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Financial devolution among States

Context:

  • Recently various Opposition-ruled States especially from the southern part of India have claimed that they have not been receiving their fair share as per the present scheme of financial devolution.
  • They have raised various issues about their less than proportionate share of receipt in tax revenue when compared to their contribution towards tax collection.

What is meant by divisible pool of taxes?

  • Article 270 of the Indian Constitution provides for the scheme of distribution of net tax proceeds collected by the Union government between the Centre and the States.
  • The taxes which need to be 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.
  • This division of the revenue is based on the recommendation of the Finance Commission (FC) which is constituted every five years as per the terms of Article 280.
  • Apart from the share of taxes, States are also provided grants-in-aid as per the recommendation of the Finance Commission.
  • However it is important note that the divisible pool does not include cess and surcharge that are levied by the Centre.

How is the Finance Commission constituted?

  • The FC is constituted every five years and is a body which is exclusively constituted by the Union Government.
  • It consists of a chairman and also four other members who are appointed by the President.
  • The Finance Commission (Miscellaneous Provisions) Act, 1951, has specified the qualifications for chairman and also for other members of the commission.
  • The Union government has notified the constitution of the 16th Finance Commission under the chairmanship of Dr. Arvind Panagariya for making its recommendations for the duration 2026-31.

Basis of allocation by the Finance Commission:

  • The share of States from the divisible pool (vertical devolution) stands at 41% as per the recommendation of the current 15th FC.
  • The distribution among the States which is known as horizontal devolution is based on various criteria.

Major issues:

1. Cess and surcharge:

  • They are collected by the Union government and 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.
  • For example the GST compensation cess is for the repayment of loans taken to compensate States for the shortfall in tax collection due to GST implementation for the period 2017-22.
  • Some of these amounts are also used for centrally sponsored schemes which benefit the States.
  • But the States have no control over these components.

2. The amount each State gets back for every rupee they contribute to Central taxes shows steep variation.

  • It is seen that industrially developed States received much less than a rupee for every rupee they contributed as against States like Uttar Pradesh and Bihar.
  • This is partly due to the reason that many corporations are headquartered in these State capitals where they would remit their direct taxes.
  • However this variation can also be attributed to the difference in GST collection between various States.

3. The percentage share in the divisible pool of taxes has been reducing for southern States over the past six FCs.

  • This is attributable to the higher weightage being given for equity (income gap) and also needs (population, area and forest) rather than efficiency (demographic performance and tax effort).
  • Finally, grants-in-aid as per the recommendation of the FC varies among different States.
  • As per the 15th FC, there are revenue deficit, sector-specific and State-specific grants given to various States as well as grants to local bodies which are given based on population and area of States.

Way forward:

  • It must be noted that States generate around 40% of the revenue but bear around 60% of the expenditure.
  • The Finance Commission and its recommendations are meant to assess this imbalance and are meant to propose a fair sharing mechanism.
  • There are three important reforms which may be considered for maintaining the balance between equity and federalism while sharing revenue.
  • The divisible pool can be enlarged by including some amount of cess and surcharge in it and 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 formula by the Finance commission should be increased.
  • GST being a consumption-based destination tax which 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.
  • Therefore, 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 in the future.

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