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Centre State Financial Relations & Impacts on Indian Financial System

Due to federal structure of India power of finance should be distributed
between Centre & State, but in practical sense distribution of powers is not
always equal. The provisions are as follows:
Sub step 1: Types of Distribution as per Indian Constitution
1. Taxes levied by the Union but collected and kept by the States.
2. Taxes levied and collected by the Union but assigned to the States.
3. Taxes levied by Union and distributed between the Union and the States
4. Grant-in-aid from the Centre to the States

1. Taxes levied by the Union but collected and kept by the States.
As per Article 268 of the Indian Constitution deals with which taxes are
levied by the Union & collected by the states.
But introduction of GST in the Indian Economy has significantly changed
the landscape of financial relations between the centre and states.
Position after GST
GST is categorized into CGST, SGST or IGST depending on whether the
transaction is Intrastate or Interstate supplies.
Inter-state and Intra-state Supplies: a) Intra-State supply of goods or
services: In these kinds of transactions, the location of the supplier and the
place of supply are in the same state. b) Inter-State Supply of Goods and
Services: when the supplier is located in some other state or union territory
and the place of the supply is in another state/UT, or when the supply of
goods or services is made to or by a Special economic zone (SEZ) unit. So,
under the GST law, the central government will collect CGST, SGST or
IGST depending upon whether the transaction is intrastate or interstate.

Further, stamp duties on bills of exchange, cheques and promissory notes

as levied by the Government of India and appropriated by the States.
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2. Taxes levied and collected by the Union but assigned to the States.

As per Article 269 of the Indian Constitution deals with which taxes are levied &
collected by the Union but assigned to the states. It includes all the taxes on the
“sale or purchase of goods“ and “taxes on the consignment of goods” except
those included in Article 269 A.
3. Taxes levied and distributed between the Union and the States:
Article 270 of the Indian Constitution basically deals with the subject of how the
taxes are levied and distributed between the Union and the states. It lays down
the procedure of the appropriation for certain taxes i.e., all the taxes except
those mentioned under Article 268, 269.
It may include taxes such as:

• Excise Duty on Non-GST products

• Income Tax
• Basic Customs Duty etc.
• Taxes on income other than agricultural income and excise duties
other than those on medicinal and toilet preparations are levied and
collected by the Union Government but shared with the states on an
equitable basis.
4. Grant-in-aid from the Centre to the States
Apart from the distribution of taxes between the Centre and the States, there
are certain articles in the Constitution which provide the scope for Grants-in-
aid. Under Article 275 and Article 282, the Parliament may make grants-
in-aid from the Consolidated Fund of India to such States as are in need of
assistance, particularly for the promotion of the welfare of tribal areas,
including a special grant to Assam.
Types of Grants:
a) Statutory grants are provided for the welfare of scheduled areas and
scheduled tribes, including a special grant to Assam.
b) Discretionary grants are provided by the Centre upon its own
discretion can grant aid to certain States for the public purpose. These
grants are not compulsory in nature. The centre used to make these
grants on the recommendations of the NITI Aayog.
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Sub step 2: Centre State relations & Impacts on Indian Financial

System
The financial relations between the central and state governments in India have
evolved over time and are guided by the principles laid down in the Constitution of
India. The impact of these relations on the Indian financial system is substantial
and plays a key role in shaping fiscal policies, economic development, and overall
governance.
Finance Commission of India plays an important role on this aspect.The
President of India appoints Finance Commission after every five years as
per Article 280 of Indian Constitution .
Objectives of Finance Commision:
The Finance Commission places its recommendations reagarding
allocation of taxes & other fiscal matters between Centre & States for the
next five years, strengenthening cooperative federalism, improving
quality of public spending & helping to protect fiscal stability.

A) Overall Impacts on IFS

1) Constitutional Framework:
The Constitution of India defines the financial relations between the center and states
through various articles. & further the Finance Commission to recommend the
distribution of taxes between the center and the states.
2) Distribution of Tax Revenue:
The distribution of tax revenue between the central and state governments is a
critical aspect of financial relations. Taxes are collected by both entities, and there
is a need to allocate the revenue appropriately to meet the expenditure
requirements. The Finance Commission plays a significant role in recommending
the sharing of taxes.
3) Vertical and Horizontal Devolution:
The distribution of resources involves both vertical and horizontal devolution.
Vertical devolution pertains to the share of states in the central taxes, while
horizontal devolution deals with the distribution of resources among the states.
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A fair and balanced devolution is essential for ensuring financial autonomy

to the states.
4) Impact on Fiscal Policies:
The financial relations between the center and states influence fiscal policies at
both levels of government. The sharing of resources affects the capacity of states
to implement their policies and programs. Which tax structure to be imposed
like, Progressive on direct tax, Regressive on indirect tax or differential on
indirect tax. Developing country like India needs a well-balanced distribution.
5) Economic Development:
The financial relations have a direct impact on the economic development of
states. Adequate financial resources enable states to invest in infrastructure,
education, healthcare, and other development activities. Insufficient funds, on the
other hand, can hinder the growth and progress of states.

India's federal structure creates a complex system of financial relations

between the central government and its states. This system has both
positive and negative consequences for the country's overall financial
health.

B) Positive Impacts on IFS

1) National economic integration:
The central government levies taxes like income tax and customs duties that
generate revenue for national needs like defense, infrastructure, and foreign
policy. This creates a common economic space and fosters national
integration.
2) Transfer of resources:
The Finance Commission, a constitutional body, recommends the devolution
of central taxes to states based on their needs and fiscal challenges. This
ensures resource equity and helps poorer states provide basic services and
develop their economies.
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3) Fiscal discipline:
The central government sets minimum standards for fiscal management,
debt levels, and public expenditure. This promotes financial prudence and
prevents states from resorting to excessive borrowing or unsustainable
practices.
4) Nationalization of key resources:
The central government controls vital resources like minerals and forests,
ensuring their optimal utilization and preventing exploitation by individual
states.
5) Stability and crisis management:
During national emergencies or economic downturns, the central government
can provide financial assistance and implement coordinated policies to
stabilize the economy.

C) Negative Impacts on IFS

1) Centralization of power and resources & disparities among states:
The central government has a larger revenue base and greater
borrowing capacity, resulting in a power imbalance that can lead to
dominance over states. This can stifle regional development and
create inequality among state governments.

2) Vertical fiscal imbalances:

The division of tax powers between the center and states often leads
to vertical imbalances, where states have greater expenditure
responsibilities than their own revenue allows. This makes them
dependent on central grants and limits their fiscal autonomy.
3) Political considerations:
The devolution of resources can be influenced by political factors,
leading to unfair allocation of funds and hindering equitable
development across states.
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4) Distortions in tax policies:

Different tax rates and policies across states can distort trade and
investment flows, hindering a smooth national market.
5) Bureaucracy and delays:
The transfer of funds from the center to states can be subject to
bureaucratic delays and complex procedures, impacting timely delivery
of services and development projects.

Conclusion & Open Interpretation

• the financial relations between the central and state governments in India
are integral to the functioning of the federal structure.
• The equitable distribution of resources is crucial for the balanced
development of all regions, and effective financial cooperation is essential
for the overall economic growth of the country.
• Recent reforms like the Goods and Services Tax (GST) aim to create a
unified national market and simplify tax administration, potentially improving
fiscal relations.
• Strengthening financial autonomy of states, promoting participatory
decision-making processes, and improving transparency in resource
allocation can address concerns about centralization and inequity.
• Continuous dialogue and cooperation between the centre and states, along
with independent oversight mechanisms, are crucial for maintaining a
healthy and balanced financial relationship.
• The Finance Commission, through its recommendations, should act
unbiasedly play a pivotal role in shaping these financial relations.
• Centre-State financial relations presents a complex picture. Striking a
balance between national integration, fiscal discipline, and state autonomy
is crucial for ensuring a healthy and lucrative Indian financial system.
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