Restoring Fiscal space for the States

Source: The post “Restoring Fiscal space for the States” has been created, based on “Restoring Fiscal space for the States” published in “The Hindu” on 17 October 2025. Restoring Fiscal space for the States.

UPSC Syllabus: GS Paper -3-Indian Economy and issues relating to Planning, Mobilisation of Resources

Introduction: The Goods and Services Tax (GST) has significantly altered the fiscal landscape of Indian states. While it aimed to simplify taxation and boost revenue, it has also led to a reconfiguration of fiscal space for states, with both positive and negative consequences.

GST Implementation and Its Impact:

1. Boosting Revenue: The introduction of GST was expected to stimulate demand and boost revenue by simplifying the tax structure and eliminating cascading taxes. States received GST compensation to offset any revenue shortfalls.
2. Centralised Authority: GST has led to a shift in fiscal authority from states to the centre, limiting the financial autonomy of states. The GST compensation mechanism, although initially designed to protect states, has not fully lived up to its promise, and the expected revenue growth from GST has been uneven.

Challenges Faced by States:

1. Fiscal Space Constraints: States have faced increased fiscal pressure as public expenditure commitments, such as social welfare and infrastructure development, continue to rise.  Meanwhile, their ability to generate revenue has been constrained due to the centralised nature of GST collection and the limited fiscal flexibility left for state governments.
2. Declining GST Compensation: The compensation provided under GST has been insufficient in some cases, exacerbating states’ fiscal gaps. There is a concern that the compensation has been lower than expected, leading to greater reliance on central transfers.

Impact on State Revenues:

1. Decreased Share in Tax Revenues: GST has altered the revenue-sharing arrangement between the centre and states, with the centre now collecting a larger share of taxes. This shift has reduced the financial resources available to state governments, making it harder for them to fund key expenditures.
2. Central Transfers as a Relief Measure: States are increasingly dependent on central transfers to meet their revenue needs. However, these transfers are not always transparent or guaranteed, which further complicates the fiscal situation for states.

Challenges:

1. Inadequate Compensation: The GST compensation has often been delayed or insufficient, leading to a shortage of funds for states. As states’ revenue growth has not met expectations, they struggle to balance increasing demands for expenditure with limited financial resources.
2. Dependency on Central Transfers: States’ increasing reliance on central transfers has reduced their fiscal autonomy and flexibility. They are becoming more dependent on decisions made at the central level, which diminishes their ability to independently plan and manage their finances.
3. Rising Expenditure Commitments: With growing public aspirations and expanding needs in sectors like healthcare, education, and infrastructure, states are facing mounting expenditure pressures that cannot be fully met through their current fiscal arrangements.

Way Forward:

1. Restoring Fiscal Autonomy: States need greater fiscal autonomy, which would allow them to generate and manage their own resources more effectively. This could involve revisiting the GST compensation mechanism and ensuring timely and adequate payments to states.
2. Improving Transparency in Transfers: Central transfers to states should be made more transparent and predictable. This will ensure that states have a clearer idea of their revenue inflows and can plan their budgets accordingly.
3. Fiscal Reforms at the State Level: States should focus on enhancing their own revenue generation capacities, particularly by improving tax compliance and expanding their own tax base, which could reduce their dependency on central transfers.
4. Increased Central Assistance for Development: The central government must continue to assist states in meeting their development goals by increasing grants and ensuring that they have the fiscal space needed to fund crucial infrastructure and social welfare programs.

Conclusion: GST aimed at streamlining the tax structure and boosting revenues; however, its implementation has left states facing fiscal challenges, primarily due to reduced autonomy and insufficient compensation. Restoring fiscal space for states will require reforms that ensure a more balanced, transparent, and sustainable fiscal relationship between the center and the states.

Question: How has the introduction of GST affected the fiscal space of states in India? What steps should be taken to restore fiscal space for states?