Current context:
Opposition-ruled states, particularly those in south India, have alleged that they have not been receiving their fair share under the current financial devolution scheme.
About current context:
- They have raised concerns about their less proportionate share of receipt in tax revenue compared to their contribution towards tax collection.
Vertical Devolution Basics:
- Divisible Pool of Taxes: Article 270 of the Indian Constitution outlines the distribution of net tax proceeds collected by the Union government between the Centre and the States.
- The taxes shared include corporation tax, personal income tax, Central GST, and the Centre’s share of the Integrated Goods and Services Tax (IGST).
- However, cess and surcharge levied by the Centre are not part of the divisible pool.
Vertical Devolution Share:
- As per the recommendation of the 15th FC, states receive a share of 41% from the divisible pool.
- This vertical devolution ensures that states have a fair share of tax revenues.
Horizontal Devolution Criteria:
- Income Distance: This criterion considers the income distance of a state from the one with the highest per capita income (Haryana). States with lower per capita income receive a higher share to maintain equity.
- Population: The population as per the 2011 Census determines the distribution. Earlier, weightage was given based on the 1971 Census, but this changed in the 15th FC.
- Forest and Ecology: The share of dense forest in each state relative to the aggregate dense forest of all states.
- Demographic Performance: Introduced to reward states for controlling population growth. Lower fertility ratios lead to higher scores on this criterion.
How Financial Devolution impacts the Fiscal federalism?
Financial devolution significantly impacts fiscal federalism by shaping the distribution of funds between the central government and state governments.
Increased Fiscal Autonomy:
- Recommendations by Finance Commissions: The Finance Commissions recommend the share of Union tax revenues to be devolved to states. For instance, the 14th Finance Commission recommended increasing this share from 32% to 42%1.
- Empowering States: The move was praised as a significant step towards granting states greater fiscal autonomy.
Challenges and Discrepancies:
- Reduced Financial Transfers: Despite these recommendations, the Union government has been steadily reducing financial transfers to the states. This divergence between recommendations and actions raises questions about the principles of fiscal federalism and equitable resource distribution among states.
- Gross Tax Revenue vs. Allocations: The Union government has attributed the increase in gross tax revenue to factors such as collection costs, revenue allocation to Union territories, and specific scheme expenditures.
Impact of Cess and Surcharges:
- Undermining Devolution: The increasing reliance on cess and surcharges bypasses the recommended devolution to states. These revenue streams provide additional funds to the Union government but limit states’ flexibility in managing their expenditures.
- Centralized Decision-Making: The Union government’s discretion over the utilization of cess and surcharges centralizes financial resources and decision-making, undermining the principles of fiscal federalism.
About finance commission:
- The Finance Commission (FC) is a five-year body that recommends resource division and allocates tax revenues between the Centre and states.
- It also suggests grants-in-aid to support state development programs and regional disparities.
- The 16th Finance Commission, chaired by Dr. Arvind Panagariya, is currently making recommendations for 2026-31.
- The commission also reviews fiscal policies and disaster management financing arrangements.
Challenges:
- Equity Concerns: Some states argue that their contribution to tax collection exceeds their share of receipts. Addressing this disparity is essential for balanced development.
- Need for Transparency: The process of devolution should be transparent, and states must be aware of the criteria used for allocation.
- Enhancing State Capacity: States need to improve their revenue generation capacity to reduce dependence on central grants.
Conclusion
Vertical devolution is a critical aspect of fiscal federalism. While challenges exist, a well-designed system can ensure that states receive their fair share, promoting overall economic growth and development.