Fiscal fault lines between centre and states are back in focus
The recent transformation of India's flagship rural employment guarantee programme puts a greater financial burden on states, highlighting a long-running source of friction in their relationship with the Union government.
By law, the Union government collects direct taxes and shares it with states. But states say their share has not kept pace with the growth in tax revenues, even though they bear the bulk of social and development expenditure. States also argue that their autonomy is being eroded as the Union government forces them to co-finance centrally sponsored schemes (CSS) that they did not necessarily approve.
Penalising success
Under the Constitution, only the Union government can collect direct taxes, with the Finance Commission (FC) setting the terms under which it is shared with states. FC recommendations are revised every five years. Under the 15th FC (2021 to 2026), the Union government is supposed to share 41% of the taxes it collects with states. Goods and services tax (GST) is shared through a different set of rules. However, the share of states in total taxes has hovered around 33%.
This is a key grievance of many states, especially the more affluent southern ones. They argue that despite contributing a higher share of taxes to the Union government, they are effectively penalised in favour of poorer states. This grievance has been amplified in recent years as the Union government's retained tax revenue has been growing faster than the share it passes on to the states. The main reason for this is the Union government's greater use of cesses and surcharges on income and corporate tax.
Cess chess
Under the Constitution, cesses and surcharges are not part of the shareable pool of taxes and they accrue entirely to the Union government. Before covid, cesses and surcharges averaged around 5.4% of total direct tax collections. However, their share has since risen to 9.9%. By increasing corporate and individual taxes through cesses and surcharges, the Union government is trying to have its cake and eat it too, states say.
The 15th FC's recommendations will be revised in 2026. The 16th FC, chaired by economist Arvind Panagariya, recently submitted its recommendations to the Union government on sharing revenue with states. The recommendations are not yet public, but expect the commission to weigh in on states' demand that the Union government raise funds in a way that it can be shared with them.
Conditional transfers
Another significant claim by states is that even when the Union government transfers funds to them, it constrains how they can be spent. Aside from states' share in central taxes, which they can spend how they see fit, the Union government also sends money to states to spend on so-called centrally sponsored schemes (CSS).
These schemes are usually formulated by the Union government but part-funded by states, typically in a 60:40 ratio. States argue they are forced to pay for schemes that are Union government priorities and not their own. For 2025-26, about 57.5% of total central transfers to states is expected to fall under the FC tax-sharing umbrella, meaning states can spend this money how they want. The balance comes through CSS or grants allocated by the FC for specific purposes.
Rich state, poor state
The extent to which central funds are used to fund states' expenditures varies widely across states. Poorer ones rely heavily on such funds, as do the northeast states and hilly states such as Uttarakhand, and some central schemes include terms designed specifically for them. In some of India's large but poor states such as Bihar, Uttar Pradesh and Madhya Pradesh, 40-60% of the expenditure is met through central funds. States with stronger economies—such as Maharashtra (20.8%) and Tamil Nadu (20.2%)—rely far less on central funds.
This is why richer states claim they are being shortchanged in favour of poorer ones. But this is only part of the story. Millions of workers from poorer states such as UP and Bihar work in richer states for low wages. Also, despite being poorer, northern states provide an enormous market for goods manufactured in richer states.
Political penalty
It's thus debatable whether richer states would be as well-off if it weren't for the abundant cheap labour that northern states provide. However, the fiscal disparities are real. The average central transfer per person is much higher in poorer states, and accounts for a greater share of average income than in richer states.
The issue will be especially important in the next census, scheduled for 2027. After the census, the Union government is likely to redraw boundaries of state and central constituencies based on population. This is likely to result in more parliamentary seats and political power for heavily populated, poorer states. Thus, richer states complain, they are being penalised in both fiscally and politically. One way to address the increasing political imbalance post-delimitation, experts have said, would be to transfer more funds to states and give them greater autonomy on spending.