For the past couple of months, the Chief Ministers of South Indian states have been complaining bitterly about ‘economic injustice’—the union government’s conscious strategy to deprive them of their share of tax revenue. New Delhi, in turn, calls this a “separatist mindset.” In part one of this series, we assess how money is shared—and who is right. In part two, we will look at how this plays out in elections.
Editor’s note: Unlike many other election specials, these special deep dives don’t focus on everyday party politics—who is ahead and why etc. Our aim is to help you understand how the system works—so you can understand where it is broken or working well. We start today with money. How do state and union governments collect money—and how is that money distributed? A simple question that is shrouded in excruciating jargon. It is also a critical question because—as we will see in part two—the person who holds the purse strings often has all the electoral power.
PS: Please say hello to Chirag Chinnappa who is the editor of our ‘24 Questions election project. You can email him at chirag@splainer.in with questions and feedback. And a big shout out to Nirmal—who is his partner-in-arms.
First, the backstory
The distribution of revenue goes to the heart of the idea of federalism. If states are not financially independent, then they will remain at the mercy of the union government. And in a vastly diverse nation, each state should have the freedom to meet its unique needs and challenges. But, but, but: If states are free to raise and spend their own money, the union government will have little power to ensure the development and growth of the nation in its entirety. This is how the Constitution tried to resolve that tension.
Article 246: of the Constitution deals with the so-called Seventh Schedule. It divides areas of governance into three lists: Union, state and concurrent. The first two are self-explanatory. Responsibility for the third is shared between the two. A rough distribution looks like this:
- Union: Defence, ports, railways, highways, communication
- State: Police, public health, hospitals, sanitation, public order
- Concurrent: Education, forests, unions, justice
The Finance Commission: Article 280 defines how the money is distributed between the government and the states. It requires the President of India to constitute a Finance Commission every 5 years—which consists of a Chairman and 4 other members. The Commission makes recommendations on:
- Tax revenue—how it should be divided between the union and the state governments.
- Grants—broad principles that ought to guide grants made by the Centre to states.
The Commission makes its recommendations—which are tabled in front of Parliament for approval. Once the Parliament signs off, these recommendations become mandatory—the Centre has to follow them. There have been 15 Finance Commissions to date. The sixteenth is getting ready to submit its report by October 31, 2025.
Point to note: The Commission is supposed to be independent, but it is “constituted by the President and is mainly staffed by civil servants whose careers can be shaped by the government of the day.”
The very important bit: The union government, however, has the power to define the “terms of reference”—factors the Commission must consider when making its recommendations. As we will see, these can make a significant difference as to who gets what.
Why the FC matters: Over time, the Commission has governed increasing percentages of money that flows from the Centre to the states. Before liberalisation (1985-1990), 60% were determined by the FC. Since 2015/2016, it has jumped to 70%. It means the power of the union government to distribute funds as it wishes—as opposed to a formula by the FC—has decreased.
Gimme the money: Collection of revenue
The union government: has two sources of revenue. One: taxes. This includes all the big ones: income tax, a great chunk of GST, custom duties etc. Also cesses—like the kind for Swacch Bharat, Krishi Kalyan. Two: everything else—this means dividends, interest, or money from selling public enterprises (think: sale of Air India). Of course, the giant share of the revenue collected by the government—86%—comes from taxes. Of that tax revenue—50% comes from income taxes.
Plus the debt: There is inevitably a gap between how much money the Centre receives—and how much it spends. It makes up the shortfall by taking loans—which adds to the total kitty. In the budget presented in February, it accounted for the highest share—28%—of that total. Income tax came in second at 19%.
The state government: has far fewer sources of revenue. It has excise duties—slapped on things like alcohol, fuel or cigarettes. There’s the state’s share of the GST—which is smaller than the Centre’s haul. Also: stamp duty, taxes on bijli, paani etc.
The big imbalance: The balance between what states collect and what they spend is inherently lopsided. A state government has to allocate money for everything from social welfare to police and education. See, for example, this chart of Kerala’s budget for 2020-2021:
But states also raise far less money than the Centre. So they make less and spend more:
The Union government currently receives roughly two-thirds of all the tax revenue raised, while being responsible for just over a third of all expenses. Even those expenditures, for the most part, are in areas that are either explicitly state subjects, or areas the Union usurped from states. The Union spends a rather small ratio of its overall expenditure on the core functions of the Union government, such as defence and foreign affairs.
The Finance Commission’s 2019 report noted that the Union government raised 62.7% of all resources raised—but States bore 62.4% of the aggregate expenditure. This is what that split looks like visually:
The key point to note: This is not an accident—but baked into the Constitution, according to Nilakantan RS: “The theory is that the Union owns the mobile sources of revenue – such as corporate and personal income taxes, for example – so that states do not get into unhealthy competition amongst themselves.”
Show me the money: Distribution of revenue
Given this severe imbalance, the Constitution also made arrangements to correct it through two mechanisms: the ‘divisible pool’ and union grants.
The divisible pool: It is made up of tax revenue collected by the union government—which is divisible between the Centre and the states. Until 1995, only union excise duties and personal income taxes went into this shared kitty—85% of the personal income taxes and 40-45% of excise duties were shared with the state governments.
The expanding pool: In 2000—thanks to a Constitutional amendment—all union taxes became part of the divisible pool. And happily for the states, each successive Finance Commission has also allocated them a greater share of the tax revenue haul. Their share rose 32% for 2010-15 to 41% for 2021-26.
Union government grants and schemes: The Centre also transfers money to states via central sector schemes—which are fully funded—or centrally sponsored schemes—where the costs are shared between Centre and state.
The big ‘But, but, but’: Theory vs practice
Here’s a big picture view of how money is transferred from the Centre to the states:
Did you notice the mismatch between the percentage mandated by the 15th Finance Commission (41%) and the percentage actually transferred (38.1%) from the divisible pool? The union government has not, in fact, given the states what is their due—what is required by law.
That is just one way in which the Centre has skewed the distribution of funds to states—hence earning the ire of South India. Here are some of the others.
Terms of reference: As we said before, the union government gives each Finance Commission ‘terms of reference’ that sets its parameters. These parameters affect not only the division of revenues between Centre and states—they also determine the distribution of revenues between states. This helps maintain equity—making sure that states that cannot raise as much revenue do not get left behind. One example:
For instance, the mountainous states of India’s northeast aren’t densely populated and won’t have a sufficient population base to raise their own revenue, as other states do. The share of taxes collected by the Union from states with a lower base will also likely be low.
The big buckets: for these terms are as follows:
- A state’s needs—Size of its population and area, share of dense forest and ecology.
- Principle of equity—this is the difference between the income of a given state and the richest state.
- A state’s performance—how much tax it raises, population control etc.
The population factor: In 2015, the government made a singlemost important change—changing the population criterion from the 1971 census to the 2011 census. The Fourteenth Finance Commission awarded 17.5% to the 1971 census and 10% for the 2011 census. In 2017, the Fifteenth Finance Commission entirely discarded the 1971 census—and gave 15% weightage to the 2011 census.
To see the what this means, look at the radical increase in the gap between the populations of Rajasthan and Kerala since the 1970s:
The fallout: The weightage became as follows: needs was 40%, equity 45%, and 15% for performance. The needier the state—higher population, area etc—the more it received. But South Indian states received lesser reward for performance—controlling their populations, raising more in tax revenue.
According to this formula, Uttar Pradesh and Bihar got 17.9% and 10% of the divisible pool—far higher than Karnataka (3.65%), Kerala (1.93%) and Tamil Nadu (4.08%). In fact, the share of the Southern states has been declining steadily over the past decades. But the shares of other wealthy states like Maharashtra have remained unaffected. Hence, the outrage.
Key point to note: Senior Fellow Avani Kapur of Centre for Policy Research points out:
[I]f you look in pure proportional terms, the inter-state share [to be distributed] decreased for several states between the 14th and 15th FC including Karnataka from 4.7% to 3.6%, Kerala from 2.5% to 1.9%, Andhra from 4.3% to 4.04%, Telangana from 2.4% to 2.1% etc.
Here comes the mighty cess! The other sore spot for the states: The long parade of special cesses imposed by the union government. This is all the extra taxes you see on your bill—example: Road and Infrastructure cess, Health and Education cess etc. They are slapped on everything from income tax to excise and service tax. A cess technically has to be used for a specific purpose. Its cousin—the surcharge—does not.
Here’s the big picture of how tax revenue is distributed between the Centre and the states:
Why does this hurt? The Centre does not have to share the revenue it raises through a cess or surcharge with the states. So greater the amount raised through cesses, less there is for the divisible pool. And the government has become addicted to raising revenues through cesses–which it can keep to itself. As a percentage of all tax revenue, cesses accounted for 18.2% in 2019-20–jumping to 25.1% in 2020-21 and 28.1% in 2021-22.
Vivek Kaul points out what happens when the government turns taxes on petrol and diesel into a cess:
For 2021-22, only ~5% of the excise taxes on petrol and diesel will go to the divisible pool. The rest (~95%) will be kept by the central government. In 2020-21, this portion was at around 91% for petrol and 85% for diesel.
Making things worse: The union government doesn’t always use the cess money for its assigned purpose—which might offer some benefit to states. Analyses of expenditure shows that a great percentage of these fund is simply retained by the Centre for its own purposes:
Various cesses and charges are imposed by the government to raise resources. They are transferred to Reserve Funds to ensure that they are being used for the intended purpose. Worryingly, in FY20, about 40% of the cesses levied — worth ₹78,000 crore [780 billion] — were not transferred to the Reserve Funds. Between FY10 and FY20, ₹1.28 lakh crore [1280 billion] was collected as a cess on crude oil. However, not a single penny was transferred to the Oil Industry Development Board (OIDB).
The bottomline: In part two, we will look at how this imbalance plays out in the electoral arena. We will lay out how it helps turbocharge the BJP’s promise of a ‘double engine’ sarkar—and wins elections.
Reading List
Mint explains how funds are transferred from the Centre to states. Suyash Rai and Milan Vaishnav’s paper on fiscal transfers is best on the role and history of the Finance Commission. The Hindu breaks down the data on why some states get more money from the Centre. Also in The Hindu: a look at whether the central government really transfers the money it owes to states. Check out Scroll for more on why the government charges cess. Vivek Kaul has a lucid example of how the government raises revenue by charging cess on petrol. Nilakantan RS’ book ‘South vs North: India’s Great Divide’ highlights the structural imbalances that exist between different states.
