Doling it out in drops: are the States being squeezed out of funds by the Centre?

The Hindu

6 hours ago

Is the Centre financially squeezing the States? The question arises as the Union government has been increasingly sharing less revenue with the States at a time when the ability of the States to generate revenue has weakened and their borrowing capacity curtailed.
In 1962, several States complained to the Third Finance Commission (FCIII) about a 'tendency to centralise resources and functions belonging to the States'. The Commission reported a widespread sentiment among States that their autonomy was being eroded through directions on State subjects and unilateral financial decisions by the Centre.
This discontent had emerged despite the Congress ruling at the Centre with a massive mandate and heading most major State governments. The Commission observed that 'federal finance in India today (1962) is such that the States are dependent on central assistance on an ever-increasing scale. This dependence is diluting, on the one hand, the accountability of State Cabinets to their legislatures, and on the other, hampering the growth of administrative responsibility in the States.' It called this trend 'disturbing'.
More than 60 years have passed since. Indian States have grown more politically, socially, economically, and ideologically apart. A coalition now governs at the Centre, and major Indian States are led by Chief Ministers from at least nine different parties. The 1991 liberalisation had boosted the economies of many southern and western States, whereas much of the east, central, and northern parts continue to lag. Economic advancement and ideological divergence meant that while some States now rival Western nations in social indicators, others mirror sub-Saharan Africa.
Due to such stark inequalities among States, today, the 'disturbing' trend seen 60 years ago is still prevalent and has reached a boiling point. The clamour against the dilution of States' financial rights is louder than ever. The tug-of-war over fiscal federalism is now playing out in increasingly visible and confrontational ways.
Three layers
The latest fight between the States and the Centre over money is unfolding across three distinct layers.
First, the money States receive from the Centre. This includes a wide array of contentious issues: how much should be shared by the Centre with the States (vertical devolution), how it should be distributed among the States (horizontal devolution), and, more crucially, what exactly should be shared (divisible pool of taxes).
Second, the money States generate on their own — known as States' Own Tax Revenue (SOTR). Here, the concern is that avenues for independent revenue generation are shrinking, and growth in SOTR remains sluggish especially among many advanced States, limiting their fiscal autonomy.
Third, the rules governing how States can borrow have become another flashpoint. States are subject to limits set by the Centre. Moreover, even borrowings made by a State's entities — such as public sector undertakings — are being counted as part of the State's debt, tightening the fiscal leash further.
Problems in vertical devolution
As decided by the 15th FC, currently, 41% of the divisible pool of taxes is shared by the Centre with all the States — this is called vertical devolution. The divisible pool includes all tax revenues collected by the Centre — excluding cesses, surcharges, and the cost of collection.
To illustrate, imagine that the Centre collects ₹100 in total. Of this, let us say ₹12 comes from cesses, ₹8 from surcharges, and ₹80 from various taxes and duties. If it costs ₹2 to collect these taxes, then ₹78 (i.e., ₹80 minus ₹2) forms the divisible pool. From this amount, 41% —about ₹32— is devolved to the States, while the remaining ₹46 and the ₹20 from cesses and surcharges is for the Centre to spend. The figures in this paragraph are meant only to demonstrate how the concept works.
Over the past year, 14 out of the 15 States that met with the 16th FC demanded that the devolution share be increased to 50% from 41%. This includes BJP-ruled States such as Odisha, Haryana, and Gujarat, as well as southern States like Kerala and Tamil Nadu. So, this is not a south versus north debate.
Pinaki Chakraborty, a distinguished professor at the National Institute of Public Finance and Policy, says that the States are not wrong in asking for extra funds.
M. Govinda Rao, member of the 14th FC, agrees and says that States are within their rights to demand a higher share. 'During the 14th FC's tenure, Gujarat with Narendra Modi as CM had demanded a 50% share in the divisible pool,' he added.
The current demand cuts across political and regional lines — and the reason is simple: states are being squeezed out of funds, some States more than others. This squeeze is applied in multiple ways. One prominent example is the rising share of revenue collected through cesses and surcharges, which are kept outside the divisible pool — and therefore beyond the reach of States.
The rise in the share of cesses and surcharges started somewhere after the 14th Finance Commission had increased the vertical devolution for the years FY16 to FY20 to 42% from 34%. The Central government was not happy with this increase. As revealed by Niti Aayog CEO B.V.R. Subrahmanyam during a seminar last year, the Narendra Modi government had asked the Commission to not go ahead with the move. But the then chairman Y.V. Reddy did not yield, a news report said.
While the chairman did not yield, in the following years the share of cesses and surcharges began to rise sharply. The share of cesses and surcharges, along with the cost of collection, reached a high of ₹13.5 for every ₹100 collected as taxes by the Centre in 2021-22 — the highest ratio in at least over a decade. Since then, it has gradually declined and is expected to be around ₹11 for 2025-26. In contrast, in many years before the pandemic, this figure ranged only between ₹5 and ₹7 (Chart 1).
GST compensation cess was not included in the list of cesses considered for analysis, as it was collected to compensate the States for revenue loss due to the implementation of GST.
Given that the share of cesses and surcharges has increased, the divisible pool has shrunk. Since the pandemic year 2020-21, the divisible pool has fallen to less than ₹90 for every ₹100 that the Centre collects. It is expected to remain below ₹90, according to Budget Estimates for 2025-26. In contrast, in many years before the pandemic, this figure ranged between ₹91 and ₹95 (Chart 2).
The consistent rise in the share of cesses and surcharges has meant that the FC's recommendations have been rendered less effective, as the divisible pool, upon which the FC's formula is applied, itself is shrinking. Many experts have previously pointed out that despite a formula in place, in practice the actual devolution to the States falls short of the agreed recommendations. This way, the 41% share looks unchanged on paper, but the actual amount devolved to the States is effectively reduced by the Centre (Chart 3).
Dilution of the Finance Commission
Now, if the 16th Finance Commission recommends raising the shareable portion to 50%, as many States have demanded, it remains to be seen whether the Centre will adopt a similar strategy again — by further expanding the cess and surcharge component.
Article 271 empowers the Union government to levy cesses and surcharges. 'This practice has been used to dilute the recommendations of the Finance Commission relating to the devolution of taxes,' Mr. Rao said. In the past, many commissions have adversely commented on it by saying that though there is a constitutional provision to levy cesses and surcharges, it should be used to meet temporary exigencies and should not be a permanent measure, Mr. Rao added.
'States have also been demanding the Finance Commission to recommend a cap on the cesses and surcharges to a specific percentage of the gross tax revenue or alternatively consider anything above the cap as constituting a part of the divisible pool. But that won't be possible without a constitutional amendment,' Mr. Rao said.
In fact, BJP-ruled Odisha's memorandum before the 16th Finance Commission is damning in its assessment. 'Overuse of cess and surcharges need to be contained, and the Commission may consider suggesting stricter tests for the cess and surcharges to qualify for exclusion from the divisible pool, through a constitutional amendment, if necessary,' said the memorandum, according to a media report.
Odisha also asked for a share from cesses and surcharges. While successive Finance Commissions have recommended the inclusion of cesses and surcharges in the divisible pool and recommended a constitutional amendment to make this happen, it has not happened so far, Mr. Chakraborty observed.
Inequalities in horizontal devolution
So far, we have looked at the issues surrounding what the Centre owes to all the States. But another contentious point has been how that money is distributed among the States. In other words, how the 41% States' share in the divisible pool was divided among them by the 15th FC. This distribution was based on several criteria — such as population, demographic performance (i.e. population control), forest cover, geographical area, and efficiency in tax collection. However, the weightage assigned to these factors is where disagreements surfaced.
The 15th FC gave the highest weight — 45% — to the 'income distance' criterion. This measures how far a State's per capita income is from that of the richest State. In effect, States with lower per capita income receive a larger share to promote equity.
This was followed by 15% each for a State's population and area — meaning, the larger the population and land area, the higher the share. Forest and ecology got 10%, based on a State's share of dense forests in India's total forest cover.
Demographic performance — favouring States with better population control — got 12.5%, while tax effort (how efficiently a State collects taxes) was given just 2.5%, the lowest weight.
Unsurprisingly, this formula drew criticism, particularly from the southern States, which tend to rank lower on the first three high-weightage factors — income distance, population, and area, which together accounted for 75% of the total. These States excel in population control and tax efficiency, but those factors collectively carried only 15% weight — much to their frustration.
In other words, if a State has successfully controlled its population and improved its economy, it ends up receiving a lower share — essentially disincentivising those States. In the past too, FCs had similar formulas because of which, the share of various States in the divisible pool has undergone significant changes since FY02. The share of all the southern States has fallen. Kerala's share fell from 3.08% in FY02 to 2.5% in FY17 and is estimated to fall even further to 1.9% in FY26 (BE). Tamil Nadu's share shrunk from 5.46% in FY02 to 4.02% in FY17 and is expected to remain at the same level in FY26. Karnataka's has come down from 4.98% in FY02 to 3.6% in FY26 BE. The share of Andhra Pradesh and Telangana together declined from 7.7% in FY02 to 6.75% in FY17 and is expected to drop to 6.1% in FY26. West Bengal and Odisha's shares have also come down consistently in the period. In contrast, the shares of Madhya Pradesh, Maharashtra, Rajasthan, and Gujarat have increased in this period.
States such as Uttar Pradesh and Bihar continue to receive the bulk of the share. Bihar is expected to get 10.1% in FY26, slightly lower than 11.49% in FY02; and Uttar Pradesh is expected to get 17.9% in FY26, slightly lower than 19.15% in FY02.
So, not only is the divisible pool shrinking, but the share allocated to certain States — most of which are in southern India and parts of the east — is also dwindling. This imbalance explains why many of these States now feel shortchanged.
Telangana wants 50% weightage to Gross State Domestic Product instead of the income criteria. Similarly, Tamil Nadu has suggested that a State's contribution to the country's economy be made a new criterion with a 15% weightage. Gujarat too wants a higher weightage for the performance of the States. Goa wants sustainable development goals to be given 12.5% weightage, and, together with Kerala, it wants to reduce income distance weightage from 45% to 30%.
Own tax revenue dips
In the first part, we discussed how the Centre has deliberately reduced the divisible pool by increasingly relying on cesses and surcharges and adversely impacting vertical devolution. We also examined how skewed weightages in horizontal devolution have led to a shrinking share of transfers for certain States. In the second part, we will explore how States are now finding it more difficult than ever to raise their tax and non-tax revenues.
For over a decade now, States' tax revenue as a share of their total revenue has remained considerably below the 50% mark, while in the 2000s and the early 2010s, it had crossed the 50% mark for many years or remained close to it. The own tax revenue of States includes money raised through stamp duty, registration fees, motor vehicle tax, and other taxes, along with the State GST (SGST).
Moreover, while SGST accounted for 15% of the States' total revenue in FY18, it currently makes up about 22%. Consequently, the share of own tax revenue, without the contribution from SGST, has declined from 34% to 28%.
It is important to note that the SGST is earned based on rates set by the GST Council and these rates have remained a bone of contention. In the past, Finance Ministers of many Opposition-ruled States, including Tamil Nadu, Kerala, and West Bengal, have spoken out against the Council's decisions.
So, on the one hand, the share of States' own tax revenue has declined, and on the other, the introduction of GST has limited their autonomy in deciding how tax revenue is collected.
More importantly, the collection of own tax revenues relative to the size of a State's economy shows a marked decline for six States in particular, notably, some of them are economically advanced States.
For Tamil Nadu, the own tax revenue to GSDP ratio has gradually declined from 7.72% in FY13-15 to 6.17% in FY 22-24. This has been the case in Karnataka, Kerala, Bihar, Delhi, and Madhya Pradesh, too. While the ratio has risen in Maharashtra, Manipur, Meghalaya, Odisha, and Uttarakhand, it has remained stagnant in other States.
'Sales tax was giving States the buoyancy, before the GST was introduced, by contributing almost 60% of the tax revenues. Now unless GST revenues become buoyant the States will not have better tax revenue to GSDP ratios. This is particularly true of producing States as the GST reform has made the consumption tax destination-based. It was hoped that the power to levy tax on services under GST would offset the loss from this change, but in States like Karnataka, much of the value added in services is exported and therefore, zero-rated,' Mr. Rao said.
Improving tax administration and enforcement, reducing the number of tax rates under GST and including petroleum products in the GST calculation can boost tax revenues for the States, Mr. Rao added.
There are similar issues on the non-tax revenue front too. The share of non-tax revenue in States' total revenue is likely to go below the 24% mark in FY25 for the first time in the past 25 years. Non-tax revenue of States includes grants from the Centre, earnings from social, fiscal, economic, and general services rendered by the States, interest receipts, and dividends/profits from State public sector enterprises.
Interest receipts have not exceeded 5% of States' non-tax revenues in the last decade compared to the 2000s and first half of 2010s when it formed 5-9% of non-tax revenue. Moreover, the share of dividends and profits garnered from State public sector enterprises has remained under 1%.
Earnings from services rendered, such as public health (social service) and power (economic service), did not cross the 30% mark in the last decade. It is only estimated to cross the mark in FY25. Compare this to the 2000s and the first half of 2010 when it crossed the mark in many years.
Put together, over the past decade, as a share of States' total revenue, States' own tax revenue is trending down, non-tax revenue is also going down, and that means, they have been relying more and more on transfers and grants from the Centre.
Sample this, in the last decade (FY16 to FY25), 23-30% of the total revenue of States was collected from the Centre as transfers. However, in the 2000s and the first half of 2010, the share was lower at 20-24%. Also, close to 65-70% of the non-tax revenue of States was collected from the Centre as grants in the last decade compared to the 2000s and the first half of the 2010s when the share was lower at 55-65%.
When the first and second parts are read together, a concerning trend becomes evident. The Centre has been transferring progressively less to the States. Despite this decline, the share of transfers from the Centre in the States' total revenue has actually increased over the years. This highlights the growing financial struggles faced by the States in generating their own revenue, leading to increased dependence on the Centre — ironically, even as those central transfers are being reduced.
Limits on borrowing
With the States struggling to raise their own revenue and the transfers from the Centre curtailed, borrowing remains a viable alternative. In the third and final part, we will discuss how the States' borrowing is curtailed by the Centre.
Constitutional provision Article 293 allows the Centre to set a Net Borrowing Ceiling (NBC) for the States. The ceiling is determined by the Centre based on the Fiscal Responsibility and Budget Management Act and the Finance Commission recommendations. It allows States to borrow up to 3% of their GSDP.
The Centre sees this limit as a way to achieve fiscal consolidation by minimising the fiscal deficit. States see it as their liberty to borrow being curtailed, and their avenues to balance their budgets being limited.
'The FRBM Acts for each State is passed by that State setting the limit. Of course, under Article 293 of the Constitution, the States can borrow domestically, but if they are indebted to the Union government, they have to seek the latter's permission. This effectively means that the borrowing limits are set by the Union government,' Mr. Rao said.
Notably, the Centre wants the off-budget borrowings accounted for in the State's budget and the limit be applicable on their final debt position.
Off-Budget borrowings are loans obtained by government entities, such as PSUs or special purpose vehicles, on behalf of the government to finance its expenditure. These borrowings are typically not included while computing the debt and the fiscal deficit of the State governments. However, the State government is responsible for repaying the loan and servicing the debt from its Budget. But now States have to show them in their books.
Kerala took the Centre to the Supreme Court in 2023 for placing a 'financial embargo' on the State by imposing a limit on its borrowings through the new borrowing ceiling (NBC) which is fixed at 3% of the GSDP. The apex court refused to grant the State relief in the matter.
Mr. Chakraborty explains that the constitutional provision that places restrictions on borrowing of the States is prudent since the Centre has to ensure macroeconomic stability. He adds that having unlimited borrowing at the sub-national level is not a great idea.
'It is not a question of Centre vs States but of reducing general government debt. For an improvement of the debt-to-GDP ratio of the General Government (Centre + States), the Centre has to do the heavy lifting in terms of correction of debt ratio as 65% of the general government debt is with the Centre and only 35% is with the States, ' he said.
While the Centre's logic in restricting the States may be sound, the fact that it curtails another avenue of raising funds for the States cannot be refuted.
The big squeeze
With States struggling to raise their own funds, central transfers shrinking year after year, and borrowing limits firmly in place, the States are ultimately being squeezed out of financial space.
As the 16th Finance Commission prepares to make its recommendations for the five-year period starting April 2026, all eyes are on the course it will chart. An overwhelming majority of the States it has visited so far have called for an increase in vertical devolution, along with sweeping changes to the criteria used for horizontal devolution. The ball is now in the Commission's court.
What will be even more interesting, however, is the Centre's response once the recommendations are released. Given the reactions that followed the last significant increase in vertical devolution, and with a similar proposal likely this time, India could be heading into yet another critical test of its already strained federal structure.