Government’s Role in Fiscal Federalization: Expenditure, Taxation, and Transfers

Every rupee the government spends, every tax it collects, and every scheme it funds is part of a much larger economic story. In a country as vast and diverse as India, this story gets more complicated because there is not just one government making these decisions but three tiers: the Centre, the states, and local bodies. Understanding how these layers share the job of raising money and spending it is the heart of fiscal federalism. This post breaks down what governments actually do economically, how that work is split between the Centre, states, and local bodies, and why getting this division right matters for everyone who depends on public services.

What governments actually do in an economy 🔗

Governments are not just tax collectors. They are active participants in the economy who buy goods and services, hand out money without expecting anything in return, and even run businesses. Broadly, government economic activity falls into a few categories: spending on goods and services, transfer payments and subsidies, and production through public enterprises. Each of these has a distinct purpose and a distinct impact on citizens.

Spending on goods and services 🔗

The most visible form of government activity is direct expenditure. This includes salaries for teachers and doctors, building roads and hospitals, running defence establishments, and maintaining law and order. Economists split this into consumption expenditure, which covers the day-to-day running of public services, and capital expenditure, which covers long-term investments like highways, irrigation systems, and power plants. Together, these two categories form the backbone of what shows up in a country’s GDP calculations as government spending, since this is money that directly buys goods, services, or assets for public use.

Transfer payments and subsidies 🔗

Unlike regular spending, transfer payments involve the government giving money without receiving a good or service in exchange. Pensions, unemployment benefits, and scholarships are classic examples. Subsidies work a little differently: they are payments made to reduce the cost of something for consumers or producers, such as subsidised fertiliser for farmers or cooking gas cylinders for households. Both transfers and subsidies are tools of redistribution rather than production, and they are recorded separately from consumption spending in government accounts, since they do not directly add to output the way building a road does.

Where the money comes from 🔗

None of this spending is possible without revenue, and governments have a handful of ways to raise it.

Taxation: the primary revenue engine 🔗

Taxes remain the single largest source of government revenue almost everywhere, and India is no exception. What makes the Indian system distinctive is how carefully the Constitution divides taxing powers between the Union and the states. Part XII of the Constitution lays out detailed provisions on which government can levy which tax, how non-tax revenue is treated, and how borrowing powers work. Income tax and corporation tax largely sit with the Centre, while land revenue, stamp duties, and state excise belong to the states, and the Goods and Services Tax is now jointly administered through the GST Council, a body where the Centre and states negotiate rates and rules together.

User fees and non-tax revenue 🔗

Beyond taxes, governments also charge for specific services they provide, from toll roads to municipal water connections to passport fees. These user charges work on a simple logic: if a person directly benefits from a government service, they should bear at least part of its cost. This keeps a closer link between what is paid and what is received, compared to general taxation, which funds a broad pool of public goods that everyone uses regardless of how much tax they personally contribute.

Public corporations: government as producer 🔗

Not all government economic activity happens through spending or taxing. Governments also run enterprises that produce and sell goods and services directly, often called public sector undertakings in India. These range from railways and power generation companies to banks and oil corporations. Public corporations occupy an interesting middle ground: some operate almost like private businesses, pricing their output to cover costs and even earn profits, while others are deliberately run at subsidised rates because their output is considered essential, such as postal services in remote areas. This dual role, part commercial enterprise and part public service provider, is a recurring feature of how modern governments organise economic activity.

Intergovernmental transfers: connecting the tiers 🔗

Here is where the federal structure becomes central to the story. In India, the states and local bodies are responsible for a large share of actual spending, especially on education, health, and welfare, but they do not raise a proportional share of revenue. This mismatch, known as vertical fiscal imbalance, is bridged through transfers from the Centre to the states and from states to local governments.

The Finance Commission and tax devolution 🔗

Article 280 of the Constitution requires the President to set up a Finance Commission every five years to work out how central taxes should be shared with the states. This process has two parts: vertical devolution, which decides what share of the central tax pool goes to states as a group, and horizontal devolution, which decides how that share is split among individual states based on criteria like population, income levels, and area. The Commission also recommends grants-in-aid for states that need additional support beyond their tax share, drawing on the Consolidated Fund of India.

Grants-in-aid and centrally sponsored schemes 🔗

Alongside the formula-based devolution recommended by the Finance Commission, the Centre also funds states through centrally sponsored schemes tied to specific programmes, such as rural employment guarantees or nutrition missions. These schemes come with conditions attached, which means states have less freedom in how the money is used compared to their share of devolved taxes. This creates an ongoing tension: formula-based transfers respect state autonomy, while scheme-based transfers let the Centre steer national priorities, and Indian fiscal federalism constantly negotiates the balance between the two.

The assignment problem: who should do what? 🔗

All of this raises a deeper question that economists call the assignment problem: which level of government should be responsible for which function? Should primary education be a state subject or a central one? Should highways be built by the Centre or by states? There is no universal answer, but a few principles guide the decision.

Efficiency, accountability, and local preferences 🔗

The general rule is that services with strictly local benefits, like garbage collection or street lighting, are best handled by local governments, since local bodies understand local preferences and can be held accountable more directly by residents. Services with national scope or spillover effects across state borders, like defence or monetary policy, are better centralised. A National Institute of Public Finance and Policy study notes that clear assignment of responsibilities functions much like the assignment of property rights, since ambiguity about who is responsible for what tends to produce inefficiency and buck-passing between governments. The same study cautions that arguments for decentralising a service sometimes turn out to be arguments for privatising it instead, so the assignment question needs regular review rather than a one-time decision.

India’s expenditure-heavy, revenue-light decentralization 🔗

India’s federal system is unusual in one respect: it is far more decentralised in spending than in revenue collection. Research on India’s fiscal structure has found that the Centre historically controlled a smaller share of actual expenditure while collecting a much larger share of total revenue, with states and local bodies doing the opposite: raising less revenue than they end up spending. This pattern persists today. Recent estimates suggest that states accounted for about 55 percent of total government expenditure but only around 38 percent of tax revenue in a recent financial year. That gap is exactly what intergovernmental transfers are designed to close, but it also means state finances remain sensitive to how generous or restrictive those transfers are in any given year.

Getting the balance right 🔗

None of these pieces work in isolation. Expenditure decisions depend on what revenue is available, revenue collection depends on which taxes are assigned to which level, and both depend on how well the assignment of functions matches administrative capacity at each tier. When the balance works well, public services get delivered efficiently and governments stay accountable to the people who use those services. When it does not, you get the familiar complaints: states that feel shortchanged by the Centre, local bodies starved of funds despite carrying heavy responsibilities, and schemes that look good on paper but struggle in implementation because the government funding them is not the one actually running them on the ground.

India’s ongoing efforts to strengthen the GST Council, reform Finance Commission formulas, and empower local self-governments are all attempts to fine-tune this balance rather than settle it once and for all. As the economy grows and priorities shift, the question of who should tax, who should spend, and who should transfer to whom will keep coming back for review.

What do you think? Do you think local governments in India have enough financial independence to deliver services effectively, or are they still too dependent on transfers from above? And should the criteria for sharing central taxes among states focus more on need or more on performance?

References

1. https://www.drishtiias.com/daily-updates/daily-news-editorials/fiscal-centralisation-concerns-in-india
2. https://fincomindia.nic.in/portal/
3. https://www.shankariasparliament.com/current-affairs/gs-ii/gs-ii-bodies-constitutional-statutory-regulatory/finance-commission-of-india
4. https://www.nipfp.org.in/media/medialibrary/2013/08/Fiscal_Decentralization_to_Rural_Local_Governments_in_India.pdf
5. https://www.imf.org/external/pubs/ft/seminar/2000/fiscal/rao.pdf
6. https://forumias.com/blog/decentralization-in-india-federalism-for-development/