Centre to cut states' share of federal taxes from 41% to 40% from 2026

The Indian government of Prime Minister Narendra Modi is seeking to cut the federal tax revenues that states receive, three sources with the direct knowledge of the matter said.

The suggestion will be made to the constitutionally-appointed Finance Commission of India, which makes recommendations on tax sharing along with other aspects of federal-state fiscal relations, and could lead to a flaring of tensions between the two tiers of government.

The panel, headed by economist Arvind Panagariya, will submit its recommendations by October 31 to be implemented from fiscal year 2026-27. The recommendations are binding.

The federal government will recommend the share of taxes going to states be reduced to at least 40 per cent from the current 41 per cent, said one of the sources.

The proposal is likely to be cleared by the cabinet of ministers headed by Modi by the end of March and then be sent to the Finance Commission, said a second of the sources.

A 1 per cent swing in the states share of tax revenues could give the federal government about Rs 35,000 crore ($4.03 billion), based on the expected tax collections for the current year. The final number will vary based on the individual year's tax collections.

An email sent to the Ministry of Finance and the Finance Commission did not get any response.

The share of taxes going to the state governments has jumped from 20 per cent in 1980 to 41 per cent now. But spending requirements for the federal government, particularly in years of economic slowdown, have increased, the first source said.

This has led to calls for a lower share of tax revenues going to states, the sources said.

India's federal government fiscal deficit is estimated at 4.8 per cent of gross domestic product for 2024-25, while the states have a fiscal deficit of 3.2 per cent of the national GDP.

States have a share of over 60% in total government spending in the economy and typically spend more on social infrastructure like health and education while the federal government's spending is more focused on physical infrastructure.

However, the states have limited discretion in raising revenue since the implementation of the national Goods and Services Tax in July 2017.

The federal government since the Covid-19 pandemic has also increased the share of cesses and surcharges, which are not shared with the states, to over 15 per cent of the gross tax revenue from 9 per cent-12 per cent earlier.

A shift in resources available to the states could lead to changes in spending priorities.

The federal government is also likely to suggest ways to discourage states from giving cash handouts, debt waivers and other so-called freebies by the states for political gains, one of the sources said.

One way to do this would be to link federal grants given to states to make up the shortfall in state tax revenue to meeting certain conditions, the source said, adding that only after meeting those conditions will the states be eligible for such grants.

It was not immediately clear whether federal government would deny grants to states seen as offering freebies.

In the last five years, these revenue-deficit grants have declined from Rs 1.18 trillion ($13.61 billion) in 2021/22 to Rs 13,70 crore ($1.58 billion) estimated in the budget for 2025/26.