[Answered] Examine the necessity of protecting the fiscal space of States to meet multiple challenges. Justify the need for increasing tax receipts for both the Union and State governments.

Introduction

India’s States undertake nearly 60% of public expenditure, including health, education and infrastructure, yet their fiscal space has declined in recent Finance Commission cycles, necessitating strengthened transfers and enhanced tax revenues for national development.

Why Protecting States’ Fiscal Space Is Crucial

1. States are Primary Providers of Public Services: States finance 85% of law and order, 80% of health, and 70% of education services (RBI State Finances Report). Flagship outcomes—learning levels, NCD control, skilling—depend heavily on adequate State resources.
2. Growing Responsibilities Amid Shrinking Revenues: Despite the 14th Finance Commission raising tax devolution from 32% to 42%, States’ actual fiscal space fell during the 15th FC period: States’ revenue share dipped from 68.08% (14th FC) to 67.39% (15th FC). Decline resulted from: Rising cesses and surcharges, which are non-divisible under Article 270. Reduced states’ own revenue, especially post-GST compensation cess withdrawal in 2022. High-income States (Tamil Nadu, Karnataka, Kerala, Maharashtra, Haryana) saw a decline of 0.38 percentage points in fiscal space.
3. Federal Balance and Cooperative Federalism: Squeezing State finances disrupts the constitutional vision of a Union of States (Article 1). Over-centralised schemes, conditional grants, and discretionary transfers undermine fiscal autonomy.
4. Meeting New Developmental Challenges: To address multidimensional issues, States need stable finances: Climate adaptation and disaster management (example: Kerala floods, Himachal landslides). Social sector stress post-pandemic. Urbanisation pressures—Indian cities need USD 840 billion by 2036 (World Bank). Infrastructure under PM-Gati Shakti framework, requiring State-level logistics reforms. Without fiscal space, States cannot deliver on SDGs, NIP projects, or public welfare.

Why Both Union and States Need Higher Tax Receipts

(a) Revenue–Expenditure Gap Widening Across Levels: India’s tax-to-GDP ratio remains around 11–12%, far below OECD average of 34%. States’ tax capacity is constrained post-GST, with 70% of indirect tax base centralised.

(b) Meeting National Commitments: Both levels require enhanced taxes for: Defence modernisation (Union Budget’s capital outlay rising steadily).  Green transitions, energy storage, and COP30 commitments. Social protection for 800 million people (NFSA, PMGKAY). Infrastructure: India needs USD 1.4 trillion under National Infrastructure Pipeline (NIP).

(c) Need for Predictable and Equitable Transfers: 16th FC must re-evaluate horizontal devolution formula, especially “distance criterion,” to protect high-performing States. The Centre must reduce reliance on cesses/surcharges and expand the divisible pool. Strengthening GST 2.0 with fewer slabs and expanded base will enhance national tax productivity.

(d) Improving Tax Administration: Increased receipts should come through: Digitised compliance (e-invoicing, AI-based audits). Tackling tax evasion (India loses billions to GST fraud cases yearly). Broadening direct-tax base: only 6.5 crore Indians file returns in a population of 1.4 billion.

Way Forward

1. Expand divisible pool by limiting cesses.
2. Reform GST for buoyancy and stability.
3. Strengthen FC recommendations for equity and efficiency.
4. Enhance States’ capacity to raise own-source revenues (property tax reforms, better excise systems).
5. Build predictable Centre–State fiscal cooperation mechanisms via Inter-State Council and GST Council 2.0.

Conclusion

Ensuring States’ fiscal space is foundational to cooperative federalism. As emphasised in the RBI and 15th FC reports, sustainable development demands strengthening tax capacity across government tiers to balance autonomy, equity, and national priorities.