Centre–State Fiscal Relations in a Changing Fiscal Landscape

Syllabus: GS2/ Polity and Governance

Context

• The finance minister has said the Union government transferred 41% of the divisible pool to the states and the share of no state has been reduced.

What is Tax Devolution?

• Tax devolution refers to the distribution of tax revenues between the central government and the state governments. 
• The Finance Commission decides what proportion of the Centre’s net tax revenue goes to the States overall (vertical devolution) and how this share for the States is distributed among various States (horizontal devolution). 
  • The 15th Finance Commission recommended that 41% of the divisible pool of taxes be d evolved to the States. 
• The horizontal devolution of funds between States is usually decided based on a formula created by the Commission that takes into account a State’s population, fertility level, income level, geography, etc. 
• The Centre also aids States through additional grants for certain schemes that are jointly funded by the Centre and the States.

Friction between the Centre and States

• The Centre and the States have been at loggerheads over the issue of sharing tax revenues.
• The Centre collects major taxes such as the income tax, the corporate tax, and the Goods and Services tax (GST) while the States primarily rely on taxes collected from the sale of goods such as liquor and fuels that are beyond the ambit of GST. 
• This has led to complaints that the Centre has reduced the power of the States to collect taxes and that it does not give enough funds to the States to match with the scale of their responsibilities.

Key Demands of the States

• Demand for more funds: States argue they should receive more funds than recommended by the Finance Commission. States have greater responsibilities, including education, healthcare, and policing services.
• Divisible Pool Concerns: Cesses and surcharges, which are not shared with the States, can constitute up to 28% of the Centre’s tax revenues, leading to reducing the size of the shareable revenue base.
• Criticism of the Finance Commission: Critics believe the Finance Commission may not be fully independent due to the Centre’s role in appointing its members, leading to potential political influence.

Way Ahead

• The 16th Finance Commission should reassess the balance between shareable and non-shareable revenues to address structural fiscal imbalances.
• Greater transparency and rationalisation of cesses and surcharges can strengthen trust and expand the effective divisible pool.
• Institutional dialogue through bodies like the Inter-State Council and GST Council should be deepened to promote cooperative fiscal federalism and coordinated fiscal planning.

Source: TH