Table Of Content
In 1962, a number of States complained to the Third Finance Commission (FCIII) a few “tendency to centralise sources and capabilities belonging to the States”. The Commission reported a widespread sentiment amongst States that their autonomy was being eroded by means of instructions on State topics and unilateral monetary selections by the Centre.
This discontent had emerged regardless of the Congress ruling on the Centre with a large mandate and heading most main State governments. The Commission noticed that “federal finance in India at present (1962) is such that the States are depending on central help on an ever-increasing scale. This dependence is diluting, on the one hand, the accountability of State Cabinets to their legislatures, and on the opposite, hampering the expansion of administrative duty within the States.” It referred to as this development “disturbing”.
More than 60 years have handed since. Indian States have grown extra politically, socially, economically, and ideologically aside. A coalition now governs on the Centre, and main Indian States are led by Chief Ministers from no less than 9 completely different events. The 1991 liberalisation had boosted the economies of many southern and western States, whereas a lot of the east, central, and northern components proceed to lag. Economic development and ideological divergence meant that whereas some States now rival Western nations in social indicators, others mirror sub-Saharan Africa.
Due to such stark inequalities amongst States, at present, the “disturbing” development seen 60 years in the past continues to be prevalent and has reached a boiling level. The clamour towards the dilution of States’ monetary rights is louder than ever. The tug-of-war over fiscal federalism is now taking part in out in more and more seen and confrontational methods.
Three layers
The newest combat between the States and the Centre over cash is unfolding throughout three distinct layers.
First, the cash States obtain from the Centre. This consists of a wide selection of contentious points: how a lot needs to be shared by the Centre with the States (vertical devolution), the way it needs to be distributed among the many States (horizontal devolution), and, extra crucially, what precisely needs to be shared (divisible pool of taxes).
Second, the cash States generate on their very own — referred to as States’ Own Tax Revenue (SOTR). Here, the priority is that avenues for unbiased income era are shrinking, and progress in SOTR stays sluggish particularly amongst many superior States, limiting their fiscal autonomy.
Third, the foundations governing how States can borrow have turn out to be one other flashpoint. States are topic to limits set by the Centre. Moreover, even borrowings made by a State’s entities — resembling public sector undertakings — are being counted as a part of the State’s debt, tightening the fiscal leash additional.
Problems in vertical devolution
As determined by the fifteenth FC, presently, 41% of the divisible pool of taxes is shared by the Centre with all of the States — that is referred to as vertical devolution. The divisible pool consists of all tax revenues collected by the Centre — excluding cesses, surcharges, and the price of assortment.
To illustrate, think about that the Centre collects ₹100 in complete. Of this, allow us to say ₹12 comes from cesses, ₹8 from surcharges, and ₹80 from numerous taxes and duties. If it prices ₹2 to gather these taxes, then ₹78 (i.e., ₹80 minus ₹2) kinds the divisible pool. From this quantity, 41% —about ₹32— is devolved to the States, whereas the remaining ₹46 and the ₹20 from cesses and surcharges is for the Centre to spend. The figures on this paragraph are meant solely to reveal how the idea works.
Over the previous yr, 14 out of the 15 States that met with the sixteenth FC demanded that the devolution share be elevated to 50% from 41%. This consists of BJP-ruled States resembling Odisha, Haryana, and Gujarat, in addition to southern States like Kerala and Tamil Nadu. So, this isn’t a south versus north debate.
Pinaki Chakraborty, a distinguished professor on the National Institute of Public Finance and Policy, says that the States usually are not incorrect in asking for additional funds.
M. Govinda Rao, member of the 14th FC, agrees and says that States are inside their rights to demand a better share. “During the 14th FC’s tenure, Gujarat with Narendra Modi as CM had demanded a 50% share within the divisible pool,” he added.
The present demand cuts throughout political and regional strains — and the reason being easy: states are being squeezed out of funds, some States greater than others. This squeeze is utilized in a number of methods. One outstanding instance is the rising share of income collected by means of cesses and surcharges, that are stored exterior the divisible pool — and due to this fact past the attain of States.
The rise within the share of cesses and surcharges began someplace after the 14th Finance Commission had elevated the vertical devolution for the years FY16 to FY20 to 42% from 34%. The Central authorities was not proud of this enhance. As revealed by Niti Aayog CEO B.V.R. Subrahmanyam throughout a seminar final yr, the Narendra Modi authorities had requested the Commission to not go forward with the transfer. But the then chairman Y.V. Reddy didn’t yield, a information report mentioned.
While the chairman didn’t yield, within the following years the share of cesses and surcharges started to rise sharply. The share of cesses and surcharges, together with the price of assortment, reached a excessive of ₹13.5 for each ₹100 collected as taxes by the Centre in 2021-22 — the very best ratio in no less than over a decade. Since then, it has regularly declined and is anticipated to be round ₹11 for 2025-26. In distinction, in a few years earlier than the pandemic, this determine ranged solely between ₹5 and ₹7.
GST compensation cess was not included within the checklist of cesses thought of for evaluation, because it was collected to compensate the States for income loss as a result of implementation of GST.
Given that the share of cesses and surcharges has elevated, the divisible pool has shrunk. Since the pandemic yr 2020-21, the divisible pool has fallen to lower than ₹90 for each ₹100 that the Centre collects. It is anticipated to stay beneath ₹90, in line with Budget Estimates for 2025-26. In distinction, in a few years earlier than the pandemic, this determine ranged between ₹91 and ₹95.
The constant rise within the share of cesses and surcharges has meant that the FC’s suggestions have been rendered much less efficient, because the divisible pool, upon which the FC’s method is utilized, itself is shrinking. Many specialists have beforehand identified that regardless of a method in place, in apply the precise devolution to the States falls in need of the agreed suggestions. This method, the 41% share seems to be unchanged on paper, however the precise quantity devolved to the States is successfully lowered by the Centre.
Dilution of the Finance Commission
Now, if the sixteenth Finance Commission recommends elevating the shareable portion to 50%, as many States have demanded, it stays to be seen whether or not the Centre will undertake an identical technique once more — by additional increasing the cess and surcharge part.
Article 271 empowers the Union authorities to levy cesses and surcharges. “This apply has been used to dilute the suggestions of the Finance Commission referring to the devolution of taxes,” Mr. Rao mentioned. In the previous, many commissions have adversely commented on it by saying that although there’s a constitutional provision to levy cesses and surcharges, it needs to be used to fulfill non permanent exigencies and shouldn’t be a everlasting measure, Mr. Rao added.
“States have additionally been demanding the Finance Commission to suggest a cap on the cesses and surcharges to a selected proportion of the gross tax income or alternatively take into account something above the cap as constituting part of the divisible pool. But that received’t be doable with out a constitutional modification,” Mr. Rao mentioned.
In reality, BJP-ruled Odisha’s memorandum earlier than the sixteenth Finance Commission is damning in its evaluation. “Overuse of cess and surcharges should be contained, and the Commission might take into account suggesting stricter assessments for the cess and surcharges to qualify for exclusion from the divisible pool, by means of a constitutional modification, if crucial,” mentioned the memorandum, in line with a media report.
Odisha additionally requested for a share from cesses and surcharges. While successive Finance Commissions have beneficial the inclusion of cesses and surcharges within the divisible pool and beneficial a constitutional modification to make this occur, it has not occurred up to now, Mr. Chakraborty noticed.
Inequalities in horizontal devolution
So far, now we have seemed on the points surrounding what the Centre owes to all of the States. But one other contentious level has been how that cash is distributed among the many States. In different phrases, how the 41% States’ share within the divisible pool was divided amongst them by the fifteenth FC. This distribution was based mostly on a number of standards — resembling inhabitants, demographic efficiency (i.e. inhabitants management), forest cowl, geographical space, and effectivity in tax assortment. However, the weightage assigned to those elements is the place disagreements surfaced.
The fifteenth FC gave the very best weight — 45% — to the ‘earnings distance’ criterion. This measures how far a State’s per capita earnings is from that of the richest State. In impact, States with decrease per capita earnings obtain a bigger share to advertise fairness.
This was adopted by 15% every for a State’s inhabitants and space — which means, the bigger the inhabitants and land space, the upper the share. Forest and ecology obtained 10%, based mostly on a State’s share of dense forests in India’s complete forest cowl.
Demographic efficiency — favouring States with higher inhabitants management — obtained 12.5%, whereas tax effort (how effectively a State collects taxes) was given simply 2.5%, the bottom weight.
Unsurprisingly, this method drew criticism, significantly from the southern States, which are likely to rank decrease on the primary three high-weightage elements — earnings distance, inhabitants, and space, which collectively accounted for 75% of the overall. These States excel in inhabitants management and tax effectivity, however these elements collectively carried solely 15% weight — a lot to their frustration.
In different phrases, if a State has efficiently managed its inhabitants and improved its financial system, it finally ends up receiving a decrease share — primarily disincentivising these States. In the previous too, FCs had related formulation due to which, the share of varied States within the divisible pool has undergone vital modifications since FY02. The share of all of the southern States has fallen. Kerala’s share fell from 3.08% in FY02 to 2.5% in FY17 and is estimated to fall even additional to 1.9% in FY26 (BE). Tamil Nadu’s share shrunk from 5.46% in FY02 to 4.02% in FY17 and is anticipated to stay on the similar stage in FY26. Karnataka’s has come down from 4.98% in FY02 to three.6% in FY26 BE. The share of Andhra Pradesh and Telangana collectively declined from 7.7% in FY02 to six.75% in FY17 and is anticipated to drop to six.1% in FY26. West Bengal and Odisha’s shares have additionally come down persistently within the interval. In distinction, the shares of Madhya Pradesh, Maharashtra, Rajasthan, and Gujarat have elevated on this interval.
States resembling Uttar Pradesh and Bihar proceed to obtain the majority of the share. Bihar is anticipated to get 10.1% in FY26, barely decrease than 11.49% in FY02; and Uttar Pradesh is anticipated to get 17.9% in FY26, barely decrease than 19.15% in FY02.
So, not solely is the divisible pool shrinking, however the share allotted to sure States — most of that are in southern India and components of the east — can be dwindling. This imbalance explains why many of those States now really feel shortchanged.
Telangana needs 50% weightage to Gross State Domestic Product as an alternative of the earnings standards. Similarly, Tamil Nadu has urged {that a} State’s contribution to the nation’s financial system be made a brand new criterion with a 15% weightage. Gujarat too needs a better weightage for the efficiency of the States. Goa needs sustainable growth objectives to be given 12.5% weightage, and, along with Kerala, it needs to scale back earnings distance weightage from 45% to 30%.
Own tax income dips
In the primary half, we mentioned how the Centre has intentionally lowered the divisible pool by more and more counting on cesses and surcharges and adversely impacting vertical devolution. We additionally examined how skewed weightages in horizontal devolution have led to a shrinking share of transfers for sure States. In the second half, we are going to discover how States are actually discovering it harder than ever to lift their tax and non-tax revenues.
For over a decade now, States’ tax income as a share of their complete income has remained significantly beneath the 50% mark, whereas within the 2000s and the early 2010s, it had crossed the 50% mark for a few years or remained near it. The personal tax income of States consists of cash raised by means of stamp responsibility, registration charges, motorized vehicle tax, and different taxes, together with the State GST (SGST).
Moreover, whereas SGST accounted for 15% of the States’ complete income in FY18, it presently makes up about 22%. Consequently, the share of personal tax income, with out the contribution from SGST, has declined from 34% to twenty-eight%.
It is essential to notice that the SGST is earned based mostly on charges set by the GST Council and these charges have remained a bone of competition. In the previous, Finance Ministers of many Opposition-ruled States, together with Tamil Nadu, Kerala, and West Bengal, have spoken out towards the Council’s selections.
So, on the one hand, the share of States’ personal tax income has declined, and on the opposite, the introduction of GST has restricted their autonomy in deciding how tax income is collected.
More importantly, the gathering of personal tax revenues relative to the scale of a State’s financial system exhibits a marked decline for six States particularly, notably, a few of them are economically superior States.
For Tamil Nadu, the personal tax income to GSDP ratio has regularly declined from 7.72% in FY13-15 to six.17% in FY 22-24. This has been the case in Karnataka, Kerala, Bihar, Delhi, and Madhya Pradesh, too. While the ratio has risen in Maharashtra, Manipur, Meghalaya, Odisha, and Uttarakhand, it has remained stagnant in different States.
“Sales tax was giving States the buoyancy, earlier than the GST was launched, by contributing nearly 60% of the tax revenues. Now until GST revenues turn out to be buoyant the States won’t have higher tax income to GSDP ratios. This is especially true of manufacturing States because the GST reform has made the consumption tax destination-based. It was hoped that the facility to levy tax on companies below GST would offset the loss from this variation, however in States like Karnataka, a lot of the worth added in companies is exported and due to this fact, zero-rated,” Mr. Rao mentioned.
Improving tax administration and enforcement, decreasing the variety of tax charges below GST and together with petroleum merchandise within the GST calculation can increase tax revenues for the States, Mr. Rao added.
There are related points on the non-tax income entrance too. The share of non-tax income in States’ complete income is more likely to go beneath the 24% mark in FY25 for the primary time prior to now 25 years. Non-tax income of States consists of grants from the Centre, earnings from social, fiscal, financial, and basic companies rendered by the States, curiosity receipts, and dividends/income from State public sector enterprises.
Interest receipts haven’t exceeded 5% of States’ non-tax revenues within the final decade in comparison with the 2000s and first half of 2010s when it fashioned 5-9% of non-tax income. Moreover, the share of dividends and income garnered from State public sector enterprises has remained below 1%.
Earnings from companies rendered, resembling public well being (social service) and energy (financial service), didn’t cross the 30% mark within the final decade. It is simply estimated to cross the mark in FY25. Compare this to the 2000s and the primary half of 2010 when it crossed the mark in a few years.
Put collectively, over the previous decade, as a share of States’ complete income, States’ personal tax income is trending down, non-tax income can be taking place, and which means, they’ve been relying an increasing number of on transfers and grants from the Centre.
Sample this, within the final decade (FY16 to FY25), 23-30% of the overall income of States was collected from the Centre as transfers. However, within the 2000s and the primary half of 2010, the share was decrease at 20-24%. Also, near 65-70% of the non-tax income of States was collected from the Centre as grants within the final decade in comparison with the 2000s and the primary half of the 2010s when the share was decrease at 55-65%.
When the primary and second components are learn collectively, a regarding development turns into evident. The Centre has been transferring progressively much less to the States. Despite this decline, the share of transfers from the Centre within the States’ complete income has truly elevated through the years. This highlights the rising monetary struggles confronted by the States in producing their very own income, resulting in elevated dependence on the Centre — sarcastically, at the same time as these central transfers are being lowered.
Limits on borrowing
With the States struggling to lift their very own income and the transfers from the Centre curtailed, borrowing stays a viable different. In the third and ultimate half, we are going to focus on how the States’ borrowing is curtailed by the Centre.
Constitutional provision Article 293 permits the Centre to set a Net Borrowing Ceiling (NBC) for the States. The ceiling is decided by the Centre based mostly on the Fiscal Responsibility and Budget Management Act and the Finance Commission suggestions. It permits States to borrow as much as 3% of their GSDP.
The Centre sees this restrict as a approach to obtain fiscal consolidation by minimising the fiscal deficit. States see it as their liberty to borrow being curtailed, and their avenues to steadiness their budgets being restricted.
“The FRBM Acts for every State is handed by that State setting the restrict. Of course, below Article 293 of the Constitution, the States can borrow domestically, but when they’re indebted to the Union authorities, they’ve to hunt the latter’s permission. This successfully signifies that the borrowing limits are set by the Union authorities,” Mr. Rao mentioned.
Notably, the Centre needs the off-budget borrowings accounted for within the State’s price range and the restrict be relevant on their ultimate debt place.
Off-Budget borrowings are loans obtained by authorities entities, resembling PSUs or particular objective automobiles, on behalf of the federal government to finance its expenditure. These borrowings are usually not included whereas computing the debt and the fiscal deficit of the State governments. However, the State authorities is chargeable for repaying the mortgage and servicing the debt from its Budget. But now States have to point out them of their books.
Kerala took the Centre to the Supreme Court in 2023 for putting a ‘monetary embargo’ on the State by imposing a restrict on its borrowings by means of the brand new borrowing ceiling (NBC) which is mounted at 3% of the GSDP. The apex courtroom refused to grant the State aid within the matter.
Mr. Chakraborty explains that the constitutional provision that locations restrictions on borrowing of the States is prudent for the reason that Centre has to make sure macroeconomic stability. He provides that having limitless borrowing on the sub-national stage isn’t an excellent thought.
“It isn’t a query of Centre vs States however of decreasing basic authorities debt. For an enchancment of the debt-to-GDP ratio of the General Government (Centre + States), the Centre has to do the heavy lifting by way of correction of debt ratio as 65% of the overall authorities debt is with the Centre and solely 35% is with the States, ” he mentioned.
While the Centre’s logic in proscribing the States could also be sound, the truth that it curtails one other avenue of elevating funds for the States can’t be refuted.
The massive squeeze
With States struggling to lift their very own funds, central transfers shrinking yr after yr, and borrowing limits firmly in place, the States are in the end being squeezed out of monetary house.
As the sixteenth Finance Commission prepares to make its suggestions for the five-year interval beginning April 2026, all eyes are on the course it would chart. An overwhelming majority of the States it has visited up to now have referred to as for a rise in vertical devolution, together with sweeping modifications to the factors used for horizontal devolution. The ball is now within the Commission’s courtroom.
What will probably be much more attention-grabbing, nonetheless, is the Centre’s response as soon as the suggestions are launched. Given the reactions that adopted the final vital enhance in vertical devolution, and with an identical proposal possible this time, India could possibly be heading into yet one more essential check of its already strained federal construction.
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