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Restoring fiscal space for the States

 Why is it in the News?

  • The GST compensation cess has been merged with the regular GST, ending the compensation mechanism for States.
  • This move is expected to pass on over₹2 lakh crore in tax benefits to consumers and potentially boost local demand.
  • Certain States fear revenue losses and erosion of fiscal autonomy, arguing that no proper estimation of losses has been made.
  • The decision reignites discussions on Centre-State fiscal relations, cooperative federalism, and the sharing of tax powers.

Relevance

  • GS-3: Indian Economy – Taxation, Centre-State relations, Fiscal Federalism, Public Finance, Revenue Sharing.

GST and Fiscal Policy

GST Introduction:

  • Launched in July 2017 through the 101st Constitutional Amendment.
    • Replaced multiple indirect taxes with a common destination-based tax, shared between Centre and States.
    • Initial GST compensation mechanism ensured States were not worse off due to revenue loss.

Centre-State Fiscal Relations:

  • Articles 246–293 govern taxation powers and transfers.
    • Finance Commission (Article 280) recommends devolution of funds to States.
    • Central transfers still account for 44% of States’ revenue receipts, with Bihar at 72% dependence, Haryana at 20%.
    • Dependence on Central transfers affects liquidity, fiscal autonomy, and political leverage.

Revenue Sharing History:

  • Pre-GST (2012-17): Centre collected 67%, States 33%. Post-GST (2018-23): ratio remained similar.
    • Devolution share recommended by Finance Commissions increased from 29.5% (11th FC) → 42% (14th FC), but actual devolution fell short due to cesses and surcharges, which remain non-shareable.

Overview

Impact of GST Compensation Cess Merger

  • Consumers may benefit from lower prices, boosting demand.
  • States risk revenue loss: compensation previously guaranteed annual shortfalls.
  • Cess and surcharge previously gave the Centre additional leverage, now merged, reducing that buffer.

Erosion of Fiscal Autonomy

  • GST centralises tax power in the GST Council, dominated by the Centre.
  • States’ ability to independently raise revenue is limited.
  • Progressive States (e.g., Tamil Nadu, Maharashtra) contribute more to taxes but cannot fully retain the benefits.

Structural Issues in State Finances

  • Expenditure responsibilities are higher at State level: health, education, agriculture, local governance.
  • Central transfers and grants (CSS, CFS, Finance Commission) supplement but are performance-based or conditional.
  • Heavy dependence on the Centre creates fiscal vulnerability and political friction, especially in opposition-ruled States.

Proposed Solutions for Greater Fiscal Autonomy

  • Sharing personal income tax base with States on a 50:50 basis, similar to GST.
  • Allowing States to top up income tax rates without altering the current levy system.
  • Such reforms would:
    • Reduce dependency on Centre.
    • Improve liquidity and planning.
    • Reward progressive States contributing higher revenue.

Comparative Perspective

  • Example of Canada: Federal govt collects 46%, sub-national governments 54%; federal spends 40%, provinces spend 60%.
  • Suggests a model where States have more autonomy in raising resources and spending, improving accountability and service delivery.

Takeaway

  • GST restructuring is a double-edged sword: consumer benefit vs. potential revenue loss for States.
  • Centralised tax authority ensures uniformity but reduces State fiscal autonomy.
  • A dynamic approach to tax sharing and grants is critical to maintain cooperative federalism.
  • Fiscal reform may require structural redesign of transfers, tax bases, and conditionalities to empower States.

October 2025
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