The Fiscal Tug of War, States’ Shrinking Space and the Quest for Equity in India’s Federal Compact

The Fiscal Tug of War, States’ Shrinking Space and the Quest for Equity in India’s Federal Compact

The intricate financial relationship between the Union (Central) government and the States forms the bedrock of Indian federalism. This relationship, mediated primarily through the constitutional body of the Finance Commission (FC), dictates how the colossal fiscal resources of the nation are shared, determining the capacity of state governments to fund healthcare, education, infrastructure, and social welfare. Recent trends, however, point to a growing tension: a palpable squeeze on the fiscal space available to states, threatening their autonomy and their ability to meet the aspirations of their people. As the recently constituted 16th Finance Commission begins its critical task of shaping the fiscal landscape for the latter half of this decade, it must navigate the complex legacy of its predecessors, address structural shifts in revenue collection, and craft a formula that ensures both equity and efficiency in India’s unique federal model.

The 14th Finance Commission: A High-Water Mark for State Autonomy

To understand the current concerns, one must first appreciate the landmark shift engineered by the 14th Finance Commission (2015-2020). In a bold move to enhance fiscal federalism, chaired by Dr. Y.V. Reddy, it raised the states’ share in the divisible pool of central taxes from 32% to a historic 42%. This was not merely a numerical increase; it was a philosophical commitment to cooperative federalism, trusting states with greater resources and flexibility. The data bears out its impact. During the 14th FC period, states’ share in central taxes relative to the combined revenue receipts of the Centre and states jumped to 19.2%, from 15% in the 13th FC period. Consequently, the post-transfer fiscal space of states—their own revenue plus all central transfers—expanded significantly from 63.85% to 68.08% of combined receipts. For a brief period, the balance of fiscal power seemed to tilt perceptibly towards the states, empowering them to tailor expenditures to local priorities.

The 15th Finance Commission and the Beginning of a Contraction

The subsequent 15th Finance Commission (2020-2026), chaired by N.K. Singh, operated in a radically different context: the bifurcation of Jammu & Kashmir into two Union Territories, the economic shock of the COVID-19 pandemic, and the nascent implementation of the Goods and Services Tax (GST). Its recommendations led to a subtle but significant reversal of the previous expansionary trend.

While the statutory devolution share was retained at 41% (a 1% adjustment was made to account for the new UTs), the effective outcome tells a different story. The states’ aggregate fiscal space (own revenue + total transfers) declined from 68.08% in the 14th FC period to 67.39%. This 0.70 percentage point contraction stemmed from two key areas:

1. A Decline in Tax Devolution: The share of tax devolution in combined revenue receipts fell by 1.05 percentage points.

2. Stagnant Own Revenues: States’ own revenue receipts also dipped slightly from 37.72% to 37.35%.

The decline in devolution was partially offset by an increase in grants, both FC-mandated and discretionary non-FC grants from the Centre. However, this shift is crucial. Grants, especially non-FC grants, are often tied to specific schemes or projects dictated by central priorities, reducing the unconditional fiscal autonomy that tax devolution provides. The states, therefore, gained marginally in total funds but potentially lost in discretionary spending power.

The Structural Headwinds: Cesses, Surcharges, and GST Uncertainties

Beyond the Finance Commission awards, deeper structural issues are constricting state revenues.

1. The Proliferation of Cesses and Surcharges: Perhaps the most significant critique of recent fiscal management is the Centre’s increasing reliance on cesses and surcharges. Unlike taxes, which are part of the divisible pool shared with states, these levies are entirely retained by the Centre. Over the years, levies like the Road and Infrastructure Cess, Health and Education Cess, and various surcharges on income tax have ballooned. This represents a backdoor reduction in the divisible pool, effectively undermining the spirit of the Finance Commission’s recommendations. When the Centre raises revenues via a cess rather than a tax, the states’ 41% share applies to a smaller base, directly eroding their entitled funds.

2. The GST Conundrum: The Goods and Services Tax, hailed as a transformative “one nation, one tax” reform, has introduced new vulnerabilities for state finances. States surrendered their sovereign taxation rights on goods and services for a guaranteed 14% annual growth in GST revenue until 2022, backed by a compensation cess. With the discontinuation of this compensation guarantee, states now face the full volatility of GST collections. Furthermore, recent reforms under the proposed “GST 2.0,” which aim for extensive rate rationalization and simplification, could lead to significant rate reductions. While beneficial for consumers and the economy, this could further pressure state GST revenues unless accompanied by a massive expansion of the tax base or an increase in the revenue-neutral rate. The uncertainty is acute for manufacturing and consumption-heavy states.

The Plight of the “High-Income” States: A Question of Incentives

The analysis by Rangarajan and Srivastava highlights a particular concern for five high-income states: Haryana, Karnataka, Kerala, Maharashtra, and Tamil Nadu. These states are the economic powerhouses of India, contributing disproportionately to the national tax kitty. However, the FC’s horizontal devolution formula heavily weights indicators like income distance (to favor poorer states) and population (as per the 2011 census, a point of contention for states that had successfully controlled population growth).

For these states, the 14th FC period already showed stagnation; increased transfers were offset by a relative fall in their own revenues. In the 15th FC period, their fiscal space actually contracted by 0.38 percentage points. This creates a perverse disincentive: states that are more efficient in economic generation and demographic management feel they are being penalized in resource allocation. They argue that the formula fails to adequately reward fiscal effort, demographic performance, or economic contribution, potentially dampening the very engines of national growth. Their demand for a greater weightage for criteria like tax effort and a freeze on the use of the 2011 census data is a central fault line in federal finance debates.

The Road Ahead: Imperatives for the 16th Finance Commission

The 16th Finance Commission, led by Chairman Arvind Panagariya, therefore steps into a fraught arena. Its mandate is extraordinarily complex, balancing competing demands in a post-pandemic economy with ambitious development goals.

1. Revisiting the Devolution Formula: The Commission must critically re-evaluate the weights assigned to different criteria in horizontal devolution. While the commitment to equity (through the income distance criterion) remains sacrosanct, there is a strong case for introducing or enhancing weights for performance-based incentives. This could include indicators for:
* Fiscal Efficiency: Revenue collection effort relative to potential.
* Human Development & Social Sector Outcomes: Quality of education, health, and nutrition.
* Ease of Doing Business & Infrastructure: Rewarding states that create growth-conducive environments.
* Demographic Management: Finding a balance between the 1971 and 2011 census data, or using a composite demographic indicator.

2. Curbing the Cess Culture: The Commission must make a strong, unambiguous recommendation to the Centre to limit the use of cesses and surcharges. It could propose a constitutional or legal cap on such levies as a percentage of total tax revenue, ensuring the integrity of the divisible pool. This is essential to restore trust in the federal bargain.

3. Providing GST Stability: With the compensation era over, the 16th FC must devise a mechanism to address the inherent volatility of GST revenues for states. This could involve recommending a permanent, calibrated GST stabilization fund or integrating GST revenue buoyancy into the devolution formula itself to protect states from systemic shocks.

4. Enhancing Own Revenue Capacity: Ultimately, sustainable fiscal space for states depends on their ability to generate their own resources. The Commission should recommend measures to strengthen the property tax base (a municipal function but critical for states), explore rationalization of stamp duties, and suggest ways to improve the efficiency of state excise on alcohol. It should also encourage the Centre and states to work collaboratively on expanding the GST base to include petroleum, real estate, and electricity.

Conclusion: For a Balanced and Dynamic Federalism

The quest for fiscal space is not a zero-sum game between the Centre and the states, nor between prosperous and less prosperous states. A strong Union needs financially robust states as partners in development. Conversely, states require a predictable, fair, and buoyant share of national resources to fulfill their constitutional obligations.

The 16th Finance Commission’s report will be more than a dry fiscal document; it will be a statement of India’s federal philosophy for the coming era. It must craft a solution that acknowledges the legitimate concerns of contributor states while unflinchingly addressing regional disparities. It must safeguard states’ autonomy by championing unconditional tax devolution over tied grants. And it must firmly address the structural loopholes, like proliferating cesses, that undermine the federal compact.

As Dr. C. Rangarajan and Dr. D.K. Srivastava note, both tiers of government need larger resources to meet India’s multifaceted challenges. This can only be achieved through a combination of robust economic growth, improved tax administration, and a fair, transparent, and incentive-compatible system of fiscal transfers. The hope is that the 16th Finance Commission will deliver a award that strengthens the foundations of Indian federalism, ensuring that “cooperative federalism” evolves into “productive federalism,” where every state is empowered to contribute to and benefit from the Indian growth story.

Q&A: Deepening the Understanding of India’s Fiscal Federalism

Q1: What is the core difference between tax devolution and grants, and why does this distinction matter for state autonomy?

A1: Tax devolution refers to the statutory, formula-based sharing of the Central government’s tax revenue (like income tax, corporation tax, GST) with states, as mandated by the Finance Commission. This money comes to states as an unconditional transfer; they can spend it according to their own priorities and needs. Grants, on the other hand, are specific-sum transfers. Finance Commission grants are typically for broad sectors (like local body grants or disaster relief) but still have defined purposes. Non-FC grants are entirely at the Centre’s discretion, often tied to specific Centrally Sponsored Schemes (CSS). The distinction matters profoundly for autonomy. Higher tax devolution empowers states with flexibility and aligns with the principle of subsidiarity (decisions made closest to the people). A shift towards grants, especially tied grants, centralizes decision-making, imposing the Centre’s priorities on states, which may not align with local contexts, thus squeezing their effective fiscal space.

Q2: Why are high-income states like Tamil Nadu and Karnataka dissatisfied with the current devolution formula, despite the overall increase in the states’ share post-14th FC?

A2: High-income states’ dissatisfaction stems from the horizontal distribution formula used after the total share for all states (e.g., 41%) is determined. This formula heavily prioritizes equity over efficiency or contribution. Key criteria include:

• Income Distance: Rewards states with lower per capita income (a larger share goes to poorer states).

• Population (2011 Census): Penalizes states that have controlled population growth, as their share is based on a higher historical population.

• Area & Forest Cover: Rewards states with challenging terrain.
  These states argue that while equity is vital, the formula fails to adequately account for:

• Tax Effort: The revenue they generate for the national pool.

• Demographic Performance: Their success in lowering fertility rates.

• Economic Contribution: Their outsized role in driving national GDP, industrial output, and services.
  They perceive this as a “penalty for success,” where their higher tax contributions are disproportionately redistributed, leaving them with less per capita resources to address the infrastructure and social needs of their own dense, urbanized populations.

Q3: How does the proliferation of cesses and surcharges by the Central government effectively bypass the Finance Commission’s recommendations?

A3: The Finance Commission determines the percentage share (like 41%) of the divisible pool of central taxes. Cesses and surcharges, by legal definition, are not part of this pool; they are levied for a specific purpose and remain entirely with the Centre. When the Centre faces a revenue need, it has an incentive to impose a new cess (e.g., Health and Education Cess) or increase a surcharge (e.g., on super-rich income) rather than raising basic tax rates (like income tax slabs). This action increases the Centre’s total tax revenue without increasing the divisible pool. As a result, the states’ fixed percentage is applied to a relatively smaller base of total central taxes. It is a legal yet contentious fiscal tool that diminishes the real value of the FC’s devolution award, contravening the spirit of cooperative federalism.

Q4: What are the major fiscal risks for states following the end of the GST compensation guarantee in 2022, and what solutions can the 16th FC propose?

A4: The end of the 14% guaranteed annual GST revenue growth compensation has exposed states to several risks:

• Revenue Volatility: GST collections are susceptible to economic cycles, making state budgets less predictable.

• Rate Rationalization (“GST 2.0”): The drive to simplify GST by merging slabs and reducing rates on many items could lead to a permanent reduction in revenue yield unless compensated by a massive base expansion.

• Lack of Fiscal Buffer: States no longer have an automatic safety net for shortfalls.
  Potential solutions the 16th FC could recommend include:

• A Permanent GST Stabilization Fund: A centrally managed fund, financed by a portion of GST collections or central revenues, to bridge shortfalls for states during economic downturns.

• Buoyancy-Based Triggers: Integrating GST revenue buoyancy (growth relative to GDP) into the devolution formula, providing higher transfers if GST underperforms relative to national growth.

• Strengthening the Council: Recommending a more robust, data-driven mechanism within the GST Council itself for addressing persistent revenue gaps for states.

Q5: Beyond tax devolution, what are key avenues for states to enhance their own source revenue, as suggested in the article?

A5: To reduce dependency on central transfers and build resilient fiscal space, states must focus on:

• Property Tax Reform: This is the most significant untapped potential. Modernizing municipal cadasters, using GIS-based mapping, and adopting market-value-based assessment can dramatically increase revenues for urban local bodies, indirectly relieving state budgets.

• Rationalizing State Excise: Alcohol is a major revenue source. Moving from a volumetric-based levy to an ad-valorem (value-based) system and improving compliance can enhance yields.

• Improving Stamp Duty and Registration Fees: Simplifying processes, reducing discretion, and aligning circle rates with market prices can curb evasion.

• User Charges for Services: Rationalizing charges for water, power, and transportation to reflect costs, while protecting the vulnerable through targeted subsidies, can improve fiscal health.

• Broadening the GST Base: Pressing within the GST Council to include high-revenue items like petroleum products, electricity, and real estate would create a larger, more buoyant common pool from which all states benefit, reducing volatility.