Financial Devolution Among States

General Studies Paper-3

Context: Recently various South Indian States raised issues about their less than proportionate share of receipt in tax revenue when compared to their contribution towards tax collection.

About the Financial Devolution Among States

• It is a critical aspect of federalism in India involving the distribution of financial resources from the Union government to the states, enabling them to meet their expenditure requirements and provide public services.
• The process of financial devolution is guided by the Finance Commission (FC).

The Divisible Pool of Taxes:

• Article 270 of the Constitution provides for the scheme of distribution of net tax proceeds collected by the Union Government between the Centre and the States.
• These include corporation tax, personal income tax, Central GST, and the Centre’s IGST
• It does not include cess and surcharge that are levied by the Union Government.
• States are provided grants-in-aidas per the recommendation of the FC, apart from the share of taxes.

Role of 15th Finance Commission

• Vertical Devolution:The FC is responsible for recommending the distribution of the net proceeds of taxes of the Union between the Union and the States, commonly referred to as vertical devolution.
• Horizontal Devolution:The FC determines the allocation between the States of the respective shares of such proceeds, known as horizontal devolution.
• Criteria For Horizontal Devolution:
• Income distance:It is the distance of a State’s income from the State with the highest per capita income.
• States with lower per capita income are given a higher share to maintain equity among States.
• Forest and Ecology:The share of dense forest of each State in the aggregate dense forest of all the States.
• Currently, 41% of taxescollected by the Union Government (as per the recommendation of 15th Finance Commission) is devolved in 14 installments among States during a fiscal year.

Challenges and Concerns

• Disproportionate Share of Receipt in Tax Revenue:Various Opposition-ruled States, especially from south India, have claimed that they have not been receiving their fair share as per the present scheme of financial devolution.
• Cess and surchargecollected by the Union government is estimated at around 23% of its gross tax receipts for 2024-25, which does not form part of the divisible pool and hence not shared with the States.
• Reduction in Financial Transfers to States:Since the start of the Fourteenth Finance Commission award period (2015-16), the Union government has been reducing financial transfers to States.
• This is particularly strange given that the Fourteenth Finance Commission recommended devolving 42% of Union tax revenues to States, which is a 10 percentage points increase over the 13th Finance Commission’s recommendation.
• State Wise Variations:The amount each State gets back for every rupee they contribute to Central taxes shows steep variation.
• It can be seen that industrially developed States received much less than a rupee for every rupee they contributed as against States like Uttar Pradesh and Bihar.
• The percentage share in the divisible pool of taxes has been reducing for southern States over the last six FCs.
• It is attributable to the higher weightage being given for equity (income gap) and needs (population, area and forest) than efficiency (demographic performance and tax effort).
• Increase in Union Government’s Discretionary Expenditure:The Union government not only reduced the financial transfers to States but also increased its own total revenue to increase its discretionary expenditure.
• The discretionary expenditures of the Union government are not being routed through the States’ Budgets, and, therefore, can impact different States in different ways.
• Decline in States’ Share in Gross Revenue:One of the reasons for the States’ share in gross revenue declining during this period is that the net tax revenue is arrived at after deducting the revenue collections under cess and surcharge.
• Against the Federal Spirit:The Constitutional scheme has always favoured a strong centre in legislative, administrative and financial relations.
• However, federalism is a basic feature and it is important that States don’t feel short-changed when it comes to distribution of resources.

Way Forward

• The States generate around 40% of the revenue and bear around 60% of the expenditure. It is the responsibility of all States to contribute towards the more equitable development of our country.
• However, there are three important reforms that may be considered for maintaining the balance between equity and federalism while sharing revenue:
• The divisible pool can be enlarged by including some portion of cess and surcharge in it.
• The weightage for efficiency criteria in horizontal devolutionshould be increased.
• Similar to the GST Council, a more formal arrangement for the participation of States in the constitution and the working of the FC should be considered.