Contemporary Issues in Indian Fiscal Federalism: Centralisation and Regional Disparities

India’s federal structure, designed to balance power between the Centre and states, is experiencing significant fiscal tensions. While the Constitution envisioned cooperative federalism with equitable resource distribution, recent trends reveal growing centralisation of financial powers and widening disparities between regions. These developments raise critical questions about the future of India’s fiscal architecture and its ability to serve diverse regional needs.

The centralisation dilemma: when the Union tightens its grip 🔗

India’s federal system has long been described as quasi-federal due to its inherent centralising features. The Union government holds residuary powers, allowing it to legislate on matters not explicitly mentioned in the Constitution. But the fiscal dimension of this centralisation has intensified dramatically in recent years, fundamentally altering the balance of financial power between the Centre and states.

One of the most contentious issues is the rising use of cesses and surcharges, which are not shared with states under constitutional provisions. Between 2015-16 and 2023-24, the collection of cesses and surcharges increased from approximately Rs 85,638 crore to Rs 3.63 lakh crore, representing a jump from 5.9% to 10.8% of the Union government’s tax revenue. These non-shareable revenues effectively shrink the divisible pool of taxes, meaning states receive a smaller proportion of total tax collections despite Finance Commission recommendations suggesting higher devolution.

Consider this: while the 14th and 15th Finance Commissions recommended that states receive 42% and 41% respectively of net tax revenue, their actual share of gross tax revenue declined from 35% in 2015-16 to just 30% in 2023-24. This gap exists precisely because cesses and surcharges are excluded from the divisible pool before states’ shares are calculated.

Centrally sponsored schemes: cooperation or coercion? 🔗

Another layer of centralisation emerges through Centrally Sponsored Schemes (CSS), where the Union government designs programmes and provides partial funding, compelling states to commit matching resources. Between 2015-16 and 2023-24, CSS allocations increased from Rs 2.04 lakh crore to Rs 4.76 lakh crore across 59 schemes. While these schemes address national priorities, they significantly limit states’ autonomy to allocate resources according to their unique needs and local contexts.

The problem intensifies when we consider that out of Rs 19.4 lakh crore allocated for CSS and Central Sector Schemes in 2023-24, only Rs 4.25 lakh crore was actually devolved to states as tied grants. States cannot freely plan their expenditure with these funds; they must follow centrally determined guidelines, essentially converting state governments into implementing agencies for Union priorities.

Regional inequality: the horizontal divide widens 🔗

India exhibits some of the highest levels of regional inequality among federal nations. Delhi’s per capita income stands at approximately 250% of the national average, while states like Bihar languish at significantly lower levels. This economic disparity directly correlates with horizontal fiscal imbalances, where states differ vastly in their capacity to raise revenue and meet expenditure needs.

The underlying issue is that poorer states have both smaller revenue bases and greater public expenditure requirements. States with lower per capita incomes typically need more investment in basic infrastructure, education, and healthcare to catch up with developed regions. Yet these are precisely the states with the weakest ability to generate own-source revenues through state taxes.

How fiscal constraints compound regional disadvantages 🔗

The Fiscal Responsibility and Budget Management (FRBM) Act, enacted to ensure fiscal discipline, imposes uniform borrowing limits on all states, typically capping fiscal deficits at 3% of Gross State Domestic Product (GSDP). While this promotes fiscal prudence, it fails to account for the vastly different starting points and development needs of various states.

A wealthy state like Maharashtra or Karnataka, with robust tax bases and high GSDP, can accomplish significant capital expenditure within the 3% limit. However, a less developed state like Bihar or Odisha, with lower GSDP and higher infrastructure deficits, finds the same percentage constraint far more restrictive in absolute terms. The uniform borrowing ceiling thus becomes a barrier to catching up, perpetuating rather than reducing regional disparities.

Kerala’s recent challenge in the Supreme Court against the Centre’s Net Borrowing Ceiling highlights these tensions. The state argued that the borrowing restrictions violated its fiscal autonomy under Article 293 of the Constitution, bringing it to the brink of financial crisis where it struggled to pay salaries and pensions.

Why fiscal transfers haven’t bridged the gap 🔗

The Finance Commission, constituted every five years, is tasked with recommending how central tax revenues should be distributed to correct fiscal imbalances between and among states. Yet despite these constitutional mechanisms, the fiscal transfer system has not effectively disrupted the vicious cycle of underdevelopment in poorer states.

The methodology problem: actual versus normative expenditure 🔗

One significant issue lies in how the Finance Commission calculates states’ needs. By using actual expenditure estimates rather than normative expenditure requirements, the commission inadvertently rewards states with higher historical spending while penalizing those that have been fiscally constrained. A state that has historically underspent due to low revenue capacity continues to receive lower allocations, while states with historically higher spending receive more-regardless of actual developmental needs.

This approach fails to account for the expenditure gap between a state’s current service delivery levels and what would be required to meet basic standards. For instance, a state with poor educational infrastructure and outcomes may need substantially more resources than its historical spending patterns suggest, but current methodologies don’t adequately capture this normative requirement.

Lack of coordinated public policy 🔗

The replacement of the Planning Commission with NITI Aayog in 2015 removed an important mechanism for addressing regional disparities. The Planning Commission, despite its limitations, had resources to allocate to states through plan grants using formulas that specifically targeted backward regions. NITI Aayog, as a policy think tank without resources to dispense, cannot play the same redistributive role, leaving a gap in coordinated policy approaches to regional development.

This institutional change means India now relies primarily on a single instrument-the Finance Commission’s recommendations-to address both vertical imbalances (between Centre and states) and horizontal imbalances (among states). This concentration of responsibility on one institution limits the policy toolkit available for tackling India’s complex regional disparities.

The GST effect: simplification with side effects 🔗

The introduction of the Goods and Services Tax in 2017 was a landmark reform that simplified India’s complex indirect tax structure and created a common national market. However, it also fundamentally altered fiscal federalism by centralising taxation powers and changing the basis of tax collection from origin to destination.

Previously, states had independent authority to levy taxes like Value Added Tax, entry taxes, and purchase taxes, giving them significant control over their revenue. Under GST, these powers have been pooled into a common system managed jointly by the GST Council, where the Centre holds greater voting weight. The shift to destination-based taxation means revenues now accrue to states where goods are consumed rather than where they are produced, benefiting large consuming states while disadvantaging manufacturing hubs.

The GST compensation mechanism, which assured states 14% annual revenue growth for five years, ended in June 2022, exposing the true fiscal capacity of states and revealing wide disparities in revenue generation capabilities. States that relied heavily on this compensation now face fiscal stress without adequate alternative revenue sources.

Breaking the cycle: what needs to change 🔗

Addressing these intertwined challenges of centralisation and regional inequality requires comprehensive reforms across multiple dimensions of fiscal federalism.

Reimagining the divisible pool 🔗

The most immediate reform needed is to bring cesses and surcharges into the divisible pool of taxes. The 16th Finance Commission should recommend strict legislative limits on the Centre’s use of these non-shareable revenues, ensuring they automatically expire after short periods and cannot be renamed to circumvent restrictions. This would ensure that states actually receive the devolution percentages recommended by Finance Commissions.

Differentiated fiscal frameworks 🔗

Rather than applying uniform borrowing constraints, India needs more nuanced fiscal frameworks that account for states’ different developmental stages and needs. Performance-based flexibility in borrowing limits, where states demonstrating good governance and fiscal management receive additional borrowing room, could incentivize improvements while providing necessary resources for development.

Additionally, relaxing borrowing constraints for poorer states specifically for capital expenditure could enable them to invest in infrastructure that accelerates growth and helps them catch up with developed regions. The key is distinguishing between borrowing for productive investments versus revenue expenditure.

Reforming transfer mechanisms 🔗

Finance Commissions need terms of reference that explicitly require addressing normative expenditure needs rather than just historical patterns. This means calculating what states would need to spend to achieve minimum standards in education, healthcare, infrastructure, and other basic services, then using these normative assessments to guide grant allocations.

Furthermore, reviving an institutional mechanism similar to the Planning Commission’s resource allocation role-perhaps through a reformed NITI Aayog with actual resources to dispense-could provide the additional policy instrument needed to tackle regional disparities systematically.

What do you think? Can India’s fiscal federalism evolve to genuinely balance national unity with regional diversity? How can we ensure that fiscal policies empower rather than constrain states in their developmental aspirations?

References

1. https://www.drishtiias.com/daily-updates/daily-news-editorials/fiscal-centralisation-concerns-in-india
2. https://forumias.com/blog/fiscal-federalism-in-india-significance-and-challenges-explained-pointwise/
3. https://www.ispp.org.in/indian-federalism-addressing-regional-and-economic-inequalities/
4. https://www.clearias.com/states-borrowing-power/
5. https://www.drishtiias.com/daily-news-editorials/redesigning-india-s-fiscal-federalism
6. https://vajiramandravi.com/current-affairs/restoring-fiscal-space-in-india/