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Centre-State Financial Relations

Centre-State financial relations in India are defined by the division of financial powers and responsibilities between the central government (Centre) and state governments. These relations are crucial in determining how financial resources are raised and shared for the smooth functioning of the federal system. The Constitution of India provides a framework for these relations, ensuring that both levels of government can function effectively while maintaining a degree of financial independence.

1. Constitutional Framework for Centre-State Financial Relations

The Indian Constitution provides the structure for the division of powers and responsibilities between the Centre and the States regarding finance. Key provisions include:

  • Article 265: No tax can be levied or collected without the authority of law.
  • Article 268 to 293: These articles lay down the distribution of tax revenue, grants, and loans between the Centre and States.
  • Article 246: It specifies the distribution of legislative powers between the Centre and States through the Union List, State List, and Concurrent List.

Union List:

  • The central government has exclusive powers to levy taxes on items like customs duties, income tax, and corporate tax.

State List:

  • States have the power to impose taxes on land revenue, state excise duties, and sales tax (now subsumed under GST).

Concurrent List:

  • Both the Centre and States can levy taxes on matters in the Concurrent List, but in case of a conflict, Central laws prevail.
2. Sources of Revenue for the Centre and States

Centre’s Revenue Sources:

  • Taxes: Income tax, customs duties, excise duties, corporation tax, etc.
  • Non-Tax Revenues: Profits from public sector enterprises, dividends, etc.
  • Borrowings: The central government can borrow funds both domestically and internationally.

States’ Revenue Sources:

  • Taxes: State sales tax (now under GST), state excise duties, stamp duties, and land revenue.
  • Non-Tax Revenues: Fees for services, fines, and profits from state-owned enterprises.
  • Borrowings: States can borrow funds from the market or the Centre (subject to limits set by the Finance Commission).
3. Transfer of Resources from Centre to States

The finance transfer from the Centre to States plays a critical role in ensuring the financial autonomy of States, enabling them to perform their functions effectively.

Types of Transfers:

  1. Tax Devolution:
    • A portion of the taxes collected by the Centre is devolved to the States based on recommendations from the Finance Commission. The proportion of devolution has been increasing over time to provide States with more financial autonomy.
  2. Grants-in-Aid:
    • The central government also provides grants to States for specific purposes, including those related to planning, development, and welfare. These grants are provided in addition to devolution.
  3. Central Assistance for State Plans:
    • The Centre allocates funds to States for financing various development programs and schemes. These funds are provided for specific areas like education, healthcare, and infrastructure.
  4. Special Assistance:
    • For States facing specific challenges, such as backwardness or natural calamities, the Centre may provide special assistance over and above the regular transfers.
4. Finance Commission

The Finance Commission of India is an important constitutional body that is responsible for recommending the distribution of financial resources between the Centre and the States. It is constituted every five years, and its primary functions include:

  • Tax Devolution Recommendations: The Finance Commission recommends how the taxes collected by the Centre should be distributed between the Centre and States.
  • Grants-in-Aid: It also decides on the grants to be provided to States, especially for those facing fiscal difficulties or special challenges.
  • Other Functions: It may recommend measures to strengthen the financial position of States and suggest ways to remove financial imbalances between the Centre and States.
5. Goods and Services Tax (GST)

The GST system, implemented in 2017, represents one of the most significant changes in the Centre-State financial relationship. It has replaced multiple indirect taxes like VAT, excise duties, and service tax with a single indirect tax on goods and services.

  • GST Council: This is a joint forum for the Centre and States to discuss and decide on the implementation of GST. The GST Council is responsible for deciding the tax rates, exemptions, and administration of the tax system.
  • Revenue Sharing: GST is a dual tax system, where both the Centre and States have the power to levy GST. The Central GST (CGST) and State GST (SGST) are levied simultaneously on transactions within a State, while Integrated GST (IGST) is applied to inter-State transactions.
6. Borrowing Powers
  • Centre: The Centre can borrow from the domestic market and foreign sources, and its borrowing is subject to the ceiling fixed by the Reserve Bank of India (RBI).
  • States: States can borrow from the market or through the Centre, but their borrowing is constrained by the Fiscal Responsibility and Budget Management (FRBM) Act. The borrowing limit is set by the Finance Commission and the RBI, and States need to adhere to fiscal discipline.
7. Issues and Challenges in Centre-State Financial Relations
  1. Vertical Fiscal Imbalance:
    • There is often a disparity between the revenues collected by the Centre and the expenditure responsibilities assigned to the States. This leads to a fiscal imbalance that requires central transfers.
  2. Uncertainty in GST Revenue Sharing:
    • The introduction of GST has caused some uncertainty regarding the adequacy of revenue sharing between the Centre and States, as some States have faced revenue shortfalls due to the transition.
  3. Dispute over Tax Devolution:
    • States often raise concerns about the adequacy of tax devolution, with some States arguing that the allocation process by the Finance Commission does not fully address their financial needs.
  4. Over-dependence on Central Grants:
    • States with limited revenue-generating capacity may become overly dependent on central transfers and grants, which can limit their fiscal autonomy and flexibility.
  5. Fiscal Deficit and Debt Sustainability:
    • Maintaining fiscal discipline is a challenge for both the Centre and States. States that exceed their borrowing limits may face difficulties in managing their finances, which impacts the overall economic stability.
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