Give states their fair share, protect their fiscal space

Source: The post “Give states their fair share, protect their fiscal space” has been created, based on “Give states their fair share, protect their fiscal space” published in “Indian Express” on 2nd December 2025.

UPSC Syllabus: GS Paper-2- Polity

Context: The Indian fiscal federal system requires both the Union and the states to possess adequate and predictable resources to meet rising developmental and governance challenges. States have increasingly expressed concerns about shrinking fiscal space, making fair tax devolution and grants crucial for cooperative federalism.

Trends in States’ Fiscal Space

1. Expansion during the 14th Finance Commission
   1. Higher Devolution Share: The 14th Finance Commission significantly enhanced states’ share in the divisible pool of central taxes from 32% to 42%, expanding their fiscal autonomy.
   2. Rise in Tax Share: The share of states in central taxes relative to combined revenue receipts rose from 15% (13th FC) to 19.2% (14th FC), marking a rise of 4.25 percentage points.
   3. Improved Post-Transfer Share: The post-transfer share of states in combined revenue receipts increased from 63.85% to 68.08%, reversing the earlier Centre–state balance.
2. Reduction in Fiscal Space
   1. Overall Decline: States’ revenue receipts (as a share of combined revenue receipts) fell from 68.08% (14th FC) to 67.39% (15th FC), indicating a fall of 0.70 percentage points.
   2. Lower Tax Devolution: This decline was driven primarily by a reduction in tax devolution from 19.2% to 18.2%, amounting to a fall of 1.05 percentage points.
   3. Only Partial Compensations: Although FC and non-FC grants increased slightly, total transfers still recorded a minor reduction of 0.23 percentage points.
   4. Reduced Own Revenues: States’ own revenue receipts also declined from 37.72% to 37.35%, reducing their independent fiscal space.

Structural Causes

1. Rise in Cesses & Surcharges: An increasing reliance on non-sharable cesses and surcharges by the Centre has reduced the size of the divisible pool
2. GST-Related Concerns: The discontinuation of the GST compensation cess and rate reductions under GST 2.0 have created risks for states’ GST revenue buoyancy.
3. Impact of State Reorganisation: The reorganisation of states into 28 units also influenced distributional outcomes under the 15th FC.

Impact on High-Income States

1. Five High-Income States: High-income states such as Haryana, Karnataka, Kerala, Maharashtra and Tamil Nadu show unique fiscal patterns across FC cycles.
2. Offsetting Trends (13th → 14th FC): During the 13th to 14th FC transition, their fiscal space remained stable because higher transfers were offset by reduced own revenue performance.
3. Decline (14th → 15th FC): These states experienced a reduction of 0.38 percentage points in their fiscal space during the 15th FC period.
4. Reasons for Decline: The fall was due to a 0.25 percentage-point decline in own revenue receipts and a 0.13 percentage-point decline in central transfers.
5. Formula-Linked Issues: Increased dependence on cesses and the weightage of the distance criterion in horizontal devolution contributed to their adverse outcomes.

Key Challenges

1. Rising Expenditure Responsibilities: States face increasing demands in health, education, infrastructure and social welfare without corresponding increases in their revenue space.
2. Shrinking Divisible Pool: The growing share of unshared cesses and surcharges reduces predictability and fairness in resource transfers.
3. GST Instability: GST structural issues, including compensation withdrawal and rate rationalisation, weaken states’ fiscal stability.
4. Horizontal Imbalance: High-income states feel relatively disadvantaged by the current horizontal devolution formula that emphasises equalisation parameters.

Way Forward

1. Reduce Cesses & Surcharges: The divisible pool must be strengthened by limiting the use of non-sharable cesses and surcharges by the Centre.
2. Reform Horizontal Formula: The 16th Finance Commission should re-examine the weight of the distance criterion and reward revenue effort more effectively.
3. Enhance Tax Buoyancy: Both the Centre and states must broaden the tax base, improve compliance and strengthen GST administration to boost revenues.
4. Stabilise GST Revenues: GST reforms should ensure long-term stability for states through rational rate structures and transitional support.
5. Predictable Grants: Non-FC grants should be made more transparent, rules-based and predictable to reduce discretionary distortions.
6. Strengthen Fiscal Federalism: Centre–state coordination through platforms like the GST Council must be enhanced to promote cooperative fiscal federalism.

Conclusion: Protecting the fiscal space of states is essential for achieving national development targets and sustaining cooperative federalism. A fair, transparent and buoyant system of revenue sharing—supported by strong tax collections at both levels—is critical to ensure states receive their rightful share and remain fiscally empowered.

Question: Shrinking fiscal space of states is undermining cooperative federalism. Discuss.