FISCAL SPACE FOR STATES

Copyright infringement not intended

Picture Courtesy: The Hindu

Context:

India’s fiscal system has undergone major reforms since the introduction of the Goods and Services Tax (GST) in 2017. While GST simplified indirect taxation, it has also significantly changed the resource position and fiscal autonomy of the States. With the end of GST compensation, many States now face rising expenditure needs but limited revenue flexibility.

What are fiscal relations?

Fiscal relations refer to the financial arrangements between different levels of government — mainly the Union (Central) Government and the State Governments — in a federal system like India.

They define how powers to raise revenue and responsibilities to spend that revenue are divided between the Centre and the States.

Constitutional Basis: The Indian Constitution lays down fiscal relations mainly in Articles 268 to 293 (Part XII), covering:

• Distribution of tax powers between the Union and States (Articles 246 & 268–270).
• Grants-in-aid and loans (Articles 275–281).
• Role of the Finance Commission (Article 280).
• Borrowing powers (Articles 292–293).

Role of the Finance Commission: The Finance Commission, established under Article 280, is a constitutional body that reviews fiscal relations every five years. It recommends:

• The percentage of central taxes to be shared with States.
• Grants-in-aid to meet States’ revenue deficits.
• Steps to strengthen fiscal discipline and promote equity.

Evolution of Fiscal relations:

Current status of Fiscal relations in India:

• For FY 2024-25, the Union government has proposed to share about 32% of central taxes with States, which is significantly lower than the 41% recommendation of the 15th Finance Commission. (Source: BS)

• From April to July of FY 2025-26, the Centre transferred about ₹4,28,544 crore to States as tax devolution. This is ₹61,914 crore more than what was transferred during the same period in the previous year. (Source: Free Press Journal)

• In 2024-25 (April-Feb), aggregated data from 23 States shows that about 36% of their total revenue receipts came from transfers by the Centre (tax devolution + grants), while approximately 64% was from their own revenues (own tax + non-tax revenues) . (Source: nipfp.org.in)

• Revenue deficit grants (under the 15th Finance Commission meant to help States cover shortfall after devolution) have dropped drastically, from ~₹1,18,452 crore in 2021-22 to ~₹24,483 crore in 2024-25. A further decline (to ~₹13,705 crore) is expected in FY 2025-26. (Source: mint)

• Revenue growth for many States is projected to be 7-9% in FY 2025-26, driven by GST collections and central tax devolution. Own tax revenue growth has been forecasted at around 8%. (Source: TOI)

Current Issues in Fiscal Relations:

• Declining Fiscal Autonomy of States: After GST implementation, States lost independent power to levy indirect taxes. The GST Council—where the Centre has higher voting weight—dominates tax policy decisions. States’ own tax revenue growth slowed from 2% (FY 2024) to 8.6% (FY 2025) for 23 major States. (Source: TOI)

• Rising Dependence on Central Transfers: Most States rely heavily on Union transfers for revenue, limiting their fiscal flexibility. Central transfers account for 44% of total State revenue receipts; in poorer States like Bihar, dependence reaches 72%. (Source: Economic Survey 2024-25)

• Reduced Devolution Despite Higher Recommendations: Though the 15th Finance Commission recommended 41% devolution, actual transfers remain lower due to cesses and surcharges being excluded from the divisible pool. For FY 2024-25, the effective share transferred is around 32-36%, not 41%. (Source: Money Control)

• Growth in Non-Shareable Cesses and Surcharges: The Centre increasingly uses cesses and surcharges to fund its schemes, which are not shared with States, shrinking their fiscal space. Cesses and surcharges amounted to ₹4.23 lakh crore (BE 2025-26), a rise from ₹3.86 lakh crore (RE 2024-25). (Source: Union Budget 2025-26)

• Falling Grants-in-Aid and Revenue Deficit Support: Finance Commission and scheme-based grants have declined sharply, impacting weaker States. Revenue deficit grants fell from ₹1.18 lakh crore (2021-22) to ₹24,483 crore (2024-25), projected ₹13,705 crore (2025-26). (Source: TOI)

Government measures to improve fiscal relations:

• 16th Finance Commission Review: The 16th Finance Commission (set to cover 2026–2031) is currently reviewing how central taxes are shared with the States. Most States have demanded that their share be increased from the current 41% to 50%. This would give them greater fiscal autonomy and help them meet rising expenditure needs in areas like health, education, and infrastructure. (Source: Business Standard, 2025)

• Inclusion of Cesses and Surcharges in Shared Taxes: States have also requested that cesses and surcharges—special taxes collected by the Centre—be included in the pool of revenue that is shared with them. At present, these are not shared, which reduces the States’ effective share of central revenue. Including them would make tax distribution more equitable and transparent.
  (Source: Salar News, 2025)

• Strengthening Fiscal Discipline: The Centre is considering linking certain grants and transfers to how responsibly States manage their finances. This would encourage better debt control, reduce wasteful spending, and promote efficient use of funds.
  (Source: Business Standard, 2025)

• Reforming Centrally Sponsored Schemes (CSS): There are over 130 centrally sponsored schemes that require joint funding by the Centre and the States. The government is working to streamline these schemes, reduce duplication, and allow more flexibility for States in implementing them according to their local needs. (Source: NITI Aayog, 2025)

• Reforming the GST Council Structure: Discussions are ongoing to give States a stronger voice in the GST Council by revisiting voting powers and compensation mechanisms. This aims to restore States’ confidence and autonomy in the post-GST fiscal environment. (Source: Economic Survey 2024–25)

Way Forward:

• Enhance States’ Share in Central Taxes: The 16th Finance Commission (2026–31) should consider increasing the States’ share in central taxes from 41% to at least 45–50%. he Centre’s share in total government expenditure rose to 58% in 2024, while States’ share fell to 42%, showing the need for better fiscal balance. (Source: Business Standard, March 2025)

• Include Cesses and Surcharges in the Divisible Pool: Currently, cesses and surcharges—making up around 18% of gross tax revenue (2024)—are excluded from the divisible pool shared with States. Bringing these into the sharing mechanism would make fiscal transfers more transparent and equitable. (Source: PRS Legislative Research, 2024)

• Reform Centrally Sponsored Schemes (CSS): The Centre should rationalize and merge overlapping CSS to reduce administrative burden and increase States’ flexibility in fund usage. As of FY 2024–25, India had 131 CSS consuming nearly 25% of total central expenditure, but many had low utilization and duplication. (Source: NITI Aayog Report on CSS Reform, 2024)

• Strengthen Fiscal Responsibility and Transparency: Adopt uniform Fiscal Responsibility and Budget Management (FRBM) targets across States to maintain debt sustainability. The combined debt of Centre and States stood at ~83% of GDP in FY 2024–25, higher than the desired 60% target. (Source: Reserve Bank of India, State Finances Report 2024)

• Promote Decentralised Fiscal Federalism: Encourage local bodies (Panchayats and Municipalities) to mobilize own revenues via property tax digitization and municipal bonds. Local body revenues are only 1% of GDP, compared to 6–7% in countries like Brazil and South Africa. (Source: NIPFP Fiscal Federalism Report, 2024)

Source: The Hindu