Restoring Fiscal Space for the States
Kartavya Desk Staff
Syllabus: Economy
Source: TH
Context: The abolition of the GST compensation cess marks a turning point in Centre–State fiscal relations. Several States have raised concerns over the loss of fiscal autonomy and revenue stability, demanding reforms in India’s tax-sharing mechanism to strengthen cooperative federalism.
About Restoring Fiscal Space for the States:
Fiscal Policy Evolution and GST Impact:
• Shift from Origin to Destination-Based Taxation: The 101st Constitutional Amendment (2017) introduced GST, replacing multiple indirect taxes with a destination-based system, reducing States’ authority to levy taxes independently.
• Centralised Decision-Making in GST Council: Despite being a joint forum, the Centre holds dominant voting power (33%), giving it a decisive edge in policy formulation.
• End of GST Compensation Era: The cessation of the GST compensation cess (July 2025) leaves resource-poor States vulnerable to revenue shocks.
• Restructuring of Tax Slabs: The latest GST slab restructuring aims to pass ₹2 lakh crore in benefits to consumers but also shrinks States’ fiscal space.
• Erosion of Fiscal Federalism: By merging major tax sources under one umbrella, GST has centralised taxation authority, weakening States’ fiscal sovereignty.
Role of the Finance Commission and Fiscal Transfers:
• Constitutional Mandate: The Finance Commission (Article 280) determines vertical (Centre–State) and horizontal (among States) tax distribution, but its criteria vary, causing perceived unfairness.
Eg: The 15th Finance Commission reduced the States’ share from 42% to 41% post J&K bifurcation.
• Rise of Cesses and Surcharges: These account for ₹4.23 lakh crore in Budget Estimates 2025–26, but are excluded from the divisible pool, reducing actual transfers to States.
Eg: The 15th FC noted that 18% of the Centre’s tax receipts come from non-shareable cesses.
• Falling Devolution Ratios: Despite higher recommendations, the actual share of States in Gross Tax Revenue (GTR) has dropped to below 33%, eroding trust in federal finance.
Eg: Between FY2018–FY2023, the Centre retained ~₹12 lakh crore extra via non-divisible revenues.
• Dependency on Central Transfers: States rely on the Centre for nearly 44% of their total revenue receipts, with poorer States like Bihar (72%) and U.P. (61%) showing extreme dependence.
Eg: Economically advanced States like Tamil Nadu (31%) get proportionally less.
• Uneven Grants and Criteria: States allege bias in Centrally Sponsored Schemes (CSS) and grant disbursals, which distort fiscal equity and autonomy.
Eg: After the Planning Commission’s abolition (2014), CSS allocations became politically influenced.
Growing Fiscal Imbalance between Centre and States:
• Centralised Resource Control: The Centre collects about 67% of India’s total tax revenue, while States collect only 33%, despite handling over 50% of total expenditure.
Eg: RBI’s “State Finances Report 2025” confirms this persistent mismatch.
• Higher Expenditure Responsibilities: States manage critical sectors — health, education, law & order, and local governance — which consume over 52% of total national spending.
Eg: During COVID-19, States bore 70% of public health expenditure but lacked revenue backing.
• Political and Fiscal Friction: Opposition-ruled States often cite delays in fund release and conditional grants as tools of fiscal control.
Eg: The GST compensation delay of ₹78,000 crore (FY2021–22) deepened mistrust.
• Design Asymmetry in Federal Finance: The Centre’s power to raise taxes is centralised, while expenditure duties are decentralised, causing vertical fiscal imbalance.
Eg: OECD ranks India among the most fiscally centralised federal systems globally.
• Liquidity and Autonomy Challenges: Overdependence on the Centre forces States to borrow more, straining debt sustainability.
Eg: States’ debt-to-GSDP ratio rose to 31.2% in FY2024, above FRBM thresholds.
Towards Fiscal Autonomy and Reforms Proposed:
• Revising Tax-Sharing Principles: Economists suggest a new vertical devolution formula reflecting rising State expenditure and regional disparities.
Eg: 16th Finance Commission (2025–30) is expected to revisit the 41% devolution ceiling.
• Sharing Personal Income Tax (PIT): Proposal to share the ₹13.57 lakh crore PIT base (BE 2025–26) equally (50:50) between Centre and States.
Eg: This could raise effective State devolution by over ₹7 lakh crore annually.
• Allowing PIT Top-Ups: States could levy a small surcharge (1–2%) on personal income tax collected within their boundaries.
Eg: This model mirrors Canadian federal taxation, which grants provinces greater flexibility.
• Merging Cesses with Divisible Pool: Integrating cess and surcharge revenue into the shared pool will expand fiscal space and transparency.
Eg: If merged, States could gain ₹1.5 lakh crore more annually, per NIPFP estimates (2024).
• Strengthening Fiscal Federalism: Empowering States improves local accountability and aligns with cooperative federalism principles under the Constitution.
Eg: Tamil Nadu’s expert committee (2025) recommended incentive-linked fiscal autonomy.
Conclusion:
India’s fiscal federalism is at a crossroads. With States shouldering greater welfare and development responsibilities, restoring fiscal autonomy is imperative. Strengthening tax devolution, integrating cesses, and sharing income tax bases can rebuild trust and balance power. True cooperative federalism lies in empowering States—not just administratively, but financially.