Key Aspects of Fiscal Federalism: Division of Functions and Revenue Powers

Every democracy with more than one layer of government has to answer one basic question: who spends the money, and who raises it? In a country as large and diverse as India, this question gets even trickier. The Union government looks after the nation as a whole, while 28 states and multiple union territories manage their own priorities. Fiscal federalism is the framework that decides how governmental functions and financial resources are divided between these layers of government. It sounds technical, but it shapes everything from how much a state spends on schools to how GST revenue reaches your local municipality.

What fiscal federalism actually means 🔗

At its core, fiscal federalism is about matching responsibilities with resources across different levels of government. The economist Richard Musgrave, who is credited with popularising the term, grouped the core functions of any government into three broad categories, and Indian fiscal federalism largely follows this logic, as explained in detail by ClearIAS’s overview of the subject.

Economic stabilisation 🔗

Managing inflation, unemployment, and overall macroeconomic stability requires a national approach. A single state cannot control interest rates or the exchange rate on its own, so this function naturally sits with the central government.

Income redistribution 🔗

Reducing inequality between rich and poor, or between prosperous and lagging regions, is also best handled centrally. If states alone tried to redistribute income, wealthier states could simply attract more people and businesses, defeating the purpose.

Resource allocation 🔗

Deciding how to provide local public goods like roads, water supply, and primary healthcare is better handled by state and local governments. They understand local needs and preferences far better than a distant central authority.

Why India needed a rulebook for this division 🔗

India’s Constitution creates what is often called a dual polity: the Union at the centre and the states, each with sovereign powers in their own assigned areas. This is not accidental. The framers wanted a strong Centre capable of holding together a newly independent, diverse nation, while still giving states enough room to govern effectively. Rather than leaving this division open to interpretation, the Constitution lays it out explicitly.

The seventh schedule: the constitutional blueprint 🔗

The main instrument for dividing governmental functions in India is the Seventh Schedule, read along with Article 246 of the Constitution. It splits legislative subjects into three lists, and this structure is what most clearly operationalises fiscal federalism on the ground, as detailed on the Seventh Schedule’s constitutional entry.

The union list 🔗

Subjects of national importance, where consistency across the country matters most, sit here. Only Parliament can legislate on these matters.

The state list 🔗

Subjects touching everyday life at the regional level fall under state control, giving states the autonomy to design policies suited to their populations.

The concurrent list 🔗

Here, both the Centre and states can make laws, but if their laws conflict, the central law generally prevails. This list also carries the country’s residuary powers in practice – any subject not explicitly listed anywhere defaults to the Union, a feature that distinguishes India’s model from federations like the United States, as noted in the entry on the Concurrent List.

This built-in tilt toward the Centre is why scholars often describe India as a quasi-federal system, or a federation with a unitary bias, rather than a purely federal one like the US or Australia.

Dividing the revenue powers 🔗

Functions are only half the story. A state cannot run public health programmes or schools without money, so the Constitution also divides taxation powers between the Union and the states, broadly along the same lines as the Seventh Schedule.

The Centre generally levies taxes that need uniform, nationwide application: income tax, corporation tax, and customs duties. States, in turn, control taxes closer to local economic activity: land revenue, excise on alcohol, electricity duty, and stamp duties. This division reflects a simple principle – taxes that are easy to shift across state borders, or that need a single national rate, work better under central control, while taxes tied to local resources and consumption fit naturally with states.

GST and cooperative federalism 🔗

The introduction of the Goods and Services Tax changed this picture significantly. Instead of the Centre and states taxing separately, GST created a dual tax structure where both levels tax the same transaction simultaneously, replacing a patchwork of older indirect taxes, as explained in the government’s own concept note on GST.

To manage this shared taxing power, the Constitution created the GST Council under Article 279A, a joint body where the Union Finance Minister and every state’s finance minister sit together to decide tax rates and rules. It is often described as the country’s first genuinely federal decision-making body, and its structure and functioning are laid out on the official GST Council website. This is a good example of what is called cooperative federalism – the Centre and states working through a shared institution rather than operating in silos.

The finance commission: bridging the gaps 🔗

Even with taxation powers divided on paper, an imbalance remains. The Centre tends to collect more revenue than it needs for its own functions, while states often need more money than their own tax base provides. This is called a vertical imbalance. There is also a horizontal imbalance – richer and poorer states have very different revenue-generating capacities.

Article 280 of the Constitution addresses both by establishing the Finance Commission, a body reconstituted roughly every five years to recommend how the divisible pool of central taxes should be shared with states, and how much each state should receive. Its core mandate is to decide the share of central tax revenue going to states and to lay down principles for grants-in-aid, a role clearly set out on the government-run Arthapedia platform of the Indian Economic Service.

Over the decades, the criteria used for sharing this revenue have grown more sophisticated. Early commissions relied mostly on population figures, while recent ones factor in indicators like income distance between states, forest cover, demographic performance, and fiscal discipline. This body is often nicknamed the “balancing wheel” of Indian fiscal federalism because of how central its role is in keeping the system functional, a description echoed in the Finance Commission’s own constitutional profile.

Where the tensions lie 🔗

No system this large runs without friction. States frequently argue that the Centre’s share of the divisible tax pool leaves them underfunded relative to their responsibilities, especially since many welfare schemes are implemented at the state level but designed centrally. The rise of centrally sponsored schemes, where the Centre funds a programme but attaches conditions on how states must spend the money, has also been a persistent point of debate, since it can dilute state autonomy even in areas technically under the State List.

At the same time, the residuary powers resting with the Union, along with the wide interpretation courts have given to some Union List entries, keep the “unitary bias” alive. Bodies like the erstwhile Sarkaria Commission and the Punchhi Commission have both recommended greater consultation with states before legislating on Concurrent List subjects, though these recommendations have not translated into constitutional changes so far.

Why this matters beyond the exam hall 🔗

Fiscal federalism is not just constitutional theory. It decides how quickly a state can respond to a public health emergency, how much money reaches a village panchayat for a water project, and how GST rate changes get negotiated between 30-plus governments with different priorities. Understanding this framework helps make sense of recurring headlines about states demanding a higher share of central taxes, or disputes over GST compensation.

What do you think? Should India move toward giving states a larger share of tax revenue to strengthen their autonomy, or does a strong Centre remain necessary to hold together such a diverse country? And does the current Seventh Schedule structure still fit the economic realities of India in 2026, or is it due for a rethink?

References

1. https://www.clearias.com/fiscal-federalism/
2. https://en.wikipedia.org/wiki/Seventh_Schedule_to_the_Constitution_of_India
3. https://en.wikipedia.org/wiki/Concurrent_List
4. https://www.dor.gov.in/concept-note-gst
5. https://www.gstcouncil.gov.in/
6. https://ies.gov.in/arthapedia/concept/finance-commission
7. https://en.wikipedia.org/wiki/Finance_Commission