FINANCIAL DEVOLUTION OF STATES

• The President issues a Presidential Order to constitute the Finance Commission.
• The Finance Commission typically consists of a Chairman and four other members, who are appointed by the President. The members are selected based on their expertise in various fields, including finance, economics, and public administration
• The qualifications and criteria for the appointment of the Chairman and members are specified in the Presidential Order. The Commission is expected to have a diverse set of skills and knowledge relevant to fiscal matters
• The President also specifies the terms of reference for the Finance Commission. These terms outline the scope and responsibilities of the Commission, including the principles governing the distribution of finances between the Union government and the states
• The Finance Commission is expected to function independently and make recommendations without external influence. This independence is crucial to ensure impartiality in the distribution of financial resources
• The primary task of the Finance Commission is to make recommendations regarding the sharing of central tax revenues between the Union and the states, as well as the principles governing grants-in-aid to states. The Commission examines various factors such as population, income levels, and special circumstances of states to make these recommendations
• Once the Finance Commission completes its deliberations, it submits a report to the President. This report is then laid before both houses of Parliament

The 15th Finance Commission's recommendation allocates 41% of the divisible pool to States through vertical devolution. The horizontal devolution, determining distribution among States, relies on specific criteria outlined in Table 1, covering the 11th to 15th Finance Commissions.

Explaining the 15th Finance Commission's criteria:

• 'Income distance' measures a State's income relative to Haryana, the State with the highest per capita income. States with lower per capita income receive a higher share for equity.
• 'Population' is based on the 2011 Census, diverging from the 14th Finance Commission, which considered the 1971 Census.
• 'Forest and ecology' assesses each State's share of dense forest in the total dense forest across all States.
• 'Demographic performance' rewards States controlling population growth, with lower fertility ratios earning higher scores.
• 'Tax effort' acknowledges States with efficient tax collection, offering a criterion to reward higher tax collection efficiency

5. Challenges

 

• The constitutional framework has consistently favored a robust central authority in legislative, administrative, and financial matters. Nonetheless, while federalism is a fundamental aspect, it is imperative to ensure that States do not feel disadvantaged in resource distribution. Despite the political divergences between the Union government and opposition-led States, there are legitimate concerns that merit attention.
• Firstly, approximately 23% of the Union government's gross tax receipts for 2024-25 are attributed to cess and surcharge, which are not part of the divisible pool and, consequently, not shared with the States.
• To illustrate, the Union government's total tax revenue for the years 2022-23 (actual), 2023-24 (revised estimates), and 2024-25 (Budget estimates) is ₹30.5, ₹34.4, and ₹38.8 lakh crore, respectively.
• The State's share for the corresponding periods was/is ₹9.5, ₹11.0, and ₹12.2 lakh crore, constituting around 32% of the Center's total tax receipts, considerably less than the 41% recommended by the 15th Finance Commission.
• Cesses, such as the GST compensation cess, aim to repay loans taken to compensate States for tax collection shortfalls during the 2017-22 GST implementation period. Some of these funds also support centrally sponsored schemes benefiting the States. However, States lack control over these components.
• Secondly, the disparity in the amount each State receives for every rupee contributed to Central taxes is substantial. Chart 1 for the year 2021-22 illustrates that industrially developed States receive considerably less than a rupee for every contributed rupee, contrasting with States like Uttar Pradesh and Bihar.
• This variance is partly due to many corporations being headquartered in these State capitals, where they remit direct taxes. However, differences in GST collection among States also contribute to this variation.
• Thirdly, there has been a decreasing trend in the percentage share of southern States in the divisible pool of taxes over the last six Finance Commissions, as depicted in Chart 2. This trend is attributed to higher consideration given to equity (income gap) and needs (population, area, and forest) compared to efficiency (demographic performance and tax effort).
• Lastly, grants-in-aid recommended by the Finance Commission vary among States, encompassing revenue deficit, sector-specific, and State-specific grants, as well as grants to local bodies based on States' population and area

 

6. Way forward

 

It's important to highlight that States contribute approximately 40% of the revenue and bear around 60% of the expenditure. The Finance Commission (FC) and its recommendations aim to address this imbalance and propose a fair mechanism for revenue sharing. Ensuring a more equitable development across the country is a collective responsibility of all States. However, three key reforms can be considered to maintain a balance between equity and federalism in revenue sharing.

Firstly, there is the possibility of expanding the divisible pool by incorporating a portion of cess and surcharge. The Centre should gradually phase out various cesses and surcharges by rationalizing tax slabs. Secondly, it is suggested to increase the emphasis on efficiency criteria in horizontal devolution. Given that GST is a consumption-based destination tax, evenly split between the Union and the States, State GST accrual (including Integrated GST settlement on inter-state sales) should be equivalent to the Central GST accrual from a State. Therefore, incorporating the relative GST contribution from States as a criterion with appropriate weightage in future Finance Commissions is advisable. Finally, akin to the GST council, a more formal structure for the involvement of States in the constitution and functioning of the Finance Commission should be explored.

 

For Prelims: Finance Commission, Eligibility, Availability and Appointment of Finance Commissioner For Mains: Devolution of Taxes among States by Finance Commission

 

Previous Year Questions   1.With reference to the Finance Commission of India, which of the following statements is correct? (UPSC CSE 2011) A.It encourages the inflow of foreign capital for infrastructure development. B.It facilitates the proper distribution of finances among the Public Sector Undertaking. C.It ensures transparency in financial administration. D.None of the statements (a), (b) and (c) given above is correct in this context. Answer (D)

Source: The Hindu