{"id":42319,"date":"2024-09-06T10:23:41","date_gmt":"2024-09-06T04:53:41","guid":{"rendered":"https:\/\/vajiramandravi.com\/current-affairs\/?p=42319"},"modified":"2025-05-05T08:55:44","modified_gmt":"2025-05-05T03:25:44","slug":"understanding-vertical-fiscal-imbalance-in-indias-federal-system","status":"publish","type":"post","link":"https:\/\/vajiramandravi.com\/current-affairs\/understanding-vertical-fiscal-imbalance-in-indias-federal-system\/","title":{"rendered":"Understanding Vertical Fiscal Imbalance in India\u2019s Federal System"},"content":{"rendered":"<h2><strong>What\u2019s in today\u2019s article?<\/strong><\/h2>\n<ul>\n<li>Why in News?<\/li>\n<li>Central Transfers to States<\/li>\n<li>Vertical Fiscal Imbalance (VFI) in India<\/li>\n<\/ul>\n<h2><strong>Why in News?<\/strong><\/h2>\n<p>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.<\/p>\n<p>This imbalance means that States rely heavily on transfers from the Union government to meet their expenditures. The result is a <strong>Vertical Fiscal Imbalance (VFI)<\/strong> in India&#8217;s fiscal federalism, where the decentralisation of expenditure responsibilities exceeds the States&#8217; revenue-raising capacity.<\/p>\n<h2><strong>Central Transfers to States<\/strong><\/h2>\n<ul>\n<li><strong>About<\/strong>\n<ul>\n<li>The Finance Commissions recommend the <strong>States\u2019 share in the net tax revenue of the Union government<\/strong>.<\/li>\n<\/ul>\n<\/li>\n<li>Under Article 280, the President is required to constitute a Finance Commission (FC) at an interval of five years or earlier.<\/li>\n<li>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.\n<ul>\n<li>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.<\/li>\n<\/ul>\n<\/li>\n<li><strong>Composition of transfers<\/strong>\n<ul>\n<li>The central taxes devolved to states are untied funds, and states can spend them according to their discretion.\u00a0<\/li>\n<li>Over the years, tax devolved to states has constituted over 80% of the total central transfers to states.\u00a0<\/li>\n<li>The centre also provides grants to states and local bodies which must be used for specified purposes.\u00a0<\/li>\n<\/ul>\n<\/li>\n<li>These grants have ranged between 12% to 19% of the total transfers.<\/li>\n<li><strong>Tax devolution to states<\/strong>\n<ul>\n<li>The 14th FC considerably increased the devolution of taxes from the centre to states from 32% to 42%.\u00a0<\/li>\n<\/ul>\n<\/li>\n<li>In the 15th FC, share of states in the central taxes for the 2021-26 period is recommended to be 41%.<\/li>\n<li>The adjustment of 1% is to provide for the newly formed union territories of J&amp;K, and Ladakh from the resources of the centre.\n<ul>\n<li>The Commission had recommended that tax devolution should be the primary source of transfer of funds to states.\u00a0<\/li>\n<li>This would increase the flow of unconditional transfers and give states more flexibility in their spending.<\/li>\n<\/ul>\n<\/li>\n<li><strong>Formula used to distribute fund among states<\/strong><\/li>\n<\/ul>\n<figure class=\"image image_resized\"><img decoding=\"async\" src=\"https:\/\/vajiram-prod.s3.ap-south-1.amazonaws.com\/Formula_used_to_distribute_fund_among_states_a537bcc3d2.webp\" alt=\"Formula used to distribute fund among states.webp\" \/><\/figure>\n<ul>\n<li><strong>Population\/Demography &#8211; <\/strong>Population is an indicator of the expenditure needs of a state.<\/li>\n<li><strong>Demographic performance<\/strong> &#8211; Demographic performance criterion rewards states for their efforts to control population growth.<\/li>\n<li>The commission considered indicators like fertility rate, infant mortality rate, and sex ratio to assess states&#8217; efforts.\n<ul>\n<li><strong>Income distance<\/strong> \u2013 It is the difference between the per capita income of a state with the average per capita income of all states.<\/li>\n<\/ul>\n<\/li>\n<li>States with lower per capita income may be given a higher share to maintain equity among states<strong>.<\/strong>\n<ul>\n<li><strong>Area<\/strong> is used as a criterion as a state with larger area has to incur additional administrative costs to deliver services.<\/li>\n<li><strong>Forest &amp; Ecology <\/strong>&#8211; it indicates that states with large forest covers bear the cost of not having area available for other economic activities.<\/li>\n<\/ul>\n<\/li>\n<li>Therefore, the rationale is that these states may be given a higher share.\n<ul>\n<li><strong>Tax and fiscal efforts<\/strong><\/li>\n<\/ul>\n<\/li>\n<li><strong>Grant in aid<\/strong>\n<ul>\n<li>Besides the taxes devolved to states, another source of transfers from the centre to states is grants-in-aid.\u00a0<\/li>\n<li>As per the recommendations of the 15th Finance Commission, the following grants will be provided to states from the centre\u2019s resource:\u00a0\n<ul>\n<li><strong>Revenue deficit grants<\/strong><\/li>\n<li><strong>Sector-specific grants<\/strong>: Sector-specific grants is given to states for eight sectors: health; school education; higher education, etc.\u00a0<\/li>\n<li>A portion of these grants will be performance-linked.<\/li>\n<li><strong>State-specific grants<\/strong>: These will be given in the areas of: social needs; administrative governance and infrastructure; water and sanitation etc.<\/li>\n<li><strong>Grants to local bodies<\/strong><\/li>\n<li><strong>Disaster risk management<\/strong><\/li>\n<\/ul>\n<\/li>\n<\/ul>\n<\/li>\n<\/ul>\n<h2><strong>Vertical Fiscal Imbalance (VFI) in India<\/strong><\/h2>\n<ul>\n<li><strong>Constitutional Division of Financial Duties<\/strong>\n<ul>\n<li>In India, the Union and State governments have distinct responsibilities for revenue collection and expenditure.<\/li>\n<li>The Union government collects taxes like Personal Income Tax, Corporation Tax, and certain indirect taxes to maximise tax collection efficiency.<\/li>\n<li>However, on the expenditure side, local governments are best positioned to efficiently deliver public goods and services to citizens.<\/li>\n<\/ul>\n<\/li>\n<li><strong>Rising VFI in India<\/strong>\n<ul>\n<li>India&#8217;s Vertical Fiscal Imbalance (VFI) is larger and increasing compared to other federal systems, as noted by the 15th Finance Commission.<\/li>\n<li><strong>Crises like the <\/strong><a href=\"https:\/\/vajiramandravi.com\/quest-upsc-notes\/covid-19\/\" target=\"_blank\"><strong>COVID-19<\/strong><\/a><strong> pandemic<\/strong> have further deepened the gap between the revenue generated and expenditure responsibilities of State governments.<\/li>\n<\/ul>\n<\/li>\n<li><strong>The Role of the Finance Commission<\/strong>\n<ul>\n<li>The Finance Commission is responsible for addressing VFI by determining how to distribute taxes collected by the Union government to the States.<\/li>\n<li>This is based on the &#8220;Net Proceeds,&#8221; which include the Union\u2019s Gross Tax Revenue minus surcharges, cesses, and collection costs.<\/li>\n<li>The primary challenge of VFI relates to the allocation of these proceeds to the States.<\/li>\n<li>In addition to tax devolution, the Finance Commission recommends grants under <strong>Article 275<\/strong> of the Constitution for States needing financial assistance.<\/li>\n<\/ul>\n<\/li>\n<li>However, these grants are often temporary and for specific purposes.\n<ul>\n<li>Additionally, the Union government makes tied transfers through centrally sponsored and central sector schemes, which come with conditionalities<strong>, under Article 282<\/strong>.<\/li>\n<\/ul>\n<\/li>\n<li><strong>Unconditional Transfers: A Key Solution<\/strong>\n<ul>\n<li>Among the various transfers, only the devolution of taxes from net proceeds is untied and unconditional.<\/li>\n<li>This makes it crucial for addressing the fiscal needs of the States without additional burdens or restrictions.<\/li>\n<\/ul>\n<\/li>\n<li><strong>Raising Tax Devolution to Address VFI<\/strong>\n<ul>\n<li>Many States have demanded that the 16th Finance Commission raise the share of tax devolution from the net proceeds to 50%.<\/li>\n<li>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.<\/li>\n<li>Various analysts support this demand, showing that States&#8217; actual expenditures align with their borrowing limits.<\/li>\n<li>To eliminate VFI, the share of net proceeds devolved to the States should rise to around 49%.<\/li>\n<\/ul>\n<\/li>\n<li>This would provide States with more untied resources, allowing them to respond better to local needs, enhance spending efficiency, and foster cooperative fiscal federalism.<\/li>\n<\/ul>\n<hr \/>\n<h3><strong>Q.1. What is Vertical Fiscal Imbalance (VFI) in India?<\/strong><\/h3>\n<p>VFI refers to the gap where States are responsible for the majority of expenditure but collect significantly less revenue, making them reliant on transfers from the Union government.<\/p>\n<h2><strong>Q.2. How can increasing tax devolution reduce VFI?<\/strong><\/h2>\n<p>Increasing tax devolution to 49-50% would provide more untied resources to the States, allowing them to better meet local needs, improve expenditure efficiency, and foster cooperative fiscal federalism.<\/p>\n<p><strong>Source: <\/strong><a href=\"https:\/\/www.thehindu.com\/business\/Economy\/what-is-vertical-fiscal-imbalance\/article68611117.ece\" target=\"_blank\" rel=\"nofollow noopener\">What is vertical fiscal imbalance?<\/a> | <a href=\"https:\/\/prsindia.org\/theprsblog\/central-transfers-to-states-role-of-the-finance-commission\" target=\"_blank\" rel=\"nofollow noopener\">PRS<\/a> |<a href=\"https:\/\/www.thehindu.com\/opinion\/lead\/the-unions-reins-on-financial-transfers-to-states\/article67818520.ece\" target=\"_blank\" rel=\"nofollow noopener\">The Hindu<\/a> | <a href=\"https:\/\/prsindia.org\/policy\/report-summaries\/report-15th-finance-commission-2021-26\" target=\"_blank\" rel=\"nofollow noopener\">PRS<\/a><\/p>\n","protected":false},"excerpt":{"rendered":"<p>Vertical Fiscal Imbalance (VFI) occurs when States incur 61% of revenue expenditure but collect only 38% of revenue receipts, making them dependent on Union transfers. Explore how this affects fiscal federalism in India.<\/p>\n","protected":false},"author":5,"featured_media":42320,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[18],"tags":[],"class_list":{"0":"post-42319","1":"post","2":"type-post","3":"status-publish","4":"format-standard","5":"has-post-thumbnail","7":"category-upsc-mains-current-affairs","8":"no-featured-image-padding"},"acf":[],"_links":{"self":[{"href":"https:\/\/vajiramandravi.com\/current-affairs\/wp-json\/wp\/v2\/posts\/42319","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/vajiramandravi.com\/current-affairs\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/vajiramandravi.com\/current-affairs\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/vajiramandravi.com\/current-affairs\/wp-json\/wp\/v2\/users\/5"}],"replies":[{"embeddable":true,"href":"https:\/\/vajiramandravi.com\/current-affairs\/wp-json\/wp\/v2\/comments?post=42319"}],"version-history":[{"count":0,"href":"https:\/\/vajiramandravi.com\/current-affairs\/wp-json\/wp\/v2\/posts\/42319\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/vajiramandravi.com\/current-affairs\/wp-json\/wp\/v2\/media\/42320"}],"wp:attachment":[{"href":"https:\/\/vajiramandravi.com\/current-affairs\/wp-json\/wp\/v2\/media?parent=42319"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/vajiramandravi.com\/current-affairs\/wp-json\/wp\/v2\/categories?post=42319"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/vajiramandravi.com\/current-affairs\/wp-json\/wp\/v2\/tags?post=42319"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}