Introduction

India’s fiscal federalism has long been guided by the principle of cooperative balance, where both the Centre and States share resources, responsibilities, and accountability. However, the post-GST era has altered this equilibrium. The recent merger of the GST compensation cess with regular tax marks a watershed moment, ending an era of fiscal cushioning for States and raising pressing questions about States’ financial independence.

With rising public aspirations, widening service delivery gaps, and increased welfare commitments, States are grappling with constrained fiscal space. The centralisation of taxation powers, growing dependence on Central transfers, and the limited flexibility to raise revenue are redefining India’s fiscal federalism.

Why in the News?

The abolition of the GST compensation cess, after five years of implementation, marks a turning point in India’s fiscal framework. For the first time since GST’s rollout in 2017, the compensation mechanism, which assured States 14% annual revenue growth, has ended.

This is significant because:

• The cess previously cushioned States from revenue shortfalls during GST transition.
• Its removal exposes the true fiscal capacity of States, revealing wide disparities in revenue generation.
• The Centre’s growing use of cesses and surcharges, which are not shareable with States, has further squeezed State finances.
• The resulting imbalance has rekindled the debate on “fiscal autonomy versus fiscal efficiency.”

Evolving Fiscal Architecture

How has GST altered India’s tax landscape?

1. Shift from origin-based to destination-based taxation: GST replaced multiple State taxes with a unified structure, eroding the States’ control over indirect taxes.
2. Shared tax base: Both Centre and States levy GST, but decision-making lies with the GST Council, where the Centre has a dominant role.
3. Erosion of fiscal autonomy: States lost independent authority to adjust tax rates or design fiscal responses tailored to their economies.
4. Cess and surcharge dominance: These have become a parallel fiscal instrument for the Centre, bypassing the divisible tax pool.

Changing Centre–State Financial Relations

How have constitutional mechanisms evolved over time?

1. Articles 268–293 define the fiscal relationship between Centre and States.
2. The Finance Commission (Article 280) determines devolution, but several States allege that the criteria penalise progressive, industrial States.
3. With the abolition of the Planning Commission in 2014, only two main transfer channels remain, Finance Commission grants and Centrally Sponsored Schemes (CSS).
4. Article 282 allows discretionary Central grants, often perceived as politically influenced, affecting opposition-ruled States disproportionately.

Declining Devolution and Fiscal Dependence

How serious is the resource imbalance between Centre and States?

1. Despite recommendations of 42% devolution (14th Finance Commission), actual transfers as a share of gross tax revenue have declined.
2. Cesses and surcharges, which are non-shareable, reached ₹3.86 lakh crore (RE 2024–25) and are projected at ₹4.23 lakh crore (BE 2025–26).
3. Central transfers still account for 44% of States’ revenue receipts, ranging from 72% for Bihar to 20% for Haryana, highlighting the uneven dependency landscape.
4. The Centre collects 67% of total tax revenue, while States handle over 52% of total expenditure, particularly in health, education, and agriculture.
5. This structural mismatch constrains States’ fiscal flexibility and deepens intergovernmental friction.

Emerging Demands for Fiscal Reforms

What are States and experts proposing for fiscal autonomy?

1. Restructuring tax-sharing principles: Revisiting Finance Commission formulas to reflect true expenditure needs and reward performance equitably.
2. Personal Income Tax sharing: Proposal to share or allow States to “top up” the personal income tax base to reduce fiscal dependence.
3. Learning from Canada: Canadian provinces collect 54% of taxes and spend 60%, offering a model of greater subnational flexibility.
4. Transparent devolution: Merging cesses and surcharges into the divisible pool could enhance transparency and equity.
5. Independent fiscal oversight: Establishing a permanent intergovernmental fiscal council for mediation and coordination.

The Way Forward: Towards Cooperative Fiscal Federalism

How can fiscal space be restored to States?

1. Revisit GST architecture: Grant States limited powers to vary tax rates within a band for specific commodities or services.
2. Rationalise CSS schemes: Allow greater flexibility for States to design locally suited welfare interventions.
3. Enhance fiscal responsibility: Encourage States to improve tax compliance, widen base, and adopt technology-driven revenue administration.
4. Periodic fiscal reviews: Institutionalise data-based monitoring to balance efficiency with equity.
5. Political cooperation: Encourage a non-partisan GST Council model where fiscal debates remain guided by economic logic, not politics.

Conclusion

India’s growth story is fundamentally federal. The vitality of its States determines the resilience of its economy. As the GST compensation era ends and States’ expenditure responsibilities rise, restoring their fiscal autonomy is essential for sustainable growth. True cooperative federalism demands not just consultation but real power-sharing in fiscal decision-making. Empowering States fiscally is not a concession — it is a constitutional necessity for a balanced and vibrant India.

PYQ Relevance

[UPSC 2024] What changes has the Union Government recently introduced in the domain of Centre-State relations? Suggest measures to be adopted to build the trust between the Centre and the States and for strengthening federalism.

Linkage: The phasing out of the GST compensation cess and rising use of non-shareable cesses and surcharges reflect the Centre’s growing fiscal dominance, compelling States to seek reforms in tax devolution to rebuild trust and uphold true cooperative federalism.

Get an IAS/IPS ranker as your 1: 1 personal mentor for UPSC 2024

Attend Now