States’ Fiscal Space Is Squeezed from Both Sides
A State may have a large budget and still have surprisingly little freedom over how that money is used.
That is because the problem facing Indian States is not simply the amount of revenue available to them. It is the combination of what they are required to spend on, which revenues they can alter, and how much of their budget is already committed before new priorities are considered.
This distinction becomes important when the Finance Commission’s 41% devolution is discussed as though it captures the entire fiscal position of States. The figure tells us how much of the divisible pool is assigned to States. It does not tell us how much usable fiscal room remains after existing obligations and institutional constraints are taken into account.
India’s States therefore face pressure at two points. Their responsibilities have expanded, while some of the instruments through which they could independently adjust revenues have become more limited.
The fiscal problem begins with a mismatch
India’s federal structure deliberately separates much of the power to raise revenue from the responsibility for delivering public services.
The Union has access to major national tax bases, while States operate much closer to citizens and are responsible for services such as health, education, agriculture, law and order and local government. These responsibilities also expand as public expectations rise and urbanisation creates new demands on infrastructure and municipal services.
The consequence is that States require more than a predictable flow of money. They require resources that can be redirected when circumstances change.
A transfer can increase a State’s resources without necessarily increasing its freedom to decide where those resources should go.
That distinction becomes particularly important after GST.
GST changed the State’s room for tax adjustment
Before GST, States had greater control over several important indirect taxes. Since July 2017, major decisions concerning the GST tax base and rates have been located within a common institutional framework through the GST Council.
The change had an obvious benefit: it replaced a fragmented indirect-tax structure with a common system.
But it also changed the way a State can respond when its own revenues weaken.
A State still possesses its own tax instruments. Yet it cannot respond to a fiscal shock simply by altering major indirect-tax rates in the manner that was possible before GST. Important elements of the tax system are now determined collectively.
This creates a distinction between having revenue and having a revenue lever.
A State may receive tax devolution and collect its own taxes while still having fewer immediate instruments with which to respond to an unexpected fiscal shortfall.
That is why the 41% figure, by itself, cannot measure fiscal autonomy.
The end of GST compensation changed who bears the risk
GST compensation was introduced to protect States during the transition to the new tax regime.
The arrangement was based on an assumed 14% annual growth rate over the 2015-16 base year for the five-year transition period. The protection ended in June 2022, when transfers from the GST compensation cess ceased.
During the compensation period, a State had some protection if its GST revenue trajectory fell below the guaranteed path.
That protection no longer operates in the same form.
The significance is not that GST revenues stopped growing. It is that States now bear more of the difference between their actual revenue performance and what they might require to finance their existing commitments.
The effect is unlikely to be identical everywhere. A State with a broad and diversified tax base has more ways to absorb a slowdown than one with a narrower revenue base.
The issue, therefore, is not merely how much GST raises.
It is how the risk of an uneven revenue trajectory is distributed across States.
The expenditure side creates a second constraint
Revenue limitations tell only half the story.
The other constraint arises when a State has to commit its own resources to programmes whose broad design and objectives are determined elsewhere.
Centrally Sponsored Schemes can serve legitimate national objectives. But a co-funded programme also creates a budgetary commitment for the participating State.
Once a State allocates its share to that programme, those funds cannot simultaneously finance another State priority.
This creates an important distinction:
A State can have spending responsibility without having equivalent spending discretion.
The difference becomes more significant when several such commitments exist alongside salaries, pensions, interest payments, subsidies and State-level development programmes.
The issue is therefore not that every centrally sponsored programme necessarily reduces investment. Such a claim would be too broad.
The narrower point is that co-financing can reduce the portion of a State budget that remains available for independent prioritisation.
Welfare spending makes the constraint visible
The changing financing pattern of welfare programmes illustrates the problem.
The post-2015 framework increased State participation in the financing of many Centrally Sponsored Schemes. In the 2026-27 Budget framework, for example, the new VB-G RAM G arrangement involves a 60:40 Centre-State funding structure.
The significance lies in what happens when this commitment is placed alongside everything else a State must finance.
A State that meets the matching requirement has fewer resources available for independently designed programmes. A State that gives greater priority to its own programmes may have to scale back participation elsewhere. If neither can be accommodated within available revenues, borrowing becomes one possible adjustment.
The resulting pressure is therefore cumulative rather than attributable to any single scheme.
Borrowing can postpone the constraint
When expenditure obligations exceed the flexible resources available to a State, the adjustment has to come from somewhere.
Revenue can be increased, expenditure can be reduced, or borrowing can fill the gap.
For States, the revenue option is constrained by the post-GST structure and by the relatively limited number of major taxes over which they retain independent control.
Expenditure is also difficult to compress quickly. Salaries, pensions, interest payments and essential public services make a substantial portion of revenue expenditure relatively rigid.
Borrowing consequently becomes an important means of managing the difference between current commitments and current resources.
But borrowing changes the timing of the problem rather than automatically eliminating it. Today’s borrowing creates future interest and repayment obligations.
Its fiscal effect also depends on what the borrowed money finances.
Borrowing for productive infrastructure may strengthen the future economic and revenue base. Borrowing that repeatedly finances revenue shortfalls does not create the same capacity.
The evidence across States reflects this diversity. Punjab, for instance, has combined a high debt burden with a revenue deficit, while other indebted States face different combinations of liabilities, expenditure commitments and revenue capacity.
There is therefore no single explanation for State indebtedness.
GST did not mechanically create State debt, just as higher Union transfers would not automatically resolve every State-level fiscal problem.
State governments also make decisions about subsidies, taxation, expenditure priorities, public enterprises and borrowing.
Fiscal space is consequently the result of both institutional constraints and State-level choices.
The 41% figure captures only one layer
This brings the discussion back to the Finance Commission.
The 41% vertical devolution determines the States’ share of the divisible pool. But the fiscal position of an individual State also depends on its own revenues, grants, centrally sponsored programmes, borrowing limits and expenditure commitments.
The same transfer architecture can therefore have different consequences in different States.
A State with a strong own-revenue base may have considerable fiscal capacity even with a smaller dependence on transfers.
A State with a narrow revenue base and substantial expenditure needs may have much less room to manoeuvre even after receiving its share of central taxes.
The relevant question is therefore not simply:
How much does the Centre transfer?
It is:
How much of the State’s total fiscal resources can the State actually control and redirect?
That is the distinction between fiscal share and fiscal space.
States are part of the fiscal equation too
It would also be misleading to treat States as passive recipients of a fiscal system designed entirely by the Union.
States differ substantially in tax administration, the size of their formal economies and their ability to generate own revenues.
Their expenditure choices differ as well.
Pensions, subsidies, power-sector liabilities, cash-transfer programmes and other revenue commitments can put pressure on State finances independently of the Union’s transfer architecture.
The same is true of borrowing.
If additional fiscal room is used primarily to finance recurring expenditure, a larger transfer does not necessarily create a durable improvement in fiscal capacity.
This produces a genuine tension.
Greater untied resources can expand the range of choices available to States. They do not determine which choices States will make.
Fiscal federalism therefore has to accommodate both questions: whether States possess enough room to act, and how that room is used.
The real question is about fiscal capacity, not Centre versus States
The usual debate asks whether the Union should transfer more money to States.
That is only one part of the problem.
The larger institutional question is whether tax powers, expenditure obligations and fiscal flexibility remain sufficiently aligned.
GST has integrated the tax system while changing the independent tax levers available to States.
Centrally Sponsored Schemes can advance national objectives while requiring States to commit their own resources.
Borrowing can smooth temporary fiscal pressures while creating future obligations.
Transfers can reduce differences in fiscal capacity without eliminating the underlying differences in State revenue bases.
The result is that a State can receive its prescribed share of central taxes and still have relatively little room to alter its spending priorities.
It can have a large budget but limited discretionary expenditure.
It can borrow more without necessarily becoming fiscally stronger.
That is why fiscal space is a more revealing concept than fiscal share.
The 41% number is only the starting point
The 41% devolution figure is important, but it should not be mistaken for a complete measure of State fiscal autonomy.
A State’s usable fiscal room emerges only after several things have been considered together:
- the revenues it can raise independently;
- the transfers it receives;
- the taxes over which it has limited or shared control;
- the expenditure commitments it must meet;
- the share of its budget tied to co-funded programmes;
- and the borrowing obligations created by earlier decisions.
This produces a more precise understanding of the federal fiscal problem.
The question is not simply how much money moves from the Union to the States.
It is how much predictable and flexible fiscal capacity remains with the State after its responsibilities and existing commitments have been accounted for.
That is the space within which a State can actually choose.
And that is ultimately what fiscal autonomy means in practice.