Fiscal Federalism Debate Over States’ Share in Taxes

Why in the News ?

The Union government accepted the Sixteenth Finance Commission (FC16) recommendation retaining States’ share at 41% of the divisible tax pool. However, concerns have emerged as the divisible pool’s share in total tax revenues has declined, raising debates about Centre–State fiscal relations and federal balance.

Changing Dynamics of Fiscal Federalism in India

• The Union government’s Explanatory Memorandum (February 2026) accepted most recommendations of the Sixteenth Finance Commission (FC16), including maintaining States’ share at 41% in the divisible tax pool.

• While the percentage remains unchanged, the divisible pool itself has shrunk relative to gross tax revenues, largely due to the increasing use of cesses and surcharges by the Union government.

• Unlike normal taxes, cesses and surcharges are not shared with States, allowing the Centre to retain the entire revenue, similar to how ex post facto fiscal adjustments can impact state budgets.

• Data cited by the Commission shows that the divisible pool declined from 89.2% of gross tax revenue during the FC13 period to 78.3% during FC15, indicating a structural shift in fiscal transfers.

• Consequently, 41% of a shrinking pool effectively reduces the financial resources available to States, despite the headline figure suggesting continuity.

Structural Fiscal Challenges Faced by States

• The Sixteenth Finance Commission discontinued several grants, including revenue deficit grants, sector-specific grants for environmental clearances and forest conservation act compliance, and State-specific grants, which previously provided targeted financial support.

• States have also faced fiscal stress following the end of GST compensation in June 2022, which had guaranteed 14% annual growth in State GST revenues, while simultaneously managing costs related to environmental impact assessment and coastal regulation zone regulations.

• Some States reported significant fiscal gaps; for example, Tamil Nadu estimated a revenue shortfall of nearly ₹20,000 crore in 2024–25, partly due to increased expenditure on ensuring a pollution free environment and implementing the polluter pays principle.

• The Commission highlighted growing State debt burdens, with Punjab’s debt reaching 42.9% of GSDP, while West Bengal, Rajasthan, and Andhra Pradesh also recorded high debt levels, compounded by obligations arising from retrospective environmental clearances and compliance with EIA notification requirements.

• Additionally, many States rely on off-budget borrowings through government-controlled entities, which hides actual fiscal deficits and creates long-term financial risks, particularly when addressing post facto regulatory compliance and environmental jurisprudence mandates.