Why in news?

The financial relationship between the Union government and the States in India is asymmetrical, reflecting a common feature in federal systems. The States are responsible for 61% of the revenue expenditure but collect only 38% of the revenue receipts, as highlighted by the 15th Finance Commission.

This imbalance means that States rely heavily on transfers from the Union government to meet their expenditures. The result is a Vertical Fiscal Imbalance (VFI) in India's fiscal federalism, where the decentralisation of expenditure responsibilities exceeds the States' revenue-raising capacity.

What’s in today’s article?

• Central Transfers to States
• Vertical Fiscal Imbalance (VFI) in India

Central Transfers to States

• About
  • The Finance Commissions recommend the States’ share in the net tax revenue of the Union government.
    • Under Article 280, the President is required to constitute a Finance Commission (FC) at an interval of five years or earlier.
    • Article 280(3)(a) says that the FC has the responsibility to make recommendations regarding the division of the net proceeds of taxes between the Union and the states.
  • The difference between the gross and the net tax revenue includes collection costs, tax revenue to be assigned to Union territories, and cess and surcharges.
• Composition of transfers
  • The central taxes devolved to states are untied funds, and states can spend them according to their discretion.
  • Over the years, tax devolved to states has constituted over 80% of the total central transfers to states.
  • The centre also provides grants to states and local bodies which must be used for specified purposes.
    • These grants have ranged between 12% to 19% of the total transfers.
• Tax devolution to states
• The 14th FC considerably increased the devolution of taxes from the centre to states from 32% to 42%.
  • In the 15^th FC, share of states in the central taxes for the 2021-26 period is recommended to be 41%.
  • The adjustment of 1% is to provide for the newly formed union territories of J&K, and Ladakh from the resources of the centre.
• The Commission had recommended that tax devolution should be the primary source of transfer of funds to states.
• This would increase the flow of unconditional transfers and give states more flexibility in their spending.
• Formula used to distribute fund among states
  • 
  • Population/Demography - Population is an indicator of the expenditure needs of a state.
  • Demographic performance - Demographic performance criterion rewards states for their efforts to control population growth.
    • The commission considered indicators like fertility rate, infant mortality rate, and sex ratio to assess states' efforts.
  • Income distance – It is the difference between the per capita income of a state with the average per capita income of all states.
    • States with lower per capita income may be given a higher share to maintain equity among states.
  • Area is used as a criterion as a state with larger area has to incur additional administrative costs to deliver services.
  • Forest & Ecology - it indicates that states with large forest covers bear the cost of not having area available for other economic activities.
    • Therefore, the rationale is that these states may be given a higher share.
  • Tax and fiscal efforts
• Grant in aid
  • Besides the taxes devolved to states, another source of transfers from the centre to states is grants-in-aid.
  • As per the recommendations of the 15th Finance Commission, the following grants will be provided to states from the centre’s resource:
    • Revenue deficit grants
    • Sector-specific grants: Sector-specific grants is given to states for eight sectors: health; school education; higher education, etc.
      • A portion of these grants will be performance-linked.
    • State-specific grants: These will be given in the areas of: social needs; administrative governance and infrastructure; water and sanitation etc.
    • Grants to local bodies
    • Disaster risk management

Vertical Fiscal Imbalance (VFI) in India

• Constitutional Division of Financial Duties
  • In India, the Union and State governments have distinct responsibilities for revenue collection and expenditure.
  • The Union government collects taxes like Personal Income Tax, Corporation Tax, and certain indirect taxes to maximise tax collection efficiency.
  • However, on the expenditure side, local governments are best positioned to efficiently deliver public goods and services to citizens.
• Rising VFI in India
  • India's Vertical Fiscal Imbalance (VFI) is larger and increasing compared to other federal systems, as noted by the 15th Finance Commission.
  • Crises like the COVID-19 pandemic have further deepened the gap between the revenue generated and expenditure responsibilities of State governments.
• The Role of the Finance Commission
  • The Finance Commission is responsible for addressing VFI by determining how to distribute taxes collected by the Union government to the States.
  • This is based on the "Net Proceeds," which include the Union’s Gross Tax Revenue minus surcharges, cesses, and collection costs.
  • The primary challenge of VFI relates to the allocation of these proceeds to the States.
  • In addition to tax devolution, the Finance Commission recommends grants under Article 275 of the Constitution for States needing financial assistance.
    • However, these grants are often temporary and for specific purposes.
  • Additionally, the Union government makes tied transfers through centrally sponsored and central sector schemes, which come with conditionalities, under Article 282.
• Unconditional Transfers: A Key Solution
  • Among the various transfers, only the devolution of taxes from net proceeds is untied and unconditional.
  • This makes it crucial for addressing the fiscal needs of the States without additional burdens or restrictions.
• Raising Tax Devolution to Address VFI
  • Many States have demanded that the 16th Finance Commission raise the share of tax devolution from the net proceeds to 50%.
    • This demand is supported by the exclusion of significant amounts of cesses and surcharges from the net proceeds, reducing the total funds available for devolution.
  • Various analysts support this demand, showing that States' actual expenditures align with their borrowing limits.
    • To eliminate VFI, the share of net proceeds devolved to the States should rise to around 49%.
  • This would provide States with more untied resources, allowing them to respond better to local needs, enhance spending efficiency, and foster cooperative fiscal federalism.