Restoring Fiscal Space for the States

18.10.2025

1. Restoring Fiscal Space for the States

Context

The abolition of the GST Compensation Cess in July 2025 marks a turning point in Centre–State fiscal relations. Several States have voiced concerns about shrinking revenue autonomy and financial instability, calling for a renewed approach to tax devolution and cooperative federalism.

About the Topic

Fiscal Policy Evolution and GST Impact

• The 101st Constitutional Amendment (2017) introduced the Goods and Services Tax (GST), replacing multiple indirect taxes with a destination-based system. While simplifying taxation, it curtailed States’ independent taxing powers.
• The GST Council, though a joint decision-making body, grants the Centre a 33% voting share, giving it effective control over rate and policy changes.
• With the cessation of GST compensation, resource-poor States face widening revenue gaps. Recent GST slab revisions—designed to aid consumers—have further narrowed States’ fiscal flexibility and deepened dependence on central transfers.

Role of the Finance Commission and Fiscal Transfers

• Under Article 280, the Finance Commission recommends revenue-sharing between the Centre and States. However, varying criteria and the exclusion of cesses and surcharges from the divisible pool have reduced effective transfers.
   The 15th Finance Commission lowered the States’ share from 42% to 41% post–J&K bifurcation.
• In 2025–26, cesses and surcharges amounting to ₹4.23 lakh crore remain outside the sharing pool, limiting devolution. States now receive less than 33% of gross tax revenue, despite managing key sectors such as health, education, and policing.
• Fiscal dependence on the Centre, particularly for poorer States like Bihar and Uttar Pradesh has increased, with delayed or conditional fund releases undermining fiscal equity.

Growing Fiscal Imbalance

• The Centre collects nearly two-thirds of total tax revenue, while States bear over half of public expenditure responsibilities.
•  This mismatch—centralized revenue powers coupled with decentralized expenditure duties—has created a vertical fiscal imbalance.
•  Rising borrowing needs have elevated States’ debt-to-GSDP ratio to 31.2% (FY2024), threatening fiscal sustainability and autonomy.

Reform Proposals

Economists advocate revising vertical devolution formulas to reflect States’ expanding welfare and development roles.
 The 16th Finance Commission (2025–30) could revisit the 41% ceiling and consider:

• Sharing personal income tax more equitably between Centre and States.
   
• Allowing limited State-level surcharges on income tax, inspired by the Canadian model.
   
• Merging cesses and surcharges into the divisible pool, potentially adding ₹1.5 lakh crore annually to State revenues.
   Such reforms would strengthen cooperative federalism and enhance local accountability.
   

Conclusion

India’s fiscal federalism is at a crossroads. With States shouldering a growing share of welfare and development expenditure, restoring fiscal autonomy is vital.
 Broader tax devolution, integration of cesses into the sharing pool, and equitable income tax distribution would rebuild trust, rebalance fiscal power, and reinforce the spirit of true cooperative federalism.