India's Fiscal Federalism Under Strain

Executive Summary

India's fiscal federalism stands at a structural inflection point. The architecture of Centre-State financial transfers, built on the twin pillars of tax devolution and grants-in-aid, faces a confluence of stresses that have been years in the making. States collectively account for over 52 percent of total public expenditure — shouldering primary responsibility for health, education, agriculture, and local governance — yet their ability to raise own-source revenues has been progressively narrowed.

The Goods and Services Tax, while rationalising India's indirect tax landscape, collapsed the independent fiscal base of states by subsuming VAT, entry tax, and purchase tax into a jointly administered framework. Simultaneously, the Centre's growing reliance on cesses and surcharges — instruments constitutionally excluded from the divisible pool under Articles 270 and 271 — has quietly eroded the quantum of resources available for sharing. What states gain in the headline devolution percentage, they lose in the base on which that percentage is applied.

Section 1

GST and the Erosion of States' Fiscal Autonomy

1.1 The Pre-GST Fiscal Landscape

Before July 2017, states operated with a meaningful portfolio of independent tax instruments. Value Added Tax on most goods, entry taxes, octroi, purchase tax, and levies on certain services collectively constituted States' Own Tax Revenue — a revenue stream over which state legislatures exercised genuine autonomy in design, rate-setting, and administration. The 101st Constitutional Amendment, which gave effect to GST through the insertion of Article 246A, fundamentally altered this arrangement. The new regime replaced origin-based taxes with a destination-based consumption tax jointly administered by the Union and states through the GST Council, a body under Article 279A where the Centre holds one-third of the voting weight.

1.2 The GST Compensation Mechanism and its Aftermath

The GST (Compensation to States) Act, 2017 guaranteed states a 14 percent annual growth in protected revenue for five years. The mechanism worked adequately initially. By 2020-21, the COVID-19 pandemic devastated consumption and GST collections, opening a compensation gap the Centre could not fill. When the compensation period ended in June 2022, states lost both the guaranteed revenue floor and the institutional backstop it had provided. The post-compensation landscape has seen SGST revenues recover in absolute terms, but the structural autonomy problem remains unresolved.

1.3 The Cess and Surcharge Problem

The deeper erosion of states' fiscal position lies in the Centre's systematic expansion of revenue instruments constitutionally excluded from the divisible pool. Under Articles 270 and 271, cesses and surcharges are not shared with states. In the early 2010s, these levies constituted approximately 9.5% of gross tax revenue. By 2024-25, they are projected at approximately ₹4.23 lakh crore — constituting around 23% of gross tax receipts, fully retained by the Centre.

NIPFP estimates from 2024 suggest that merging cesses and surcharges into the divisible pool could increase states' aggregate receipts by approximately ₹1.5 lakh crore annually. A further governance concern, documented by the CAG, is that ₹3.69 lakh crore in cess collections had not been transferred to designated reserve funds as of March 2024.

Data

Evolution of Vertical Devolution

Section 2

The Devolution Formula and Finance Commission Architecture

The Finance Commission's recommendations operate on two axes. Vertical devolution determines what proportion of the divisible pool is transferred to states collectively. Horizontal devolution allocates the aggregate states' share among the twenty-eight states based on a multi-criteria formula. The 15th FC's horizontal formula assigned weights as: Income Distance (45%), Population/Demographic Performance combined (25% using 2011 Census data), Area (15%), Forest and Ecology (10%), and Tax and Fiscal Effort (2.5%).

The 16th FC has revised this formula, notably introducing a new “Contribution to GDP” criterion at 10% while removing the Tax and Fiscal Effort parameter. The complete formula now distributes weights as: Income Distance 42.5%, Population 17.5%, Demographic Performance 10%, Area 10%, Forest and Ecology 10%, and Contribution to GDP 10%.

The Southern States' Grievance

Southern states — Tamil Nadu, Kerala, Karnataka, Andhra Pradesh, and Telangana — have invested heavily in demographic transition since the 1970s, successfully bringing total fertility rates below replacement level. The shift from 1971 to 2011 Census data effectively penalised these states for this demographic success. Under the 16th FC, Karnataka was the largest gainer at +0.48%, while Tamil Nadu saw only a negligible increase from 4.079% to 4.097% — reflecting the reduced weight given to the demographic performance criterion.

Cesses and Surcharges vs. Divisible Pool

Sources: CSEP (2026), Union Budget Documents, Finance Commission Reports; RBI State Finances 2024-25.

Section 3

Grants, Tied Transfers, and the Autonomy Problem

Centrally Sponsored Schemes are joint funding programmes through which the Centre finances national development and welfare priorities in areas that fall within the State or Concurrent Lists. The constitutional basis is primarily Article 282, which allows the Union to make grants for any public purpose regardless of legislative domain. From approximately 50 schemes in the early Planning Commission era, CSS proliferated to over 131 schemes with more than 200 sub-components as of the current period.

CSS now accounts for approximately 1.5% of GDP and constitutes over 50% of Centre-State transfers. The critical problem with CSS dominance is not the quantum of resources transferred but the conditionality attached. The Special Assistance to States for Capital Investment (SASCI) scheme is illustrative: the share of unconditional funds within SASCI declined from 80% in 2022-23 to only 38% in 2025-26.

A particularly regressive dimension is the uniform 60:40 Centre-State matching ratio applied across fiscally heterogeneous states. Bihar, which depends on Central transfers for over 72% of its revenue receipts, faces an entirely different burden in mobilising a 40% match than Karnataka. The Karnataka experience with PM Awas Yojana is illustrative: despite the nominal sharing norm, the State spends ₹4-5 lakh per housing unit while the Centre's contribution is less than ₹1 lakh.

Section 4

The 16th Finance Commission — What Changed and What Was Missed

The 16th Finance Commission, constituted on December 31, 2023, and chaired by Dr. Arvind Panagariya, submitted its report to President Droupadi Murmu on November 17, 2025. It was tabled in Parliament alongside Union Budget 2026-27 on February 1, 2026, covering the five-year award period from April 1, 2026 to March 31, 2031.

The Commission's most consequential decision was to retain vertical devolution at 41% — unchanged from the 15th FC, despite demands from multiple states for an increase to at least 50%. Total grants recommended amount to ₹9.47 lakh crore for the five-year period. The most significant departure is the complete discontinuation of revenue deficit grants, sector-specific grants, and state-specific grants.

The most significant characterisation of the 16th FC's philosophical orientation is the shift from “entitlement-based” to “compliance-driven” fiscal federalism. When revenue deficit grants are abolished simultaneously with tighter fiscal deficit ceilings and more conditional grant architecture, states with structurally weak revenue bases face a simultaneous reduction in the unconditional resources available to them.

Notably, the 16th FC does not address the cess-and-surcharge expansion directly, does not recommend a structural rationalisation of CSS, and does not establish a permanent institutional mechanism for Centre-State fiscal consultation beyond the Finance Commission's quinquennial cycle.

Recommendations

Six Policy Reforms

Conclusion

India's fiscal federal architecture is not broken — it is under structural strain that, if unaddressed, risks becoming self-reinforcing. The 16th Finance Commission's report represents a thoughtful attempt to balance discipline with equity, performance with need. But it operates within the same constitutional parameters and institutional constraints that have produced the strains this paper has documented.

The reforms required are not exotic. They are largely incremental — legislative, institutional, and design changes that adjust the incentive structure of intergovernmental finance without requiring constitutional amendment. What they require is political will on the part of a Centre that has, over the past decade, found fiscal leverage in precisely the mechanisms this paper recommends reforming.

The strongest argument for reform is not normative but instrumental: a fiscal federal architecture perceived as inequitable by the states that generate the bulk of India's economic growth will, over time, produce cooperative deficits in infrastructure, health, and education that undermine that growth.

Key Sources