Evolving Fiscal Space of Indian States

Syllabus: GS2/ Centre-State Fiscal Relations, GS3/Indian Economy

Context

• India needs to ensure equitable fiscal federalism by strengthening states’ financial autonomy and restoring balance in tax devolution and grants.

About India’s Fiscal Federalism

• Fiscal federalism is the division of governmental functions and financial relations among levels of government in a federal system. In India, it involves:
  • Vertical Devolution: Sharing of central taxes with states, determined by the Finance Commission.
  • Horizontal Devolution: Distribution among states based on criteria like population, income distance, and fiscal discipline.
  • Grants-in-aid: Targeted transfers for specific purposes or to address fiscal imbalances.

Changing Dynamics of Fiscal Transfers

• 14th Finance Commission (2015–20): It increased the states’ share in the divisible pool of central taxes from 32% to 42%, significantly enhanced the states’ autonomy over resources. During this period:
  • The share of states in central taxes rose from 15% (13th FC) to 19.2% of combined revenue receipts — a 4.25 percentage point increase.
  • Consequently, the post-transfer fiscal share of states increased from 63.85% to 68.08%, reversing the earlier balance between the Centre and the states.
  • Both Finance Commission (FC) and non-FC grants remained largely stable, maintaining the overall composition of transfers.
• 15th Finance Commission (2020–25): States’ aggregate revenue receipts fell from 68.08% (14th FC) to 67.39% of combined revenue receipts — a 0.70 percentage point reduction.
  • The share of tax devolution declined by 1.05 percentage points, from 19.2% to 18.2%, though partially compensated by slightly higher FC and non-FC grants.
  • The states’ own revenue receipts also dipped marginally from 37.72% to 37.35%.
  • Several structural changes contributed to this decline:
    • The number of states reduced to 28 following the bifurcation of Jammu and Kashmir.
    • The Centre increased the use of cesses and surcharges, which are non-sharable with the states.
• High-Income States: The situation is more concerning for high-income states such as Haryana, Karnataka, Kerala, Maharashtra, and Tamil Nadu.
  • Between the 13th and 14th FC periods, there was no net gain in their fiscal space — increases in transfers were offset by declines in own revenues.
  • However, from the 14th to 15th FC period, their fiscal space fell by 0.38 percentage points of combined revenue receipts.

Underlying Causes in Changing Dynamics of Fiscal Transfers

• Rising non-sharable cesses and surcharges limited the divisible pool.
• The horizontal devolution formula may have disadvantaged high-income states by giving greater weight to equity criteria.
• The recent GST 2.0 reforms, involving extensive rate reductions and the end of GST compensation cess, further threaten states’ fiscal capacity.

Policy Implications and the Way Forward

• Need for Balanced Fiscal Federalism: The experience since the 14th FC underscores the need to strike a balance between equity and fiscal autonomy.
  • States require adequate resources not only for development but also to fulfill constitutional responsibilities in health, education, and infrastructure.
• Rethinking Cesses and Surcharges: The Centre’s increasing reliance on non-divisible revenue instruments undermines cooperative federalism.
  • Reining in cesses and surcharges would restore fiscal trust and expand the divisible pool.
• Enhancing Tax Buoyancy: Both the Centre and the states must focus on increasing tax efficiency and compliance.
  • Stronger GST collections and rationalized direct taxes can expand the overall fiscal pie.
• Role of the 16th Finance Commission: The 16th Finance Commission, having submitted its report recently, faces the challenge of correcting recent imbalances. It is expected to:
  • Revisit the ‘distance criterion’ in horizontal devolution to ensure fairer treatment of high-income states.
  • Safeguard fiscal space through a more equitable sharing framework.

Conclusion

• India’s fiscal federal architecture has evolved toward greater state empowerment since the 14th Finance Commission.
  • However, the 15th FC period reveals emerging strains, particularly for high-income states facing erosion of fiscal autonomy. 
• As the 16th Finance Commission’s recommendations await implementation, the future of fiscal federalism depends on ensuring that both the Centre and the states have the resources and flexibility needed to meet shared developmental goals.

Source: IE