India’s federal structure, enshrined in its Constitution, delineates the fiscal responsibilities and powers between the Union and the States. Over the years, this dynamic has evolved, influenced by economic reforms, political shifts, and institutional changes. In 2025, as India aspires to become a developed nation by 2047, understanding the nuances of fiscal federalism becomes imperative.

Understanding Fiscal Federalism in India

Fiscal federalism refers to the financial relations between units of governments in a federal system. In India, this encompasses the distribution of taxation powers, expenditure responsibilities, and financial transfers between the Centre and the States. The Constitution provides a framework for this distribution, with the Finance Commission playing a pivotal role in recommending the sharing of central taxes and grants-in-aid. 

Current Fiscal Landscape

Union Budget 2025-26 Highlights:

• Total Receipts (excluding borrowings): ₹34.96 lakh crore
• Total Expenditure: ₹50.65 lakh crore
• Net Tax Receipts: ₹28.37 lakh crore
• Fiscal Deficit: 4.4% of GDP
• Capital Expenditure: ₹11.21 lakh crore (3.1% of GDP) 

These figures underscore the Centre’s commitment to fiscal consolidation while ensuring substantial capital investment to spur economic growth. 

Challenges in Fiscal Federalism

1. Vertical Imbalance:

A significant challenge in India’s fiscal federalism is the vertical imbalance, where the Centre controls a larger share of revenue sources but the States bear the brunt of expenditure responsibilities. As per recent data, the Union commands 63% of national fiscal resources but is responsible for only 38% of total public expenditure. Conversely, States, with just 37% of resources, shoulder 62% of public expenditure, leading to fiscal stress at the state level. 

2. Dependence on Centrally Sponsored Schemes (CSS):

States often rely heavily on CSS for funding critical sectors like health, education, and agriculture. While these schemes aim to ensure uniform development, they sometimes restrict States’ flexibility to tailor programs to local needs, leading to inefficiencies. 

3. Goods and Services Tax (GST) Implementation:

The introduction of GST subsumed several state-level taxes, leading to concerns about revenue autonomy. While GST aimed to create a unified tax structure, delays in compensation payments and rate rationalizations have strained Centre-State fiscal relations. 

4. Borrowing Constraints:

States’ borrowing capacities are regulated under the Fiscal Responsibility and Budget Management (FRBM) Act. Recent instances, such as the Centre reducing Punjab’s borrowing limit due to fiscal mismanagement, highlight the tensions arising from these constraints. 

Recent Developments and Initiatives

1. Fiscal Health Index (FHI) 2025:

Launched by NITI Aayog, the FHI provides a comprehensive assessment of the fiscal health of 18 major States based on five sub-indices: Quality of Expenditure, Revenue Mobilization, Fiscal Prudence, Debt Index, and Debt Sustainability. Odisha topped the ranking with a cumulative score of 67.8, followed by Chhattisgarh and Goa. 

2. Investment Friendliness Index:

To promote competitive cooperative federalism, the Centre announced the launch of an Investment Friendliness Index of States in 2025. This index aims to assess and encourage States to create conducive environments for investment, fostering economic growth. 

3. Discussions on Tax Devolution:

Reports suggest that the Centre plans to propose a reduction in the States’ share of federal tax revenues from 41% to at least 40% starting from the fiscal year 2026-27. This move, aimed at addressing increased central spending needs, has raised concerns among States about potential impacts on their fiscal autonomy. 

Way Forward: Strengthening Fiscal Federalism

1. Enhancing Revenue Autonomy:

Empowering States with greater taxation powers can reduce their dependence on central transfers. Revisiting the GST structure to allow more flexibility and ensuring timely compensation can bolster States’ revenues.

2. Rationalizing Centrally Sponsored Schemes:

Streamlining CSS and allowing States to adapt programs based on regional needs can enhance efficiency and effectiveness. 

3. Transparent and Predictable Transfers:

Ensuring that financial transfers from the Centre to States are timely, predictable, and based on transparent criteria can build trust and facilitate better fiscal planning at the state level.The 

4. Encouraging Fiscal Discipline:

While providing autonomy, it’s essential to encourage States to maintain fiscal discipline. Instruments like the Fiscal Health Index can serve as benchmarks, promoting healthy competition among States

Conclusion

India’s journey towards becoming a developed nation hinges on the harmonious functioning of its federal structure. Addressing the challenges in fiscal federalism requires collaborative efforts, mutual trust, and a commitment to equitable development. By empowering States, ensuring transparent financial relations, and fostering cooperative federalism, India can pave the way for inclusive and sustainable growth.