Evolving Fiscal Space of Indian States

Evolving Fiscal Space of Indian States: An Erosion of Autonomy?

The sharp decline in states' fiscal space over the past decade reveals systemic fault lines in India’s fiscal federal architecture. While the 14th Finance Commission (FC) heralded a brief era of states' enhanced autonomy, subsequent developments—particularly the growing reliance on cesses and surcharges and the limitations of GST—underscore a deeper tension in vertical and horizontal devolution. The evolving fiscal structure tilts increasingly in favour of the Centre, undermining cooperative federalism and the core constitutional principle of decentralised governance.

The Institutional Landscape: Shifting Roles and Powers

India’s fiscal federalism operates under a constitutional framework outlined primarily in the Seventh Schedule, where Article 246 bifurcates taxation powers between Union and State Lists, while excluding taxation from the Concurrent List. The GST regime, introduced via the 101st Constitutional Amendment and Article 246A, fundamentally altered states' financial autonomy. By subsuming indirect taxes—VAT, entry tax, service tax—states relinquished direct control over vital revenue streams, with the promise of compensation and an equitable fiscal sharing framework.

The role of Finance Commissions, especially the 14th and 15th FCs, must be dissected. The 14th FC increased states’ share in central taxes to 42%, upending the prior Planning Commission-driven resource allocation model. However, with time, this devolved share has faced erosion due to rising non-divisible cesses and surcharges and stagnating rates of horizontal devolution. By the 15th FC period, the states' aggregate revenue share dropped to 67.39% from 68.08% under the 14th FC—a subtle but concerning decline.

Making the Case: Erosion of Fiscal Space

The increasing reliance on cesses and surcharges is the most palpable culprit in the erosion of fiscal autonomy. Article 270 excludes these instruments from the divisible pool of taxes, allowing the Centre to retain entire proceeds. By 2023, data from the Comptroller and Auditor General (CAG) highlighted that cesses and surcharges constituted nearly 12% of gross tax revenue—up from 8% a decade earlier. This diversion directly shrinks the states' revenue base.

The horizontal devolution formula compounds the problem. While equity considerations—based on income distance, population, and fiscal discipline—are constitutionally mandated, high-income states, including Maharashtra, Tamil Nadu, and Karnataka, argue that the weightage given to equity disproportionately penalises them. Between the 14th and 15th FCs, their fiscal space declined by 0.38 percentage points, as NSSO reports reveal stagnation in their overall revenue shares despite robust economic growth.

GST reforms further aggravate states' woes. Rajasthan and Chhattisgarh Ministries noted in 2024 that the cessation of GST compensation cess after five years—a mechanism promised to offset initial losses—has left many states scrambling to mobilise revenue. The so-called "GST 2.0", with rate reductions in 2022 aimed at boosting consumption, has paradoxically reduced the tax buoyancy states once relied on.

Countering the Narrative: Equity and National Vision

The Centre often defends its position by invoking equity and national developmental imperatives. The argument hinges on redistribution—the idea that lower-income states such as Bihar or Uttar Pradesh require greater fiscal support to reduce regional disparities. Critics also highlight that states' own revenue mobilisation remains insufficient, with MASA (Monthly Average State Accounts) data showing stagnation in property tax collections and excise duties despite rising local consumption.

While these points are valid, they fail to address the structural inequities introduced by the Centre's fiscal behaviour. The increasing dominance of non-sharable instruments displaces equitable redistribution goals, creating dependency without solving capacity deficits. Redistribution cannot justify diminishing autonomy.

International Comparisons: Lessons from Germany

Germany’s fiscal federalism offers instructive contrasts. The German Basic Law (Grundgesetz) ensures robust financial autonomy for state (Länder) governments through independent taxation systems, including control over property and inheritance taxes. Additionally, Germany operates an explicit equalisation scheme (Länderfinanzausgleich) where wealthier states contribute to the fiscal pool, but the federal government’s contribution is mandated to match state transfers. Unlike India, no parallel equivalent to cesses disrupts the divisible pool, preserving cooperative federalism while addressing disparities.

Assessment: A Way Forward

India’s fiscal federalism must undergo reforms to restore balance. First, the Centre must address the disproportionate reliance on non-sharable cesses and surcharges. A cap on these instruments or an amendment to Article 270 could ensure greater fiscal trust. Second, horizontal devolution formulas need recalibration. The ‘distance criterion’ must consider high-income states’ developmental expenditures rather than penalising their fiscal efficiency.

The 16th Finance Commission has a pivotal role in implementing these changes. Beyond formulaic devolution, the Commission must institutionalise mechanisms to strengthen states’ own revenue-generation capacities, such as tax buoyancy initiatives tied to GST compliance. Cooperative federalism must exist not as rhetoric but as policymaking grounded in equity and autonomy.

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