A STUDY OF UNION-STATES FINANCIAL RELATIONS

This article is written by Harshita of 9th semester of B. Com LL. B of IMS Law College, Noida, an intern under Legal Vidhiya

ABSTRACT

This research delves into the intricate framework of financial relations between the Union and the State governments as enshrined in the Indian Constitution. The financial allocation and distribution of resources between these two tiers of government have profound implications for the functioning of India’s federal system.

It elucidates the constitutional provisions governing financial relations, with a focus on Articles 264 to 293. It analyzes the principles of revenue collection, sharing, and distribution through mechanisms like grants-in-aid, tax sharing, and devolution of funds including the critical roles of the Finance Commission and Planning Commission (now NITI Aayog).

In conclusion, this research underscores the critical importance of harmonizing financial relations in India for sustainable economic growth and equitable development. Understanding these dynamics is essential for fostering cooperative federalism and ensuring effective governance in the world’s largest democracy.

Keywords: Financial Relations, Constitution, Fiscal Federalism, Taxation Powers, Cooperative Federalism

INTRODUCTION

The financial relationship between the Union and States under the Indian Constitution is a cornerstone of India’s federal system of governance. This complex web of fiscal arrangements enshrined in the Constitution of India plays a pivotal role in determining the economic stability and growth of the nation.

However, in order to function effectively as a united and harmonious nation, a mechanism was required to allocate financial resources equitably, manage public finances efficiently, and promote cooperative federalism. To address these needs, the Indian Constitution outlines a comprehensive framework encompassing revenue sharing, taxation powers, grants-in-aid, and various other financial provisions.

This intricate system of financial relations is governed by several key articles and provisions in the Constitution, prominently including Articles 264 to 293. These articles delineate the powers of taxation, the distribution of revenue between the Union and States, and the mechanisms for financial transfers. Additionally, the recommendations of the Finance Commission, which are periodically constituted by the President of India, are instrumental in determining the sharing of finances between the Union and States.

Over the years, the financial relationship between the Union and States has evolved to meet the changing needs of India’s diverse and dynamic population. It has become a dynamic arena where fiscal policies, resource allocation, and economic planning converge to drive the nation’s progress.

DIVISION OF TAXATION POWERS

Article 246 of the Indian Constitution provides for the distribution of legislative powers between the Union (central government) and the States by dividing the subjects of legislation into three lists:

1. List I (Union List): It includes subjects on which the Parliament has exclusive authority to make laws. This list includes taxes such as customs duties, excise duties, income tax, and other central taxes.
2. List II (State List): It includes subjects on which only the State Legislatures can make laws. This list includes taxes like land revenue, state excise, and taxes on agricultural income.
3. List III (Concurrent List): It includes subjects on which both the Union and the States can make laws, but in case of a conflict, the Union law generally prevails.

Taxation Only by Law: Article 265 of the Indian Constitution mandates that taxes can only be imposed and collected under the authority of law. This means that no tax can be levied arbitrarily, and it must be in accordance with a specific legislative framework passed by the appropriate authority.

REVENUE DISTRIBUTION BETWEEN THE UNION AND THE STATES

Article 268 to 281 of the Indian Constitution deals with the distribution of revenues between the Union and the States. These articles provide diverse revenue sources, grants-in-aid, and the pivotal role of the Finance Commission in formulating equitable revenue-sharing principles. They establish the foundation for fiscal cooperation and resource allocation, ensuring financial stability and balanced development across the nation while respecting the autonomy of both the Union and the States in matters of finance and taxation.

DUTIES IMPOSED BY THE UNION BUT COLLECTED AND APPROPRIATED BY THE STATES

Article 268 provides for the levying and collection of stamp duties mentioned in the Union List. These duties are levied by the Government of India but collected differently depending on the jurisdiction. In Union territories, the collection is done by the Government of India, while in states, it is collected by the respective state government. The proceeds of these duties collected within a State do not go to the Consolidated Fund of India but are assigned to that specific State.

TAXES LEVIED AND COLLECTED BY THE UNION BUT ALLOCATED TO THE STATES

Article 269 which was amended by Constitution (80th Amendment) Act, 2000, deals with the distribution of authority and revenue between the central and state governments regarding taxes on the sale or purchase of goods and taxes on the consignment of goods in the context of inter-State trade or commerce.

Clause 1 of the article states that taxes on the sale or purchase of goods and taxes on the consignment of goods will be collected and levied by the Government of India. However, these taxes shall be assigned and shall be deemed to have been assigned to the States from April 1, 1996 as specified in Clause 2.

In the context of inter-State trade or commerce, the term “Taxes on the sale or purchase of goods” refers to taxes imposed on transactions involving goods, excluding the newspapers and “Taxes on the consignment of goods” refers to taxes levied on the consignment of goods, regardless of whether the consignment is directed to the initiator or any other party involved in the transaction.

Clause 2 specifies that the net proceeds of these duties and taxes, excluding the portion related to Union territories, will not be part of the Consolidated Fund of India. Instead, they will be assigned to the States where these duties or taxes are collected in a particular financial year and the distribution among the states shall be according to the principles formulated by Parliament through law.

Clause 3 empowers Parliament to establish principles for determining when a sale or purchase of goods or consignment of goods is considered to occur in the course of inter-State trade or commerce.

Article 269A inserted through the Constitution 101st Amendment Act, 2016^[1] deals with the levy and collection of the goods and services tax (gst) in the context of inter-state trade or commerce. It provides that (1) Goods and services tax on supplies occurring during inter-State trade or commerce will be imposed and collected by the Government of India. The distribution of this tax revenue between the Union and the States will be determined by Parliament, following recommendations from the Goods and Services Tax Council.

Explanation. —For the purposes of this clause, the supply of goods or services, or both, during import into India’s territory shall be considered as if it were a supply of goods or services, or both, in the context of inter-State trade or commerce.

(2) The portion allocated to a State under clause (1) shall not be included in the Consolidated Fund of India.

(3) Where an amount collected as tax under clause (1) has been used to pay the tax imposed by a State under Article 246A, that amount shall not be a part of the Consolidated Fund of India.

(4) Similarly, when an amount collected as tax under Article 246A by a State has been used to pay the tax levied under clause (1), it shall not form a part of the Consolidated Fund of the State.

(5) Parliament may, by law, formulate the principles for determining the place of supply and identifying when a supply of goods, services, or both takes place during inter-State trade or commerce.

In the case of State of Andhra Pradesh vs National Thermal Corporation Ltd^[2] The Supreme Court clarified the scope and definition of what constitutes inter-state trade or commerce under Sections 3 and 6 of the Central Sales Tax Act, 1956. The court’s ruling established the following key principles:

1. For a transaction to qualify as inter-state trade or commerce: The terms of the contract must explicitly or implicitly include a provision related to the inter-state movement of goods.
2. Mere inclusion of such a provision in the contract is not sufficient on its own; there must also be actual movement of goods from one state to another as a result of that contract.
3. The goods involved in the transaction must physically move from one state to another, and the contract of sale must be concluded in a state other than the one from which the goods originally originated.

TAXES LEVIED AND DISTRIBUTED BETWEEN THE UNION AND THE STATES

Article 270 of the Constitution which deals with the distribution of taxes and duties between the Union and the States has undergone amendments through the 80th Amendment Act of 2000 and the 101st Amendment Act of 2016. Article 270(1) provides that All taxes and duties mentioned in the Union List (except those specified in Articles 268, 269, 269A, and surcharge on taxes and duties under Article 271) shall be levied and collected by the Government of India and these taxes and duties shall be distributed between the Union and the States as per the provisions of clause (2).

Clause 2 of the article specifies that a certain percentage of the net proceeds of these taxes or duties will not be a part of the Consolidated Fund of India but will be assigned to the States where these taxes or duties are leviable in a given financial year and shall be distributed among the States in such manner and from such time as may be prescribed in clause 3.

Clause 3 defines the term “prescribed” for the purposes of this article. It states that the prescription of percentages and distribution mechanisms will be determined by the President. Until a Finance Commission is constituted, the President will prescribe them by order, and after a Finance Commission is in place, the President will prescribe them after considering the recommendations of the Finance Commission.

Clause (1-A) and (1-B) has also been inserted by the Constitution (101st Amendment) Act, 2016 which are:

Clause (1-A) provides that the tax collected by the Union under clause (1) of Article 246A, shall also be distributed between the Union and the States as per the provisions of clause (2).

Clause (1-B) provides that tax levied and collected by the Union under clause (2) of Article 246A and Article 269A, which has been used for payment of the tax levied by the Union under clause (1) of Article 246A, and the amount apportioned to the Union under clause (1) of Article 269A, shall also be distributed between the Union and the States as per the provisions of clause (2).

The Supreme Court in the case of T.M. Kanniyan vs Income-Tax Officer^[3] held that Article 270 of the Indian Constitution establishes that income tax collected from Union territories is consolidated into the Consolidated Fund of India. It emphasized that there is no need for a separate distribution of income tax revenue from Union territories because these territories are centrally administered by the President of India. The court rejected the argument that the absence of an express grant of power in Article 270 meant that the President could not extend the Income-tax Act to Union territories. Instead, it confirmed that the President, in the exercise of his powers under Article 240, could make regulations, such as Regulation No. 3 of 1963, extending the Income-tax Act to Union territories.

TAXES AND DUTIES FOR THE PURPOSE OF THE UNION

Under Article 271 of the Constitution, the Parliament is empowered to increase any of the duties or taxes at any time referred to in articles 269 and 270, except the goods and services tax under article 246A, by a surcharge for purposes of the Union, and the whole proceeds of any such surcharge shall form part of the Consolidated Fund of India.

The Allahabad High Court in Ved Vyas Chawla vs The Income Tax officer^[4] dismissed the writ petition challenging the levy of additional surcharge. The court ruled that Article 271 allows Parliament to levy surcharge on taxes and duties as referred to in Articles 269 and 270 “at any time,” and it does not restrict Parliament from imposing surcharges in different forms to address changing circumstances. Additionally, the court emphasized that Parliament can levy surcharges in different forms or under different names to address varying circumstances and it must do so based on a real and substantial difference between the classes, and there must be a reasonable connection between the imposition of the surcharge and the objectives it seeks to accomplish and this discretion does not violate the constitutional framework.

GRANTS FOR EXPORT DUTY ON JUTE AND JUTE PRODUCTS

Article 273 of the Indian Constitution stipulates that grants in lieu of a share of export duty on jute and jute products shall be provided to the states of Assam, Bihar, Orissa, and West Bengal from the Consolidated Fund of India and these prescribed sums will continue to be charged on the Consolidated Fund of India as long as the Government of India imposes export duty on jute and jute products or until ten years from the commencement of the Indian Constitution, whichever is earlier.

Grants from the Union to certain States: Under article 275 the Parliament is empowered to allocate funds from the Consolidated Fund of India as grants to states requiring financial assistance. These grants may vary among states and are intended to support their revenues. Also, special provisions are made for the State of Assam, including grants to cover past expenditure excess and development schemes. Additionally, if an autonomous state is formed under Article 244A, grants may be apportioned accordingly.

Article 282 allows both the Union and states to provide grants for public purposes, even if such purposes are not within the legislative authority of Parliament or the state legislature.

TAXES ON PROFESSIONS, TRADES, CALLINGS AND EMPLOYMENTS

Article 276 empowers state legislatures to levy taxes on professions, trades, callings, or employments, without these taxes being considered invalid as taxes on income. However, it imposes a cap of 250 rupees per annum on the total tax payable by any individual to the state or local authorities. If, prior to the Constitution’s enactment, a higher tax rate was in force, it can continue until Parliament passes a contrary law. This provision doesn’t limit Parliament’s authority to enact laws related to income taxes derived from professions, trades, callings, or employment.

Whereas, Article 277, known as the “Savings” clause, permits the ongoing collection of taxes, duties, cesses, or fees by State governments, municipalities, or local authorities, even if these items are listed in the Union List (which usually falls under the jurisdiction of the central government). These funds can continue to be collected and used for their designated purposes until Parliament passes a law stating otherwise.

The Supreme Court in B.M. Lakhani vs Municipal Committee^[5] held that if a taxpayer pays taxes that exceed the limits set by Article 276 of the Constitution, they have the legal right to file a suit to seek a refund of the excess amount. This observation emphasized the importance of adhering to constitutional limitations on taxation and provides a legal recourse for individuals or entities who have been subjected to excessive taxation by state or local bodies. The Court also clarified that while there are limits (or caps) on the amount of tax that can be imposed under Article 276, there is no absolute bar on the exercise of taxation powers by state or local bodies.

GOODS AND SERVICES TAX COUNCIL

The Constitution (One Hundred and First Amendment) Act, 2016, introduced Article 279A, establishing the Goods and Services Tax (GST) Council.

It is provided under Article 279A, Clause 1, that within sixty days of the commencement of the Constitution (One Hundred and First Amendment) Act, 2016, the President shall establish a council named the Goods and Services Tax Council through an official order. The GST Council shall consist of:

• The Union Finance Minister as the Chairperson
• The Union Minister of State in charge of Revenue or Finance as Member
• Members nominated by each State Government.

The members nominated by the State governments as referred shall select one among themselves to serve as the Vice-Chairperson of the Council. This Vice-Chairperson shall have specific responsibilities within the Council.

Functions and powers of the council: As provided under clause 4 of the article the Council shall make recommendations to the Union and the States on –

1. The taxes, cesses, and surcharges levied by the Union, States, or local bodies which may be subsumed into the GST.
2. Advise on goods and services to be included or exempted from GST.
3. Formulating model GST laws and principles.
4. Setting thresholds for exemptions, determining GST rates, and considering special rates during natural disasters.
5. The Goods and Services Tax rates, which comprise both minimum floor rates and various bands
6. Addressing specific provisions with respect to the States of Arunachal Pradesh, Assam, Jammu and Kashmir, Manipur, Meghalaya, Mizoram, Nagaland, Sikkim, Tripura, Himachal Pradesh and Uttarakhand
7. Any other matters related to GST.

The Council shall make recommendations on the date on which GST should be applied to specific petroleum products, including petroleum crude, high-speed diesel, petrol (motor spirit), natural gas, and aviation turbine fuel and it is specified by clause 6 of the article that while discharging the functions conferred by this article, the Council shall be guided by the need for a harmonized structure of goods and services tax and for the development of a harmonized national market for goods and services.

Clause 7 mentions one-half of the total number of members shall constitute the quorum for its conducting meetings. The council shall also determine the procedure in the performance of its functions provided under clause 8.

Decision-Making: Every decision of the council shall be made by a majority of not less than three-fourths of the weighted votes where

1. The vote of the Central Government holds a weightage of one-third of the total votes cast.
2. The votes of all State Governments taken together carry a weightage of two-thirds of the total votes cast.

It is provided under the article that no act or proceedings of the GST Council shall be invalidated due to:

1. Vacancies in the Council.
2. Defects in the constitution of the Council.
3. Defects in the appointment of a person as a Member of the Council.
4. Procedural irregularities that do not affect the merits of the case.

Article 279A establishes a mechanism for adjudicating disputes arising from the Council’s recommendations or their implementation. These disputes can be between the Government of India and one or more States, between the Government of India and any State or States on one side and one or more other States on the other side, or among two or more States.

FINANCE COMMISSION

The Finance Commission is a constitutional body established under Article 280 of the Indian Constitution. This commission plays a crucial role in the distribution of financial resources between the Union and the States.

Constitution of the Commission (Clause 1)

The President of India is required to constitute a Finance Commission within two years from the commencement of the Indian Constitution.

1. Subsequently, the President should appoint a new Finance Commission every five years or earlier if deemed necessary.
2. The Finance Commission is to consist of a Chairman and four other members who are appointed by the President.

The Finance Commission (Miscellaneous Provisions) Act of 1951^[6] enacted by the Parliament in accordance with Article 281 of the Indian Constitution provides that the Chairman of the Commission shall be selected from among persons who have had experience in public affairs, and the four other members shall be selected from among persons who meet one of the following requirements

1. are, or have been, or are qualified to be appointed as Judges of a High Court
2. have specialized knowledge in finances and accounts of Government
3. have wide experience in financial matters and administration
4. have specialized knowledge in economies

Duties of the Finance Commission (Clause 2)

It is the duty of the commission to make recommendations to the President regarding several financial matters. These recommendations include:

1. The distribution of the net proceeds of certain taxes between the Union (Central Government) and the States, and also among the States themselves.
2. The principles governing grants-in-aid from the Union to the States from the Consolidated Fund of India. These grants are meant to support the finances of the States.
3. Any other financial matter referred to the Commission by the President in the interest of maintaining sound financial management.

The Finance Commission has the authority to determine its own procedure for carrying out its functions and the Parliament is empowered to confer additional powers on the Finance Commission through legislation as provided under clause 4 of the article. This clause ensures that the Commission can effectively carry out its duties and functions as mandated by the Constitution.

The Planning Commission of India was established in March 1950 by the Government of India. Its formation was a result of the need for systematic economic planning and development in India after gaining independence. It aimed to coordinate economic development, formulate Five-Year Plans, and allocate resources efficiently.

 However, in 2014 the Union Cabinet approved a resolution which outlined the decision to dissolve the Planning Commission as it faced criticism for its top-down approach, lack of flexibility, and bureaucratic functioning and to establish a new institution called NITI Aayog. NITI Aayog (National Institution for Transforming India Aayog) on 1st January, 2015 was established to replace the Planning Commission of India. It serves as a government think tank, offering strategic counsel and conducting research. Unlike the Planning Commission, it doesn’t allocate funds or engage in centralized planning. Instead, it fosters cooperation among central and state governments, promotes state-level competition, and provides guidance on development initiatives. NITI Aayog is highly flexible, adapting to evolving economic and social conditions, emphasizing innovation, and tailoring solutions to individual states’ needs. Therefore, it is a platform for both the central and state governments to collaborate on policy formulation and implementation.

EXEMPTION OF PROPERTY OF THE UNION FROM STATE TAXATION

Article 285 of the Constitution deals with the exemption of property belonging to the Union (i.e., the central government) from taxation by the State governments or any authorities within the States. It provides that the property owned by the Union (central government) is generally exempt from all taxes imposed by a State government or any authority within a State and the Parliament has the power to make laws that can specify exceptions to this exemption. Until Parliament enacts a law to the contrary, State authorities are allowed to continue levying taxes on Union property if such taxes were applicable immediately before the commencement of the Indian Constitution.

Furthermore, Article 287 prohibits State laws from imposing taxes on the consumption or sale of electricity used by the Government of India or railway companies for construction, maintenance, or operation of railways. If a state does impose such a tax on the sale of electricity, it must ensure that the price charged to the government or railway company for their consumption is reduced by the amount of the tax, in comparison to other consumers of substantial electricity quantities.

EXEMPTION OF PROPERTY AND INCOME OF A STATE FROM UNION TAXATION

Under Article 289 of the Constitution, the property and income of a State within India are generally exempt from taxation by the Union government. However, the Union government has the authority to impose taxes on the trade or business conducted by or on behalf of a State government, its associated operations, property used for such activities, or income derived from them. However, this imposition is subject to the extent and conditions set by Parliament through law. Whereas, clause 3 of the article exempts certain trade or business activities that Parliament declares as incidental to the ordinary functions of government from Union taxation and these activities are not subject to the provisions mentioned in clause (2).

This article ensures that a State’s property and income are shielded from Union taxation, except when it comes to specific trade or business activities carried out by the State government, subject to parliamentary regulations, or activities declared incidental to government functions, which remain exempt.

BORROWING POWER OF THE UNION AND STATES

Article 292 of the Indian Constitution grants the Union government the authority to borrow money using the Consolidated Fund of India as security. This borrowing power is subject to limits that Parliament may establish through legislation. Additionally, the Union government can also provide guarantees for borrowing within limits defined by Parliament through law.

Whereas, article 293 outlines the borrowing power of the States. It provides States with the authority to borrow funds within India, using their Consolidated Fund as security. However, the limits on borrowing are set by the State’s legislature through law. Clause 2 of the article states that the Union government can lend money to States or provide guarantees for State loans, as long as these actions adhere to the borrowing limits specified in Article 292 and funds for these loans are drawn from the Consolidated Fund of India. However, a State cannot raise a loan without the consent of the Government of India if any part of a previous loan or a guaranteed loan remains outstanding. Such consent can come with additional conditions imposed by the Government of India.

FINANCIAL RELATIONS BETWEEN THE CENTRE AND STATES DURING EMERGENCY

During a National Emergency^[7] the President can issue directions to States regarding revenue allocation and resource utilization, curbing the financial autonomy of the States. Grant-in-aids from the Union to States can be suspended temporarily but must be reinstated after the financial year in which the emergency ends.

In a Financial Emergency^[8] the Central government gains substantial control over States’ finances. The President can direct salary reductions for State employees, including High Court judges, alter tax distribution between the Centre and States, and enforce financial propriety principles laid down by Parliament. States may also be required to seek the President’s consideration for all financial and money bills, even after State Legislature approval.

These emergency provisions grant the Centre significant authority during crises, affecting the financial dynamics between the Centre and States.

CONCLUSION

The financial relations between the Union and States in India are a complex yet integral part of the country’s federal system of governance. The Indian Constitution, through its various provisions, delineates the powers of taxation, revenue distribution, and financial cooperation. Over the years, this system has evolved to meet the changing needs of India’s diverse population and dynamic economic landscape.

The establishment of the Goods and Services Tax (GST) Council and the role of Finance Commissions have added layers of sophistication to this system, ensuring equitable resource allocation and cooperative federalism. However, it’s essential to recognize that during emergencies, the balance of financial power can shift, with the Union government gaining temporary control over State finances.

In essence, India’s financial relationship between the Centre and States reflects the delicate balance between unity and diversity, cooperation and autonomy. This intricate web of fiscal arrangements serves as the lifeblood of the nation’s economic stability and growth, impacting the development and well-being of every citizen. As India continues to evolve, understanding and managing these financial relations remain crucial for the nation’s progress and harmonious coexistence.

REFERENCES

1. GST Council https://gstcouncil.gov.in/sites/default/files/consti-amend-act.pdf (Last Visited 25 Sep, 2023)
2. Ved Vyas Chawla vs The Income Tax Officer AIR 1965 All 37, 1965 57 ITR 749 All
3. T.M. Kanniyan vs Income-Tax Officer 1968 AIR 637, 1968 SCR (2) 103
4. State Of A.P vs National Thermal Power Corporation Civil Appeal 3112 of 1990 Transfer Case (civil) 3 of 1998
5. B. M. Lakhani vs Municipal Committee, Malkapur AIR 1970 SC 1002, (1970) 2 SCC 267

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^[1] GST Council https://gstcouncil.gov.in/sites/default/files/consti-amend-act.pdf (Last Visited 25 Sep, 2023)

^[2] State Of A.P vs National Thermal Power Corporation Civil Appeal 3112 of 1990

^[3] T.M. Kanniyan vs Income-Tax Officer 1968 AIR 637, 1968

^[4] Ved Vyas Chawla vs The Income Tax Officer AIR 1965 All 37, 1965

^[5] B. M. Lakhani vs Municipal Committee, Malkapur AIR 1970 SC 1002

^[6] The finance commission (miscellaneous provisions) act, 1951

^[7] INDIA CONST. art. 352

^[8] INDIA CONST. art. 360