| India’s states rival countries — Maharashtra’s economy is the size of Singapore’s; Uttar Pradesh’s population is close to that of Brazil; and Tamil Nadu’s per capita income equals Vietnam’s. The size and diversity make a center-leaning federal structure even tougher to manage. The task has doubled in size this month as states face the maximum brunt of US President Donald Trump’s 50% tariff and Prime Minister Narendra Modi’s consumption tax cuts. Modi’s coming for them politically as well. This will create new stresses for India’s already-frayed fiscal federal framework, Yamini Aiyar, public policy expert and visiting senior fellow at Brown University, said to me. It will also have implications for the country’s slowing economy. Let’s first take stock of the looming financial impact on states. Already, their fiscal situation has deteriorated in recent years. States’ aggregate fiscal deficit (shortfall in revenue versus expenditure) has risen from 2.6% of GDP in 2022-23 to 3.3% last year on account of slower revenue growth and higher expenditure, Madhavi Arora, chief economist at Emkay Global Financial Services, said to me. The budget gap is set to worsen as Modi’s decision to lower goods and services tax rates leaves states bearing two-thirds of the revenue loss — this at a time of slowing tax collections. The most affected will be large states like Haryana, Karnataka, Maharashtra, Bihar, Kerala, Gujarat, Telangana, Uttar Pradesh and Andhra Pradesh, which source 30% and more of their revenue from GST collections, according to an Ambit Capital report. For some like Kerala the impact will be more severe if the GST rate changes lead to higher tax on lotteries, one of the few remaining independent sources of revenue for states. At the same time, Trump’s 50% tariff will most hurt labor-intensive products such as textiles and apparel, seafood, gems and jewelry. Here too, some states such as Tamil Nadu, Maharashtra, Gujarat, West Bengal, Andhra Pradesh, Uttar Pradesh and Punjab face a disproportionate impact, and their fiscal ability to mitigate the fallout on jobs and output is mixed. “States’ capital expenditure is almost certain to be a casualty in fiscal 2025-26,” Arora said. Their expenditure on vote-wooing subsidies and cash transfer schemes may also have to be reined in to free up funds for tariff-affected firms and employees, or else budget gaps will widen further, she cautioned. States account for 50% of India’s government expenditure, which has been a key driver of growth in recent years. Belt-tightening will have an impact. To be clear, the Modi government is said to be mulling ways to compensate states for tariff and tax blows. But past such negotiations have been fraught with politics and mistrust. Aiyar points to how Modi’s government has over time reduced the pool of taxes to be shared between center and states. Large producer states have often complained of being short-changed by a revenue distribution formula that favors less-developed states. States have also railed against conditional access to central financing, including the renaming of welfare schemes after the prime minister. Even Modi’s unilateral announcement of the GST rate rationalization on Independence Day ran counter to the promise of joint decision-making with states. “New challenges are likely to create new sites of contestation,” Aiyar said, adding that they must be addressed by an imminent Finance Commission report on revenue sharing. It can be argued that the financial impact on states may be short-lived as tax cuts will over time boost consumption, and eventually a trade deal with the US could lower tariffs. But timing is everything in a country headed to key state elections — especially next year in opposition-ruled Tamil Nadu, West Bengal and Kerala. Already opposition parties are wary of Modi’s plans to hold simultaneous elections and redraw electoral constituencies. This month they were further alarmed by the sudden introduction of a draft law that allows the unseating of any central or state minister arrested under a serious charge and not granted bail within 30 days. With key investigating agencies under Modi’s control and a backlogged judicial system, opposition politicians are concerned false cases may be used to force them out of office sans a conviction. August then serves as a reminder of two things. States need to strengthen their financial position via tougher reforms — such as reducing power sector losses, improving agriculture productivity and monetization of assets such as land. And Modi, who’s remained unyielding to Trump’s carrot-and-stick approach, should ditch the same tactics himself. Slowing growth raises no one’s chances of victory, in trade negotiations or elections. | 
