Union Government Proposes Tax Revenue Cuts for States

The Union government of India is considering a reduction in the share of central tax revenues allocated to states. This proposal will be presented to the Finance Commission of India. The Commission is responsible for recommending tax sharing and federal-state fiscal relations. The potential changes could escalate tensions between the central and state governments. The recommendations are expected by October 31 and will be applicable from the fiscal year 2026-27.

Current Tax Revenue Distribution

Currently, states receive 41% of central tax revenues. This is increase from 20% in 1980. The increase reflects the growing financial needs of state governments. However, the federal government argues that its spending requirements have also surged, especially during economic downturns.

Financial Implications of Proposed Changes

The proposed reduction in states’ tax share to 40% could yield approximately 350 billion rupees for the federal government. This amount is based on anticipated tax collections for the current year. The actual figure may vary depending on yearly tax revenues.

Fiscal Deficits of Government Entities

For the fiscal year 2024-25, the Union government’s fiscal deficit is projected at 4.8% of GDP. In contrast, states are expected to have a fiscal deficit of 3.2% of the national GDP. States play important role in government spending, accounting for over 60% of total expenditures, primarily on social services.

Limitations on State Revenue Generation

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

Potential Changes in Spending Priorities

A shift in tax revenue allocation may alter states’ spending priorities. The federal government is likely to propose measures to discourage states from providing cash handouts or debt waivers, often termed as “freebies.” This could involve linking federal grants to specific conditions that states must meet.

Declining Revenue-Deficit Grants

In recent years, revenue-deficit grants to states have decreased. From 1.18 trillion rupees in 2021-22, the estimated grants for 2025-26 have dropped to 137 billion rupees. This decline raises concerns about the financial autonomy of states.

Future Recommendations and Conditions

The Finance Commission’s recommendations will be binding. The federal government may impose conditions for states to receive federal grants. This approach aims to ensure responsible financial management by state governments.

Questions for UPSC:

1. Examine the implications of fiscal federalism on state autonomy in India.
2. Critically discuss the impact of the Goods and Services Tax on state revenue generation.
3. What are the challenges faced by state governments in managing fiscal deficits? Discuss.
4. With suitable examples, discuss the role of federal grants in shaping state financial policies.

Answer Hints:

1. Examine the implications of fiscal federalism on state autonomy in India.

1. Fiscal federalism defines the financial relationship between the central and state governments.
2. State autonomy is influenced by the allocation of tax revenues and grants from the central government.
3. Changes in tax sharing can lead to tensions and affect states’ ability to implement local policies.
4. Increased central control may limit states’ discretion in revenue generation and spending priorities.
5. Fiscal constraints can hinder states’ ability to respond to local needs and economic challenges.

2. Critically discuss the impact of the Goods and Services Tax on state revenue generation.

1. The Goods and Services Tax (GST) centralized tax collection, limiting states’ ability to raise their own revenues.
2. States receive a share of GST, but the overall revenue growth has been inconsistent post-GST implementation.
3. States have faced challenges in adapting to the new tax regime, affecting their financial autonomy.
4. GST has streamlined tax processes but has also resulted in revenue losses for some states.
5. States now depend more on federal transfers, impacting their fiscal independence and planning.

3. What are the challenges faced by state governments in managing fiscal deficits? Discuss.

1. State governments are often burdened by high expenditure on social services, leading to fiscal deficits.
2. Revenue generation is limited due to constraints imposed by GST and reduced central tax shares.
3. Economic downturns exacerbate fiscal pressures, restricting states’ ability to balance budgets.
4. States face challenges in accessing credit markets due to perceived fiscal mismanagement.
5. Declining federal grants and revenue-deficit grants further strain state finances.

4. With suitable examples, discuss the role of federal grants in shaping state financial policies.

1. Federal grants provide essential funding for states to support social infrastructure projects, such as health and education.
2. Conditional grants can incentivize states to adopt specific policies or reforms, influencing their financial management.
3. For example, the Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA) is funded through federal grants, shaping rural employment policies.
4. Declining revenue-deficit grants can lead to austerity measures in states, affecting their financial priorities.
5. Federal grants can also be a tool for the central government to influence state governance and policy decisions.