FINANCIAL RELATIONSHIP BETWEEN UNION AND STATE

Indian Constitution has made elaborate provisions, relating to the distribution of the taxes as
well as non-tax revenues and the power of borrowing, supplemented by provisions for grants-
in-aid by the Union to the States. Article 268 to 293 deals with the provisions of financial
relations between Centre and States. The financial relationship has been changed after the
introduction of Goods and Services Tax in September 2016. The 101st Amendment to
Constitution introduces new articles that explain the division of power and financial relation
between state and union. We will first discuss the old regime, before entering into the GST
regime.

The Constitution divides the taxing powers between the Centre and the states as follows:

The Parliament has exclusive power to levy taxes on subjects enumerated in the Union List,
the state legislature has exclusive power to levy taxes on subjects enumerated in the State
List, both can levy taxes on the subjects enumerated in Concurrent List whereas residuary
power of taxation lies with Parliament only.

Distribution of the tax-revenue

1. Duties Levied by the Union but Collected and Appropriated by the States: Stamp
duties on bills of Exchange, etc., and Excise duties on medical and toilet preparations
containing alcohol. These taxes don’t form the part of the Consolidated Fund of India,
but are assigned to that state only.
2. Service Tax are Levied by the Centre but Collected and Appropriated by the Centre
and the States.
3. Taxes Levied as Well as Collected by the Union, but Assigned to the States: These
include taxes on the sale and purchase of goods in the course of inter-state trade or
commerce or the taxes on the consignment of goods in the course of inter-state trade
or commerce.
4. Taxes Levied and Collected by the Union and Distributed between Union and the
States: Certain taxes shall be levied as well as collected by the Union, but their
proceeds shall be divided between the Union and the States in a certain proportion, in
order to effect on equitable division of the financial resources. This category includes
all taxes referred in Union List except the duties and taxes referred to in Article 268,
 268-A and 269; surcharge on taxes and duties mentioned in Article 271 or any Cess
levied for specific purposes.
5. Surcharge on certain duties and taxes for purposes of the Union: Parliament may at
any time increase any of the duties or taxes referred in those articles by a surcharge
for purposes of the Union and the whole proceeds of any such surcharge shall form
part the Consolidated Fund of India.

Grants-in-Aid

Besides sharing of taxes between the Center and the States, the Constitution provides for
Grants-in-aid to the States from the Central resources.

There are two types of grants:-

1. Statutory Grants: These grants are given by the Parliament out of the Consolidated
Fund of India to such States which are in need of assistance. Different States may be
granted different sums. Specific grants are also given to promote the welfare of
scheduled tribes in a state or to raise the level of administration of the Scheduled areas
therein (Art.275).
2. Discretionary Grants: Center provides certain grants to the states on the
recommendations of the Planning Commission which are at the discretion of the
Union Government. These are given to help the state financially to fulfill plan targets
(Art.282).

Effects of Emergency on Center-State Financial Relations:-

1. During National Emergency: The President by order can direct that all provisions
regarding division of taxes between Union and States and grants-in-aids remain
suspended. However, such suspension shall not go beyond the expiration of the
financial year in which the Proclamation ceases to operate.
2. During Financial Emergency: Union can give directions to the States:-
 To observe such canons of financial propriety as specified in the direction.
 To reduce the salaries and allowances of all people serving in connection with the
affairs of the State, including High Courts judges.
 To reserve for the consideration of the President all money and financial Bills,
after they are passed by the Legislature of the State.
Finance Commission

Although the Constitution has made an effort to allocate every possible source of revenue
either to the Union or the States, but this allocation is quite broad based. For the purpose of
allocation of certain sources of revenue, between the Union and the State Governments, the
Constitution provides for the establishment of a Finance Commission under Article 280.
According to the Constitution, the President of India is authorized to set up a Finance
Commission every five years to make recommendation regarding distribution of financial
resources between the Union and the States.

Constitution
Finance Commission is to be constituted by the President every 5 years. The Chairman must
be a person having ‘experience in public affairs’. Other four members must be appointed
from amongst the following:-

1. A High Court Judge or one qualified to be appointed as High Court Judge;

Functions
The Finance Commission recommends to the President as to:-

1. The distribution between the Union and the States of the net proceeds of taxes to be
divided between them and the allocation between the States of respective shares of
such proceeds;
2. The principles which should govern the grants-in-aid of the revenue of the States out
of the Consolidated Fund of India;
3. The measures needed to augment the Consolidated Fund of a State to supplement the
resources of the Panchayats and Municipalities in the State;
4. Any other matter referred to the Commission by the President in the interest of sound
finance.
New Regime of GST

The 101st Constitutional Amendment to be basis of new tax regime. The Constitutional
amendment for the introduction of goods and services tax (GST) is likely to make more than
a dozen changes in the articles relating to Centre-state financial relations, besides changing
entries in the Central and state lists. The Constitutional amendment will be the basis for the
new tax regime and will be followed by adoption of separate state and Central GST laws. The
last amendment to the Constitution dealing with a financial matter was in 2000, when the
Centre was given the power to tax services. Senior officials told Business Standard the
Ministry of Finance was in consultation with the law ministry on drafting of the amendment
Bill. Simultaneously, a joint working group, comprising officials of the central and state
governments, is working on the amendment draft. “The Ministry of Law and Justice has
conveyed that the amendment will need to make 10-15 changes in various articles since
changes in the lists are linked to these provisions. The law ministry is, therefore, trying to
ensure the amendment does not make changes in the basic structure of the Constitution,
which can be challenged in a court,” an official said. A crucial issue being discussed is the
wording of entries in the lists. Article 246 in Part 11 of the Constitution defines matters on
which the Centre and states will have the authority to frame laws. These matters are
enumerated in the Seventh Schedule under Union, state and concurrent lists. At present, the
Centre is entitled to tax manufacturing of goods and services, while states can tax only sale of
goods. “While making changes, the power to tax goods and service cannot be placed in the
concurrent list since, in that case, the central law will prevail over the state law. Central GST
and state GST also cannot be explicitly listed in the respective lists since specific taxes are
not mentioned in the lists,” an official said. Experts see the Constitutional changes as being
“technical in nature”. Satya Poddar, partner, Ernst & Young, said: “There may not be
substantial hurdles in the passing of the Bill, assuming there will be a consensus on the broad
design of GST. The Constitution was drafted more than 50 years ago when the state of the
economy and taxation was different. Revisions should be made to the Constitution,
compatible with modern reality.” According to him, the current approach in lists is sectoral.
For instance, in Canada, states have the power to tax within the state and the Centre has the
power to tax anywhere. “Only restriction is territorial. There are no distinctions, like indirect
and direct taxes.”