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The Union Budget has projected tax devolution to states at ₹14.22 trillion for 2025-26, which constitutes one-third of the gross tax receipts of the Centre. This is only slightly more than the 33.1 per cent projected at the revised level for the current financial year. In this respect, the devolution in proportion to gross tax receipts would be the highest in FY26 since the Covid-hit year of 2020-21.
However, devolution over these years has been much lower than the 15th Finance Commission’s recommendation of 41 per cent, leaving less than the suggested funds to states for their needs. During the pre-Covid period (from 2015-16), tax devolution was much higher but still below the recommendations of the 14th Finance Commission at 42 per cent. The 14th Finance Commission's recommendations were for the five-year period beginning FY16, while those of the 15th were given in two phases: for one year — 2020-21 — and for five years beginning FY22.
For 2014-15, devolution was much less. This was because the 13th Finance Commission had recommended that devolution be 32 per cent of the gross tax receipts of the Centre. The actual devolution was much less than that (see chart). The 13th Finance Commission’s recommendations were for the five-year period beginning FY11.
The Centre circumvents Finance Commissions’ recommendations by imposing cess and surcharges. These two heads do not form part of a divisible pool, which the Centre has to share with states in line with the relevant Finance Commission's recommendations.
In the pre-Covid period, barring 2014-15, which related to the 13th Finance Commission’s recommendations, tax devolution to states was much higher than since 2020-21 when coronavirus hit the country — if one takes the Modi government period into account. This was because the government had imposed a health cess of 5 per cent on imports of certain medical equipment in the 2020-21 Budget. The next year’s Budget imposed the Agriculture Infrastructure and Development Cess (AIDC) on imports of products such as gold, silver, alcoholic beverages, crude edible oils, etc. Besides, cess was also imposed from the excise side at the rate of ₹2.5 per litre on petrol and ₹4 per litre on diesel.
That is why devolution to states now constitutes 26 per cent of the states’ own tax revenues, which is much lower than the pre-Covid period, barring 2014-15 and 2017-18.
Aggrieved by this trend, states have already pitched for increasing the devolution to 50 per cent of the gross tax receipts, and capping cess and surcharge at 10 per cent of the gross tax receipts of the Centre.
For instance, Tamil Nadu Chief Minister MK Stalin, in his representation to the 16th Finance Commission, said cess and surcharges, which constitute 16.83 per cent of the Centre’s gross tax revenue, were not shared with states, diminishing their “rightful” share. The state suggested a mechanism to curb the indiscriminate levy of cess and surcharges, with a recommended cap of 10 per cent of the Centre’s gross tax revenues.
“Any excess collections should be merged into the divisible pool,” Stalin suggested.
The Tamil Nadu chief minister wanted the commission to recommend devolution of at least 50 per cent of the divisible pool to states, if not more.
To help states, the Centre in recent years has been advancing tax devolution to the states. However, this only addresses liquidity issues of states.
Buoyant state goods and services tax (GST) helped states meet their needs to some extent. States’ own tax revenues comprised 50 per cent of the revenue receipts during 2024-25 (Budget Estimates), the highest in the past 11 years. A portion of cess and surcharges is also used to fund centrally sponsored schemes (CSS) such as those related to education, health or roads.
However, these schemes have been revamped after a committee under former Madhya Pradesh chief minister Shivraj Singh Chouhan gave its recommendations in 2015.
While earlier, the Centre-state ratio for funding schemes such as the Sarva Shiksha Abhiyan and the National Health Mission was 70:30 or 75:25, it has now been changed to 60:40, said Govinda Rao, former director at the National Institute of Public Finance and Policy (NIPFP) and a member of the 14th Finance Commission.
Sunil Kumar Sinha, professor of economics at the Chandigarh-based Institute for Development and Communication, explained that some states have their reservations about some of these schemes since they no longer suit their purpose. For instance, Kerala has been saying that Sarva Shiksha Abhiyan does not suit it to the extent it did earlier because while literacy might be a challenge for states such as Bihar, it isn't so for Kerala.
To help states fund their capital expenditure needs, the Union government has been providing special assistance to the states in the form of 50-year interest-free loans. This is pegged at ₹1.5 trillion for the next financial year, the same as was proposed for the current financial year (Budget Estimates). However, due to absorptive capacities, the states are now projected to get ₹1.25 trillion for FY25 (Revised Estimates).
Does this loan meet the funding needs of the states? “It does not,” said Rao.
He explained that overall borrowing needs of the states are capped at 3 per cent of their respective gross state domestic product (GSDP), besides a 0.5 per cent leeway given to those that carry out power reforms. This cap also includes capital loans given by the Centre, he pointed out.
Since the fiscal deficit of states is capped, either the states will have to cut their capital expenditure or the revenue deficit will rise, he explained.
However, the cost of borrowings will come down since these are zero-interest loans, Rao added. Sinha said the capex loan scheme appeared good if one looked at it at a broader level. However, states struggle to meet their revenue expenditure since they incur most of their expenditure under this head, while the Centre earns most of the revenue. In this area, capex loans are not going to help, he said. If states need money for revenue expenditure, they will borrow funds from the market and use it for funding revenue deficits, he pointed out.
