08 February 2024 – The Hindu

India’s Fiscal Centralization Concerns

• The Union government has been cutting back on financial transfers to States ever since the start of the 14th Finance Commission (FC) award term (2015–16). This is especially odd considering that the 14th FC advocated giving the States 42% of Union tax revenues—a clear 10% increase over the 13th FC’s recommendation.
• This 41% suggestion was kept by the 15th Finance Commission, with the exception of the devolution to J&K and Ladakh, which were reclassified as Union Territories. It should be 42% if the shares of J&K and Ladakh are taken into account. In order to raise its discretionary spending, the Union administration boosted overall revenue while simultaneously decreasing budgetary transfers to the States.

Fiscal Federalism: What Is It?

• The division of financial authority and responsibility among the several tiers of a nation’s government is known as fiscal federalism.
• It entails decisions about whether services and tasks should be handled by the federal government or the state governments, how to raise and distribute funds, and how to distribute transfers and grants in a way that ensures efficiency and equity.

What Distinct Provisions Concerning Centre State Financial Relations Are There?

• Part XII of the Constitution: The Indian Constitution contains detailed provisions for the allocation of non-tax revenues, taxes, and borrowing authority. These are enhanced by provisions for grants-in-aid that the Union provides to the States. Articles 268 through 293 address the terms governing the financial interactions between the Centre and the States.
• The discretionary distribution of funding from the federal government to state governments for particular initiatives or goals is known as the grants-in-aid system, as defined by Article 275.
• As mandated by Article 280 of the Constitution, the Finance Commission is tasked with making recommendations about the allocation of tax income between the federal government and the state governments. It also makes recommendations for how to strengthen public finances, encourage restraint, and guarantee stability in fiscal affairs.
• In accordance with Article 280(3) of the Constitution, the Centre may request that the FC investigate any other matter “in the interest of sound finance,” in addition to suggesting that taxes and grants-in-aid be devolved to the States.
• The Union List’s subjects are susceptible to taxation only by the Parliament.
• The only body authorised to impose taxes on items included in the State List is the state legislature.
• While Parliament alone has the residual ability to impose taxes, both can impose taxes on the topics listed in the Concurrent List.

Which Union Government Actions Have Caused a Reduction in the Total Amount of Fund Transfers to States?

Growing Fiscal Power Centralization:

• The percentage of non-shareable income—such as levies and cesses—that goes to the federal government has increased over time.
• As a result, states are pushing for increased economic independence and a bigger portion of all taxes collected by the federal government.

State Tax Autonomy is Eroding:

• States no longer have as much power to determine tax rates on their own sources of income. This loss happened after the value-added tax (VAT) was imposed on intrastate commerce in goods.
• States no longer have as much discretion in choosing their tax laws and methods of raising money.

Limitations on the Flexibility of State Expenditure:

• States’ ability to spend freely is limited by the growing popularity of tied and conditional grants.
• These grants restrict states’ ability to distribute monies in accordance with their own priorities and local requirements. They target goods that are included in the state list.
• Consistent Budgetary Objectives Ignoring State Differences:
• The problem is made worse by the Fiscal Responsibility and Budget Management (FRBM) Act of 2003, which imposes consistent fiscal targets on all governments.
• States’ capacity to successfully manage their budgets is further restricted by these targets, which do not take into consideration the various fiscal needs and economic circumstances of each state.
• The Goods and Services Tax (GST) is being implemented.
• Since the first Federal Constitution was established in 1951, the most significant fiscal adjustment has been the 101st Constitutional Amendment of 2016, which grants the Union and the states concurrent authority over indirect taxation.
• Both the vertical and horizontal dynamics of federalism are altered when indirect taxes are collected in the state where products or services are consumed rather than in the state where they are produced.
• Horizontal imbalances have resulted from the transfer of tax burdens from rich and manufacturing states to consuming states.
• For example, the integrated goods and services tax (IGST) that was imposed during the interstate delivery of products or services has been moved to the state of destination. The principle of destination, as opposed to the principle of origin, is changing the way states balance power.

Guidelines for allocating each state’s portion of all federal taxes, Eleventh through Fourteenth Finance Commissions:

What is the state of fiscal transfers to states as of right now?

Reduction in the Gross Tax Revenue Share:

• Despite the fact that the 14th and 15th FCs proposed that the States get 42% and 41%, respectively, of the net tax revenue, the share of gross tax revenue was only 35% in 2015–16 and 30% in 2023–24 (Budget Estimates).
• The States’ portion of Union tax revenue climbed from Rs 5.1 lakh crore to Rs 10.2 lakh crore over these two years, even though the Union government’s gross tax collection increased from Rs 14.6 lakh crore in 2015–16 to Rs 33.6 lakh crore in 2023–24.

State Grants-in-Aid Reduction:

• The total amount of grants-in-aid given to the States fell between 2015–16 and 2023–24, from Rs 1.95 lakh crore to Rs 1.65 lakh crore. As a result, the total statutory financial transfers’ share of the Union government’s gross tax revenue decreased from 48.2% to 35.32%.

Augmenting Tax Revenue in Cess and Surcharge Domains:

• The fact that the net tax revenue is calculated after subtracting the revenue collected under the cess and surcharge, the revenue collected from the Union Territories, and the expense of tax administration is one of the reasons why the States’ share of gross revenue decreased during this time.
• The greatest and fastest-growing income collection among the three factors is the cess and surcharge.
• The GST cess, which is collected to make up for the states’ revenue losses as a result of the adoption of the GST through June 2022, is not included in this computation.

Fears of Financial Centralization:

• There are two more avenues via which the Union government can directly transfer funds to the States: Central Sector Schemes (CS) and Centrally Sponsored Schemes (CSS).
• Through CSS, wherein the Union government provides partial money and the States are responsible for the remaining portion, the government influences the priorities of the States. Put another way, it suggests the plans, and the States carry them out while also contributing financial resources.
• The allocation for CSS grew through 59 CSS from Rs 2.04 lakh crore to Rs 4.76 lakh crore between 2015–16 and 2023–24.
• As a result, the Union government requires the State to provide roughly equal amounts of financial resources.

Problems Concerning Rich vs. Poor States:

• One significant feature of CSS shared schemes is the availability of matching grants to States able to commit matching funds from their own state budgets. Regarding interstate equity in public budgets, this has two distinct effects.
• Rich States can afford to use CSS to apply equal financial commitments and turn Union finances inward.
• States with lower incomes will be forced to invest their borrowed funds in these CSS, which will raise their own liabilities. For the main reason being CSS, these diverse State public finance trends highlight inter-State disparities in public budgets.
• Greater Financial Authority of the Union Government with Restricted Spending Capabilities:
• In 2023–24, the overall financial transfers as a percentage of gross tax revenue were just 47.9% when combined with statutory grants.
• The Union government not only keeps almost 50% of its gross tax receipts, but it also runs a 5.9% GDP budget deficit. As a result, the Union government has considerable financial authority but little responsibility for spending.

What Actions Are Needed to Guarantee a Better Devolution of Finances?

• Reexamine the Tax-Sharing Principles: In light of India’s evolving fiscal federalism, the FCs should be instructed to revisit the tax-sharing principles. Regarding the Union and the states’ unified indirect tax base, their mandates ought to be perfectly linked.
• Redesign the Statutory Sharing of Indirect Taxes: As a result of the modifications, the vertical and horizontal statutory sharing of indirect taxes must be reevaluated and revised.
• Vertical Devolution: It’s critical to redefine the divisible pool in order to bring the concept of vertical sharing into compliance with the existing framework. For example, the 16th FC will have to outline how IGST will be fully integrated into the pool.
• Horizontal Devolution: It will be necessary to review the standards for allocating the divisible pool among the states. The current standards—particularly for grant equalization—have developed into a production-based tax structure. This must be revised to accommodate a consumption-based tax structure.
• Calculating and Allocating the Cost of Collecting: The cost of tax collection has increased significantly and is now widely variable due to the new GST administration, which collects taxes from both the Union and the states. The price range for this is 7% to 10%.
• As a result, it should be the responsibility of the ensuing FCs to suggest a strategy for figuring out and allocating the expense of collecting indirect taxes.
• They should also make recommendations on how to lower these levies and increase the effectiveness of their collection.
• Redesign the Grant Mechanism: In light of the compensation legislation introduced by the GST Council, the 1935 “gap-filling” strategy, which was carried out under Article 275, should be revised. This was suggested by British banker Otto Niemeyer.
• The fiscal year following that will serve as the base year for the 16th FC award, which will be in effect from 2027 to 2032, with the GST compensation grants extended until March 31, 2026.
• It is obvious that every state will want to see the compensation plan extended. Because the purpose of the 16th FC was to “compensate losses in transition to GST,” it is therefore advisable to enjoin them to investigate the necessity for compensation.
• The GST Council and the Finance Commission are required to have a formal interaction under the new federal finance institutional framework since they determine the size and distribution of the divisible pool.
• The FCs ought to look into ways whereby the GST Council, in place of the Fiscal Council, might supervise the execution of its award when it is not in existence.
• It is concerning that the Union government has significantly decreased its financial transfers to the States since the start of the 14th FC award period, especially in light of the suggested rise in devolution to 42%.
• The amount allotted to the States has not increased proportionately, even though the Union government’s gross tax collection has increased significantly. The dependence on CS and CSS reduces State autonomy in financial management and exacerbates inter-State inequalities.
• This situation casts doubt on the future equal allocation of financial resources among States and erodes cooperative federalism.