Indian Government Proposes Tax Revenue Cuts for States

February 28, 2025

The Government of India is considering a reduction in federal tax revenues allocated to states. This proposal is set to be presented to the Finance Commission of India, which plays important role in tax sharing and fiscal relations between the federal and state governments. The recommendations from the commission are expected by October 31, 2025, and will be binding.

Current Tax Revenue Distribution

Currently, states receive 41% of tax revenues, increase from 20% in 1980. This share has risen due to the growing fiscal needs of state governments. States primarily spend on social infrastructure, such as health and education, while the federal government focuses on physical infrastructure.

Proposed Changes and Financial Implications

The federal government aims to reduce the states’ share to at least 40%. This 1% reduction could generate approximately Rs 35,000 crore ($4.03 billion) for the federal government, based on anticipated tax collections. The cabinet is expected to approve this proposal by March 2025 before it is forwarded to the Finance Commission.

Fiscal Deficits and Spending Priorities

India’s fiscal deficit is projected at 4.8% of GDP for 2024-25, while states have a deficit of 3.2%. States account for over 60% of total government spending, often prioritising social sectors. The federal government’s spending has increased , particularly post-Covid-19, leading to calls for a reassessment of tax revenue distribution.

Impact of Goods and Services Tax

The implementation of the Goods and Services Tax (GST) in July 2017 has limited states’ ability to raise revenue independently. This has intensified the need for states to rely on federal allocations, making any proposed cuts more impactful.

Conditional Grants and Political Implications

The federal government is likely to suggest linking federal grants to states with specific conditions. This could discourage states from offering cash handouts or debt waivers for political gain. The decline in revenue-deficit grants from Rs 1.18 trillion in 2021/22 to an estimated Rs 13,70 crore in 2025/26 reflects this shift.

Future Considerations

The proposed changes could lead to shifts in state spending priorities. States may need to adjust their budgets to cope with reduced federal support. The overall fiscal landscape in India may evolve, impacting both governance and public welfare initiatives.

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