Government’s Tax Devolution to States

General Studies Paper -2

Context: The Central Government has released an instalment of  ₹1.39 lakh crore for tax devolution to the states.

About

• It includes the regular devolution amount for June 2024 and an additional instalment, enabling State Governments to accelerate development and capital spending.
  • The additional funds will support State Governments in enhancing their developmental activities and infrastructure projects, thereby boosting economic growth at the state level.
• The Interim Budget for FY25 had earmarked Rs. 12.19 trillion towards devolution of taxes to states. With this release, the total amount devolved for FY25 to states till 10 June stands at Rs. 2.8 trillion.

About Tax devolution

• It is a crucial revenue stream for states, involving the Centre allocating tax collection to states.
• 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.
• The taxes that are shared between the Centre and the States include corporation tax, personal income tax, Central GST, the Centre’s share of the Integrated Goods and Services Tax (IGST) etc.
• Article 280(1) of the Constitutions lays down that the modalities for setting up of a Finance Commission to make recommendation on the distribution of net proceeds of taxes between the Union and the States, allocation between the States of respective shares of such proceeds; grants- in-aid and the revenues of the States and measures needed to supplement the resources of the Panchayats during the award period.
• The divisible pool, however, does not include cess and surcharge that are levied by the Centre. the basis for allocation
• The share of States from the divisible pool (vertical devolution) stands at 41% as per the recommendation of the 15th FC.
• The distribution among the States (horizontal devolution) is based on various criteria. The criteria as per the 15th FC can be briefly explained as follows.
  • ‘Income distance’ is the distance of a State’s income from the State with highest per capita income.
  • States with lower per capita income would be given a higher share to maintain equity among States.
  • ‘Population’ is the population as per the 2011 Census. Till the 14th FC, weightage was given for the population as per the 1971 Census but that has been discontinued in the 15th FC.
  •  ‘Forest and ecology’ consider the share of dense forest of each State in the aggregate dense forest of all the States.
  • ‘The demographic performance’ criterion has been introduced to reward efforts made by States in controlling their population.
  • States with a lower fertility ratio will be scored higher on this criterion.
  • ‘Tax effort’ as a criterion has been used to reward States with higher tax collection efficiency.

Criticism and Issues

• 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.
• While there are always political differences between the Union government and Opposition-ruled States that exacerbate the problem, there are genuine issues that need to be considered.

Suggestions and Way Ahead

• The divisible pool can be enlarged by including some portion of cess and surcharge in it.
• The Centre should also gradually discontinue various cesses and surcharges it imposes by suitably rationalising the tax slabs.
• The weightage for efficiency criteria in horizontal devolution should be increased.
• GST being a consumption-based destination tax that is equally divided between the Union and the State means that State GST accrual (inclusive of Integrated GST settlement on inter-state sales) should be the same as the Central GST accrual from a State.
  • Hence, relative GST contribution from States can be included as a criterion by providing suitable weightage in future FCs.
• Finally, 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.
• These are measures that need to be implemented by the Centre after discussion with all the States.
• It is also imperative that the States uphold principles of fiscal federalism by devolving adequate resources to local bodies for vibrant and accountable development.