Tax Revenue Cuts for States

The Government of India, led by Prime Minister Narendra Modi, is proposing a reduction in the federal tax revenues allocated to states. This proposal, which is under consideration by the Finance Commission of India, could impact the fiscal relationship between the federal and state governments. The recommendations from the Commission are set to be submitted by October 31, 2025, for implementation in the fiscal year 2026-27.

Current Tax Revenue Distribution

Currently, states receive 41% of federal tax revenues. This share has increased from 20% in 1980. The proposed reduction to at least 40% could yield an additional Rs 35,000 crore (approximately $4.03 billion) for the federal government. This shift is driven by increasing spending needs at the federal level, especially during economic slowdowns.

Impact on State Finances

States have a fiscal deficit of 3.2% of the national GDP, while the federal government’s deficit is estimated at 4.8%. States are responsible for over 60% of total government spending, focusing on social infrastructure like health and education. The reduction in tax revenue could force states to alter their spending priorities, potentially impacting essential services.

Limitations on State Revenue Generation

Since the implementation of the Goods and Services Tax (GST) in July 2017, states have faced restrictions in raising their own revenues. The federal government has also increased the share of cesses and surcharges, which are not shared with states, from 9-12% to over 15% of gross tax revenue.

Conditions for Federal Grants

The federal government may introduce conditions for federal grants to states, linking these grants to the states’ fiscal management practices. States that continue to offer cash handouts or other incentives for political gain may find their eligibility for these grants restricted.

Trends in Revenue-Deficit Grants

Revenue-deficit grants to states have seen decline, dropping from Rs 1.18 trillion ($13.61 billion) in 2021-22 to an estimated Rs 13,70 crore ($1.58 billion) for 2025-26. This trend indicates a tightening of fiscal resources available to states.

Future Implications

The proposed changes could exacerbate tensions between the federal and state governments. States may resist reductions in their tax revenue share, fearing detrimental effects on their budgets and services. The dynamics of federal-state fiscal relations could shift, leading to broader implications for governance and public welfare.

Questions for UPSC:

1. Critically analyse the implications of reduced tax revenue for state governments in India.
2. What are the potential consequences of linking federal grants to state fiscal management practices?
3. Estimate the impact of the Goods and Services Tax on state revenue generation capabilities.
4. Point out the reasons for the decline in revenue-deficit grants to states over recent years and its effects.

Answer Hints:

1. Critically analyse the implications of reduced tax revenue for state governments in India.

1. Reduction from 41% to 40% in federal tax revenue share could limit states’ budgets.
2. States may have to cut essential services like health and education due to budget constraints.
3. Increased fiscal stress could lead to higher borrowing or reliance on federal grants.
4. Potential for increased tensions between state and federal governments over resource allocation.
5. States may struggle to meet developmental goals and social welfare commitments.

2. What are the potential consequences of linking federal grants to state fiscal management practices?

1. States may face restrictions on grants if they do not adhere to fiscal discipline.
2. This could incentivize better financial management but may also limit state autonomy.
3. Linking grants to conditions may lead to inequities among states based on their fiscal health.
4. States might prioritize compliance over innovative policy-making to secure funding.
5. Potential for reduced political support for federal initiatives if states feel penalized.

3. Estimate the impact of the Goods and Services Tax on state revenue generation capabilities.

1. GST implementation in 2017 centralized tax collection, limiting state revenue autonomy.
2. States have less flexibility to raise taxes independently, impacting their revenue streams.
3. Revenue-sharing under GST has not fully compensated for lost state tax powers.
4. States may struggle to adapt to the new tax regime, affecting fiscal health.
5. Dependence on federal transfers has increased, making states vulnerable to federal policy changes.

4. Point out the reasons for the decline in revenue-deficit grants to states over recent years and its effects.

1. Declining revenue-deficit grants from Rs 1.18 trillion to Rs 13,70 crore indicates fiscal tightening.
2. Increased federal fiscal deficits necessitate reduced transfers to states.
3. Focus on federal spending priorities may divert resources away from state needs.
4. States may face growing fiscal pressures, leading to cuts in public services.
5. Long-term implications could include increased state-level debt and economic instability.