A Federal Dilemma: How The New Income Tax Bill 2025 Threatens State Revenues And Fiscal Autonomy

The New Income Tax Bill 2025 is regarded as a significant reform intended to streamline tax systems and enhance compliance. Nonetheless, its effects reach well beyond individual taxpayers and businesses, as it poses serious implications for state finances and the structure of federalism. While income tax is an exclusive Union subject under Entry 82 of the Union List (Seventh Schedule), states rely heavily on their portion of central taxes as provided in Article 270 of the Constitution. Any changes to tax brackets, exemptions, or additional levies can drastically reduce the amount of the divisible pool, thereby decreasing state revenues.

This article critically examines how the New Income Tax Bill 2025 jeopardizes fiscal federalism, the growing dependence on non-divisible surcharges and levies, and the potential risks states may soon face with diminishing financial strength and reduced fiscal autonomy.

WILL CHANGES IN TAX SLABS REDUCE THE MONEY GIVEN TO STATES?

Although the New Income Tax Bill 2025 does not make any new adjustments to tax slabs or rates compared to those presented in the Union Budget 2025, any changes in tax income could impact state revenues. Although this approach might look politically appealing, it reduces the overall direct tax base, ultimately reducing the funds available for Finance Commission-mandated devolution under Article 270. Since states receive 41% of net income tax collections (as per the Fifteenth Finance Commission's recommendations), a decrease in net taxable income will lead to direct revenue losses for states.

HOW DO SURCHARGES AND CESSES KEEP MORE MONEY WITHIN THE CENTRE?

A more subtle way to weaken state finances is through the ongoing growth of cesses and surcharges, which do not fall under the divisible tax pool in Article 270. The new bill raises surcharges on high-income individuals and corporations, ensuring that a greater portion of direct tax revenue remains with the central government rather than being allocated to the states. The Supreme Court, in the case of Krishnan Kakkanth v. Government of Kerala (1997), observed that cesses and surcharges should be allocated for specific uses; however, their increasing use as a revenue-shielding mechanism by the Centre raises constitutional concerns.

CAN STATES RAISE THEIR TAXES TO COMPENSATE?

In contrast to the US, where each state has substantial taxing autonomy, Indian states can only impose taxes on agricultural income (Entry 46, List II), professional income (Entry 60, List II), and specific goods and services. The Income Tax Bill 2025 would further hamper state taxation powers through its definition of taxable income and deductions. States that attempt to impose new direct taxes tend to meet broad constitutional barriers, as shown in the decision of State of West Bengal v. Kesoram Industries Ltd. (2004), where the Supreme Court held that states cannot impose taxes that are in the deemed subjects of the Union List.

POLICY SOLUTIONS: RESTORING FISCAL BALANCE

To address the increasing fiscal imbalance, the following policy reforms should be evaluated:

1. Amend Article 270 to include a specified proportion for the cesses and surcharges in the divisible tax pool so that states receive a proportion for all direct tax collections.

2. Permit states to impose supplementary taxation on high-income earners and digital services, thereby enabling direct taxation in a very limited and yet significant way.

3. Create a constitutional fiscal review mechanism that obliges the Finance Commission to evaluate how changes in Union tax policies affect states, with provisions for compensation if devolution drops below a specific level.

4. Improve transparency in the calculations for tax devolution, requiring the Union government to reveal the anticipated effects of income tax reforms on state revenues before their implementation.

THE FUTURE OF INDIAN FISCAL FEDERALISM

The New Income Tax Bill 2025 marks a subtle yet important move toward fiscal centralization. Although it is presented as an initiative for tax reform, the consequences on state revenues and their financial autonomy are largely ignored. If these issues are not promptly resolved through constitutional and policy reforms, India's states could soon find themselves deprived of taxation authority and sufficient financial resources, effectively becoming mere administrative extensions of the Union government. This situation transcends a simple tax reform concern; it is evolving into a crisis of federalism.

REFERENCES

1. The Income-tax Bill, 2025, Ministry of Finance, Government of India, (Feb 13, 2025), https://incometaxindia.gov.in/Documents/income-tax-bill-2025/income-tax-bill-2025.pdf (last visited Mar. 06, 2025).
2. India Const. Seventh Schedule, List I (Union List), Entry 82, https://www.mea.gov.in/images/pdf1/S7.pdf
3. India Const. Art. 270, https://indiankanoon.org/doc/1465729/
4. Fifteenth Finance Commission,
   Report of the Fifteenth Finance Commission for 2021-26, Volume I (2021), available at https://fincomindia.nic.in/commission-reports-fifteenth
5. Krishnan Kakkanth v. Govt. of Kerala, (1997) 9 SCC 495: AIR 1997 SC 128, https://indiankanoon.org/doc/1159367/
6. State of W.B. v. Kesoram Industries Ltd., (2004) 10 SCC 201,
   https://digiscr.sci.gov.in/admin/judgement_file/judgement_pdf/2004/volume%201/Part%20I/the%20state%20of%20west%20bengal%20and%20ors._kesoram%20industries%20ltd.%20and%20ors._1699001642.pdf

Authors are students at Maharashtra National Law University, Aurangabad. Views Are Personal.