Fiscal Federalism and the Debate Over the 41% Tax Devolution

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• The Union government’s acceptance of the 16th Finance Commission’s recommendation to retain 41% tax devolution to States has sparked debate about the changing nature of fiscal federalism in India. 

Fiscal Federalism in India

• Fiscal federalism refers to the distribution of financial powers and responsibilities between different levels of government in a federal system. 
• In India, fiscal federalism determines how tax revenues are shared between the Union government and the States.
• The Constitution provides a framework for fiscal relations through several provisions:
  • Articles 268-281: These articles govern taxation powers and revenue sharing between the Centre and the States.
  • Article 280: Provides for the establishment of the Finance Commission to recommend tax devolution and grants to States.
  • 7th Schedule: Divides taxation powers between the Union List and the State List.
• Since the Union government collects a large portion of taxes, a mechanism is needed to distribute revenue fairly among States. The Finance Commission performs this role by recommending how the divisible pool of central taxes should be shared.
• Over the years, tax devolution to States has increased. The 14th Finance Commission raised the States’ share to 42%, which was slightly reduced to 41% by the 15th Finance Commission after the reorganisation of Jammu and Kashmir.
• The 16th Finance Commission has now recommended continuing the 41% share of the divisible pool for States.

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Understanding the Divisible Pool

• The divisible pool refers to the portion of central tax revenues that is shared with States.
• However, not all tax revenues are included in this pool. Certain components, such as cesses and surcharges, are excluded from sharing with States.
• These taxes are levied by the Union government for specific purposes and are retained entirely by the Centre.
• According to Finance Commission data, the share of the divisible pool in gross tax revenues has gradually declined:
  • During the 13th Finance Commission period, the divisible pool averaged 89.2% of gross tax revenues.
  • During the 14th Finance Commission period, it fell to 82.1%.
  • During the 15th Finance Commission period, it further declined to 78.3%. 
• This trend suggests that although the States’ share is officially 41%, the actual amount transferred may be lower because the base itself has been shrinking.

Recommendations of the 16th Finance Commission

• The 16th Finance Commission examined the fiscal position of both the Union and State governments and proposed several recommendations regarding tax sharing and fiscal discipline.
• The Union government accepted several key recommendations, including:
  • Retaining 41% tax devolution to States
  • Accepting the horizontal distribution formula among States
  • Approving local body grants
  • Supporting the disaster management funding framework 
• However, several structural reforms proposed by the Commission were deferred. These include:
  • Reform of Fiscal Responsibility Legislation (FRL) frameworks
  • Regulation of off-budget borrowings by States
  • Reforms in the power sector distribution companies (DISCOMs)
  • Rationalisation of subsidies
• The Union government indicated that these issues would be examined separately at a later stage.

Structural Issues in State Finances

• The Finance Commission’s analysis highlights growing fiscal stress in several States.
• For instance:
  • Punjab’s debt-to-GSDP ratio reached 42.9% in 2023-24, along with a revenue deficit of 3.7% of GSDP.
  • Rajasthan’s liabilities stood at 37.9% of GSDP.
  • West Bengal recorded liabilities of 38.3% of GSDP.
  • Andhra Pradesh had liabilities of about 34.6% of GSDP. 
• In some cases, borrowing is used primarily to meet revenue expenditure, such as salaries and interest payments, rather than to create productive capital assets.
• Another concern is off-budget borrowing, where States borrow through government-controlled entities and repay the loans using public funds. This practice keeps liabilities outside official fiscal deficit figures.
• The Finance Commission recommended tighter regulation of such borrowing practices, but implementation has been deferred.

Changes in the Horizontal Devolution Formula

• The Finance Commission also revised the formula used to distribute funds among States.
• Previously, a portion of transfers depended on tax and fiscal effort, which rewarded States that improved their tax collection efficiency relative to their economic capacity.
• Under the new formula, this criterion has been replaced by a “contribution to GDP” indicator, which carries a weight of 10% in the allocation formula. 
• This shift benefits economically stronger States such as Maharashtra, Gujarat, and Karnataka.
• These States contribute significantly to the national GDP and already have relatively strong fiscal capacity.
• On the other hand, poorer States such as Bihar, Jharkhand, and Uttar Pradesh, which rely more heavily on central transfers, may benefit less from this criterion.
• Critics argue that this change weakens the principle of fiscal equalisation, which traditionally aimed to help less developed States.

Local Body Grants and Conditionalities

• Another major component of the Finance Commission transfers involves grants to local governments.
• The Sixteenth Finance Commission recommended Rs. 7,91,493 crore in grants for rural and urban local bodies. 
• These grants are divided into two categories:
  • Basic grants – Provided to support essential services and administrative functions of local governments.
  • Performance grants – Provided only if certain conditions are met, such as:
    • Timely constitution of State Finance Commissions
    • Maintenance of audited accounts
    • Compliance with central data reporting systems
• While these conditions aim to improve governance, some analysts argue that they may disproportionately affect States with weaker administrative capacity.
• During the previous Finance Commission period, only about 62.6% of recommended urban local body grants were actually released, indicating implementation challenges.

Implications for India’s Fiscal Federalism

• The recent developments reflect broader trends in India’s fiscal federal system.
• Three key implications emerge:
  • Growing Centre-State asymmetry: Increasing reliance on cesses and surcharges allows the Union government to retain a larger share of tax revenues.
  • Shift in allocation principles: Greater weight to GDP contribution may favour richer States over poorer ones.
  • Delayed structural reforms: Important issues such as fiscal discipline rules and power sector reforms remain unresolved.
• Together, these trends may gradually reshape fiscal relations between the Union and the States.

Source: TH