so-called sin goods. These changes took effect from 22 September 2025.

The reform, dubbed GST 2.0, aimed to lower prices on essentials, reduce classification disputes, and boost consumption. Notably, some States raised concerns about the potential revenue loss from the rate cuts, yet the Council reached its decision by consensus without requiring a formal vote. This suggests that, despite recurring friction, the cooperative machinery can still function when there is political will.

The underlying tension, however, has not disappeared. The debate over cesses outside the divisible pool, the demands for a larger devolution share, and the question of how much autonomy States genuinely retain all point to an unfinished project. Fiscal federalism in India remains a continuous negotiation rather than a settled arrangement.

What do you think? Does the GST Council’s voting structure genuinely protect state autonomy, or does it concentrate too much power in the hands of the Centre? And if a future crisis strains the system again, should the Constitution be amended to make compensation guarantees legally binding rather than dependent on political goodwill?

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Table of Contents

The constitutional framework of financial relations 🔗

How taxes are levied and shared 🔗

Grants, loans, and the safety net 🔗

The Finance Commission as the balancing wheel 🔗

The Sixteenth Finance Commission 🔗

GST: the biggest shift in fiscal federalism 🔗

How GST actually works 🔗

The GST Council and cooperative federalism 🔗

The voting design 🔗

When cooperation was tested: the COVID-19 compensation crisis 🔗

GST 2.0 and the road ahead 🔗