Redefining India’s Fiscal Architecture: Strengthening Cooperative Federalism

Every year, the Centre collects the bulk of India’s taxes, but it is states, municipalities, and gram panchayats that build the roads, run the schools, and staff the primary health centres people actually use. That gap between who collects and who spends sits at the heart of India’s fiscal federalism, and it has only grown sharper since the Goods and Services Tax folded most indirect taxes into one shared pool. With the 16th Finance Commission’s award period now underway, a fresh conversation is happening around three institutions: the Finance Commission, NITI Aayog, and the often-ignored third tier of local government. Getting their roles right could decide whether India’s growth reaches every district or stays concentrated in a handful of states.

Why India’s fiscal architecture needs a rethink 🔗

India’s Constitution splits taxing powers and spending responsibilities unevenly. The Centre raises a disproportionate share of national revenue, while states carry the heavier load of actual public spending on health, education, agriculture, and law and order. Add the GST regime, which took away states’ freedom to set their own indirect tax rates, and you get what economists call vertical imbalance: states need more money than they can raise on their own.

There is also horizontal imbalance. States differ hugely in per-capita income, population growth, and administrative capacity, so a one-size formula for sharing central taxes rarely feels fair to everyone. Southern and western states with slower population growth and stronger tax bases often argue they are penalised for good governance, while less-developed states insist they need proportionally more support to catch up. These tensions are not new, but three institutions now shoulder the job of managing them: the Finance Commission, NITI Aayog, and state-level bodies responsible for local government finance.

Reforming the finance commission for the next generation 🔗

The Finance Commission, constituted under Article 280, remains the primary channel through which central tax revenue flows to states. Every five years it decides what share of the divisible pool goes to states collectively, and how that share is split among them.

Narrowing the focus to essential public goods 🔗

One influential line of reform argues that the Finance Commission should concentrate on funding basic public goods, primary health, elementary education, drinking water, and sanitation, rather than trying to be a catch-all body for every sector. A sharper mandate would let the Commission build simpler, more predictable formulas instead of juggling dozens of competing criteria. This distinction also matters because it separates recurring welfare needs, which the Finance Commission is well suited to fund through tax devolution and grants-in-aid, from long-gestation capital projects, which need a different kind of institutional support altogether.

Protecting the divisible pool 🔗

A recurring complaint from states is that an increasing share of central revenue comes from cesses and surcharges, which by design sit outside the divisible pool and therefore are not shared with states at all. This has meant that even when the headline devolution share stays around 41 percent, the effective transfer to states shrinks. Reform proposals range from capping cess collections to gradually folding more of them into shareable taxes, so that the states’ share reflects the Centre’s actual revenue rather than a shrinking slice of it.

NITI Aayog: closing India’s infrastructure and capital gap 🔗

If the Finance Commission is meant to fund the everyday running of government, NITI Aayog is increasingly positioned to fill a different hole: long-term capital investment and infrastructure planning, areas where five-year devolution formulas struggle to keep pace with project timelines.

Bankrolling capital expenditure 🔗

This shift is already visible in practice. The Centre’s Special Assistance to States for Capital Investment scheme channels long-term, interest-free loans to states for projects in health, education, irrigation, power, roads, and bridges, precisely the kind of capital-heavy work that annual devolution formulas were never designed to finance. Because capital spending carries a much larger growth multiplier than routine revenue expenditure, routing these funds through a dedicated, project-linked mechanism rather than a blanket formula makes the money more likely to translate into actual assets on the ground.

Building competitive federalism 🔗

NITI Aayog’s other contribution is less about money and more about coordination. As the apex platform bringing together the Prime Minister and all chief ministers, it has pushed states to share best practices, adopt model laws, and compete on outcomes such as health indices, ease-of-doing-business rankings, and sanitation performance. Critics point out that NITI Aayog still lacks the statutory backing and resource-allocation powers the old Planning Commission once had, which limits how far this coordination role can go. Still, for a body with no constitutional mandate to move money, its influence on how states plan and prioritise infrastructure spending has grown steadily.

Strengthening local public finance: the missing third pillar 🔗

Even a well-reformed Finance Commission and an empowered NITI Aayog leave a gap: India’s third tier of government, panchayats and municipalities, remains chronically underfunded relative to what it is asked to deliver.

A dedicated fund for cities and panchayats 🔗

Local bodies currently depend heavily on grants that arrive through the Centre and the states rather than on resources they raise or control themselves. One proposal gaining ground is to route a defined share of CGST and SGST collections directly into a consolidated fund earmarked for urban local bodies and panchayats, giving cities and villages a steadier, more predictable revenue stream instead of relying on discretionary transfers each year. Finance Commission grants to Panchayats and Municipalities already run into tens of thousands of crores each award period, but a large share of this money is tied to specific uses such as water supply and sanitation, leaving local bodies with little discretion to address other pressing local needs like waste management, urban health infrastructure, or road maintenance.

Giving state finance commissions real teeth 🔗

Constitutionally, it is the State Finance Commission, not the Union body, that is supposed to decide how state-level taxes and grants are shared with panchayats and municipalities. In practice, many states have been inconsistent about constituting these commissions on time or acting on their recommendations. States like Karnataka periodically reconstitute their commissions to review devolution to zilla panchayats, municipal corporations, and town panchayats, but the process often lacks the urgency and statutory weight given to the Union Finance Commission. Research on local body devolution has repeatedly found that even where State Finance Commission recommendations exist on paper, states frequently fail to implement them fully, which keeps local governments financially dependent and administratively weak. Giving these commissions a status closer to that of the Union Finance Commission, with fixed timelines, mandatory implementation, and independent staffing, would go a long way toward making the third tier a genuine layer of self-government rather than an administrative afterthought.

Simplifying GST to support the federal bargain 🔗

GST was itself a landmark act of fiscal federalism: states gave up the right to independently vary indirect tax rates in exchange for a share of a unified national tax and a compensation guarantee. But a complex, multi-slab structure created years of classification disputes and compliance headaches for businesses and tax administrators alike.

The rate rationalisation carried out through GST 2.0 has moved India toward a simpler two-rate structure of 5 percent and 18 percent, with a separate higher rate reserved for luxury and sin goods. Industry bodies have welcomed the simplification as a step that should reduce disputes and improve compliance, which matters for fiscal federalism because a cleaner, more predictable GST base makes the divisible pool itself more stable and easier for the Finance Commission and GST Council to plan around. A transparent, well-functioning GST Council, one that shares data openly and involves states as genuine partners rather than rubber-stamping bodies, is just as important to cooperative federalism as the formulas used by the Finance Commission.

Bringing the three pillars together 🔗

None of these reforms work in isolation. A useful way to see how they fit together is to think of India’s fiscal architecture as three complementary pillars, each with a distinct job.

When these three pillars are aligned, welfare spending, infrastructure building, and local service delivery each have a clear institutional home instead of competing for the same pool of discretionary grants. When they are misaligned, as has often happened, states end up negotiating separately with multiple central bodies for overlapping purposes, which slows down implementation and blurs accountability.

What do you think? If you were designing India’s fiscal architecture from scratch, would you give local governments direct access to a share of GST revenue, or keep that decision layered through the states? And do you think NITI Aayog needs statutory powers to truly complement the Finance Commission’s role?

References

1. https://prsindia.org/policy/report-summaries/devolution-of-funds-under-panchayati-raj-system
2. https://www.pib.gov.in/PressReleaseIframePage.aspx?PRID=1935378&reg=3&lang=2
3. https://niti.gov.in/index.php/cooperative-federalism
4. https://www.pib.gov.in/PressReleasePage.aspx?PRID=2223103&reg=3&lang=1
5. https://www.deccanherald.com/india/karnataka/karnataka-govt-forms-fifth-state-finance-commission-2723348
6. https://www.business-standard.com/markets/capital-market-news/gst-rate-rationalisation-exercise-is-a-landmark-reform-says-ficci-president-125090400494_1.html