Does The Union Budget Reflect The True Spirit Of Fiscal Federalism In India?

The Union Government’s gross tax revenue comprises the divisible pool, cesses, and surcharges. The proceeds from income tax, corporation tax, union excise duties, and customs are factored into the divisible pool. On the recommendation of the Finance Commission formula, these are eventually shared with the states, hence the name divisible pool. However, the receipts from cesses and surcharges are not shareable with states. They are exclusively reserved for the Union Government’s use. 

The Union Government levies cess to provide necessary financial stimulus to a particular sector. Surcharges are imposed on existing taxes as an additional charge. They can be levied for any public purpose. Over the past few years, the quantum of Cess and Surcharges has seen a tremendous increase, pointing at the increased reliance of the Union Government on these. This frustrates the very rubric of fiscal federalism as laid by the Finance Commission recommendations. 

The idea of empowering states through adequate financial devolution appears increasingly flawed. Between 2010-2011 and 2024-2025, total devolution to states grew 4.9 times—from ₹2.19 trillion to ₹12.47 trillion. However, over the same period, cesses and surcharges surged 9.2 times, from ₹496 billion in 2010-2011 to ₹5.39 trillion in 2024-2025. Since proceeds from cesses and surcharges do not form part of the divisible pool, the Union government’s tax policy appears skewed towards revenue centralisation. The growing reliance on these levies effectively shrinks the divisible pool, offsetting the Centre’s perceived revenue losses from higher devolution. Additionally, cesses and surcharges as a share of Gross Tax Revenue rose from 6.3% in 2010-2011 to 10.1% in 2024-2025, further eroding states’ revenue entitlements. This limits their fiscal space, undermining the objective of decentralised financial empowerment.

The 14th Finance Commission’s decision to raise states’ share in the divisible pool from 32% to 42% aimed to grant them greater fiscal autonomy. However, the Union government has increasingly raised revenue outside the divisible pool, effectively bypassing the states. This runs counter to the spirit of the 14th Finance Commission. The 15th Finance Commission recommended a 41% share for states in the divisible pool for 2021-2026. However, the actual ratio of devolution to Gross Tax Revenue has remained well below this benchmark. In 2010-2011, it stood at 27.7%, rising only to 32.5% in 2024-2025. This highlights the persistent gap between devolution commitments and actual transfers, constraining states’ fiscal space.

While tax changes require amendments in law, cesses can quickly be introduced by merely drafting a notification. Therefore, cesses have been found with the Union government. In recent times, newer cesses and surcharges have been introduced. The most recent of those is the Agricultural Infrastructure Development Cess. Besides, the taxation rates of some have risen. The climb in the share of cesses and surcharges in the gross tax revenue can also be interpreted as a drop in the state's revenue. It appears that the Union government is conveniently raising monies outside the divisible pool and enlarging available resources while the states remain fiscally frustrated.

The existing devolution mechanism appears antagonistic to the idea of healthy fiscal federalism. States’ economic freedom stands deeply compromised. This, in effect, means that states' dependence on the Union has deepened. It is not an overstatement that cesses and surcharges are eating into India’s federalism.

Article 270 of the Indian Constitution excludes the surcharge on taxes and duties referred to in Article 271 and any cess levied for specific purposes under any law made by Parliament from being distributed between the Union and the states. Therefore, there is a need for a constitutional amendment. In the Union Budget 2025-26, the Union Government should transfer 50% of the cesses and surcharges to the states. This will increase the consolidated funds of the states, and as a result, the states can finance more expenditures. The sharing of the cesses and surcharges to the states will reduce their fiscal deficits.