States Must Fix Their Own Economies and Address Structural Issues

States Must Fix Their Own Economies: The Imperative of Structural Reforms Amid Fiscal Dependency

The rising fiscal dependency of states on Union transfers highlights a deep-rooted structural imbalance that jeopardizes the principles of India’s federalism. While Crisil's projection of 7–9% revenue growth for FY26 presents an optimistic narrative, this growth masks troubling trends: soaring debt burdens, erosion of fiscal autonomy, and underinvestment in critical sectors. The obsession with fiscal discipline, reflected in states’ adherence to the FRBM Act's deficit targets, has come at the cost of substantive development and investment. India’s fiscal federal architecture stands at a precipice, requiring urgent recalibration.

The Anatomy of Fiscal Imbalance: An Institutional Dysfunction

The fiscal architecture of states remains precarious, as revealed by Crisil and PRS Legislative Research data. The systemic reliance on Union transfers, constituting 42% of states' revenues, reveals an unhealthy dependency. Compounding this is the surging share of cesses and surcharges raised by the Union — from 10% of gross tax revenue in 2011-12 to over 25% by 2024 — which are not shared with the states. This proliferation of non-shared revenues exacerbates the vertical fiscal imbalance, undermining equitable resource allocation.

Even states' ‘own revenue’, comprising own tax revenue (OTR) and own non-tax revenue (ONTR), offers little room for optimism. This category forms only 58% of total state revenue receipts, demonstrating stagnation in traditional revenue streams such as property taxes, stamp duties, and GST compliance. Following the expiry of the GST compensation cess in 2022, several states—especially poorer ones—have struggled to meet revenue expectations, underscoring a decline in indirect tax autonomy and fiscal sustainability.

Debt Sustainability: Clouds Over Fiscal Health

States’ debt-to-GSDP levels are soaring, standing at an average of 28.5% in 2023–24, far above the FRBM target of 20%. Alarmingly, 12 states breached the 35% debt-GSDP threshold, raising concerns about fiscal sustainability. While gross fiscal deficit levels (2.7% of GDP) show adherence to FRBM mandates, this tight fiscal control risks crippling states' ability to invest in growth-promoting sectors like health, education, and infrastructure. The Ministry of Finance often touts fiscal discipline as an achievement, but NSSO data on public health spending (which remains abysmally low at 1.3% of GDP) paints a starkly different picture of the consequences of scrimping expenditures.

Implementation and Structural Failures: The Root Causes

Several structural deficiencies are evident. Property tax collections remain inefficient, plagued by outdated land records and lack of enforcement. GST compliance—despite being heavily technology-driven—faces loopholes like invoice matching failures and tax evasion. States’ revenue growth (projected at 7-9% in FY26) remains below the decade-long average of 10%, reflective of stagnating petroleum tax revenues and underutilized local tax options. The National Green Tribunal’s rulings on municipal waste management charges have also been routinely ignored by urban local bodies, weakening state-level ONTR collections.

The long-term effects of delayed and unpredictable Union transfers, including Finance Commission (FC) grants and GST compensation, have compounded these structural inefficiencies. For instance, arbitrary reductions in FC-recommended grants disproportionately affect poorer states, deepening regional inequalities and impeding fiscal planning.

Countering the Argument for Devolution Alone

The strongest argument against the thesis of state accountability is the historical imbalance in resource distribution under India’s quasi-unitary federal model. Wealthier states such as Maharashtra and Gujarat routinely express concern over what they term “reverse subsidies” provided under Central redistribution mechanisms. Such tensions are valid in part—how can states fix their economies when even baseline funding is unequal?

However, this argument overlooks institutional reforms that states themselves must undertake — reforms in GST collections, digitization of property tax systems, and fraud detection mechanisms for excise duty collections. The narrative that Central redistribution alone constrains states ignores the fact that richer states have underutilized their ONTR capacities while relying excessively on Union transfers.

Lessons from Germany: Cooperative Federalism Done Right

Germany’s fiscal federalism offers a sharp contrast to India’s imbalances. The German model operates under the principle of “cooperative federalism,” allocating revenue streams predictably and transparently between states and municipalities. Unlike India, where cesses and surcharges have burgeoned unchecked, Germany enforces rigorous caps on federal-level levies. Länder governments enjoy substantial autonomy over income tax administration and local infrastructure spending due to constitutional provisions like Article 107 of the German Basic Law, which mandates equitable sharing frameworks. What India calls cooperative federalism often devolves into top-down mandates riddled with arbitrary grants—a flaw Germany avoids through structured constitutional guarantees.

Assessment: Rebuilding State Economies, One Reform at a Time

India’s states must break away from the dual traps of fiscal dependency and underutilization of their own revenue-generating capacities. Modernization of tax systems—leveraging AI, analytics, and blockchain for invoicing—should move from pilot initiatives to actionable policies. ONTR, often relegated to secondary importance, must be revitalized with multilayered reforms in property tax enforcement and urban tax collection mechanisms.

The Union government must act responsibly, capping surcharges and cesses and allocating predictable transfers as per Finance Commission recommendations. States must demand—not meekly accept—greater autonomy under cooperative federalism’s principles. Only then can the long-term economic sustainability of India’s federal structure be realized.

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