Union government’s reins on financial transfers to States 

The Finance Commission of India is a constitutional body established under Article 280 of the Indian Constitution. Its primary function is to define the financial relations between the Union Government and the State Governments. 

Functions

• Recommend the distribution of the net proceeds of taxes between the Union and the States.
• Recommend the principles governing grants-in-aid to the States out of the Consolidated Fund of India.
• Review the existing system of revenue collection and suggest measures for improving it.
• Examine the financial position of the Union and the States and suggest measures to improve their fiscal health.

Composition

• The Commission is chaired by a Chairperson, who is usually a retired judge or eminent economist.
• Other members include representatives from the Union Government and the State Governments.
• The Commission is constituted every five years.

Recent Developments

• The 15th Finance Commission submitted its report in 2020, recommending a 41% share in the net tax revenue for the States (excluding J&K and Ladakh).
• The 16th Finance Commission is currently in operation and is expected to submit its report by October 2025.

Criticisms and Challenges

• Some critics argue that the Commission's recommendations favour the Union Government over the States.
• Others point to the complex and opaque nature of its calculations.
• There have also been concerns about the timeliness and implementation of its recommendations.

Cooperative federalism in India refers to the collaborative relationship between the central government and the state governments, aimed at achieving shared goals, promoting inclusive development, and ensuring effective governance across the country. It emphasizes partnership, coordination, and mutual respect between different tiers of government.

Constitutional Framework

India follows a federal system of governance, where powers and responsibilities are divided between the central and state governments as outlined in the Constitution. The Seventh Schedule of the Constitution delineates the powers of the Union and State governments, ensuring a clear demarcation of authority while also allowing for cooperation and coordination.

Principles of Cooperative Federalism

• Mutual Respect and Recognition: Cooperative federalism emphasizes the recognition of each level of government's autonomy and authority, respecting their jurisdiction and decision-making powers.
• Shared Responsibility: It underscores the idea of shared responsibility in addressing national challenges and achieving common objectives, with both the central and state governments contributing to policy formulation and implementation.
• Consultative Process: Cooperative federalism involves a consultative and participatory approach, where decisions are made through dialogue, consensus-building, and collaboration among all stakeholders.
• Decentralization of Power: It advocates for decentralization and devolution of powers to the grassroots level, empowering local governments and communities to participate in decision-making and governance processes.
• Fiscal Federalism: Cooperative federalism also encompasses fiscal federalism, ensuring equitable distribution of financial resources, tax revenues, and grants-in-aid among different tiers of government.

Key Initiatives and Mechanisms

• Inter-State Council: Established under Article 263 of the Constitution, the Inter-State Council serves as a platform for fostering cooperation and coordination among states and between the central and state governments on issues of common interest.
• Goods and Services Tax (GST): The introduction of GST exemplifies cooperative federalism by creating a unified tax regime across the country, with both the central and state governments jointly administering and sharing revenues.
• National Institution for Transforming India (NITI Aayog): NITI Aayog acts as a platform for cooperative federalism by facilitating dialogue, policy coordination, and collaboration between the central government, state governments, and other stakeholders.
• Schemes and Programs: Several schemes and programs launched by the central government involve active participation and cooperation from state governments, such as the Swachh Bharat Mission, Ayushman Bharat, and Smart Cities Mission.

Challenges

Despite significant progress, challenges remain in realizing the full potential of cooperative federalism in India. These include issues related to inter-state disparities, administrative capacity, and political will. Strengthening cooperative federalism requires continuous dialogue, institutional reforms, capacity-building measures, and a shared commitment to inclusive and sustainable development.

4. Analysis of Tax Revenue and States' Share

The Finance Commissions recommend the allocation of States' share in the net tax revenue of the Union government. However, the difference between gross and net tax revenue factors in collection costs, allocations to Union territories, and various cess and surcharges. Despite the recommendations of the Fourteenth and Fifteenth Finance Commissions for higher shares (42% and 41% respectively) of net tax revenue to States, the actual share of gross tax revenue was considerably lower, standing at 35% in 2015-16 and decreasing to 30% in 2023-24 (Budget Estimate).

Growth Disparity

While the gross tax revenue of the Union government soared from ₹14.6 lakh crore in 2015-16 to ₹33.6 lakh crore in 2023-24, the States' share in Union tax revenue only doubled, rising from ₹5.1 lakh crore to ₹10.2 lakh crore during the same period. This indicates a significant disparity, with the gross tax revenue doubling while the States' share merely doubled.

Decline in Grants-in-Aid

Grants-in-aid to States, another form of statutory financial transfers recommended by the Finance Commission, witnessed a decline from ₹1.95 lakh crore in 2015-16 to ₹1.65 lakh crore in 2023-24. Consequently, the combined share of statutory financial transfers in the gross tax revenue of the Union government dwindled from 48.2% to 35.32%.

Factors Contributing to Decline

One of the primary reasons for the decline in the State's share of gross revenue is the calculation of net tax revenue, which deducts revenue collections from cess and surcharge, collections from Union Territories, and tax administration expenditures. Among these factors, revenue collection through cess and surcharge has seen the most significant increase. In 2015-16, cess and surcharge collections accounted for 5.9% (₹85,638 crore) of the gross tax revenue, escalating to 10.8% (₹3.63 lakh crore) in 2023-24.

Impact of Cess and Surcharge

The Union government's emphasis on increasing tax collection under the cess and surcharge categories, primarily to fund its own schemes in specific sectors, has contributed to this rise. Importantly, the revenues generated through these avenues need not be shared with the States, further reducing the States' share in the overall tax revenue.

5. Centralisation of Public Expenditure

With the decline or disproportionate increase in financial transfers to States compared to the growth in gross revenue of the Union government, there arises a scenario where the Union government possesses larger discretionary funds for expenditure. This could potentially impact the equitable distribution of financial resources among States, leading to concerns about centralization of public expenditure.

Centrally Sponsored Schemes (CSS)

The Union government influences State priorities through CSS, where partial funding is provided by the Union government, and States are required to commit their financial resources. Between 2015-16 and 2023-24, the allocation for CSS increased substantially from ₹2.04 lakh crore to ₹4.76 lakh crore, with 59 CSS in place. However, the actual financial transfers to States under CSS amounted to only ₹3.64 lakh crore in 2023-24, retaining a significant portion of the CSS allocation for other expenses.

Implications of CSS on Inter-State Equity

CSS create disparities in inter-state equity in public finances. Wealthier States can afford to commit equivalent finances and leverage Union finances inward, while less affluent States may need to borrow finances to participate in CSS, thus increasing their own liabilities. This differential trajectory accentuates inter-state inequality in public finances, primarily due to CSS.

Central Sector Schemes (CSec Schemes)

Fully funded by the Union government, CSec Schemes are implemented in sectors where the Union government holds exclusive legislative or institutional controls. The allocation for CSec Schemes substantially increased from ₹5.21 lakh crore in 2015-16 to ₹14.68 lakh crore in 2023-24, covering over 700 schemes.

Allocation Disparity and Motives

The Union government's allocation of a larger share of finances to CSec Schemes raises concerns about the possibility of directing financial resources to benefit specific States or constituencies. Since CSec Schemes are directly implemented by the Union government, only a fraction of the funds (₹60,942 crore in 2023-24) is devolved to States under this scheme.

Combined Allocation and Devolution

In 2023-24, the combined allocation for CSS and CSec Schemes amounted to ₹19.4 lakh crore, whereas only ₹4.25 lakh crore was devolved to States. This highlights a significant disparity between the allocation of funds and their devolution to States, further exacerbating concerns about centralization of public expenditure and inter-State equity.

6. Potential for Anti-Federal Fiscal Policies

There exists a significant scope for anti-federal fiscal policies, primarily stemming from the structure and allocation of financial transfers through Centrally Sponsored Schemes (CSS) and Central Sector Schemes (CSec Schemes).

Non-Statutory Transfers and Their Impact

Financial transfers via CSS and CSec Schemes are non-statutory, lacking legal provisions or formulas determined by the Finance Commission. These transfers constitute 12.6% of gross tax revenue. When combined with statutory grants, total financial transfers amount to only 47.9% of gross tax revenue in 2023-24. Furthermore, non-statutory grants are tied grants, restricting States from spending them only on specific schemes allocated by the Union government. This diminishes States' autonomy in public expenditure decisions.

Union Government's Fiscal Powers

The Union government retains over 50% of gross tax revenue and incurs a fiscal deficit of 5.9% of GDP, indicating significant financial power with limited expenditure responsibilities. This asymmetry in fiscal powers further consolidates the Union government's control over financial matters.

Potential Arguments for Downward Revision

The Fifteenth Finance Commission observed the Union government's advocacy for reducing States' share in Union tax revenue from 42% to 41%. Despite the Commission retaining the share at 41%, the Union government might repeat its argument before the Sixteenth Finance Commission, citing higher expenditure commitments. This trend undermines the principles of cooperative federalism.