Debate on State Share in Tax Pool - A Critical Challenge for the 16th Finance Commission

Context:

• The 16th Finance Commission (FC) faces growing demands from Indian states to increase their share in the divisible tax pool - with some suggesting a rise from the current 41% to as high as 50%.
• This has reignited a crucial debate on fiscal federalism, central transfers, and the nature of India’s intergovernmental fiscal architecture.

Background - Decline in States’ Effective Share:

• History of devolution trends:
  • 14th Finance Commission (2015–20): Increased states’ share in divisible pool to 42%.
  • 15th Finance Commission (2020–25): Maintained it at 41% (due to reorganization of J&K as a Union Territory).
• Shrinking divisible pool:
  • Despite higher nominal devolution, Centre imposed more cesses and surcharges, which are non-shareable with states.
  • As per RBI data:
    • Shareable tax pool reduced from 88.6% (2011–12) to 78.9% (2021–22) of gross tax revenue.
    • States have effectively received only 32% of total gross tax revenues over six years.

Key Issues for the 16th Finance Commission:

• Fiscal constraints of the Union government:
  • Increased devolution reduces the Centre’s fiscal capacity.
  • Centre already borrows to transfer to states.
  • Challenge to create fiscal space for Union List priorities amid politically-driven centrally sponsored schemes (CSS).
• Tied vs untied transfers: Refer to the conditions placed on how the funds are used.
  • States already spend around 60% of general government expenditure.
  • Thus, the states’ demand for greater fiscal autonomy could be met by increasing the share of untied transfers.
  • This would require the need to rationalize CSS to allow more untied funds. However, rationalizing CSS is complex due to political and developmental compulsions.
  • Also, untied transfers may lead to increased revenue expenditure on populist schemes like cash transfers and subsidies, rather than on productive capital investments.

Concerns Over States' Spending Quality:

• Rising revenue deficits:
  • States increasingly borrow for revenue expenditure (e.g. salaries, subsidies).
  • Examples: Karnataka slipping into revenue deficit; Punjab's high revenue deficit hampers capital expenditure.
• Risk of populist spending:
  • 14 states have launched cash transfer schemes (adding up to 0.6% of the GDP).
  • As India is moving towards some form of quasi-universal income transfer (driven by electoral politics), these cash transfers are being financed through a combination of expenditure switching and higher borrowings.

Equity and Efficiency in Public Service Delivery:

• Inter-State disparities:
  • Spending by low-income states (e.g. Bihar) is much lower than richer states.
  • Concern: Will increasing untied funds narrow or widen inequality in service delivery?
• Devolution to local governments (3rd tier):
  • Indian third-tier governments (Panchayats, Municipalities) get much less compared to peers in China, South Africa.
  • States are often reluctant to devolve functions and finances.
  • Question: Will higher state share incentivize more devolution to local bodies?

Conclusion and Way Forward:

• The 16th Finance Commission must strike a balance between:
  • Enhancing states’ fiscal autonomy.
  • Ensuring fiscal sustainability of the Centre.
  • Promoting efficient and equitable spending.
  • Encouraging genuine federalism through local empowerment.
• A holistic approach is required, considering constitutional, economic, and political dynamics that shape India’s fiscal federalism.

Q1. Why are Indian states demanding a higher share in the divisible tax pool?

Ans. States argue that the Centre’s rising use of cesses and surcharges—whose revenues are not shared—has effectively reduced their overall fiscal share.

Q2. What are the fiscal implications for the Union government if the states’ share is increased further?

Ans. Increasing states’ share would constrain the Centre’s fiscal space, as it already borrows to fund transfers.

Q3. How do centrally sponsored schemes (CSS) impact fiscal federalism in India?

Ans. CSS, driven by central priorities, often intrudes into the State and Concurrent Lists, thereby diluting state autonomy and complicating the rationalisation of tied versus untied transfers.

Q4. What concerns arise from rising untied transfers to states?

Ans. Untied transfers may lead to increased revenue expenditure on populist schemes like cash transfers and subsidies, rather than on productive capital investments.

Q5. How does limited devolution to the third tier affect grassroots governance in India?

Ans. Despite constitutional provisions, most states restrict financial and functional devolution to local bodies, leading to weak grassroots governance and poor service delivery compared to countries like China and South Africa. 

Source:IE