States of Imbalance

The first of a two-part series examines how India’s federal fiscal structure strained by populist spending and uneven GST revenues threatens to upend the nation’s pursuit of long-term economic stability.

The Indian economy has lately taken some curious turns. The sting of tariff disruptions still lingers, but the festive season’s buoyancy and the continuing benefits of the Goods and Services Tax (GST) reforms have revived momentum. Exports have been dented by American tariffs and the uneasy dance around Russian oil imports, yet domestic demand has powered ahead, masking external fragilities. Encouragingly, the optimism is not confined to India’s own corridors of power; multilateral institutions too spy a rare combination of resilience and reform.

Fiscal imprudence

As the government touts its vision of a developed India by 2047, its arithmetic of ambition is getting complicated. Fiscal prudence, once the sacred mantra of policymakers, is losing its sanctity. But while populism may deliver at the hustings, it also threatens the long-term health of public finances. A recent study by PRS India offers a sobering reminder of how precariously balanced India’s fiscal federalism has become.

India’s Constitution carefully calibrates this balance of power. Articles 268 to 293 map a federal compact that allows states fiscal autonomy while keeping the Centre in command of coordination. The Union levies certain taxes, such as stamp duties, which are collected and appropriated by states. Other taxes, like estate duties and terminal levies, belong to states even though they are collected by Delhi. Income tax, under Article 270, is shared between the two, while Article 271 grants the Centre a carte blanche to impose surcharges that need not be shared. Both sides may dispense discretionary grants under Article 282.

In theory, the states are no fiscal weaklings. They enjoy exclusive rights over duties on alcohol, motor vehicles, and professions, among others. The Finance Commission, established under Article 280, periodically decides how the spoils of national taxation are to be split and how grants-in-aid are to be distributed among deficit-ridden states and local bodies.

The mix is uneven. In the financial year 2024–25, states’ own tax revenues are budgeted at 7.12 percent of their combined gross state domestic product (GSDP), up from 6.84 percent two years earlier, making up just over half of their total revenue. The State GST remains the dominant pillar, accounting for between 60 and 68 percent of own-tax collections. Excise duties, stamp duties and motor-vehicle taxes trail behind.

Yet the broad trend is one of tightening space. Despite a rebound in state-level tax mobilisation after the pandemic, total revenue receipts remain below their pre-Covid trajectory, largely because central support has withered. Grants-in-aid have fallen from 1.92 percent of GSDP in 2022–23 to an expected 1.78 percent this fiscal year. The expiry of the GST compensation cess in June 2022 removed an important cushion. States must now learn to stand more firmly on their own fiscal feet.

Clipped revenues

The GST, introduced in 2017 as the most sweeping tax reform since independence, simplified India’s patchwork of indirect taxes but also clipped state revenues. Taxes that were folded into the GST once yielded 6.5 percent of national GDP; by 2023–24, they produced barely 5.5 percent. States, which earlier collected about 2.8 percent of GDP from these levies, now earn an average of 2.6 percent through the State GST.

The pandemic drove SGST receipts down to 2.3 percent of GDP, before a recovery to 2.8 percent in 2024–25. The Reserve Bank of India’s projection of a 7 percent GST-to-GDP ratio remains aspirational. Twenty states now earn less under GST than they did before it. Only five small North-Eastern states - Meghalaya, Manipur, Mizoram, Nagaland and Sikkim - have gained, courtesy of GST’s destination-based design.

Punjab, Chhattisgarh, Karnataka, Madhya Pradesh and Odisha have been hit hardest, Punjab most of all, having once leaned heavily on manufacturing taxes. The end of GST compensation has worsened the strain. Even with recent rate rationalisations, the revenue yield looks weak, casting doubt on the fiscal sustainability of many states.

If revenues are under stress, expenditures are even more worrying. Over the decade to 2022–23, states’ committed expenditures (wages, pensions and interest payments) rose two and a half times, while subsidies grew more than threefold. These obligatory items now devour 62 percent of states’ revenue receipts, leaving scant room for investment in infrastructure or human capital.

Subsidies, fuelled by loan waivers and free power schemes, have swollen to politically irresistible proportions. Punjab spends nearly 17 percent of its revenues on subsidies alone, much of it financed by borrowing. Overall, revenue expenditure gobbles up 84.7 percent of total state spending, leaving capital outlays at a meagre 2.8 percent of GSDP.

Fiscal rigidity

Fiscal rigidity has squeezed states’ room for manoeuvre. Discretionary spending has fallen from 57 percent of revenue expenditure a decade ago to barely a third today. Chronic deficit states such as Andhra Pradesh, Punjab, Kerala and West Bengal have pared back development budgets as committed costs - wages, pensions and interest - consume over 80 percent of their income. Subsidies now often exceed revenue deficits, meaning governments borrow to fund populism.

The ‘golden rule’ of borrowing only for investment has been all but forgotten. At the same time, central transfers have grown more prescriptive: under the Fifteenth Finance Commission, 60 percent of rural grants are tied to specific uses, while untied funds have shrunk to 64 percent of total grants, leaving states with little fiscal flexibility to meet local priorities or emergencies.

Centrally Sponsored Schemes (CSS), another conduit of federal funding, further blur accountability. They oblige states to co-finance and comply with central diktats, often measuring inputs rather than outcomes. The result is a fiscal architecture where states function less as laboratories of democracy and more as executors of Delhi’s blueprints.

The Covid-19 pandemic laid bare the consequences of this centralisation. In the rush to contain the crisis, fiscal autonomy quietly ceded ground to administrative command. Reversing that drift will require more untied transfers and a rethink of how India practises cooperative federalism.

India’s economic health, often judged by national GDP numbers, depends in no small measure on the fiscal discipline of its states. As India chases the dream of prosperity by 2047, that discipline forms the foundation on which the edifice of a ‘Viksit Bharat’ must stand.

(The author is a Chartered Accountant with a leading company in Mumbai. Views personal.)