Fiscal Federalism Under Strain: States Decry Conditional Grants, Demand Autonomy

Delhi, NCT – A palpable undercurrent of discontent is brewing among states across India, cutting across political divides, as they increasingly push back against what they term as an erosion of fiscal federalism.

The epicentre of this friction lies in the burgeoning conditionalities tied to central grants and the growing ambit of Centrally Sponsored Schemes (CSS), which states argue are straitjacketing their developmental priorities and undermining their financial autonomy.

The debate is rapidly moving from backroom discussions to public forums, signaling a significant recalibration in Centre-state financial dynamics.

Key points

* States are strongly resisting increased conditionalities on central transfers, arguing it infringes on their constitutional autonomy and ability to tailor development policies to local needs.

* The rising share and strictures of Centrally Sponsored Schemes (CSS) are a major point of contention, with states bearing a significant financial burden for programmes designed centrally.

* Concerns are mounting over the ending of GST compensation, coupled with limited untied funds, leaving many states fiscally constrained and overly reliant on specific-purpose grants.

* Experts warn that continued friction over fiscal federalism could strain Centre-state relations, potentially impeding national development goals and exacerbating regional disparities.

* There are growing calls for a more robust and equitable devolution mechanism, with the upcoming 16th Finance Commission tasked with addressing these critical financial grievances.

The Union government, while asserting its role in promoting national priorities and ensuring fiscal discipline, faces a united front from various state administrations.

Kerala and Telangana have been particularly vocal, citing instances where central schemes dictate minutiae of spending, often requiring states to contribute a substantial share without adequate flexibility.

Even states governed by the ruling BJP and its allies have, in private and through institutional channels like NITI Aayog meetings, expressed similar concerns regarding the increasing prescriptive nature of central funding.

"The very essence of federalism is autonomy in decision-making, especially concerning public finance and development tailored to local contexts," stated Hon.

Suresh Reddy, Finance Minister of Telangana, in a recent press conference in Hyderabad. "When central grants come with a laundry list of mandates – from specific project designs to procurement methods – it turns states into mere implementing agencies for Delhi, rather than sovereign constitutional entities.

This is not cooperative federalism; it is conditional federalism, an encroachment on our mandate from the people." Reddy specifically pointed to initiatives where states are incentivised with additional borrowing limits linked to 'reforms' in sectors like power, arguing these are often sector-specific conditionalities overriding state legislative jurisdiction and financial prudence.

Data from the Comptroller and Auditor General (CAG) and various state finance departments underscores the growing reliance on Centrally Sponsored Schemes.

Over the last decade, expenditure on CSS has seen a significant upward trend, with states often struggling to meet their matching share commitments.

While the 14th Finance Commission recommended an increase in the divisible pool share for states to 42%, states argue that this gain has been offset by the proliferation of CSS and a reduction in untied discretionary grants.

For instance, according to a report by the National Institute of Public Finance and Policy (NIPFP), the actual untied transfers to states, when accounting for CSS and other specific-purpose grants, have not seen a proportional increase, making states more dependent on centrally dictated programmes.

"The issue isn't merely about the quantum of funds, but the quality of funds," explained Ms.

Preeti Sharma, Principal Economist at the Centre for Policy Research. "Untied funds allow states the flexibility to allocate resources based on their unique socio-economic landscape and electoral promises.

Conditional grants, while often well-intentioned for national priorities like health or education, can distort state spending patterns, leading to suboptimal outcomes or neglect of equally pressing local needs not covered by central schemes.

Furthermore, the operational overheads and administrative complexities of managing numerous CSS schemes can be quite burdensome for state treasuries and bureaucracies."

Officials within the Union Ministry of Finance, speaking off the record, contend that conditionalities are necessary to ensure accountability, achieve national objectives, and promote fiscal discipline among states. "The Centre has a responsibility to ensure that public funds, collected through national taxes, are utilised effectively and for strategic national goals," a senior Finance Ministry official elucidated. "In sectors like power, health, or infrastructure, certain minimum standards and reforms are essential for long-term growth and efficiency.

These conditions are not punitive but facilitative, aiming to build state capacity and encourage best practices that benefit citizens across the country." They also highlight that many conditionalities are often consultative and agreed upon in forums like the NITI Aayog.

Background

The evolution of fiscal federalism in India has been a dynamic interplay between the Union and states, guided by the Constitution and successive Finance Commissions.

Historically, states relied heavily on central transfers, with the Finance Commission determining the share of central taxes and grants-in-aid.

The introduction of Centrally Sponsored Schemes (CSS) began as a mechanism to promote national priorities in areas like social welfare and rural development.

However, their proliferation and the increasing proportion of state expenditure tied to them have long been a point of contention.

The implementation of the Goods and Services Tax (GST) in 2017 further reshaped fiscal federalism, subsuming various state taxes into a national framework.

While initially compensated for revenue losses for five years, the cessation of GST compensation in 2022 has left several states with significant revenue shortfalls, exacerbating their dependence on central grants and loans, thereby amplifying the impact of any attached conditionalities.

The recommendations of the 14th Finance Commission to increase states' share in the divisible pool to 42% were widely hailed, but the concurrent rise in cesses and surcharges, which do not form part of the divisible pool, and the increasing centralisation of spending through CSS have been viewed by states as undermining this enhanced devolution.

What it means

The growing friction over fiscal federalism carries significant implications for India's administrative and political landscape.

First, it could lead to suboptimal resource allocation, where states are forced to prioritise projects or reforms dictated by central funding conditions over their own pressing developmental needs, potentially impacting welfare and growth indicators specific to their regions.

Second, it strains Centre-state relations, fostering an environment of mistrust and confrontation rather than cooperation, which is crucial for a diverse federal nation.

Third, it could exacerbate regional inequalities if states with weaker fiscal health or differing political affiliations feel disproportionately burdened by central mandates.

Lastly, it undermines the very spirit of accountability in a democracy, as state governments, elected to serve local constituencies, find their policy choices constrained by central directives, blurring lines of responsibility and performance.

This also impacts the ability of state governments to introduce innovative solutions that might not fit centrally prescribed models.

Reactions

Reactions to this simmering fiscal dispute have been varied yet increasingly consolidated among states.

Opposition-ruled states like Kerala, Telangana, Karnataka, and Punjab have been at the forefront of the critique, often accusing the Union government of systematically undermining state autonomy and using financial leverage for political ends.

Their finance ministers have regularly raised these concerns in pre-budget consultations, NITI Aayog meetings, and through public statements. "The current framework incentivises compliance over innovation and financial prudence over tailored development," remarked Hon.

Dr.

Balamurugan, Finance Minister of Karnataka, during a recent state assembly debate. "We are witnessing an unprecedented level of micromanagement from the Centre, which ultimately slows down progress and dilutes local accountability."

Even several BJP-ruled states, while not publicly as vociferous, have expressed similar concerns in closed-door meetings, particularly regarding the practical difficulties of implementing complex central schemes and the burden of matching grants.

Economists are divided: while some support the Centre's emphasis on fiscal discipline and national uniformity, others, like Dr.

K.

S.

Ramanujam, Former Chief Secretary of Tamil Nadu, warn of the long-term consequences. "A strong Centre does not necessitate weak states," Dr.

Ramanujam observed. "A truly strong India requires strong, financially autonomous states capable of responding effectively to the unique challenges and opportunities of their populace.

Over-centralisation can stifle local initiative and breed resentment, which is detrimental to national cohesion in the long run." Civil society organisations and think tanks have also begun to weigh in, with many arguing that the erosion of state autonomy could lead to a 'one-size-fits-all' approach that neglects local diversity and grassroots needs.

What happens next

The immediate focus shifts to the upcoming 16th Finance Commission, which is mandated to recommend the distribution of taxes between the Union and states for the period commencing April 1, 2026.

This commission will be under immense pressure to address the contentious issues of conditionalities, the increasing share of cesses and surcharges not part of the divisible pool, and the overall framework of Centre-state fiscal transfers.

States are expected to make robust representations, advocating for greater untied transfers and a re-evaluation of the CSS framework.

Furthermore, the political landscape will likely see this issue become a prominent talking point in state elections and potentially the next general election, with regional parties leveraging it to garner support.

Debates in parliamentary forums and inter-state councils are also expected to intensify.

Without a significant recalibration, the current trajectory risks deepening fissures in India’s federal structure, potentially leading to increased legal challenges and political confrontations over financial control and policy autonomy.