Margins to Mainstream: Greater say for states in fiscal devolution

India’s Goods and Services Tax (GST), hailed as a landmark reform, has undoubtedly unified the domestic market and improved indirect tax compliance. Yet beneath the surface of record-high collections — Rs 2.10 lakh crore in April 2024 alone — lie simmering tensions between the Centre and the states. While states broadly support GST’s objectives, many argue that the current sharing mechanism undermines their fiscal autonomy and exacerbates a growing resource crunch. As the 16th Finance Commission begins its work, these concerns have taken centre stage.

Centre–State GST discords

GST fundamentally altered the Centre-State fiscal dynamic. Pre-GST, states had greater autonomy over a variety of taxes, including VAT, octroi, and entertainment taxes. Post-GST, these were subsumed under a uniform structure. While revenue pooling streamlined collections, it also reduced the states’ discretionary powers. In return, the Centre guaranteed compensation for revenue shortfall for five years.

This compensation period ended in June 2022. Since then, states — particularly manufacturing-heavy ones like Tamil Nadu, Gujarat, and Maharashtra — have faced significant revenue constraints. The core of the disagreement lies in the dual control without dual autonomy: while GST is governed by the GST Council, the Centre continues to exercise significant control over policy and rate-setting.

Expanding gap in sharing

States are the principal agents of development — they finance over 60% of total public expenditure in India. Their share of capital expenditure has also risen to 72% in 2023-24 compared to 58% a decade ago. But their share in the divisible pool of taxes — despite the 15th Finance Commission’s 41% recommendation — has declined in effective terms to 29-30%, largely due to the Centre’s increasing use of cesses and surcharges, which are not shared with states. In 2014-15, cesses and surcharges accounted for 10.4% of gross tax revenue; by 2023-24, this had nearly tripled to 26.7%, reducing the pool of taxes available for devolution. For example, in 2021-22, Rs 8.27 lakh crore was collected as gross tax revenue, but only Rs 2.8 lakh crore was devolved to states. This structural compression coincides with rising social sector obligations for states. Health, education, urban development, and now climate mitigation have expanded the expenditure commitments of states without corresponding fiscal space. Additionally, the shift in Centre-State cost-sharing ratios in schemes like PMAY, Jal Jeevan Mission, and Ayushman Bharat (from 90:10 to 60:40 or 50:50) has pushed greater financial burdens onto states.

Centre's genuine challenges

To be fair, the Centre also faces complex obligations. Defence expenditure, debt servicing, subsidies, and national infrastructure development require enormous outlays. Central tax collections fund pan-India programs such as PM-KISAN, and the Centre is responsible for funding Union Territories without legislatures. Moreover, post-pandemic recovery efforts demanded extraordinary spending by the Union government. Furthermore, the Centre has been frontloading GST compensation through back-to-back borrowing since FY2020- 21 to support states — amounting to Rs 1.59 lakh crore in FY2021- 22 alone. This indicates a willingness to shoulder transitional costs and also highlights long-term limitations in sustaining such mechanisms.

The GST Council, designed as a consensus-building forum, has often functioned constructively. Yet, states argue that their limited voting power relative to the Centre’s weight in the Council impairs their influence on rate rationalisation and compensation discussions.

Hopes on 16th Finance panel

The upcoming 16th Finance Commission offers an opportunity to recalibrate fiscal federalism. Several states have submitted memoranda suggesting (a) the inclusion of cesses and surcharges in the divisible pool to restore horizontal equity; (b) raising the devolution share from 41% to at least 45%, or even 50%, given the sharp rise in state expenditure responsibilities; (c) a formula that rewards demographic management and fiscal effort, especially from southern states, rather than one based solely on 2011 population data; and (d) GST compensation extension for five more years to cushion the transition, particularly for manufacturing-heavy and revenue-deficient states.

The southern states, including Kerala, Tamil Nadu, and Karnataka, also point out that better population control and social indicators should not be penalised through reduced allocations.

Towards equitable federalism

This is not a call for confrontation but for recalibration. The Centre can support this by (a) creating a roadmap to gradually integrate cesses and surcharges into the divisible pool; (b) instituting a performance-based incentive mechanism that rewards states for tax compliance, innovation, and delivery efficiency; and (c) enhancing transparency in fund flow, especially in centrally-sponsored schemes.

For their part, states must commit to fiscal discipline, explore own-source revenues more effectively, and innovate in public expenditure efficiency. Capacity-building in GST administration, better local-level tax compliance, and reforming state public enterprises can help states regain some fiscal space.

Evolving a shared future

The 16th Finance Commission must address the evolving nature of Indian federalism. As states shoulder the responsibility of implementing ambitious national missions — from Digital India to Skill India to climate adaptation — they need resources that match their mandates. The fiscal federal structure must not become a zero-sum game. Rather, it should reflect India’s diversity, asymmetries, and development goals. A fair and transparent resource-sharing mechanism will not only empower states but also deepen democracy and development across the country.

India’s development story will be shaped not just by the strength of the Centre but by the vitality of its states. And for that, fiscal fairness is not optional — it is foundational.

(Dr Debdulal Thakur is a Professor at Vinayaka Mission’s School of Economics and Public Policy, Chennai; Dr Shrabani Mukherjee is an Associate Professor at the Department of Economics, Shiv Nadar University, Chennai)