Financial Relations Between the Union and the States: Distribution of Revenue

Introduction

Financial relations between the Union and the States explain how tax revenue and other public funds are collected, shared, and spent in India. Articles 264–281 of the Indian Constitution provide the main rules for distributing revenue, maintaining public funds, and ensuring that States have the resources needed to perform their responsibilities.

Meaning and Definition

Financial relations refer to the constitutional arrangements through which the Union and State governments raise revenue, share taxes, provide financial assistance, and manage public money.

The Constitution gives different taxation powers to the Union and the States. However, the Union collects some taxes that are shared with the States, and it provides grants to support State expenditure. The Finance Commission plays an important role in recommending how certain tax revenues and grants should be distributed.

These arrangements aim to balance the financial resources available to each level of government with the responsibilities it must perform.

Distribution of Tax Revenue

The Constitution provides different arrangements for imposing, collecting, and using taxes. The exact arrangement depends on the type of tax and the relevant constitutional provisions.

Taxes Collected and Used by the States

Some taxes fall within the States' taxation powers. The State government collects the revenue and uses it for State purposes, subject to the Constitution.

Examples include certain taxes on land and agricultural income, and taxes on specified activities or goods within the State's constitutional authority.

Taxes Collected and Used by the Union

The Union collects revenue from taxes assigned to it under the Constitution and uses that revenue for Union purposes, subject to constitutional rules.

Examples include customs duties and corporation tax.

Duties Imposed by the Union but Collected and Used by the States

For certain duties, the Union determines the levy (the legal imposition of a tax or duty), while the States collect and retain the proceeds according to the constitutional arrangement.

Stamp duties on specified instruments are an example of this type of arrangement.

Taxes Collected by the Union and Assigned to the States

Some taxes are collected by the Union, but their proceeds are assigned to the States according to the Constitution and applicable laws.

The details depend on the particular tax and the constitutional provisions governing it.

Taxes Shared Between the Union and the States

Certain Union taxes form part of the divisible pool (the portion of tax revenue shared with the States). The States receive their share according to the constitutional framework and the principles used for distribution.

Article 270 provides for the distribution of specified Union taxes between the Union and the States. The Finance Commission recommends how the States' share should be distributed among them.

The Goods and Services Tax (GST) has its own constitutional arrangements under Articles 246A, 269A, and 279A.

Consolidated Funds and Public Accounts

Articles 266 and 267 explain how public money is held and how funds can be used.

Consolidated Fund of India and Consolidated Funds of the States — Article 266

The Constitution provides for a separate Consolidated Fund for the Union and for each State.

The Consolidated Fund of India includes the revenues received by the Union, loans raised by it, and money received in repayment of loans. The Consolidated Fund of a State includes the corresponding receipts of that State.

Money cannot be withdrawn from a Consolidated Fund except in accordance with law and the Constitution.

This rule helps ensure that public money is spent only through authorised procedures.

Public Account of India and Public Accounts of the States — Article 266

Public money received by or on behalf of the Union or a State, other than money that must be credited to its Consolidated Fund, is placed in the relevant Public Account.

The Public Account includes money that the government holds in a position similar to that of a trustee (a person or body holding money for another purpose or person), such as certain deposits and provident fund amounts.

Contingency Funds — Article 267

Article 267 allows Parliament to establish the Contingency Fund of India by law. The fund is placed at the disposal of the President to meet unforeseen expenditure while awaiting authorisation by Parliament.

A State Legislature may also establish a Contingency Fund of the State by law. It is placed at the disposal of the Governor to meet unforeseen expenditure while awaiting authorisation by the State Legislature.

These funds help governments respond quickly to urgent financial needs.

Finance Commission — Article 280

The Finance Commission is a constitutional body that recommends how certain financial resources should be shared between the Union and the States and among the States.

Composition and Appointment

The President constitutes a Finance Commission at the intervals required by Article 280, generally every five years or earlier if necessary.

The Commission consists of a Chairperson and four other members. Their qualifications are determined under the Finance Commission (Miscellaneous Provisions) Act, 1951.

The members are selected according to the qualifications laid down by law, which cover experience in public affairs, government finance and accounts, financial administration, and economics.

Functions of the Finance Commission

The Finance Commission makes recommendations to the President on matters including:

• The distribution between the Union and the States of the shareable net proceeds of certain taxes.
• The allocation among the States of their respective shares of those proceeds.
• The principles governing grants-in-aid of State revenues from the Consolidated Fund of India.
• Measures needed to increase the resources of State funds to support Panchayats, based on recommendations made by the State Finance Commission.
• Measures needed to increase the resources of State funds to support Municipalities, based on recommendations made by the State Finance Commission.
• Any other financial matter referred to it by the President in the interests of sound finance.

The Commission makes recommendations; the constitutional process then determines how they are acted upon.

Grants-in-Aid — Articles 275 and 282

Grants-in-aid are financial transfers provided by one government to support the expenditure or responsibilities of another government.

Statutory Grants — Article 275

Article 275 provides for grants-in-aid from the Consolidated Fund of India to States that need financial assistance, as Parliament may provide by law.

The Constitution also provides for grants for the welfare of Scheduled Tribes and the administration of Scheduled Areas in specified circumstances.

These grants help States whose own revenue and share of Union taxes may not be enough to meet certain public responsibilities.

Discretionary Grants — Article 282

Article 282 allows the Union or a State to make grants for any public purpose, even if the purpose is outside its ordinary legislative field.

This provision allows governments to support development projects and other public needs through financial assistance, subject to applicable rules.

Loans and Borrowing Powers

The Union and the States may borrow money, but their borrowing powers are governed by different constitutional rules.

Borrowing by the Union — Article 292

The Union government may borrow money on the security of the Consolidated Fund of India, within limits fixed by Parliament by law.

Borrowing by the States — Article 293

A State government may borrow within the territory of India on the security of its Consolidated Fund, subject to the conditions laid down in Article 293.

A State cannot borrow outside India under this provision. Where a State owes money to the Union, further borrowing may require the Union government's consent while the relevant debt remains unpaid, subject to Article 293.

These rules affect the financial independence of States and their ability to fund public projects.

Goods and Services Tax and Financial Relations

The Goods and Services Tax (GST) changed how many indirect taxes are collected and shared between the Union and the States.

Article 246A — Power to Make GST Laws

Article 246A gives Parliament and State Legislatures the power to make laws on GST, subject to the Constitution. Parliament has exclusive power to make laws on GST where the supply of goods or services takes place in the course of inter-State trade or commerce.

Article 269A — GST on Inter-State Supplies

Article 269A provides for the levy and collection of GST on supplies made in the course of inter-State trade or commerce. The tax is collected by the Union and apportioned between the Union and the States according to constitutional and legal rules.

Article 279A — GST Council

Article 279A provides for the GST Council, which includes representatives of the Union and the States. It makes recommendations on important GST matters, including tax rates, exemptions, and model laws.

The GST Council provides a forum for joint discussion and coordination between the Union and State governments on indirect taxation.

Planning and Financial Cooperation

Financial relations also involve coordination on development priorities and the use of public funds.

Planning Commission

The Planning Commission was established in 1950 by a resolution of the Union government. It was a non-constitutional body that prepared national development plans and advised the Union government on economic and social development.

It played an important role in financial planning and the allocation of development assistance. However, the Planning Commission was replaced by NITI Aayog in 2015.

National Development Council

The National Development Council was established in 1952 to support coordination between the Union and the States on national development plans. It included Union ministers and State Chief Ministers.

It was not a constitutional body. Its historical role was linked to the Planning Commission and the Five-Year Plan system.

NITI Aayog

NITI Aayog was established in 2015 as a policy institution to promote cooperation between the Union and the States. It replaced the Planning Commission, but it does not perform the constitutional tax-sharing role assigned to the Finance Commission.

The Finance Commission and NITI Aayog therefore have different roles: the Finance Commission recommends tax devolution and grants under Article 280, while NITI Aayog focuses on policy advice and cooperative development.

Important Case Law

State of West Bengal v. Union of India (1963)

The Supreme Court of India examined the constitutional relationship between the Union and the States and the nature of Indian federalism (a system in which power is shared between national and State governments).

The Court rejected the argument that States possessed complete sovereignty independent of the Union.

Importance: The case helps explain the constitutional framework within which financial and other powers are distributed between the Union and the States.

Distinction Between the Main Public Funds

Practical Example

Suppose a State government needs additional funds to improve public hospitals and rural roads but does not have enough revenue to meet these costs.

The Finance Commission may recommend how the State should receive its share of certain Union taxes and whether grants-in-aid should be provided. The Union may also provide grants for public purposes under Article 282.

If the State faces an urgent and unforeseen expense, it may use its Contingency Fund under Article 267, subject to the applicable law and later legislative authorisation.

This example shows how tax sharing, grants, and public funds work together to help governments meet their responsibilities.

Summary

• Articles 264–281 form part of the constitutional framework for financial relations between the Union and the States.
• The Constitution distributes taxation powers and provides rules for sharing certain tax revenues.
• Article 266 establishes the Consolidated Funds and Public Accounts of the Union and the States.
• Article 267 provides for Contingency Funds to meet unforeseen expenditure while awaiting legislative authorisation.
• Article 280 establishes the Finance Commission, which recommends tax distribution and grants-in-aid.
• Articles 275 and 282 provide for different forms of grants to support public purposes and State needs.
• Articles 292 and 293 govern borrowing by the Union and the States.
• Articles 246A, 269A, and 279A provide the constitutional framework for GST and the GST Council.
• The Planning Commission was replaced by NITI Aayog in 2015, while the Finance Commission continues to perform its distinct constitutional role.