Centre–State Fiscal Relations in a Changing Fiscal Landscape

The Missing 28%: Why States Are Demanding a Restructure of Fiscal Relations

In 2026, 28% of the Union government’s total tax revenues are not shared with states. This isn’t an allegation—it’s data. These revenues, accrued through cesses and surcharges, are fully retained by the Centre and fall outside the divisible tax pool that states rely upon for their constitutionally mandated responsibilities. The implications are stark. While the Finance Ministry touts a 41% devolution to states under the 15th Finance Commission’s recommendations, the reality is that the effective shareable revenue pool is shrinking due to discretionary fiscal instruments that sidestep constitutional mandates.

The Structural Shift in Centre-State Fiscal Equations

The 15th Finance Commission’s recommendation of 41% vertical devolution—the same ratio as its predecessor—was intended to signal continuity in a federal framework where states are heavily dependent on central transfers. But the trend of the Centre increasingly relying on cesses and surcharges is tilting the fiscal scales further in its direction. For instance, between 2014-15 and 2021-22, the Centre’s collection from cesses and surcharges jumped from ₹1.5 lakh crore to ₹4.3 lakh crore, a nearly threefold increase. None of this amount is shared with states under the current framework.

Historically, India’s tax devolution system sought to address both vertical imbalances—where Centre collects most revenues but states undertake the larger share of developmental spending—and horizontal imbalances among states with divergent levels of development. However, today's landscape tells a different story. Article 280 of the Constitution, which governs the role of the Finance Commission, remains technically intact, but the growing weight of non-shareable instruments like cesses raises difficult questions about the erosion of its intended purpose to equitably share fiscal resources.

The Machinery of Tax Devolution: Centre's Command and State Discontent

Under Articles 268 to 272 of the Constitution, revenues are meant to be shared between the Union and states in a structured manner, with the Finance Commission serving as the linchpin of this arrangement. The horizontal distribution formula proposed by the 15th Finance Commission—factors like population (15%) and income distance (45%)—appeared balanced on paper but sparked significant criticism from larger states such as Tamil Nadu and Kerala that deemed it unfairly weighted against their fiscal performance and demographic transitions.

The bigger concern, however, lies in the opaque nature of cesses and surcharges, which have no constitutional obligation to be shared. These are levied for specific purposes—such as the health and education cess—but states argue that the mechanism increasingly functions as a loophole to expand central revenues outside the divisible pool. Worse still, these funds often remain underutilized. For example, a CAG report in 2023 revealed that up to 40% of education cess collections from 2020 remained unspent, raising questions of efficiency and accountability in resource use.

Fiscal Reality vs. Promises

While the government claims unfettered compliance with the Finance Commission’s recommendations, the rhetorical emphasis on “41% devolution” obscures the broader fiscal dynamics. In truth, the divisible pool of central revenues has systematically narrowed in scope. The divisible pool now effectively excludes a growing slice of total tax revenues, which reduces the real share of funds reaching states. The GST framework, implemented in 2017, further compounded state dependency on central transfers, as it subsumed multiple state-level taxes under central control.

This design problem is amplified when we factor in state responsibilities. States are tasked with implementing critical welfare schemes—such as PDS, healthcare, and policing—that require stable fiscal support. But the Centre’s dominion over high-yield revenue sources like corporate tax and GST limits their financial autonomy. As per RBI data (2023-24), states’ own-tax revenues accounted for under 40% of their total revenues, down from 46% a decade ago. Simultaneously, mounting debt burdens (states’ average debt-to-GSDP ratio stood at 31% in 2024) point to deep structural constraints.

What India Can Learn From Australia

Australia’s system of federal fiscal transfers, regulated by its Commonwealth Grants Commission (CGC), offers an interesting point of contrast. Unlike India’s Finance Commission, the CGC operates as a standing body that reviews fiscal transfers annually, allowing for adjustments to account for dynamic economic needs. Most notably, Australia's GST pool—a major component of its vertical devolution—is fully distributed among states without exclusion of any specific levy. This creates a more predictable and transparent mechanism for fiscal equalization. India’s ad hoc use of cesses and surcharges, by comparison, encourages opacity and undermines cooperative federalism.

The Bigger Question of Political Economy

The rising centralization of fiscal power is not merely a matter of policy design but also of political strategy. By controlling the purse strings, the Centre gains leverage over state governments, particularly those led by opposition parties. While central schemes like PM-Kisan or Ayushman Bharat bolster the Centre’s visibility, states are left to implement these schemes under fixed cost-sharing arrangements, further straining their finances. The risks of state-level fiscal instability are real—as seen in Bihar, Punjab, and Rajasthan, where delayed GST compensation payments in 2021 precipitated budget shortfalls.

Additionally, the appointment process of Finance Commission members, done entirely at the discretion of the President (read: central government), limits the institution’s operational independence. Enhancing its autonomy—akin to election commissions in certain democracies—would help foster trust in its recommendations. However, such reform would involve a deep restructuring of the institutional framework, which the Centre is unlikely to voluntarily prioritize.

Conclusion: Redesigning Fiscal Relations in a Federal Democracy

The upcoming 16th Finance Commission has its work cut out. Its terms of reference must address the fundamental tension between an expanding pie of cesses and a contracting divisible pool. Meanwhile, the rationalization of GST rates, greater state-level flexibility in taxation, and better fiscal accountability for centrally controlled levies should become key focal areas. Genuine cooperative federalism hinges not just on periodic devolution ratios but on correcting the power imbalances that these structural distortions perpetuate. Without this recalibration, states may remain perpetually hamstrung in fulfilling their constitutional mandates.

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