[Answered] Analyze how the expansion of cesses and surcharges outside the divisible pool has driven States toward increased market borrowings. Evaluate the implications of this shift from ‘devolution to debt’ for India’s fiscal federalism and the financial stability of States.

Introduction

Despite constitutionally mandated tax devolution, rising reliance on cesses and surcharges has weakened States’ fiscal stability, pushing them toward debt-led financing, as highlighted by Finance Commission reports and post-GST revenue trends.

From Fiscal Devolution to Fiscal Dependence: The Changing Federal Equation

1. Erosion of the Divisible Pool: Articles 270 and 271 of the Constitution envisage shared taxation as the backbone of fiscal federalism. However, the Union’s growing dependence on cesses and surcharges — non-shareable levies — has reduced effective devolution to States. While the 15th Finance Commission fixed States’ share at 41%, RBI and PRS Legislative Research estimates suggest actual transfers hover near 30–31%.
2. GST and Vertical Imbalance: Post-GST (2017), indirect taxes with high buoyancy are centrally collected and redistributed through formula-based transfers, weakening the fiscal link between State tax effort and reward, especially for industrialised States like Tamil Nadu and Maharashtra.

Rise of State Development Loans (SDLs): Debt as Shock Absorber

1. Borrowing for Revenue Expenditure: With devolution losing its counter-cyclical role, States increasingly rely on State Development Loans (SDLs) even for routine expenditures such as pensions, salaries and health insurance schemes. In 2024–25, SDLs formed 35% of Tamil Nadu’s and 26% of Maharashtra’s revenue receipts — levels once considered fiscally unsustainable.
2. Post-COVID Structural Shift: The COVID-19 shock (2020–21) marked a turning point when Central transfers proved inadequate. This debt-dependence persisted even during recovery, indicating a structural fiscal squeeze rather than a temporary crisis response.

The ‘Cess and Surcharge Trap’: Constitutional and Economic Implications

1. Parallel Budgeting by the Centre: By 2025–26, cesses and surcharges account for nearly 15–18% of Gross Tax Revenue, creating a “parallel budget” beyond Finance Commission oversight (Article 280). This dilutes cooperative federalism and sidelines States from national tax buoyancy.
2. Conditional Autonomy via CSS: Most cess-funded expenditures flow through Centrally Sponsored Schemes (CSS), compelling States to align spending with Union priorities rather than State-specific developmental needs — undermining fiscal autonomy.

Macroeconomic and Federal Consequences

1. Rising Debt-to-GSDP Ratios: States like Punjab, West Bengal and Himachal Pradesh now face debt-to-GSDP ratios exceeding 35–40% (RBI, 2024). SDL yields remaining above 7% raise interest burdens, crowding out public capital expenditure.
2. Pro-cyclical Fiscal Stress: As noted by the FRBM Review Committee (NK Singh), when transfers fall during downturns but interest obligations remain fixed, States risk entering a primary deficit trap, borrowing merely to service past debt.
3. Weakening the Finance Commission: If revenue growth bypasses the divisible pool, the Finance Commission’s constitutional role in correcting vertical and horizontal imbalances is effectively hollowed out.

Way Forward: Restoring Devolution as the Stabiliser

1. Inclusive Divisible Pool: Long-standing cesses (fuel, health, education) should be progressively merged into the divisible pool, as advocated by multiple State governments and former RBI Governors.
2. Capping Non-shareable Levies: Legislating an upper cap on cesses and surcharges (e.g., 10% of GTR) would prevent fiscal centralisation by stealth.
3. Rewarding Tax Effort: Reworking horizontal devolution criteria to give greater weight to tax effort, efficiency and compliance can restore fiscal incentives for States.

Conclusion

Strong States make a strong Union. Sustainable growth demands devolution-led stability, not debt-led survival, within India’s constitutional fiscal architecture.