Relevance: GS-3 (Economy – Federal Finance); Source: Indian Express, Finance Commission Reports

States across India have repeatedly expressed concern that their fiscal space is shrinking. Rising expenditure pressures—from welfare schemes to climate disasters—come at a time when the share of Union transfers, especially tax devolution, has stagnated or marginally fallen. As the 16th Finance Commission prepares a new formula, protecting State finances becomes central to cooperative federalism and developmental stability.

Status and Trends in State Finances

States depend heavily on transfers from the Union, which form nearly half of their total revenues. The 14th Finance Commission increased the States’ share of Union taxes from 32% to 42%, strengthening fiscal autonomy.

However, the trend has weakened since:

• In the 15th Finance Commission period, however, States’ aggregate revenue relative to combined Union–State revenue fell from 68.08% to 67.39% (≈0.7 percentage points).
• States’ own revenue as a share of combined receipts declined from 37.72% (14th FC) to 37.25% (15th FC).
• The number of centrally sponsored schemes was rationalised, but non-shareable cesses and surcharges—whose proceeds are not devolved to States—have increased, indirectly reducing State resources.

High-income States such as Haryana, Karnataka, Kerala, Maharashtra and Tamil Nadu report a more noticeable fall in fiscal space due to declining own-tax receipts and limited compensation after the end of Goods and Services Tax (GST) compensation in 2022.

Where Do States Get Their Money From?

Centre–State Transfers: Present Picture and Concerns

What worries States?

1. Less tax devolution in real terms: Because cesses and surcharges are outside the divisible pool, the shareable revenue shrinks.
2. Marginal growth in grants:  Grants from both Finance Commission and non-FC routes have not kept pace with rising needs.
3. Horizontal devolution formula issues:  The 15th Finance Commission uses parameters such as income distance, population, forest cover, demographic performance.
   High-income States argue that the formula penalises better-performing economies.
4. Rigid borrowing restrictions:  States face hard caps on borrowing, while their needs—disaster recovery, health, climate adaptation—keep expanding.

Borrowing Limits and Other Challenges

• States rely more on market borrowings (State Development Loans), but Fiscal Responsibility rules restrict deficits.
• The end of GST compensation sharply reduced predictable income for many States.
• Rising costs of welfare schemes, pensions, and infrastructure widen fiscal gaps.
• Climate-related disasters increase demand for funds, creating high vulnerability without guaranteed support.

The Way Ahead: Rebuilding Fiscal Federalism

A fair and stable fiscal system must include:

• Predictable, rule-bound devolution, with limited use of cesses and surcharges.
• A more balanced horizontal formula that rewards efficiency without hurting equity.
• Temporary and conditional relaxation of borrowing limits for capital investment.
• Strengthening States’ own revenue through:
  • better GST compliance,
  • property tax reforms,
  • modern mineral royalty structures.
• Cooperative platforms like the Inter-State Council and GST Council should be used more actively to resolve disputes transparently.

At its heart, fiscal federalism must ensure that States—who shoulder the bulk of developmental responsibilities—have adequate, predictable, and flexible resources.

Q. “Examine the factors responsible for the shrinking fiscal space of Indian States. How can the 16th Finance Commission strengthen India’s cooperative federal architecture?”