Every year, when the Finance Commission announces its recommendations, one number dominates the headlines.

41%.

It is presented as proof that Indian federalism remains fiscally healthy. After all, if the Union continues to share 41% of its taxes with the States, where is the problem?

Yet almost every major State—from Kerala and Tamil Nadu to Karnataka and Punjab—argues that its fiscal space is shrinking. State governments complain of inadequate resources, rising debt and growing dependence on market borrowings despite this seemingly generous constitutional arrangement.

At first glance, these two realities appear contradictory.

If States continue receiving 41% of Union taxes, why do they increasingly feel financially constrained?

Either the States are exaggerating.

Or the number itself is being misunderstood.

The answer lies in a distinction that rarely enters public discussion but sits at the heart of India’s fiscal federalism.

The Constitution does not promise States 41% of the Union’s total tax revenue.

It promises them 41% of the divisible pool.

Those two numbers are not the same.

Understanding that difference changes how we understand not only tax devolution but the larger transformation taking place within Indian federalism.

The Invisible Pie

Imagine the Union Government collects taxes worth ₹100.

Most people naturally assume that States receive ₹41.

That is not how the Constitution works.

Before any sharing takes place, the Constitution first determines which taxes are actually shareable. This collection of shareable taxes is known as the divisible pool, governed primarily by Article 270, while Article 280 empowers the Finance Commission to recommend how this pool should be divided between the Union and the States.

The crucial point is this:

The 41% applies only after the divisible pool has been determined.

This framework itself has evolved over time. The 14th Finance Commission had increased tax devolution to 42%, signalling a stronger commitment to fiscal federalism. After the reorganisation of Jammu & Kashmir, the share was revised to 41%, a figure that the Sixteenth Finance Commission has retained. The headline percentage, therefore, has remained largely stable; the debate today is about the changing size of the divisible pool to which that percentage applies.

This distinction remained relatively insignificant when most Union tax revenues entered the divisible pool.

Over the last decade, however, the composition of Union revenues has changed dramatically.

An increasing share of taxes is now collected through cesses and surcharges, which are constitutionally excluded from the divisible pool.

As a result, the headline percentage has remained unchanged, but the pool from which that percentage is calculated has steadily shrunk.

One observation from the Finance Commission debate captures this perfectly:

“The headline number deserves scrutiny before the settlement does. The divisible pool is not gross tax revenues.”

That single sentence explains why the debate over fiscal federalism has become so intense.

The constitutional formula has remained the same.

The amount flowing through that formula has not.

The Quiet Rise of Cesses and Surcharges

This transformation did not occur through a constitutional amendment.

It occurred through the changing structure of government revenue.

Historically, cesses were introduced to finance specific purposes—education, infrastructure or disaster relief. Surcharges were designed as temporary additions to existing taxes.

Over time, however, these instruments have become a far more significant source of Union revenue.

The numbers reveal the scale of this shift.

Around 2011-12, cesses and surcharges accounted for roughly 9.4% of the Union’s Gross Tax Revenue.

By 2024-25, their share had increased to nearly 22.2%.

In absolute terms, collections rose from about ₹44,688 crore in FY15 to over ₹2.5 lakh crore within a few years.

This means that an increasingly larger share of tax revenue never reaches the divisible pool.

Consequently, the share of the divisible pool in the Union’s Gross Tax Revenue declined from around 89% in 2014-15 to roughly 74–80% during 2020–24.

Notice what has happened.

The Constitution still says 41%.

The Finance Commission still recommends 41%.

Yet the money available for sharing has become progressively smaller.

No constitutional provision has been amended.

No Finance Commission has formally reduced tax devolution.

The change has occurred quietly, through the structure of revenue itself.

This is why the debate surrounding cesses and surcharges is not merely an accounting controversy.

It is increasingly becoming a constitutional question.

Why This Matters Beyond Budget Arithmetic

At first glance, this may appear to be a technical issue relevant only to economists and finance ministries.

It is much more than that.

Federalism is ultimately about capacity.

A State may possess constitutional authority over health, agriculture, education or local governance, but those powers become meaningful only if it has adequate financial resources to exercise them.

When the divisible pool shrinks, States lose something far more valuable than revenue.

They lose fiscal flexibility.

Fiscal autonomy is not measured only by how much money a government receives, but by how much of that money it can spend according to its own priorities.

The concern is particularly visible in high-performing States. Maharashtra, for instance, contributes around 36.1% of the Centre’s total tax revenue but receives only about 6.65% of tax devolution. This does not by itself imply constitutional unfairness, since devolution is intended to promote regional equity rather than reward tax contribution. Yet it explains why economically stronger States increasingly question whether the present fiscal framework adequately recognises their fiscal effort.

Unlike tied grants, devolved taxes allow States to decide their own priorities. They can invest according to regional needs rather than nationally designed templates. That discretion is one of the foundations of federal autonomy.

As discretionary resources decline, the nature of Centre-State relations also begins to change.

The question is no longer simply “How much money do States receive?”

It becomes:

“Who decides how that money should be spent?”

That subtle shift marks the beginning of a much deeper transformation.

Because once fiscal autonomy begins to shrink, the consequences extend far beyond government budgets.

They reshape welfare policy, development priorities and, eventually, the balance of power within the Union itself.

When Fiscal Flexibility Begins to Disappear

A shrinking divisible pool does not immediately create a constitutional crisis.

It creates something subtler.

It gradually changes the way States govern.

Unlike Centrally Sponsored Schemes, tax devolution is untied money. Once it reaches a State’s treasury, the elected government decides where it should be spent—whether on schools in Kerala, irrigation in Punjab, industrial infrastructure in Tamil Nadu or healthcare in Maharashtra.

That freedom is the essence of fiscal federalism.

As untied resources shrink, States become increasingly dependent on funds that arrive with conditions attached. Grants are linked to centrally designed priorities. Welfare programmes are structured around national missions. Performance indicators are often determined by the Union.

The issue, therefore, is no longer merely about how much money States receive.

It is increasingly about who determines the priorities attached to that money.

This marks the beginning of a structural shift.

A federal system that once relied primarily on shared resources slowly begins relying on conditional resources.

The Constitution continues to distribute powers between the Union and the States, but the practical ability to exercise those powers becomes increasingly shaped by financial incentives designed elsewhere.

This is why many scholars argue that the debate over cesses is not fundamentally about accounting.

It is about autonomy.

The Shadow Budget

The transformation becomes even more visible when we examine the Union’s expanding sources of revenue outside the divisible pool.

One striking example is the Reserve Bank of India’s record surplus transfer of approximately ₹2.87 lakh crore for FY26. Although this significantly expands the Union Government’s fiscal capacity, it does not enter the divisible pool and is therefore unavailable for tax devolution to the States.

The RBI surplus is not unique. It reflects a broader trend. Alongside the growing reliance on cesses and surcharges, it creates what may be described as a “shadow budget”—a growing pool of fiscal resources available to the Union but outside the constitutional sharing framework.

This distinction is important because it changes the balance of fiscal capacity without altering the constitutional formula itself. The Union gains additional spending space through revenues that need not be shared, while States continue to depend on a divisible pool whose relative size has steadily declined.

Nothing in the Constitution has formally changed. Yet the practical fiscal relationship between the Union and the States has quietly evolved.

This is why the debate surrounding the Finance Commission extends beyond the 41% figure itself.

Critics argue that while Article 280 empowers the Finance Commission to recommend the distribution of the divisible pool, it has little control over the growing use of cesses and surcharges that remain outside that pool. In this view, the constitutional debate is shifting from how the pie is divided to how much of the pie enters the table in the first place.

Many critics argue that maintaining the same percentage while allowing the divisible pool to shrink preserves the appearance of cooperative federalism without necessarily preserving its financial substance.

The constitutional architecture remains intact.

The incentives operating within it quietly change.

When Devolution Is Not Enough, Debt Takes Over

Governments cannot postpone governance.

Teachers must be paid.

Hospitals must function.

Pensions must be disbursed.

Roads require maintenance.

When revenues become constrained but responsibilities remain unchanged, States turn to the only instrument available to them.

Borrowing.

State Development Loans (SDLs), once used primarily to finance long-term capital projects, have increasingly become the principal mechanism through which States absorb fiscal stress.

The implications are significant.

“If debt, rather than devolution, becomes the primary shock absorber in India’s federal system, fiscal sustainability itself comes under strain.”

That single observation captures the deeper structural transformation.

Federalism traditionally stabilized State finances through shared taxation.

Increasingly, it stabilizes them through market borrowing.

The consequences extend beyond fiscal management.

Unlike the Union Government, States generally borrow at higher interest rates through SDLs. Every additional loan creates future interest obligations, reducing the fiscal space available for education, healthcare, infrastructure and welfare.

The result is a self-reinforcing cycle.

Less untied revenue.

Greater dependence on borrowing.

Higher interest payments.

Lower fiscal flexibility.

Even greater dependence on borrowing.

Debt gradually ceases to be a temporary adjustment.

It becomes a structural feature of governance.

The Hidden Transformation

Perhaps the most important insight emerging from this debate is that the fiscal architecture of Indian federalism is changing without changing the Constitution itself.

No constitutional amendment reduced tax devolution.

No Finance Commission officially lowered the States’ share.

Yet the practical experience of many States is one of shrinking fiscal autonomy.

This is why the phrase “Fiscal Illusion” is so powerful.

The illusion is not that 41% is mathematically incorrect.

The illusion is that 41% alone tells the whole story.

It does not.

The real question is:

Forty-one percent of what?

This distinction also explains an important institutional reality. The Finance Commission determines how the divisible pool is shared. It does not determine how large that divisible pool ultimately becomes. As the composition of Union revenues changes, the constitutional formula may remain unchanged even while the fiscal balance between the Union and the States evolves.

Once the answer shifts from Gross Tax Revenue to an increasingly smaller divisible pool, the federal debate looks very different.

What appears stable on paper begins to look increasingly dynamic in practice.

This is also why some analysts argue that Indian federalism is being “quietly re-engineered.”

Not by rewriting constitutional provisions.

Not by abolishing State governments.

But by altering the financial incentives that determine how constitutional powers are actually exercised.

Power, after all, follows resources.

The Bigger Pattern

Seen in isolation, cesses and surcharges appear to be technical features of public finance.

Seen within the broader federal narrative, they represent the first step in a much larger institutional transformation.

The story begins with a shrinking divisible pool.

But it does not end there.

When States possess less discretionary revenue, they still have to fund welfare programmes.

That raises expenditure obligations.

As expenditure rises faster than flexible revenue, borrowing increases.

Debt gradually replaces devolution as the stabilizer of State finances.

The wallet changes first.

Economists often describe this as a “scissors effect.” Revenue flexibility narrows even as expenditure commitments continue to widen. Over time, the two blades move further apart, leaving States increasingly dependent on borrowing to bridge the gap.

The rest of the federal system follows.

This is why the Fiscal Illusion is not merely a story about taxation.

It is the financial foundation upon which the rest of India’s evolving federal debate is built.

And that naturally leads to the next question.

If the first transformation quietly changed who holds the wallet, the second changes who carries the bill. Understanding that shift is essential to understanding why Indian federalism is entering a new phase.