Fiscal Federalism and State Finances in India (UPSC Economy)

India's Constitution creates a Union of States with an asymmetric fiscal architecture — the Union has the larger revenue handles, states have the larger expenditure responsibilities. Fiscal federalism is the set of rules and institutions — Articles 268-293, the Finance Commission, GST Council, FRBM Acts — that share this mismatch. Since the GST rollout in 2017, tensions over state fiscal autonomy, cesses, borrowing limits and centrally sponsored schemes have sharpened. This guide maps those tensions and the reform agenda now before the 16th Finance Commission.

Background: The Architecture

• Article 246 + Seventh Schedule — Union, State and Concurrent Lists.
• Articles 268-281 — tax distribution, grants-in-aid, Finance Commission.
• Article 280 — Finance Commission, constituted every five years.
• Article 293 — state borrowing requires Union consent if the state is indebted to the Union.
• Article 279A — GST Council (added by 101st Amendment).
• FRBM Acts (Union 2003; each state has its own) — fiscal deficit ceilings.

Vertical and Horizontal Imbalances

• Vertical imbalance: states collect about 37-40% of total government revenue but spend around 58-60% of total government expenditure. The gap is closed via tax devolution and grants-in-aid based on Finance Commission recommendations.
• Horizontal imbalance: per-capita incomes and tax bases vary enormously across states — the Finance Commission formula weights population, area, forest cover, demographic performance, income distance, and tax effort.

Erosion of Fiscal Autonomy Under GST

GST was a landmark reform for a single national market, but it also reshaped the vertical balance of power.

• States surrendered the power to levy many taxes — state sales tax, octroi, entertainment tax, entry tax, luxury tax.
• State governments cannot change GST rates unilaterally — any change requires a GST Council decision (3/4 weighted vote; Centre has 1/3, states jointly 2/3).
• Manufacturing states lost revenue as GST is destination-based.
• Share of own tax revenue in total state revenue fell from around 69% in 1955-56 to about 45% in 2019-20 (and even lower in specific years).
• Delay in GST compensation payments during 2020-22 strained state treasuries.
• GST compensation cess was initially for 5 years (till June 2022), extended only for repaying back-to-back loans.

Cesses, Surcharges and the Shrinking Divisible Pool

Cesses and surcharges are levied by the Centre but not shared with states. Their share in gross tax revenue has risen sharply — from around 10% a decade ago to nearly 20% recently. This means the effective share of states in Union taxes is well below the 41% headline figure recommended by the 15th Finance Commission.

Borrowing Constraints on States

• Under Article 293(3), states with outstanding loans from the Union must seek Centre's consent before borrowing.
• Under COVID-19, states were allowed additional borrowing of 2% of GSDP, tied to reforms — one nation one ration card, ease of doing business, DISCOM reforms, urban body reforms.
• States argue that conditionalities restrict their policy space, especially on social spending.
• Off-budget borrowing by state PSUs is now counted toward state FRBM limits, further tightening the envelope.

Centrally Sponsored Schemes (CSS) and Operational Autonomy

• CSS account for a large share of development expenditure in states but often come with tight central design and matching-funding requirements.
• National Development Council and Sub-group of Chief Ministers (2015) recommended rationalisation; 28 umbrella schemes now, but flexibility is uneven.
• States complain of limited ability to adapt CSS to local priorities.

Present Weaknesses in State Finances

• Revenue deficit states continue to rely on grants.
• Power sector dues and unfunded pension liabilities (post Old Pension Scheme restorations in some states) pose long-term risks.
• Debt-to-GSDP ratio crossed 31% for the states combined by FY 2023-24, above the 20% FRBM anchor for states.
• Heavy reliance on non-tax revenue from stamp duty and state excise (alcohol).

Steps to Strengthen Fiscal Federalism

• Flexible crisis taxation — states should be able to levy temporary cess during disasters, as Kerala did with a 1% calamity cess post-floods (approved by GST Council).
• Flexible FRBM limits for fiscally prudent states that have kept debt sustainable.
• Cap on cesses and surcharges — either bring them into the divisible pool after a threshold, or sunset them.
• Simplify CSS — fewer schemes, larger untied pools, flexi-funds.
• Strengthen GST Council consensus — dispute resolution mechanism; structured voting protocols.
• Revive Inter-State Council under Article 263 for broader federal dialogue.
• Fiscal Council proposed by 14th and 15th FC — independent body to monitor fiscal performance of Centre and states.

Latest Developments (2024-26)

• 16th Finance Commission (Chair: Arvind Panagariya) constituted; award period 2026-2031. Terms of reference include vertical devolution share, horizontal formula, disaster management financing, and grants to local bodies.
• Budget 2025-26 continued 50-year interest-free special assistance to states for capex at Rs 1.5 lakh crore, with stronger reform linkages (urban reforms, land digitisation, DISCOM reforms).
• GST Council decisions (2024-25) on rate rationalisation: movement toward a three-slab structure under review; GST on online gaming, real money gaming settled at 28% on face value.
• GST 2.0 / rate rationalisation proposals before the Group of Ministers for slab merger (12% and 18%).
• State debt-to-GSDP projected to moderate to around 28-29% by FY 2025-26 in RBI's State Finances Report.
• Compensation cess being reviewed as its original mandate ended; Council deliberating structural change into a new cess for specific sectors.
• Unified Pension Scheme (UPS) notified in 2024, replacing NPS for central government employees from April 2025; several states weighing adoption.

UPSC Relevance

GS-III Mapping

• Government Budgeting and fiscal policy.
• Indian Economy — Union-state financial relations, debt sustainability.
• Role of Finance Commission and GST Council.

GS-II Mapping

• Federalism — Centre-State relations, cooperative and competitive federalism.

Prelims Bullets

• Article 280 — Finance Commission; Article 279A — GST Council.
• 16th Finance Commission — Chair Arvind Panagariya, award period 2026-31.
• 15th FC recommended 41% vertical devolution to states.
• Cess and surcharge are not shared with states.
• GST Council — 3/4 weighted vote, Centre 1/3, states 2/3 combined.
• Article 293(3) — state borrowing needs Union consent if indebted to Union.
• Kerala Flood Cess — 1% calamity cess on GST, first of its kind.
• Fiscal Council — recommended by 14th/15th FC; not yet operationalised.

Mains Angles

• “The rising share of cesses and surcharges has hollowed out cooperative fiscal federalism in India.” Examine.
• "The 16th Finance Commission has the opportunity to rebalance Union-State finances post-GST. What principles should guide its recommendations?"