Centre State Financial Relation

1. Introduction-:
Centre-State relations defines the relationships between Centre and it's units where there exist a
federal structure. In a system of federal government well established and clear cut centre-state
relationship is utmost important for the proper functioning of the entire system. There is a great
need of such smooth relationships in a democracy like India due to constraints posed by
regionalism, plurality of religions, unbalanced growth, demand for self- government, differential
political interests ,caste and race. The distribution of powers is the basis of relationship between
the centre and the states in a federal structure. Part XI of the Indian constitution deals with the

provisions relating to the power distribution between the federal government (the Centre) and the
States in India. These relationships are classified into legislative, administrative and financial
relations.
 Centre-State Relations
(Part XI of Indian Constitution)

Legislative Administrative Financial

Relations Relations Relations

. Figure 1: Centre State Relationships

(i) Legislative Relations (Articles 245 to 255) -: The distribution of legislative powers in
the constitution of India has been done in such a way that the strong position of the
centre has been maintained while simultaneously dealing with the diversity among
the states. Thus in order to ensure proper distribution of legislative powers the
constitutuion has called for a three tier distribution of these powers. The various
legislative powers has been classified into three lists, namely , the Union List, State
List and the Concurrent List. The Union List comprises of the most important areas o
the administration such as Defence, Atomic Energy, Railways, Income Tax, etc. Only
the Parliament has the powers to frame laws on the subjects included in the Union
List. The State List comprises of the subjects that are of importance to a particular
state and can be decentralized among the states. The State List includes subjects such
as law and order, police, local government, public healthcare, etc. Only the State
Legislature has the powers to frame laws for the subjects mentioned under the state
list. The Concurrent List comprises of the subjects that are of importance to both the
centre and the states. These are subjects of mutual relevance such as criminal law and
procedure, stamp duties and so on. In such a case both the Parliament and the State
Legislatures have the authority to frame the law. However if a situation of conflict
 arises between the Union Law and the State Law then the Union Law will prevail.
The residual powers are vested in the Parliament

(ii) Administrative Relations (Articles 256 to 263) -: Part XI, Chapter II of the
Constitution, contains the provisions related to the administrative relations between
the Union and States. The constitution of India provides for a two tier governmental
set up, one at the centre and the other in the states. The government at the centre is
called the Union or the Central Government while the one at the state level is called
the State Government. The State Government’s administrative powers are only
limited to the subjects enumerated in the state list and also to some subjects in the
concurrent list on which there exists no central law. The Central Government has the
right to exercise its administrative powers on the matters included in the Union List
and on some matters in the concurrent list where the union law exists. The Union
Government also exercises these powers on the residuary subjects. In case of subjects
in the concurrent lists both the central and the state government have the right to
exercise their administrative power.

(iii) Financial Relations (Articles 268 to 293)-: The best system of federal finance would be
one which marks a clear-cut division of sources of the revenue between the central
and the State Governments so as to ensure financial independence of each other . To
achieve this object, the constitution of India has detailed out provisions that deal with
the distribution of the income between the centre and the states. The Indian
Constitution also lays down detailed provisions regarding the borrowing power of the
centre and the states and the matters relating to the grants-in-aid to the needy states by
the central government. There has been a detailed explanation of the pattern of
allocation of the funds between the centre and the states.

The primary objective of this chapter is to delve into the centre-state relationship from an
economic view point. Therefore we will focus more on the financial relationships between the
centre and state.
 2. Finance Commission

Article 280 of Indian constitution provides for constitution of a Finance Commission which lays
down the provisions and terms and conditions for regulating the economic and financial
relationship among the two tiers of the federal government, i.e, the centre and the state. The
detailed provisions regarding the establishment of the finance commission has been laid down in
The Finance Commission Act of 1951. The Act contains detailed information and procedures
regarding the setting up of the finance commission, the appointment of the finance commission,
the qualification and disqualification of the members of the finance commission and also the
varied powers entrusted to the finance commission. The Finance Commission is appointed for a
period of five years by the President of India to deal with the issue of division of finances
between the central and the state governments. The first such report was submitted by the
commission in 1952. It lays down the principles that should be adopted to distribute the available
financial resources among the states. It also deals with the question of grants-in-aid to be given
to the states.

Importance/ Role of Finance Commission

Finance Commission plays the much needed role in distributing the financial resources among
the centre and the state. It contributes in establishing clear cut and cordial relations between the
centre and the state governments by bringing in the much required transparency and objectivity
in the distribution of resources. The Finance Commission makes recommendations to the
President on various issues —

• The division of financial resources among the centre and the states. Such
recommendations aim at ensuring objectivity and transparency in the distribution of the
revenues collected by the government.
• The various situations, policies, procedures, rules and regulations that deal with the
approval and transfer of grants in aid to the states by the central government. Such grants
in aid are given out of the Consolidated Fund of India.
• The State Finance Commission provides advice and guidance to the states to help them
augment the Consolidated Fund of the concerned state. Such measures include
 recommendations on increasing or improving the financial resources of the municipal
corporations and panchayats as well.
• The Finance Commission also guides the government in areas such as disinvestment from
public enterprises including the timing, the mode and the extent of such disinvestment.
• In certain situations the commission may provide recommendations and advice as to the
price determination of the utilities such as water and electricity. .
• The finance commission aims at ensuring the long term fiscal sustainability. It takes
various steps aimed at enriching and improvising upon the fiscal budget through the
Fiscal Responsibility Management Act.
• The Finance Commission recommends various guidelines and steps to the debt ridden
and poor states in an attempt to augment their financial resources and increasing their
revenues.
• In certain cases the President may ask for the suggestions and opinion of the finance
commission on certain policy matters. However such suggestions or advice are not
mandatory to be considered by the government.

A brief Overview of the Finance Commissions Appointed From the Period 1952-2015.

1951 - The first finance commission was appointed in the year 1951 for the period ranging from
1952 to 1957. The chairman of the firs finance commission was Mr. K.C. Neogy.

1956 - The second finance commission was appointed in the year 1956 for the period ranging
from 1957-1962. The chairman of the second finance commission was Mr. K. Santhanam.

1960 - The third finance commission was appointed in the year 1960 for the period ranging from
1962-1966. The chairman of the third finance commission was Mr. A.K. Chanda.

1964 - The fourth finance commission was appointed in the year 1964 for the period ranging
from 1966-1969. The chairman of the third finance commission was Mr. P.V. Rajamannar.

1968 - The fifth finance commission was appointed in the year 1968 for the period ranging from
1969-1974. The chairman of the fifth finance commission was Mr. Mahaveer Tyagi.
1972 - The sixth finance commission was appointed in the year 1972 for the period ranging from
1974-1979. The chairman of the sixth finance commission was Mr. K. Brahmananda Reddy.

1977 - The seventh finance commission was appointed in the year 1977 for the period ranging
from 1979-1984. The chairman of the seventh finance commission was Mr. J.M. Shelath.

1983 - The eighth finance commission was appointed in the year 1983 for the period ranging
from 1984-1989. The chairman of the eighth finance commission was Mr. Y.B. Chavan.

1987 - The ninth finance commission was appointed in the year 1987 for the period ranging from
1989-1995. The chairman of the ninth finance commission was Mr. N.K.P Salve.

1992 - The tenth finance commission was appointed in the year 1992 for the period ranging from
1995-2000. The chairman of the tenth finance commission was Mr. K.C. Pant.

1998 - The eleventh finance commission was appointed in the year 1998 for the period ranging
2000-2005. The chairman of the eleventh finance commission was Mr. A.M. Khusro

2002 - The twelfth finance commission was appointed in the year 2002 for the period ranging
from 2005-2010. The chairman of the twelfth finance commission was Mr. C. Rangarajan.

2007 - The thirteenth finance commission was appointed in the year 2007 for the period ranging
from 2010-2015. The chairman of the thirteenth finance commission was Dr. Vijay L. Kelkar.

2013 - The fourteenth finance commission was appointed in the year 2013 for the period ranging
from 2015-2020. The chairman of the fourteenth finance commission was Dr. Y.V. Reddy.

3. Allocation of Taxing Powers Between the Centre and the States

The constitution of India has laid down various provisions to create an environment of
stability and harmony as to the working of the government. In order to ensure smooth
functioning of the government the sources of revenue have been divided among the
centre and the states. The Constitution has provided various provisions as to the
allocation of taxation powers between the centre and the states.
 • As regards to the subjects in the union list only the parliament has exclusive
power to levy taxes.
• As regards to the subjects in the state list only the state legislature has the
exclusive power to levy taxes.
• As regards to the subjects in the concurrent list both the power to levy taxes lies in
the hands of the parliament and the state legislatures.
• As regards to the residuary subjects which are not enumerated in any of the list
only the parliament has the exclusive power to levy taxes.

4. Distribution of Tax Revenues

The 80th Amendment Act of 2000 and 88th Amendment Act of 2003 have introduced
some of the important changes in the arrangement of the division of tax revenues among
the centre and the state governments.
➢ The recommendations of the 10th Finance Commission were given effect with the
enforcement of the 80thAmendment Act of 2000. The major recommendation of
10th Finance Commission was that the centre should give away 29% of the total
income obtained from all the sources. The enforcement of this provision was done
with a retrospective effect from April 1, 1996 and is known as the ‘Alternative
Scheme of Devolution’. Due to this scheme the various central taxes such as
custom duties and corporation tax have come at par to the level of sharing of the
Income Tax among the centre and the states.
➢ Article 268-A that deals with the service tax was added after the enforcement of
The 88th Amendment Act of 2003. The service tax is a tax that is imposed by the
centre but it is collected and appropriated not only by the centre but also by the
state. An additional subject was also added by entry 92-C that dealt with taxes on
services.

The Finance Commission is set up every five years by the President of India according to the
provisions of Article 280 of the Indian constitution. The aim of setting up a finance commission
is to ensure proper and judicious division of financial resources between the centre and the states
so that smooth functioning of the federal system can take place.
The current position of tax distribution in India is described in the following section:

(i) Taxes Levied by the Centre and collected and retained by the Centre:

There are certain taxes that are levied by the centre and are also collected and retained by the
same. The centre has exclusive right over the proceeds of such taxes. No portion out of these
proceeds is distributed among the states and the centre has entire control over it. Some of the
taxes that fall under this category are as follows:

(i) Taxes levied on the corporations, i.e, the corporation tax (corporate tax)
(ii) Custom duties that is levied by the centre.
(iii)Surcharge that is charge upon the basic income tax.
(iv)It also includes the tax that is levied on the value of the assets of the individual
and the companies.

(ii) Taxes that are levied by the Centre but Collected and Appropriated by the States
(Article 268):

These taxes that are levied by the centre are charged on the subjects that are included in the
union list. These taxes are collected by the states within which such duties are levied. In case of a
union territory this tax is collected by the centre itself and appropriated to the concerned union
territory. Some of the taxes that are included in this category are as follows:

(i) The stamp duties that are levied on insurance policies, bills of exchange , transfer of
shares etc. are levied by the centre but are collected by the concerned state.
(ii) The duties such as excise duty and custom duty on some medicinal products that have
alcohol or narcotics as ingredients are levied by the centre but are collected by the
states.

The tax proceeds received under this category are not merged with the consolidated fund of
India but are appropriated to the concerned state from where the proceeds have been
generated.

(iii) Taxes Levied and Collected by the Centre but Assigned to the States (Article 269):
There are certain type of taxes that are levied and collected by the centre but these taxes are
assigned to the states as per the regulatory provisions laid down in the parliament. Some of the
taxes and duties that fall in this category are as follows:

(i) The taxes or duties that are levied at the time of succession of family property (other than
agricultural land) is levied and collected by the centre but are then assigned to the
state.
(ii) Estate duty that is imposed on property excluding the agricultural land is levied down and
collected by the centre but is finally assigned to the state.
(iii) Terminal taxes that is imposed on goods and passengers that are transported by any of the
modes of transportation are levied and collected by the centre but are assigned to the
state
(iv) Certain taxes (excluding stamp duties) that are imposed on transactions happening in the
share markets are levied and collected by the centre but assigned to the state.
(v) Certain taxes that are imposed on the revenues generated on the sale of newspapers is
levied and collected buy the centre but are appropriated by the state.
(vi) Certain taxes that are imposed on the inter-state trade of goods and services is levied and
collected by the centre but are assigned to the state.

(iv) Taxes Levied and Collected by the Centre and Compulsorily Distributed between the
Centre and the States:

Article 270 of the Indian constitution holds the compulsory sharing of the income tax between
the centre and the states. Certain taxes such as income tax (other than agricultural income and
corporation tax) that are levied by the centre and collected by the same are to be divided among
the centre and the states in the manner laid down by the President of India.

(v) Taxes Levied and Collected by the Centre and may be distributed between the Centre
and the States:

Unlike the income tax (which is to be compulsorily distributed), there are certain duties that may
or may not be distributed among the centre and the states. This includes excise duties in the
union list. These duties are levied and collected by the centre. However the net receipts of these
duties will be distributed among the centre and the states only if there are provisions for the same
in the parliament. The sharing of proceeds of excise duties in the union list is optional and is
guided by the provisions in the Parliament.

(vi) Taxes Levied and Collected and Retained by States:

There are certain taxes and duties that is levied, collected and retained by the states. These are
the subjects that are included in the state list. Some of the taxes and duties that are levied,
collected and retained by the states are-:

(i) Duty charged on the succession of agricultural land is levied, collected and retained by
the state itself.
(ii) Estate duty that is imposed on agricultural land levied, collected and retained by the state
itself.
(iii) Taxes imposed on agricultural income are levied, collected and retained by the state
itself.
(iv) Taxes imposed on land and buildings are levied, collected and retained by the state itself.
(v) Taxes imposed on the sale of electricity is levied, collected and retained by the state
itself.
(vi) Taxes imposed on vehicles is levied, collected and retained by the state itself.
(vii) Sales tax imposed on the sale of goods and services is levied, collected and retained
by the state itself.
(viii) Toll taxes are levied, collected and retained by the state itself.

5. Distribution of Non Tax Revenues

Apart from the tax revenues, there are some additional sources of income for both the
central and the state governments. As regards to central government the receipts from
postal and telegraph, public sector enterprises controlled by central government, the
Indian railways, the broadcasting and banking industry, etc. are some of the important
non-tax revenue for the central government. In case of the state government revenues
 from sectors such as fisheries, irrigation, public sector enterprises un0der the state
government, forests etc. are the major sources for non-tax revenue.

6. Grants-in-Aid to the States

There are certain provisions in the constitution that provide for unilateral transfers from
the central government to the poor and needy states. These unilateral transfers in case of a
financial need of the state are known as grants-in-aid to the states. In addition to the
sharing of tax revenue between the centre and the states, the constitution provides for
grants-in-aid to the states from the centre’s pool of revenue. The grants-in-aid provided
by the centre to the states can be classified into three categories, viz., statutory grants
discretionary grants and other grants.

Grants in Aid

Statutory Discretionary Other Grants

Grants Grants

A. Statutory Grants: There are certain grants that are statutory in nature. The
provisions for transfer of these grants have been given in detail under article 275 of
the Indian constitution. The constitution authorizes the Parliament of the country to
make certain compulsory grants to the states which are financially distressed and
need special financial instance. These grants are need based and are not given to
every state. The amount of these grants may differ for different states as it is based
on the financial need of a particular state. Additionally there may be some grants that
are specifically aimed at some specific activities to be carried out by the state. The
recommendations of the Finance Commission serve as the guideline for the
allotment of these statutory grants to the state governments by the centre.
B. Discretionary Grants: In addition to the statutory grants mentioned under
article 275 of the Indian constitution there are some discretionary grants as
 well. These discretionary grants have been discussed under Article 282 of the Indian
constitution. The provisions of article 282 provide that both the central government
and state government may allocate grants for useful public purpose even if such an
activity is not within their prescribed legislative area. The Planning Commission
gives recommendations to the centre on the allocation of these discretionary grants.
These grants are Discretionary in nature as there is no compulsion on the part of the
central government and it is completely upon its discretion. These grants have the
twin fold objectives: (i) To augment the state financially so as to meet the plan
expenditures and (ii) to give influencing powers to the centre so as to ensure a a
consensus between the state developmental plan and the national plan. The share of
the discretionary grants is much larger as compared to the share of the statutory
grants.
C. Other Grants: The constitution of India also had provisions for some other
grants that were on a temporary basis. The tenure of these grants was decided
to be ten years from the date of commencement of the constitution. The
provision was made for some grants as a substitute for export duties on jute and jute
products to some states. These grants were to be given out of the consolidated fund
of India and only on the recommendations of the Finance Commission.

7. Borrowing Powers of the Government of India

The central government’s borrowing power is limited. It is limited to the extent of collateral of
the revenues of the country both within the country and outside of the country. The Borrowing
powers of the central government are fixed by the government from time to time. There are
certain limitations upon the borrowing power of the central government that are mentioned in the
constitution of the country. Such restrictions or limitations have been placed to ensure the fiscal
sustainability of the governmental set up. These limitations are as follows

(i) The funds can be borrowed only within India and not from outside the country.
(ii) The State government can borrow only within the country and that too subject to
following conditions. :
(a) The borrowing process will be guided by the provisions of the constitution.
(b) In case of an outstanding loan given by the union government to the state
government, prior consent of the union government is required to raise fresh loans.