Fiscal Federalism: What Recent Policy Shifts Mean for This Evolving Relationship

The 16^th Finance Commission submitted its report to the President in mid-November, recommending how resources are to be shared between the Union and state governments. The report will be tabled in Parliament on February 1, when the Union Budget is presented. The Constitution provides for a Finance Commission to correct for the asymmetry in the taxation powers and expenditure responsibilities between the Union and states. The Commission revisits its recommendations every five years, making the federal structure dynamic, and adaptable to changing realities.

The terms of reference of the Commission largely require it to determine how tax revenue collected by the Union is to be shared between the states, define principles for providing states with central grants, and boost the resources of local bodies. We examine two aspects, i.e., the devolution of revenue and the use of centrally sponsored schemes, in the context of recent legislative developments. Parliament passed two Bills this month, the Health Cess Bill, and the Bill replacing MGNREGA, a key welfare scheme. These are crucial pieces of legislation and their impact on various aspects of the economy merits deeper study.

The Health Cess Bill and the Bill replacing MGNREGA are expected to adversely affect the degree of the federalism in our fiscal architecture, by constraining states’ income and spending capacities.

This blog, however, focuses on how these laws reduce the amount of revenue available that is shared with states, and increases their spending burden, adversely affecting the degree of the federalism in our fiscal architecture.

The context: India’s federal architecture

The Constituent Assembly envisaged India as a Union of states with a strong Centre, to protect the idea and integrity of the country.

The Constituent Assembly envisaged India as a Union of states with a strong Centre, to protect the idea and integrity of the country.[1]^,[2] With respect to financial relations, the Union is provided with greater taxation powers, while states are provided with greater expenditure responsibilities.^2,[3] This ensures administrative ease, and greater service delivery. The Union is also empowered to determine the borrowing limits of states, to ensure overall macroeconomic stability.[4] The taxes collected by the Union government form the net divisible pool, a share of which is devolved to the states.[5] The recommendations of the 14^th Finance Commission are noteworthy in that it had recommended increasing the share of states in this pool from 32% to 42%, providing states with greater fiscal autonomy.

The Health Cess Law

In early December, Parliament passed the Health Security se National Security Cess Bill, 2025, which proposes to levy a cess on the production of sin goods such as pan masala to be used for public health and national security. It is important to revisit a few concepts before analysing the impact of this cess.

The Health Cess effectively replaces the GST Compensation Cess, which was introduced specifically to compensate states for revenue losses arising from GST.

First, cesses and surcharges levied by the Union government do not form part of the net divisible pool. This means that if the Union relies on cesses, more than taxes, it is not bound to share that revenue with the states. Second, the Health Cess effectively replaces the GST Compensation Cess, which was introduced specifically to compensate states for revenue losses arising from GST. The Compensation Cess was levied on products such as tobacco, coal, and motor vehicles, and its period was supposed to end in 2022, with some parts were extended until September this year.

What this effectively means is that the Union government has discontinued a measure meant to provide states with short-term income relief and replaced it with a levy that increases only central government resources. The proceeds from the Health Cess will only form part of central resources and cannot be devolved to states. Finance Commissions in the past have cautioned against the reliance of cesses for raising revenue, as it undermines federal principles. While it is constitutionally and legally sound to introduce such a cess, whether it was necessary and expedient to do so can be questioned. It can be argued that the Union government could have introduced a tax instead of the Health Cess, whose proceeds can then be devolved to states.

The Bill Replacing MGNREGA

The second development is the VB-G-RAM-G Bill passed by Parliament last week. The Bill seeks to replace MGNREGA, India’s biggest employment guarantee scheme. Three changes proposed in this scheme are likely to limit states’ fiscal autonomy.

The new scheme is proposed to be a centrally sponsored scheme, following a 60:40 resource-sharing ratio between the Union and state governments. This ratio is 90:10 for northeastern and hilly states. The existing sharing pattern was based on sub-components and was roughly in a 75:25 ratio. Under MGNREGS, i.e., the existing scheme, the central government bears the full cost of wages, up to three-fourths of material costs, and administrative expenses of central regulatory bodies. States are responsible for one-fourth of material costs, unemployment allowance, delay compensation, and administrative costs for their own regulatory bodies. Under the new scheme, all expenditure components, except for unemployment allowance and delay compensation, will be shared between the Union and states. Preliminary calculations suggest that this is expected to raise the spending burden for states by about ₹30,000 crore.[6]

The second change proposed under the new scheme relates to how funds are allocated. The Union government is empowered to determine a state-wise normative allocation each financial year based on specified parameters. Earlier, states used to make estimates based on the demand for work, which were then approved by the central government. The new provision gives the Union government the power to determine and change financial allocation for states. In case the central allocations fall short of the actual demand for work, states are empowered to foot the additional expenses, beyond their increased 40% share. This change in the expenditure responsibility, without any additional central transfers will seriously constrain states’ spending ability, and is likely to lead to increased deficits, at least in the short term. If additional resources are not mobilised, state expenditure on the scheme, or other expenditure items will naturally be cut.

This change in the expenditure responsibility, without any additional central transfers will seriously constrain states’ spending ability, and is likely to lead to increased deficits.

Thirdly, the Bill prohibits states from opting out of the scheme. It makes it mandatory for all states to notify a scheme similar to VB-G-RAM-G within six months of the Act being enforced. Note that a similar provision exists in MNREGA, but the fact still remains that Parliament has decided for states that they must spend additional resources on a statutory scheme. This is not to say that the Union should not nudge states to implement social welfare schemes, but more to explore whether the Union should then follow up this move by sharing additional resources with the states. Participation in centrally sponsored schemes is usually voluntary for states, and many states, such as West Bengal, have opted out of certain schemes. This aligns with the flexibility provided by India’s quasi-federal structure. However, with no option to opt out of this scheme state assemblies’ discretion over how their resources are allocated stands undermined.

Balancing central priorities with states’ fiscal autonomy is an evolving exercise, and the role of the Finance Commission becomes even more important. In recent years, the introduction of GST, a growing reliance on cesses, and a proliferation of centrally sponsored schemes has already constrained states’ fiscal autonomy.[7] It is in this context that the Health Cess and the G-RAM-G Bills have been passed, and the recommendations of the 16^th FC will be critical in determining whether these developments will be corrected.