On the national stage, India’s economic narrative heavily champions the ideal of Aatmanirbhar Bharat—a self-reliant nation capable of building its own infrastructure, securing its supply chains, and reducing its vulnerability to global shocks. Yet, beneath this macro-level push for autonomy lies a contrasting domestic reality. Over the past decade, India’s state governments have found themselves increasingly tethered to, and dependent upon, financial allocations from the Central Government in New Delhi.
While the Fourteenth Finance Commission made headlines in 2015 by raising the states’ share of the divisible tax pool from 32% to 42% (subsequently adjusted to 41%), the structural integrity of the tax pool itself has undergone a profound transformation. Seventeen years of Union Budget data reveal that even as the headline devolution percentage remained high, the actual pool of shareable tax revenue has shrunk. For states tasked with managing critical public services, this shift has created severe compliance, administrative, and revenue collection challenges.
The Structural Mismatch of Indian Fiscal Federalism
India’s constitutional framework deliberately established an asymmetrical financial architecture. State governments are directly responsible for high-expenditure public welfare sectors, including healthcare, education, agriculture, and policing. Conversely, the Central Government retains control over the most buoyant and elastic revenue streams, such as corporate tax, personal income tax, and the central portion of the Goods and Services Tax (GST).
This structural gap, known as vertical fiscal imbalance, means that states historically spend far more than they can independently raise. Some estimates place this imbalance at nearly 60% of combined government revenue. To bridge this divide, the Constitution relies on a rules-based devolution mechanism managed by the Finance Commission. However, the efficacy of this mechanism is entirely dependent on the size of the “divisible pool” of taxes. When the Centre increasingly relies on cesses and surcharges—which are constitutionally exempt from being shared with states—the pool shrinks, and states are left with a smaller slice of the fiscal pie.
The GST Impact: Compliance Pressures and Revenue Realities
The introduction of the GST in 2017 fundamentally altered state revenue dynamics. By transitioning to a unified indirect tax regime, states surrendered significant fiscal sovereignty, losing their independent powers to levy sales tax, VAT, luxury tax, and entry tax. In return, they became heavily reliant on their share of State GST (SGST) and the devolution of Central GST (CGST).
During the initial five-year transition period, the GST Compensation Cess acted as a safety net, guaranteeing states a 14% annual revenue growth rate. However, the expiration of this compensation regime has exposed states to intense fiscal volatility. To maintain budgetary stability, states must now focus intensely on maximizing local tax compliance and optimizing their administrative machinery. This shift in focus is analyzed in depth in our discussion on Structural Reforms and Fiscal Anchors, which highlights how next-generation economic reforms are reshaping state-level compliance obligations.
With the safety net gone, states face a dual challenge:
- Aggressive Compliance and Enforcement: To secure their revenue bases, state tax departments are intensifying SGST audits, leveraging data analytics to curb tax evasion, and tightening input tax credit (ITC) verification processes.
- Reliance on Non-Shareable Instruments: Because the Centre has frequently utilized non-shareable cesses to fund national initiatives, the shareable pool fell to a historic low of 71.6% in FY 2020-21. This forced states to manage local crises using discretionary grants rather than assured constitutional devolution.
This dynamic has also disproportionately impacted economically advanced states. As explored in The Tax Penalty of Progress, high-performing states that generate substantial GST revenues often receive a smaller share of central devolution, further complicating their long-term fiscal planning and infrastructure maintenance capabilities.
The Pandemic Anomaly and Discretionary Transfers
A closer look at the financial data reveals a complex paradox. During the pandemic year of 2020-21, total transfers to states—including devolution, grants, and loans—actually peaked at 59.1% of the Centre’s pre-transfer revenue. On the surface, this suggested unprecedented central support. However, this peak was largely a mathematical anomaly caused by a sharp contraction in the Centre’s own tax collections, combined with the continued disbursement of GST compensation and back-to-back loans to keep state machinery running.
As the economy recovered, this transfer ratio steadily declined, dropping to approximately 51% by FY 2024-25. The critical takeaway is the nature of these funds: instead of receiving automatic, rules-based devolution through the divisible pool, states received a significant portion of their funding via discretionary grants and loans controlled by the Centre. This shift from constitutional entitlement to discretionary central aid fundamentally alters the power balance of India’s Fiscal Tightrope, forcing states to align their local policies with central directives to secure necessary funding.
The Road to the 17th Finance Commission
As the Seventeenth Finance Commission begins its deliberations, the central debate will not merely be about the headline devolution rate, which has remained at 41%. Instead, the focus must shift to the definition and protection of the divisible pool itself. If the Centre continues to expand its reliance on cesses and surcharges, any nominal increase in the devolution rate will remain ineffective.
For true cooperative federalism to succeed, states require predictable, non-discretionary revenue streams. Without a fixed, protected tax base, states will continue to face immense pressure to tighten local compliance, curb administrative expenditures, and rely on central goodwill—a reality that directly challenges the spirit of decentralized governance.
Frequently Asked Questions
It is the structural gap between state expenditures and revenues. States are constitutionally responsible for high-expense services like health, education, and policing, while the Centre retains control over highly elastic tax streams like income tax, corporate tax, and GST, resulting in states spending far more than they can raise independently.
The divisible pool shrank because the Central Government increasingly relied on cesses and surcharges to finance its Covid-19 pandemic response. Since cesses and surcharges are constitutionally exempt from being shared with states, this reduced the overall size of the shareable tax base.
This peak was a mathematical anomaly. The Centre's own tax and non-tax revenues declined sharply during the pandemic, while mandatory GST compensation, back-to-back loans, and relief grants to states remained steady, causing the ratio of transfers relative to central revenue to spike.
The Seventeenth Finance Commission must decide whether to continue negotiating the headline devolution rate or to establish a fixed, protected tax base that prevents the divisible pool from being diluted by the Centre's use of non-shareable cesses and surcharges.
