21 India

Teresa Ter-Minassian
Published Date:
September 1997
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Richard Hemming Neven Mates and Barry Potter

India has a complex system of intergovernmental fiscal relations. This complexity has its roots in a number of factors, including substantial ethnic, social, and economic disparities among regions, as well as the long-Standing vertical imbalance between the expenditure and revenue-raising responsibilities of the state governments. This imbalance is in part covered by revenue-sharing arrangements. States also receive a variety of grants from the center, but even then states run deficits. Despite the formal absence of independent borrowing powers, states borrow both from the central government and state-owned commercial banks, with attendant macroeconomic risks. For these reasons, and because of the clear trends toward structural transformation of the economy—away from central planning—and increased claims of the states for fiscal autonomy, a comprehensive reform of center-state fiscal relations is needed.

Structure of Government

Until 1871, government in India was completely centralized, with all provincial spending financed by fixed grants from the central government. In that year, some government departments, together with their sources of revenue, were transferred to provinces, while remaining provincial expenditure continued to be financed by grants from the central government. Revenue sharing for major taxes was introduced in 1877. The Government of India Act of 1919 formally separated central and provincial revenue sources, which resulted in central government deficits that had to be covered by transfers from provinces.

The current Indian federal structure has its origins in the Government of India Act of 1935 and, following independence, in the Indian Constitution of 1950. India is not a federation but a union state, with a higher degree of centralization than found in most federations. The central (or union) government is empowered to limit the rights of the 25 state governments (and 7 union territories), and even to take over completely their administration in emergencies (including financial emergencies).

Until 1993, the Constitution did not discuss local governments. The authority of local governments—encompassing a variety of urban and rural local bodies—is still determined by the individual states and it can always be revoked. There is wide variation in expenditure and tax assignments, and transfer arrangements across local governments. A 1993 amendment to the Constitution provided for the formation of state finance commissions to review and recommend changes to fiscal relations between the states and local governments.

The Constitution specifies the expenditure responsibilities of different levels of government in three lists defining central powers, state powers, and concurrent powers where both levels of government can exercise authority, although the central government is granted supremacy. It also specifies the taxation powers of the central government and the state governments, and the principles governing the sharing of revenue and certain other resources. A Finance Commission, which is appointed every five years, recommends how the proceeds of taxes should be shared between the central government and states, how the share of states should be divided among them, and how to distribute grants-in-aid to the states. The Planning Commission plays the lead role in deciding the distribution of development grants from the center to the states.

Current Arrangements1

Expenditure Assignment

Consolidated government expenditure has been in the range of 27–30 percent of GDP during the 1990s. Table 1 shows that the central government is responsible for a little more than half of the total, and state governments for a little less than half. The Constitution assigns a wide range of government functions to the states. In particular, most spending related to agriculture and social policies is included in the state list. Although the concurrent list admits wider responsibilities for the states in the economic field, most major industries, even if not on the union list, are controlled by the central government. The actual division of expenditure responsibilities is shown in Table 2.

Table 1.India: Intergovernmental Fiscal Relations(In percent of GDP)
Central government
Gross revenue13.514.514.212.613.213.414.1
Tax revenue10.810.910.69.49.710.110.6
Nontax revenue and grants2.
States’ share of tax revenue (−)−2.7−2.8−2.9−2.8−2.6−2.7−2.8
Net revenue10.811.711.39.810.610.711.3
Of which:
Grants to states2.
Net loans to states1.
State governments
Own tax revenue5.
Nontax revenue1.
Shared taxes and grants from center5.
Consolidated government
Resources transferred to states7.
Source: Data provided by the Indian authorities.

Revised estimates.

Budget estimates.

Source: Data provided by the Indian authorities.

Revised estimates.

Budget estimates.

Table 2.India: Central and State Government Expenditures and Taxes
Central government expendituresCentral government taxes
DefenseCorporate profit tax
Railways, highways, airways, and shippingImport duties
Post and telecommunicationsProperty and wealth taxes (nonagricultural)
Heavy industryIncome tax surcharges
Strategic industriesStock exchange stamp duties
External affairs
Foreign trade
Shared expendituresShared taxes
Population and family planningPersonal income tax (except agriculture and professional self-employment)
Excise duties (except on alcohol and narcotics)
Property and wealth taxes (agriculture)
Tax on railway tickets
State government expendituresState government taxes
IrrigationPersonal income tax (agriculture and professional self-employment)
EducationSales tax (including sales tax on interstate sales)
Rural developmentExcise duties on alcohol and narcotics
RoadsUrban property tax
Public orderMineral taxes
CultureStamp and registration duties (except stock exchange)
Source: Information provided by the Indian authorities.
Source: Information provided by the Indian authorities.

Tax Assignment

One objective of the Constitution is to prevent overlapping tax powers, which translates into a requirement that one type of tax can be levied only by one level of the government. The central government is assigned the most important taxes with economy-wide implications. However, while some taxes are levied by the center for its exclusive use, the revenue from other taxes imposed and collected by the center is shared with the states (see below). The central government levies a personal income tax on all sources of income, except that from agriculture and of self-employed professionals, a corporate profit tax, income tax surcharges, and import duties. State governments are entitled to raise taxes on agricultural income and the income of self-employed professionals, but agricultural income is taxed in only a few states.

The authority to levy taxes on property, wealth, estates, and capital transactions is split between the center and the states according to whether they are related to agricultural or nonagricultural property. This appears to be consistent with the principle that lower-tier governments should be assigned taxes from relatively immobile tax bases. In practice, however, agricultural wealth and property are not taxed in any state. The central government is entitled to raise taxes on nonagricultural estates. However, because all proceeds from these taxes have to be transferred to the states, the central government does not have much incentive to levy such taxes. The states can levy stamp and registration duties, as well as a tax on urban immovable property.

The central government imposes excise duties at the production stage, except on alcohol and narcotics, which are taxed by the states. A sales tax on a fairly wide range of goods is the states’ main source of revenue. A coordinated conversion of state sales taxes into state value-added taxes is just beginning. Only limited services are taxed. States also impose a tax on sales to other states, the ceiling on which is fixed by the center at 4 percent. The states have conceded their right to levy sales tax on certain products (textiles, tobacco, and sugar) to the central government, but the revenue raised by excises on these products is passed on to the states. The distribution of revenue implied by this tax assignment is given in Table 3.

Table 3.India: Structure of Government Tax Revenue, 1995/96(Percentage shares)
Central GovernmentState Governments
Before revenue sharingAfter revenue sharingBefore revenue sharingAfter revenue sharing
Tax revenue62.144.537.955.5
Income tax100.027.972.1
Profit tax100.0100.0
Excise duties100.054.145.9
Sales tax5.
Import duties100.0100.0
Source: Data provided by the Indian authorities.
Source: Data provided by the Indian authorities.

Revenue Sharing

As Table 1 indicates, consolidated government revenue is about 20 percent of GDP, of which two-thirds is collected by the central government and one-third by the states. Given that expenditure is almost evenly divided, there is a large vertical imbalance in state government finances. The gap between states’ revenue and expenditure is bridged in part by revenue sharing. The Constitution provides that the sharing of nonagricultural, noncorporate income tax revenue is mandatory, while excise duty revenue may be shared with the states if parliament so decides. The central government retains corporate profit tax, import duty, and income tax surcharge revenue for its exclusive use. Revenue shares are not specified in the Constitution, but are recommended for a five-year period by finance commissions. While the Constitution limits finance commissions to making recommendations, its recommendations have almost always been ratified.

The share of the states in income tax revenue has tended to be increased by past finance commissions, but it was reduced from 85 percent to 77.5 percent by the most recent Tenth Finance Commission (for the period 1995—2000). The distribution of the shared revenue among the states does not follow the derivation principle. Rather, the share of each state is determined by a formula specified by the finance commission. In this sense, revenue shares can be seen as general grants to states. The formula for the five-year period beginning in 1995 attaches a weight of 20 percent to each state’s population, 60 percent to per capita income, 5 percent to area, 5 percent to economic and rural infrastructure needs, and 10 percent to tax effort.

Under the new arrangements, 47.5 percent (previously 45 percent) of excise duty revenue is passed on to states. Forty percent is shared among states according to the formula used to share income tax. The remaining 7.5 percent is shared in proportion to nonplan deficits (after revenue sharing), which reflect mainly current transactions. This represents an explicit, if limited, attempt to link shared revenues to the degree of vertical imbalance. Revenues from excises on textiles, tobacco, and sugar are distributed on the basis of estimated local consumption. Shared revenue accounts for about 55 percent of transfers from the central government to state governments. Table 3 also shows the distribution of revenue after revenue sharing.


Revenue sharing notwithstanding, vertical imbalances remain, which are filled through grants. The central government provides many types of grant to the state governments. Grants-in-aid—which represent only about 7 percent of transfers from the center to the states—are also recommended by finance commissions and are intended to close residual deficits on the state governments’ nonplan revenue accounts. Gap filling has in most cases been determined by projecting historical trends in revenue and expenditure. However, the Ninth Finance Commission (1990–95) introduced a controversial normative element into its approach, taking account of the special needs of each state.

The second group of grants is decided by the Planning Commission,2 which has to approve state development programs as a condition for development grants to be paid by the center. The Planning Commission used to plan comprehensively all development expenditure by the states, and grants were given for specific projects. Subsequently, plan grants have been given as block grants determined by the “Gadgil” formula, which currently reflects weights of 60 percent for population, 25 percent for per capita income, 7.5 percent for a combined index of tax effort, literacy, and completion of foreign aid projects, and 7.5 percent for special problems. Plan loans to states are distributed according to the same formula. Of the total funds distributed, loans make up 70 percent and grants make up 30 percent. Planning Commission transfers account for about 35 percent of the total, half of which supports state plans while the other half goes to centrally sponsored schemes.

In addition to funds allocated on the preceding basis, states can receive specific purpose grants at the discretion of the Planning Commission, such as assistance for hill area development, tribal area development, and matching grants for foreign aid projects. These have accounted for an increasing share of the grants to states in recent years. One implication of specific purpose grants is that although expenditure responsibilities have remained basically unchanged, a growing share of spending is dictated by the central government. Through its various ministries, the central government gives grants to state governments undertaking nationally important development or welfare programs. The central government also provides discretionary grants for a variety of reasons, most notably in the event of emergencies or to improve specific services.

Not only does the grant system still leave vertical imbalances—which necessitate borrowing—but it also does not fully address horizontal imbalances among states. Recognizing that they have weak revenue bases, because of their physical and economic characteristics, certain states have special category status. Both revenue sharing and grant formulas are biased in their favor, although not by enough to compensate for their additional expenditure needs. However, the largest horizontal imbalance remains in respect of poorer “general category” states.


According to the Constitution, only the central government is entitled to borrow abroad. The states are, in principle, entitled to borrow domestically, but they have to get permission from the central government if they have any outstanding liabilities to the center. All state governments have such liabilities. Market borrowing, in practice mainly from banks, used to be a captive market under the control of the central government, since the latter defined a portion of assets that banks had to invest in state securities approved by the central government. At present, the Reserve Bank of India in effect allocates state securities to commercial banks. The central government also on lends shares in funds from small savings at post offices to states; the shares reflect finance commission recommendations.

Since 1985, the states have not been allowed to run overdrafts with the Reserve Bank, and their net credit has to respect prescribed ways and means limits. However, the central government sometimes provides special assistance to clear overdrafts or short-term outstanding debts of individual states. The total indebtedness of the state governments stood at a relatively high level at the end of 1992/93, exceeding 20 percent of GDP, of which nearly two thirds was outstanding liabilities to the central government. Successive finance commissions have decided that part of state government debts should either be rescheduled or written off. The Tenth Finance Commission (1995–2000), for example, has recommended debt relief that is linked to fiscal performance, as an incentive, and to fiscal stress, out of necessity.

Administrative Structure

Tax Administration

Tax assignment is based in significant measure on the relative efficiency of the central government and state governments in collecting taxes. Thus, all central taxes are collected by the central tax authority and all local taxes are collected by state tax authorities. This arrangement, while sound in principle, raises some problems, particularly in the context of revenue sharing. The fact that the center retains different percentages of different taxes—with the rest being passed on to the states—may provide an incentive to concentrate the collection effort and resources of the central tax administration on those taxes (such as the corporate income tax and import duties) it retains in full, or in a higher percentage. The fact that separate agencies are responsible for income taxation based on the origin of income (agricultural versus nonagricultural) may create difficulties for the reform of the personal income tax. Similarly, the fact that the central government is primarily responsible for taxing production, while the states are responsible for taxing retail sales, may make it more difficult to reform domestic consumption taxes.

Budget Formulation and Implementation

The Indian fiscal year runs from April to March. The central government budget is formulated beginning in October. It is presented to parliament by the end of February and approved shortly thereafter. State budgets are formulated in tandem with the central budget and approved at the state level usually in March. There are linked, yet separate, budget formulation procedures for plan and nonplan spending. Even though an integrated budget is presented to each state parliament, separation of budget-setting procedures causes problems. In particular, the plan embodies an attempt to reconcile central spending priorities with the attraction to states of securing central resources to support local projects. In discussions with the Planning Commission, states overestimate own revenues and underestimate nonplan expenditure, thus presenting a larger-than-justified absorptive capacity for new capital projects. Discussions with finance commissions, by contrast, lay more emphasis on the prospect of rising deficits to attract larger grants (Wallich, 1982).3

A further problem in budget formulation is the rigidity of grant formulas determined for five years, combined with uncertainty about the amounts that will actually be received from revenue sharing. Thus, if shared revenue is higher (or lower) than budgeted by the center, there is no mechanism for adjusting transfers, and this is normally reflected in additional spending if revenue is higher and larger deficits if it is lower. While there have generally been three supplementary central budgets a year (in August, December, and March), these have tended to provide mainly for increased grants and loans to states, linked to additional spending at the state level. There is no systematic attempt to fine-tune transfers in response to more general developments in state finances.


Macroeconomic Management

At first glance, it might appear that the present federal system should not create serious difficulties for the short-term macroeconomic management of India’s economy, since the central government can, in principle, control the borrowing and thus also the deficits of states. However, since the mid-1970s, state government deficits have shown an increasing trend, which significantly contributed to growth in the overall public sector deficit. The main factor leading to increased deficits was expansion of states’ spending; this in part reflects the misguided incentives noted above for the states to expand their current and capital expenditure. During the recent stabilization program, the consolidated government deficit was reduced from over 10 percent in 1990/91 to 7.4 percent in 1992/93, of which the largest part was realized at the central government level. This indicates that, regardless of its formal authority, the central government has practical difficulties in imposing financial discipline on states.

The present system also raises questions regarding the incentive structure that it creates for states. The extensive use of revenue sharing and grants to fill budget gaps has had an adverse effect on states’ efforts to increase their own revenue and to control expenditure (Rao and Aggarwal, 1990). State finances have weakened mainly as a result of rising current expenditure, most of it on wages and subsidies to loss-making state electricity boards. In the process, expenditure on much-needed infrastructure and maintenance has suffered. At the same time, the link between expenditure and revenue-raising decisions has diminished (Chelliah, 1991). Although, in determining the level of grants, finance commissions have made an attempt to take into account not only the actual level of revenue but also the tax capacity of individual states, it has proved difficult at a technical level to measure tax capacity (Chelliah and others, 1992). Past debt relief has also had adverse effects on the states’ financial discipline.

The present fiscal arrangements are coming under further strain as India liberalizes its financial system, which is increasing the burden of interest expenditure and could make borrowing by states more difficult. At present, more than one-half of state financing comes from the central government and the rest from market and other borrowing. But banks do not hold state securities voluntarily, and states might have difficulty undertaking additional borrowing and even refinancing in a more liberal environment, especially if their relatively low level of own revenue and high level of debt are taken into account. This would probably increase pressure on the central government to write off a larger share of its claims on states.

A number of other developments are also changing the present relationship between central and state finances. The opening up of the Indian economy, which is supported by a lowering of tariff protection, is reducing the relative importance of import duty collections. In the past, the central government has tended to reduce its own budget deficit by raising import duties or corporate income tax, since the revenue from these taxes is not shared with the states. Rates of import duty and corporate income tax remain too high, and reducing them will further limit the central government’s room for maneuver in this regard.

While the implication is that states will automatically benefit as the center attempts to raise discretionary revenue through increasing personal income tax and excise duty collections, expenditure responsibilities are also shifting in their direction. There is a pressing need to develop economic and social infrastructure, which is largely the preserve of states. Thus, state budgets will tend to expand. At the same time, the political power of states is growing—as demonstrated by the results of the 1996 elections—and greater fiscal devolution is being called for. With the center’s ability to control state finances being diminished, greater macroeconomic risk is entailed.

Structural Reform

Besides the impact on macroeconomic management, the present form of fiscal federalism also has implications for structural reform in India. One issue is whether it is possible within this system to establish a modern and efficient tax system. As regards direct taxes, a significant problem is the separation of tax powers on the basis of agricultural versus nonagricultural income. This separation clearly provides opportunities for tax evasion by sheltering nonagricultural income, and in practice results in most agricultural income going untaxed. It also prevents the establishment of a global personal income tax with reasonable progression.

As for domestic taxes on goods and services, assigning excise duties to the central government and sales taxes to the states has created serious distortions. Since the central government is not entitled to impose a sales tax, this has induced broad use of excise taxes. At the same time, administrative difficulties with collecting sales taxes have prompted states to shift this tax increasingly from final sales to the production stage, creating a nontransparent net of cascading transactions taxes. The resulting adverse supply effects are compounded by the taxation of interstate trade. Consequently, Indian exports bear a significant indirect tax element, and states are also able to transfer their tax burden to residents of other states.

In this context, it will not be easy under the present constitutional distribution of tax authority to introduce a modern consumption tax, such as a value-added tax (VAT). The central government has introduced some elements of the VAT principle in excise duties—the so-called MODVAT—while state sales taxes are gradually being converted into state VATs. But the constitutional restriction that final sales can be taxed only by states will necessitate considerable coordination if a dual system of central and state VATs is to function like a nationwide VAT on sales. One solution could be a central VAT with revenue sharing, but this would eliminate the only major tax from which states derive tax autonomy. Anyway, the move from state sales taxes to state VATs almost certainly rules out this option.

Another issue is how to improve on the present approach to grant determination and distribution. A high degree of fiscal dependence is inherent in the tax and expenditure assignments laid out in the Constitution. The criteria adopted by finance commissions for allocating revenue shares are a combination of tax capacity and needs intended to encourage tax collection, promote horizontal equity (that is, ensure that needs are met), and reduce vertical imbalances. However, the distribution of grants-in-aid gives only a small weight to improving vertical balances. The distribution of much larger plan grants also pays little attention to vertical imbalances. A less fragmented and better targeted approach is needed.

Part of the solution lies in ending the separation between plan and nonplan assistance to states. Indeed, the plan and nonplan distinction appears to be an outdated approach to budget formulation more generally. While setting revenue shares for five years imparts useful stability and administrative simplicity to tax collection, the allocation of grants has to be more flexible if vertical and horizontal imbalances are to be more fully addressed. To avoid sharp cyclical fluctuations in states’ revenue, smoothing mechanisms could be devised. To make revenue shares more stable and predictable, and to avoid distortionary incentives, the Tenth Finance Commission recommended that the base for sharing should be shifted to total tax revenue. This recommendation has been accepted by the government, and it has been proposed that states receive 29 percent of total tax revenue from 1997/98.

While changing the details of the financial links between the central and state governments would address many of the problems with current intergovernmental fiscal relations, it would not address the more fundamental problem of how to impose effective financial discipline on states. There would appear to be three main elements to a medium-term strategy aimed at this objective: central government transfers that are more closely linked to states’ assigned expenditure responsibilities, economic capacity, social needs, and good fiscal performance; increased reliance on market borrowing, supported by the collection and wide dissemination of information on the state finances; and a firm and sustained no-bailout policy. Such arrangements should aim to give states discretion to spend only insofar as they can raise resources through taxation, cost recovery, expenditure cuts, or borrowing. Since access to market borrowing should reflect the sustainability of state finances, it can provide a disciplining mechanism that induces states to undertake reforms that strengthen their finances.


The present structure of fiscal federalism in India was formed at the time when its economy was much less market oriented than today, with the central government having a large role in regulation, administration, and planning of the economy. The allocation of tax powers also reflected a lower level of development in which taxes on international trade and the profits of state monopolies, which were later replaced by the extensive use of excises, were the main source of revenue. In these circumstances, the autonomy of states in expenditure functions was combined with a complicated system of planning arrangements complemented by large transfers of grants and loans from the central government to the states, as well as by state borrowing quotas prescribed by the center. This system is much less efficient in the present circumstances when efforts are being made to open the economy, liberalize the financial system, and increase the role of the private sector. Future economic reform must therefore include substantial changes in the system of intergovernmental fiscal relations, with the ultimate objective of substituting market discipline of state finances for existing central government controls. However, in this connection, a no-bailout policy is critical. If such a policy lacks credibility, and as a consequence states prove reluctant to push ahead with reforms, there would appear to be no alternative but to rely on tight borrowing restrictions combined with cuts in central government transfers as a disciplining mechanism.

The authors are grateful to Dimitri Tzanninis for his assistance and comments.

There are many comprehensive descriptions of the Indian federal structure and finance—see, for example, Bagchi and others (1992), Gulati (1987), and Wallich (1982).

In contrast to finance commissions, which are appointed every five years, the Planning Commission is a permanent body, which has primary authority over government capital spending. The role of the Planning Commission may decline over time as the Indian economy evolves into a more fully market-oriented one.

An additional consequence of the plan/nonplan distinction is that it encourages a segmented approach to public expenditure management and has led to inadequate medium-term planning of nonplan spending.


    Bagchi AmareshJ.L.Bajaj andWilliam A.Byrd1992State Finances in India (New Delhi: National Institute of Public Finance and Policy).

    ChelliahR.J.1991“Intergovernmental Fiscal Relations and Macroeconomic Management in India,”Senior Policy Seminar on Intergovernmental Fiscal Relations and Macroeconomic Management in Large Countries (February).

    ChelliahR.J.M.G.Rao andT.K.Sen1992“Issues Before the Tenth Finance Commission,”Economic and Political WeeklyVol. 27 (November) pp. 253950.

    GulatiIqbal S.1987Centre-State Budgetary Transfers (Oxford: Oxford University Press1987).

    RaoM.G. andVandanaAggarwal1990“Intergovernmental Fiscal Transfers in India: Some Issues of Design and Measurement,”Working Paper 5/90 (New Delhi: National Institute of Public Finance and Policy).

    Wallich ChristineR.J.Chelliah andNarainSinha1982“State Finances in India,”World Bank Staff Working Paper 523 (Washington: World Bank).

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