Article 1: Finance Commission’s Balancing Act
Why in News: Debate has emerged over whether the recommendations of the 16th Finance Commission truly strengthen fiscal federalism despite retaining the states’ share in the divisible pool.
Key Details
- The 16th Finance Commission retained the states’ share in the divisible pool at 41%.
- Growing use of cesses and surcharges by the Union reduces the effective shareable tax pool.
- Concerns persist among some states, especially southern states, regarding horizontal devolution fairness.
- Experts argue that headline ratios may mask deeper issues in India’s fiscal federal structure.
Constitutional Framework of Finance Commission
- Constitutional Mandate (Article 280): The Finance Commission (FC) is a constitutional body tasked with recommending the distribution of tax revenues between the Union and states to maintain fiscal balance.
- Vertical and Horizontal Devolution: The FC determines (i) vertical sharing between Centre and states and (ii) horizontal distribution among states based on criteria like population, income distance, and area.
- Role in Cooperative Federalism: By ensuring predictable fiscal transfers, the FC supports cooperative federalism, enabling coordination between different tiers of government.
- Evolution of Devolution: The 14th Finance Commission significantly increased states’ share to 42%, marking a major shift toward fiscal decentralisation.
The Headline 41% Devolution: Continuity or Illusion
- Retention by 16th FC: The continuation of the 41% share (recommended by the 15th FC after J&K reorganisation) appears to signal stability in Centre–state fiscal relations.
- Shrinking Divisible Pool: However, the effective benefit depends on the size of the divisible pool, which has been affected by the rising share of non-divisible revenues.
- Growing Use of Cesses and Surcharges: Over the past decade, the Union has increasingly relied on these levies, which are excluded from the divisible pool under Article 270.
- Effective Share Decline: As per various fiscal analyses, states’ effective share in gross tax revenue is lower than the headline 41%, raising concerns about transparency.
Issue of Cesses and Surcharges
- Legal but Controversial Tool: While constitutionally permitted, excessive reliance on cesses and surcharges is seen by states as bypassing the spirit of fiscal federalism.
- Rising Proportion: The share of cesses and surcharges in Union gross tax revenue has reportedly risen from around 10% in early 2010s to nearly 18–20% in recent years.
- Impact on State Finances: States bear major expenditure responsibilities in sectors like health, education, and infrastructure but receive a shrinking shareable resource base.
- Planning Uncertainty: Unpredictable transfers make it harder for states to plan long-term investments and manage fiscal deficits effectively.
Horizontal Devolution and Regional Concerns
- Southern States’ Concerns: Some southern states argue that population-based criteria disadvantage states that achieved early demographic transition and better social indicators.
- Modest Increase in Share: The rise in southern states’ share from about 15.8% to around 17% is viewed by critics as incremental rather than structural.
- Equity vs Efficiency Debate: Finance Commissions traditionally balance equity (support to poorer states) with efficiency (reward for performance), often leading to political contestation.
- Historical Trend: The southern region’s share was above 21% during the 11th FC, indicating a long-term relative decline.
Performance-Based Criteria: Limited Impact
- Introduction of GSDP Contribution: The 16th FC included states’ contribution to GDP as a criterion to recognise economic performance.
- Structural Constraints: However, Gross State Domestic Product reflects historical and structural factors, not purely current policy effort.
- Removal of Tax Effort Criterion: Dropping the explicit tax effort parameter weakens incentives for states to improve their own revenue mobilisation.
- Dominance of Population Factors: Population-based indicators continue to carry significant weight, limiting the overall impact of performance incentives.
Fiscal Federalism in Contemporary India
- Expenditure Responsibilities of States: States account for nearly 60% of public expenditure in areas such as health, education, agriculture, and local infrastructure.
- GST and Fiscal Space: The introduction of GST has reduced states’ independent taxation powers, increasing dependence on transfers.
- Borrowing Constraints: States operate under FRBM limits and require Centre’s consent for certain borrowings, affecting fiscal autonomy.
- Need for Trust-Based Federalism: Effective fiscal federalism depends not only on formulas but also on predictability, transparency, and cooperative spirit.
Conclusion
The Finance Commission’s recommendations provide important fiscal continuity, but true federal balance requires strengthening the effective divisible pool, rationalising the use of cesses and surcharges, and better rewarding states’ fiscal effort. India’s cooperative federalism will remain robust only when fiscal transfers reflect both equity and efficiency in a transparent and predictable manner.
EXPECTED QUESTION FOR UPSC CSE
Prelims MCQ
Q. Which of the following revenues are excluded from the divisible pool shared with states?
(a) Corporation tax
(b) Income tax
(c) Cesses and surcharges
(d) GST compensation cess
Answer: (c)