GST Restructuring and Centre-State Fiscal Relations

The Goods and Services Tax (GST) system in India has entered a new phase with the recent restructuring of tax slabs. This change is expected to provide over ₹2 lakh crore in tax benefits to consumers. The GST compensation cess has been abolished and merged with the regular tax, ending the compensation mechanism under GST. This move aims to boost local demand and may reduce projected revenue losses. However, some States remain concerned that their compensation demands have been overlooked and that the actual revenue loss could be higher than estimated. The evolving fiscal landscape marks tensions in Centre-State financial relations and calls for revisiting tax-sharing policies to strengthen cooperative federalism.

Evolution of GST and Fiscal Federalism

GST, launched in 2017, replaced multiple indirect taxes with a single destination-based tax. It allowed both the Centre and States to share a common tax base. However, this shift reduced States’ fiscal autonomy as tax powers moved to the GST Council, where the Centre holds influence. The new tax regime centralised revenue collection while States retained expenditure responsibilities, creating fiscal imbalances. Such imbalances require dynamic fiscal adjustments to ensure each government tier can meet its obligations effectively.

Constitutional Provisions and Finance Commission Role

Articles 268 to 293 of the Constitution of India govern Centre-State financial relations. The Finance Commission, under Article 280, recommends tax revenue transfers to States. Despite this, States often criticise the Finance Commission for inconsistent criteria and perceived unfairness, especially towards progressive States. Besides Finance Commission grants, funds flow through Centrally Sponsored Schemes and direct Union grants. Many States argue that these mechanisms lack transparency and fairness in fund allocation.

Declining State Share in Revenue and Impact

State shares in Central tax revenue increased from 29.5% to 42% over successive Finance Commissions but fell to 41% after Jammu and Kashmir’s reorganisation. Actual devolution has been lower than recommended due to increasing cesses and surcharges excluded from the shareable pool. These additional levies provide the Centre with extra fiscal space, often funding Central schemes. Consequently, States depend heavily on Central transfers, which constitute 44% of their revenue on average, undermining their fiscal independence.

Expenditure Responsibilities and Fiscal Challenges

States manage critical sectors like health, education, law and order, and agriculture. Their expenditure commitments exceed their tax-raising powers, causing fiscal stress. The Centre’s expanding role in revenue expenditure largely funds Centrally Sponsored Schemes in State domains. Heavy reliance on Central transfers affects liquidity and raises concerns over political bias, especially in Opposition-ruled States. Some States advocate for a system similar to Canada’s, where sub-national governments have greater taxing power and expenditure responsibility, enhancing fiscal autonomy.

Proposals for Enhancing State Fiscal Autonomy

To reduce dependence on the Centre, suggestions include sharing personal income tax revenue between the Centre and States on a 50:50 basis or allowing States to levy additional income tax surcharges. Such reforms would enable States to benefit from their tax bases directly and improve fiscal liquidity. The Centre would retain tools to address fiscal imbalances through grants and schemes. These proposals aim to rebalance fiscal federalism and support States in meeting growing public service demands.

Questions for UPSC:

1. Point out the challenges in Centre-State financial relations after the introduction of Goods and Services Tax (GST) in India.
2. Critically analyse the role of the Finance Commission in India’s fiscal federalism with suitable examples of its impact on State finances.
3. Estimate the implications of high dependence of Indian States on Central transfers for fiscal autonomy and governance.
4. What is cooperative federalism? Discuss how fiscal decentralisation can strengthen cooperative federalism in India with reference to tax-sharing mechanisms.

Answer Hints:

1. Point out the challenges in Centre-State financial relations after the introduction of Goods and Services Tax (GST) in India.

1. GST centralised taxation power to the GST Council, dominated by the Centre, reducing States’ fiscal autonomy.
2. States lost control over multiple indirect taxes, leading to erosion in their independent revenue sources.
3. GST compensation cess abolition raised concerns over adequate compensation for revenue losses in some States.
4. Fiscal imbalance arose as States retained expenditure responsibilities but had limited tax-raising powers.
5. Increased dependence on Central transfers and grants, affecting States’ liquidity and autonomy.
6. Some States feel their compensation demands and revenue loss estimations have been ignored, causing friction.

2. Critically analyse the role of the Finance Commission in India’s fiscal federalism with suitable examples of its impact on State finances.

1. Finance Commission (FC) constitutionally mandated to recommend tax revenue transfers and grants to States (Article 280).
2. FC criteria and weights vary across commissions, leading to perceived inconsistencies and unfairness, especially to progressive States.
3. Devolution share recommended by FCs increased from 29.5% to 42%, but actual transfers often fall short due to cesses/surcharges exclusion.
4. FC grants are supplemented by Centrally Sponsored Schemes and direct Union grants, often lacking transparency.
5. States complain about the lack of fairness and transparency in fund allocation through FC and other mechanisms.
6. Example – Progressive States feel penalised as FC formula may not fully reward higher revenue generation or expenditure needs.

3. Estimate the implications of high dependence of Indian States on Central transfers for fiscal autonomy and governance.

1. 44% of States’ revenue receipts come from Central transfers, indicating heavy fiscal dependence.
2. Dependence varies widely; some States (e.g., Bihar 72%) are highly reliant, others less so (Haryana 20%).
3. High dependence undermines States’ fiscal autonomy and limits their policy and financial flexibility.
4. Creates liquidity management challenges and vulnerability to political pressures, especially in Opposition-ruled States.
5. States bear major expenditure responsibilities (health, education, law and order) without matching tax powers.
6. Dependence on Central transfers may discourage States from mobilising own revenues effectively.

4. What is cooperative federalism? Discuss how fiscal decentralisation can strengthen cooperative federalism in India with reference to tax-sharing mechanisms.

1. Cooperative federalism is a collaborative approach where Centre and States work together for mutual benefit and shared governance.
2. Fiscal decentralisation means giving States greater tax-raising powers and financial autonomy to meet their expenditure responsibilities.
3. GST’s common tax base is a step toward cooperative federalism but central dominance limits true fiscal decentralisation.
4. Sharing personal income tax on a 50:50 basis or allowing States to levy surcharges can enhance fiscal autonomy and cooperation.
5. Decentralised fiscal power reduces dependence, improves liquidity, and aligns resources with local needs, encouraging cooperation.
6. Balanced tax-sharing mechanisms ensure equitable resource distribution while respecting States’ fiscal sovereignty.