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Critical Topics and Their Significance for the UPSC CSE Examination on September 06, 2024

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What is vertical fiscal imbalance?

For Preliminary Examination: Current events of national and international importance

For Mains Examination: GS III - Indian Economy

Context:

The role of the 16th Finance Commission should be to eliminate vertical fiscal imbalance in federal relations. What should it do when revenues are concentrated with the Union government, and the States are burdened with expenditure responsibilities?

Read about:

What is a Fiscal dilemma?

What is fiscal deficit?

Key takeaways:

The financial dynamics between the Union government and States in India are imbalanced, similar to many other federal systems. According to the 15th Finance Commission, while States account for 61% of revenue expenditure, they only generate 38% of revenue. This means that States largely depend on financial transfers from the Union government to meet their spending needs, leading to what is termed Vertical Fiscal Imbalance (VFI), where the States' expenditure responsibilities exceed their revenue-raising powers.

Why Reducing VFI is Important

• The Indian Constitution outlines separate financial responsibilities for the Union and States. On the revenue side, taxes like Personal Income Tax and Corporation Tax are more efficiently collected by the Union, whereas on the expenditure side, local governments are better suited to deliver public goods and services. This imbalance in revenue collection and expenditure creates a VFI that requires attention.
• The 15th Finance Commission observed that India's VFI is larger compared to many other federations, and this gap widened during crises like the COVID-19 pandemic, when States’ spending exceeded their revenue.
• The Finance Commission addresses VFI by focusing on two key issues. The first is determining how the Union government should distribute its tax revenue among the States.
• These transfers are a portion of the "Net Proceeds" (gross tax revenue minus surcharges, cesses, and collection costs). The second issue concerns how these funds are divided among individual States. VFI mainly emerges as part of the first issue.
• In addition to tax devolution, the Finance Commission also recommends grants to States in need, as per Article 275 of the Constitution, though these grants are usually temporary and for specific purposes.
• The Union government also provides significant funding under Article 282 through centrally sponsored and central sector schemes, but these are often tied to specific conditions, unlike the unconditional tax devolution.

Calculating VFI in India

To estimate VFI, we measure the combined Own Revenue Receipts (ORR) and tax devolution from the Union to the States against their Own Revenue Expenditure (ORE). If this ratio is below 1, it indicates that States' revenues, even with Union transfers, are insufficient to cover their expenditures. The deficit in this ratio serves as a proxy for VFI after tax devolution.

To eliminate VFI, tax devolution would need to be increased. Between 2015-16 and 2022-23, the average tax devolution to States should have been 48.94% to achieve fiscal balance, but the 14th and 15th Finance Commissions recommended only 42% and 41%, respectively.

Increasing Tax Devolution

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