Federal finance and GST

In short

Federal finance studies how taxing powers, spending responsibilities and borrowing are divided between the Union, the States and local bodies, and how the resulting gaps are closed by transfers. India's Constitution gives the Union the elastic, high-yield taxes while States carry most development spending — a built-in vertical imbalance corrected mainly by Finance Commission devolution and grants. The Goods and Services Tax (2017) is the biggest change ever made to this arrangement: it created a shared, destination-based consumption tax levied simultaneously by the Centre and the States and run by a constitutional body, the GST Council. The topic is examined in BA/MA Indian Economy and public finance papers, in UPSC/State PSC and RBI Grade B economics papers, and is asked constantly in interviews for indirect-tax and GST compliance roles (Big Four, EY/Deloitte/PwC/KPMG, CA and tax-consulting firms, Zoho/ClearTax/Tally product teams, state GST departments).

Explained

Constitutional division of financial powers

• Article 246 + Seventh Schedule: Union List (defence, income tax, customs, excise on tobacco and petroleum products, corporation tax), State List (land revenue, excise on alcohol, stamp duty, electricity duty, taxes on land and buildings, professions tax), Concurrent List (no separate tax heads worth naming after GST).
• Article 265: no tax can be levied or collected except by authority of law. Article 266: Consolidated Fund of India and of each State; Article 267: Contingency Fund; Article 112/202: the annual financial statement (Budget).
• Article 246A (inserted by the 101st Constitutional Amendment Act, 2016) gives the Union *and* every State concurrent power to tax goods and services; only Parliament may tax inter-State supplies. This is the only genuinely concurrent taxing power in the Constitution.
• Article 268: stamp duties levied by the Union but collected and retained by States. Article 269: taxes on inter-State sale/consignment assigned to States (largely spent after GST). Article 269A: IGST levied and collected by the Centre and apportioned between Centre and States.
• Article 270: all Union taxes form a shareable pool — except cesses, surcharges (Article 271) and taxes mentioned in Articles 268/269.
• Article 275: statutory grants-in-aid on Finance Commission recommendation (revenue-deficit grants). Article 282: discretionary grants — the legal hook for Centrally Sponsored Schemes.
• Borrowing: Article 292 (Union, within limits set by Parliament), Article 293 — a State may borrow only within India, and needs Union consent if it is indebted to the Centre; this is the Centre's main lever over state borrowing.
• Local bodies: 73rd and 74th Amendments (1992-93) added the Eleventh and Twelfth Schedules; Articles 243I and 243Y require each State to appoint a State Finance Commission every five years to devolve resources to panchayats and municipalities. Local bodies raise under 1% of GDP — India's weakest fiscal tier.

Vertical and horizontal imbalance, and the transfer system

• Vertical imbalance: the Centre collects roughly 60-63% of total government revenue but makes well under half of the final expenditure; States spend about 60% of general-government expenditure, including most of health, school education, police, irrigation and roads.
• Horizontal imbalance: per-capita income of the richest large State is several times that of the poorest, so equal treatment would not mean equal capacity.
• Four channels of transfer: (1) tax devolution — untied, formula-based, the largest; (2) Finance Commission grants — revenue deficit, local bodies, disaster management (SDRF/NDRF), sector- and state-specific; (3) Centrally Sponsored Schemes — tied, with a state matching share (commonly 60:40, 90:10 for Himalayan/North-Eastern States, 100% for a few); (4) loans and back-to-back arrangements.
• Untied versus tied: untied devolution respects state autonomy; tied grants let the Centre pursue national priorities but distort state choices and impose matching obligations. The long-running debate is about the mix.

The Finance Commission

• Article 280: the President constitutes a Finance Commission every fifth year — a chairman and four members — to recommend (a) distribution of net tax proceeds between Union and States (vertical devolution), (b) their allocation among States (horizontal devolution), (c) principles of grants-in-aid, (d) measures for augmenting panchayat/municipal resources, and (e) any matter referred by the President. Recommendations are advisory; by convention the devolution share is accepted and laid before Parliament with an Explanatory Memorandum (Article 281).
• Vertical share, historical: 10th FC 29% → 13th FC 32% → 14th FC 42% (a step jump, with plan grants folded in) → 15th FC 41% for 2021-26 (1% adjusted for the reorganisation of Jammu & Kashmir into Union Territories).
• 15th FC horizontal formula (2021-26): income distance 45%, area 15%, population (2011 Census) 15%, demographic performance 12.5%, forest and ecology 10%, tax and fiscal effort 2.5%. Income distance — the gap of a State's per-capita GSDP from the highest — is the equalising element; demographic performance (based on the total fertility rate) was added to answer southern States' objection to the switch from 1971 to 2011 population.
• 16th Finance Commission: constituted 31 December 2023 under Arvind Panagariya, for the five years beginning 1 April 2026. Its report has been submitted; the exact vertical share, criteria and weights it recommended (and what the Union accepted) must be read from the report and the Action Taken Report rather than assumed to repeat the 15th FC's 41% and weights.
• Finance Commission versus NITI Aayog: the FC is constitutional, periodic and deals with the division of revenue; the erstwhile Planning Commission (Gadgil-Mukherjee formula for plan assistance) is gone and NITI Aayog is advisory with no resource-allocating power.

GST: design and institutions

• What it replaced: central excise and additional excises, service tax, CVD and SAD on imports, State VAT/sales tax, Central Sales Tax, entry tax and octroi, luxury tax, entertainment tax (except that levied by local bodies), purchase tax, and most cesses on goods and services. Problems solved: cascading (tax on tax, because excise credit could not be set off against VAT), inter-State CST that taxed exports out of a State, checkposts and a fragmented market.
• Still outside GST: alcoholic liquor for human consumption (constitutionally excluded); petroleum crude, petrol, high-speed diesel, ATF and natural gas (inside GST law but at nil rate, so excise + State VAT continues until the Council decides otherwise); electricity duty; stamp duty and property tax; basic customs duty; taxes on tobacco can be levied by the Union *in addition* to GST.
• Dual GST structure: intra-State supply attracts CGST + SGST (or UTGST) at half the rate each; inter-State supply and imports attract IGST at the full rate, collected by the Centre and apportioned to the destination State. Statutes: CGST Act, IGST Act, UTGST Act, GST (Compensation to States) Act, 2017 and a SGST Act per State.
• Destination/consumption-based: tax accrues where the goods or services are consumed, determined by the place of supply rules — a shift of revenue from producing States (Gujarat, Maharashtra, Tamil Nadu) to consuming States (UP, Bihar, West Bengal).
• GST Council (Article 279A): chaired by the Union Finance Minister, with the Union MoS (Revenue/Finance) and one minister from each State. Decisions need a 75% majority of weighted votes, with the Centre holding one-third and all States together two-thirds; quorum is half the members. It recommends rates, exemptions, thresholds, model laws and the place-of-supply rules. In *Mohit Minerals* (2022) the Supreme Court held its recommendations are persuasive, not binding on legislatures.
• GSTN: the common IT backbone (registration, returns, e-way bills, e-invoicing). GST Appellate Tribunal (GSTAT) with a Principal Bench in New Delhi and State benches now hears appeals; dispute stages are adjudicating authority → first appellate authority → GSTAT → High Court → Supreme Court.

GST: how it works in practice

• Taxable event: "supply" of goods or services for consideration in the course of business (Schedule I covers specified supplies without consideration; Schedule III lists activities that are not supply, e.g. employee services to employer). Composite and mixed supplies have their own rate rules.
• Registration: PAN-based, State-wise; 15-digit GSTIN = 2-digit State code + 10-character PAN + entity code + 'Z' + checksum. Threshold aggregate turnover: ₹40 lakh for goods and ₹20 lakh for services (₹20 lakh / ₹10 lakh in special-category States); compulsory registration regardless of turnover for inter-State suppliers of goods, e-commerce operators, reverse-charge recipients, casual and non-resident taxable persons.
• Composition scheme: turnover up to ₹1.5 crore for goods (₹75 lakh in special-category States) — 1% of turnover for traders and manufacturers, 5% for restaurants; a separate 6% scheme for service providers up to ₹50 lakh. No input tax credit, no inter-State outward supplies, and the buyer gets no credit.
• Input tax credit (ITC): credit of GST paid on inputs, input services and capital goods, against output tax. Conditions (Section 16): possession of a tax invoice, receipt of goods/services, tax actually paid by the supplier and the invoice reflected in the auto-drafted GSTR-2B, and the return filed. Time limit: 30 November following the financial year, or the annual return, whichever is earlier. Blocked credits (Section 17(5)): motor cars (with exceptions), food and beverages, club and health-club membership, construction of immovable property on own account, goods lost/stolen/given as free samples.
• Set-off order (Section 49 and Rule 88A): IGST credit must be used first against IGST liability, then against CGST or SGST in any order; CGST credit cannot be set off against SGST and vice versa — the cross-utilisation bar that keeps the two governments' accounts separate.
• Returns: GSTR-1 (outward supplies), GSTR-3B (summary and payment), GSTR-9/9C (annual return and reconciliation), GSTR-4 (composition), QRMP for small taxpayers (quarterly return, monthly payment). E-invoicing is mandatory above ₹5 crore aggregate turnover; e-way bill for consignments above ₹50,000.
• Other mechanisms: reverse charge (recipient pays — e.g. goods transport agency, legal services, import of services); TDS at 2% by government deductors (Section 51); TCS by e-commerce operators (Section 52, 0.25% CGST + 0.25% SGST, halved from 1% with effect from 10 July 2024); exports and supplies to SEZs are zero-rated — either export under LUT and claim refund of unutilised ITC, or pay IGST and claim refund; refunds also arise from an inverted duty structure. Anti-profiteering (Section 171) has been sunset — no new applications accepted after 1 April 2025 — and pending matters now lie with the Principal Bench of the GSTAT, which took them over from the Competition Commission on 1 October 2024.

Rates, compensation and the current state of the debate

• Rate structure since 22 September 2025 (GST 2.0, recommended by the 56th GST Council): a two-rate structure of 5% (merit) and 18% (standard), plus a 40% demerit rate for sin and luxury goods — pan masala, tobacco products, aerated and caffeinated drinks, large cars, and a few luxury items. The earlier 12% and 28% slabs were removed, with items moved mostly down to 5% or 18%. Nil-rated items were widened (including individual life and health insurance premiums). Special rates continue: 3% on gold, silver and jewellery and 0.25% on rough diamonds. Tobacco and pan masala were held at the old 28% + cess until the compensation-cess loan obligations were met and then moved to the 40% rate — check the current notification before quoting a date or a figure for these.
• Compensation: under the GST (Compensation to States) Act, States were guaranteed 14% annual growth of protected revenue over the 2015-16 base for five years to 30 June 2022, funded by a cess on demerit goods. Because collections collapsed in 2020-21, the Centre borrowed and passed ₹2.69 lakh crore to States as back-to-back loans, and the cess was extended beyond 2022 purely to service that debt.
• Revenue performance: gross GST collections were about ₹22 lakh crore in 2024-25, with monthly gross collections running around ₹1.8-2.0 lakh crore in 2025-26; GST plus income tax buoyancy has improved, but GST's share of GDP is still close to the taxes it replaced, so it has not been the revenue bonanza once projected.
• Live federal-finance disputes: (1) cesses and surcharges are outside the divisible pool and have grown, so States' *actual* receipt is well below the headline 41%; (2) the Centre's share of expenditure through tied CSS keeps rising; (3) loss of independent indirect-tax rate-setting power has reduced State fiscal autonomy; (4) Article 293(3) consent conditions and off-budget borrowing of State PSUs; (5) petroleum and electricity remaining outside GST; (6) the FRBM Act, 2003 targets — Union fiscal deficit path with a glide to 4.5% of GDP and a debt-ratio anchor from 2026-27, and State fiscal deficit limits (typically 3% of GSDP, with extra space tied to power-sector reform or capex loans).

Key points

• Fiscal federalism - assignment of taxes, expenditure and borrowing across government tiers, plus the transfers that close the gaps.
• Vertical imbalance - Centre collects most revenue, States do most spending; corrected by devolution.
• Horizontal imbalance - unequal fiscal capacity across States; corrected by the equalising weight on income distance.
• Article 280 - Finance Commission; advisory recommendations, every five years.
• Divisible pool - net proceeds of Union taxes *after* removing cesses, surcharges, cost of collection and UT taxes.
• 41% - 15th FC vertical devolution share for 2021-26; the 16th FC's award runs from 1 April 2026 (verify its share).
• Income distance 45% - the largest weight in the 15th FC horizontal formula; demographic performance 12.5% offsets the 2011 Census switch.
• Article 293(3) - Union consent needed for State borrowing where the State owes the Centre.
• Article 246A - concurrent power to tax goods and services; only Parliament taxes inter-State supply.
• 101st Amendment, 1 July 2017 - the constitutional basis of GST and of the GST Council.
• GST Council voting - 75% weighted majority; Centre one-third, States two-thirds; recommendations persuasive, not binding.
• Dual GST - CGST + SGST intra-State, IGST inter-State; IGST apportioned to the destination State (Article 269A).
• Destination principle - tax accrues where consumption happens, decided by place-of-supply rules.
• ITC - the device that removes cascading; denied under the composition scheme and for Section 17(5) items.
• No cross-utilisation - CGST credit cannot pay SGST or vice versa; IGST credit can pay both.
• Slabs since 22 September 2025 - 5%, 18% and a 40% demerit rate, besides nil and the 3%/0.25% special rates.
• Outside GST - liquor for human consumption, five petroleum products (nil-rated for now), electricity duty, stamp duty, customs duty.
• Compensation guarantee - 14% growth on 2015-16 base, five years ended 30 June 2022; cess continued to repay ₹2.69 lakh crore of loans.

Formulas and examples

Example 1 - Divisible pool and a State's devolution. Gross Union tax revenue ₹38.00 lakh crore; cesses and surcharges ₹4.50 lakh crore; cost of collection ₹0.50 lakh crore; UT taxes ₹0.20 lakh crore. Vertical share 41%; the State's horizontal share 6.50%.

• Divisible pool = 38.00 − 4.50 − 0.50 − 0.20 = ₹32.80 lakh crore.
• Devolution to all States = 0.41 × 32.80 = ₹13.448 lakh crore.
• This State gets 0.065 × 13.448 = 0.87412 lakh crore = ₹87,412 crore.
• Effective share of *gross* taxes = 13.448 / 38.00 = 35.4%, not 41% — the arithmetic behind the States' cess-and-surcharge grievance.

Example 2 - ITC chain removes cascading. Rate 18% throughout. Manufacturer sells at ₹10,000; wholesaler at ₹14,000; retailer at ₹20,000.

• Total tax collected = 1,800 + 720 + 1,080 = ₹3,600 = 18% of the final price of ₹20,000; the consumer pays ₹23,600. Each stage pays tax only on its value addition.

Example 3 - Intra-State versus inter-State supply, and price extraction. Taxable value ₹1,00,000 at 18%.

• Supplier and recipient in Kerala: CGST ₹9,000 + SGST ₹9,000 = ₹18,000; invoice ₹1,18,000.
• Supplier in Kerala, recipient in Karnataka: IGST ₹18,000, collected by the Centre and apportioned to Karnataka (place of supply).
• If instead the MRP is ₹590 inclusive at 18%: taxable value = 590/1.18 = ₹500, GST = ₹90. If the item moves to the 5% slab, taxable value = 590/1.05 = ₹561.90 and GST = ₹28.10 — so a rate cut passed on fully would bring the price to 500 × 1.05 = ₹525.

Example 4 - Set-off order under Rule 88A. Output tax: IGST ₹50,000, CGST ₹20,000, SGST ₹20,000. Credit available: IGST ₹60,000, CGST ₹10,000, SGST ₹10,000.

1. IGST credit ₹60,000 → ₹50,000 against IGST output (nil), balance ₹10,000 against CGST.
2. CGST: 20,000 − 10,000 (IGST credit) − 10,000 (CGST credit) = nil.
3. SGST: 20,000 − 10,000 (SGST credit) = ₹10,000 payable in cash.
4. Total cash outflow ₹10,000; the SGST shortfall cannot be met from CGST credit.

Example 5 - Compensation and deficits. A State's base-year (2015-16) subsumed revenue is ₹20,000 crore.

• Protected revenue for 2020-21 (n = 5) = 20,000 × 1.14⁵ = 20,000 × 1.92541 ≈ ₹38,508 crore.
• If actual protected-tax collection was ₹30,000 crore, compensation due ≈ ₹8,508 crore.
• Same State: revenue receipts ₹1,80,000 crore, revenue expenditure ₹1,95,000 crore, capital expenditure ₹35,000 crore, non-debt capital receipts ₹2,000 crore, interest payments ₹18,000 crore, GSDP ₹10,00,000 crore.
• Revenue deficit = 1,95,000 − 1,80,000 = ₹15,000 crore = 1.5% of GSDP.
• Fiscal deficit = (1,95,000 + 35,000) − (1,80,000 + 2,000) = ₹48,000 crore = 4.8% of GSDP — above the usual 3% FRBM limit.
• Primary deficit = 48,000 − 18,000 = ₹30,000 crore (3.0% of GSDP).

Where it is used

• Indirect-tax and GST compliance practice: Big Four and CA firms — registration, monthly GSTR-1/3B filing, GSTR-2B reconciliation, annual returns, refund claims for exporters, departmental audits and GSTAT appeals.
• Finance and ERP product teams: Tally, Zoho Books, ClearTax, Marg and SAP/Oracle localisation — rate masters, e-invoicing IRN generation, e-way bills, place-of-supply logic in billing software.
• Corporate finance and supply chain: warehouse location decisions after the removal of CST and checkposts, vendor ITC-eligibility checks, pricing after a rate change, inverted-duty refund planning in textiles, pharma and fertilisers.
• Government and policy roles: State GST and Commercial Tax departments, Finance Departments preparing FRBM statements and Finance Commission memoranda, CAG audit, RBI's *State Finances: A Study of Budgets*.
• Research and economics roles: NIPFP, NIPFP-type institutes, think-tanks and rating agencies modelling devolution, GST buoyancy and State debt sustainability; questions on these appear in RBI Grade B, NABARD and UPSC economics papers.
• Real Indian instances: the shift of revenue to consuming States such as Uttar Pradesh and Bihar; Kerala's and Tamil Nadu's submissions to the 16th FC on cesses; the 2020-21 compensation-borrowing dispute between the Centre and States.

Interview questions

• Q: Why is GST called a destination-based consumption tax? A: Tax accrues to the State where the goods or services are finally consumed, decided by the place-of-supply rules, unlike the earlier origin-based CST that stayed with the producing State.
• Q: What exactly is the divisible pool? A: Net proceeds of Union taxes after deducting cesses and surcharges, the cost of collection and taxes of Union Territories; only this pool is shared with States under Article 270.
• Q: States were promised 41% — why do they receive less? A: Cesses and surcharges sit outside the divisible pool and have grown, so devolution as a share of gross Union tax revenue is typically around 33-36%.
• Q: How does the GST Council vote, and are its decisions binding? A: A 75% weighted majority with the Centre holding one-third and all States two-thirds; the Supreme Court held in *Mohit Minerals* that its recommendations are persuasive, not binding on legislatures.
• Q: Why can CGST credit not be set off against SGST? A: They accrue to two different governments; allowing cross-utilisation would transfer revenue between the Centre and a State without constitutional authority. IGST credit is the only one usable against both.
• Q: What are the GST rates now? A: Since 22 September 2025 the main slabs are 5% and 18%, with a 40% demerit rate for sin and luxury goods, besides nil-rated items and special rates of 3% on bullion and jewellery and 0.25% on rough diamonds.
• Q: Why are petrol and diesel still outside GST? A: They are legally within GST but nil-rated, so excise and State VAT continue; both governments depend heavily on that revenue and the GST Council has not agreed to bring them in.
• Q: What was the GST compensation mechanism and why did it become contentious? A: States were guaranteed 14% revenue growth over 2015-16 for five years, funded by a cess; COVID collapsed the cess so the Centre borrowed ₹2.69 lakh crore and passed it on as loans instead of grants, which several States disputed.
• Q: Distinguish tied from untied transfers and say which States prefer. A: Tax devolution is untied and spendable at the State's discretion; CSS grants are tied with matching shares and conditions. States prefer untied transfers for autonomy; the Centre prefers tied for national priorities.
• Q: If a supplier has not paid the tax, can the buyer still claim ITC? A: No — Section 16 requires that the tax be paid and the invoice appear in the buyer's GSTR-2B; this is the main practical compliance risk in vendor management.
• Q: How does Article 293 constrain a State? A: A State can borrow only within India and needs Union consent while indebted to the Centre, which lets the Centre set net borrowing ceilings and attach conditions.
• Q: What does "zero-rated" mean and how does it differ from "exempt"? A: Zero-rated (exports, SEZ supplies) carries a nil output tax but full ITC with refund; an exempt supply blocks ITC entirely, so the embedded tax becomes a cost.

Common mistakes

• Treating 41% as a share of gross Union tax revenue instead of the divisible pool, and so overstating what States get.
• Saying Finance Commission recommendations are binding — they are advisory; only convention makes the devolution share near-automatic.
• Confusing vertical devolution (Centre-States) with horizontal devolution (among States), or quoting horizontal weights as vertical shares.
• Claiming GST subsumed all indirect taxes: customs duty, stamp duty, electricity duty, State excise on liquor and property tax remain outside.
• Quoting the old 5/12/18/28 slabs — since 22 September 2025 the structure is 5/18 with a 40% demerit rate; and still describing the GST Council as having a Centre veto rather than a one-third weighted vote.
• Mixing up exempt and zero-rated supplies, and assuming a composition dealer can pass on input tax credit.
• Adding the tax twice when a price is already GST-inclusive, instead of dividing by (1 + rate) to get the taxable value.
• Treating fiscal deficit as revenue deficit, or forgetting that fiscal deficit equals total borrowing in the year.

Related topics

Economic reforms since 1991 · Indian financial system and banking reforms · Planning in India and NITI Aayog · Indian economy basics · Poverty, inequality and employment in India · Infrastructure and urbanisation