Fiscal Federalism in India

Context

• The Union Government accepted the recommendations of the 16th Finance Commission (FC16) and retained the States’ share in the divisible pool at 41%. Further, the horizontal devolution formula, local body grants, and disaster management corpus were also accepted.
• However, several structural reforms were deferred, including:
  • Amendment of Fiscal Responsibility Legislation (FRL)
  • Regulation of off-budget borrowings
  • Power sector distribution reforms
  • Subsidy rationalisation

Associated Issues

• Shrinking Divisible Pool of Taxes
  • The 41% share applies only to the divisible pool of taxes, not to total gross tax revenues.
  • Cesses and surcharges, which are retained entirely by the Union government, lie outside the divisible pool and have been increasing.
  • Consequently, the divisible pool as a share of gross tax revenues has steadily declined:
    • 89.2% during the FC13 period
    • 82.1% during the FC14 period
    • 78.3% during the FC15 period
  • This means 41% of a shrinking base does not translate into an equivalent share of total tax collections for States.

• Discontinuation of Several Grants
  • FC16 discontinued multiple fiscal support mechanisms for States, including:
    • Revenue Deficit Grants
    • Sector-specific Grants
    • State-specific Grants
  • These instruments earlier provided targeted fiscal relief to States facing structural revenue constraints.
• End of GST Compensation and Fiscal Stress
  • The GST compensation mechanism ended in June 2022, which earlier guaranteed 14% annual growth in State GST (SGST) revenues.
  • Several States have faced significant fiscal stress after its removal.
  • For instance, Tamil Nadu estimated a revenue shortfall of nearly ₹20,000 crore in 2024–25.
  • While aggregate SGST revenues may appear buoyant, distributional fiscal stress across States persists.
• Off-Budget Borrowings and Weak Fiscal Rules
  • FC16 documented the practice of States borrowing through government controlled entities and servicing these liabilities through the budget.
  • Such borrowings remain outside official deficit calculations, creating hidden fiscal liabilities.
  • The Commission recommended:
    • Discontinuation of off-budget borrowings
    • Amendments to Fiscal Responsibility Legislation (FRL) frameworks
  • However, the Union government accepted borrowing ceilings in principle but deferred action on off-budget borrowings and FRL reforms.

• Rising Debt Burdens in Several States
  • FC16’s inter-State comparison highlights fiscal stress in several States:
    • Punjab:
      • Debt to GSDP ratio: 42.9% (2023–24)
      • Revenue deficit: 3.7% of GSDP
      • Borrowing largely used for salaries and debt servicing rather than capital investment.
    • West Bengal Outstanding liabilities: 38.3% of GSDP.
  • These cases suggest persistent fiscal stress despite existing fiscal rules, which are often weakly enforced.
• Shift in Horizontal Devolution Criteria
  • FC16 replaced the tax and fiscal effort criterion used earlier in the devolution formula.
  • Under FC15, States received 2.5% weight based on tax revenue efficiency relative to economic capacity.
  • FC16 replaced it with a “contribution to GDP” criterion, assigned a 10% weight.
  • This allocates resources based on each State’s share in national GDP (square root of GSDP share).
  • Thus, beneficiaries of this will be large high-income States such as Maharashtra, Gujarat, and Karnataka.
  • States with lower per capita income and greater fiscal needs, including Bihar, Jharkhand, and Uttar Pradesh will be in disadvantaged positions.
• Conditionality in Local Body Grants
  • FC16 recommended ₹7,91,493 crore in grants to rural and urban local bodies.
  • These grants are divided into basic and performance grants.
  • Access to funds depends on conditions such as:
    • Constituted local bodies
    • Audited financial accounts
    • Timely constitution of State Finance Commissions
  • Performance grants also require:
    • Benchmarks for own-source revenue generation
    • Compliance with Central database systems
    • While individually justified, these conditions increase dependence on Central monitoring.
  • Evidence of this issue: During the FC15 period, only 62.6% of the recommended urban local body grants were actually released.

Way Forward

• Restore the Equalisation Principle: Devolution criteria should balance economic capacity with fiscal need and development disparities.
• Rationalise Cesses and Surcharges: Greater inclusion of these revenues in the divisible pool would strengthen fiscal federalism.
• Reform Fiscal Responsibility Frameworks: Clear and enforceable rules are required to regulate off-budget borrowings and improve fiscal transparency.
• Address Post-GST Fiscal Gaps: States require structural revenue stabilisation mechanisms after the end of GST compensation.
• Strengthen Cooperative Federalism: Fiscal arrangements must involve greater Centre-State consultation and shared responsibility.
• Improve Governance Capacity of States: Enhancing institutional and administrative capacity can help States meet conditionalities tied to grants.