The Union’s Reins on Financial Transfers to States

Why in News?

• The financial relationship between the Union government and the States in India has undergone significant changes since the 14thFinance Commission (FC)award period (2015-16).
• According to the official data, the Union government has been reducing financial transfers to States.
• Therefore, it is crucial to assess the intricacies of financial transfers, exploring the deviation from the recommendations of FCs, the impact on States, and the potential implications for federal fiscal policies.

An Assessment of Deviation from Finance Commission Recommendations

• Recommendation of Substantial Shift in Devolution by 14^th FC
  • Recognising the imperative of empowering the States, the 14^th FC recommended a significant increase in the devolution of Union tax revenues.
  • Specifically, the recommendation was to devolve 42% of Union tax revenues to the States, marking a substantial 10 percentage points increase from the preceding 13th FC's suggestion.
  • This ambitious shift was intended to enhance the financial autonomy of the States, aligning with the principles of cooperative federalism.
• Deviation from FC Recommendations by the Union Government
  • Instead of adhering to the recommended increase, there has been a consistent reduction in financial transfers to the States.
  • This deviation is particularly perplexing given that the 15^th FC retained the recommendation of 41%.
  • It excluded the devolution to Jammu and Kashmir (J&K) and Ladakh, which were reorganised as Union Territories.
  • If the shares of J&K and Ladakh are included, the recommended devolution should stand at 42%.

The Dynamics of Financial Transfers of Tax Revenue

• The analysis of tax revenue provides a critical understanding of dynamics of financial transfers between the Union government and the States.
• The Finance Commissions recommend the States' share based on the net tax revenue of the Union government.
• It is derived after accounting for various factors such as collection costs, revenue assigned to Union territories, and the impact of cess and surcharge.

An Analysis of Existing Tax Revenue Disparities

• Declining Trends in State’s Share: An Antithesis of FC Recommendations
  • The Fourteenth and Fifteenth Finance Commissions recommended 42% and 41%, respectively, of the net tax revenue to be the States' share.
  • In contrast, the share of the gross tax revenue was only 35% in 2015-16 and further reduced to 30% in the 2023-24 Budget Estimate.
  • This divergence is significant, especially when juxtaposed against the substantial increase in the Union government's gross tax revenue, soaring from ₹14.6 lakh crore in 2015-16 to ₹33.6 lakh crore in 2023-24.
• Disparities in Revenue Growth
  • More than two-fold growth in the Union government's gross tax revenue over this period starkly contrasts with the doubling of the States' share in Union tax revenue.
  • This raises concerns about the equitable distribution of resources.
  • In essence, the gap between the Union government's revenue generation and the States' share has widened, indicating a disproportionate increase in the former's fiscal ability.
• Declining Grants-in-Aid
  • The disparity becomes more apparent when examining grants-in-aid to States, another statutory grant recommended by the Finance Commission.
  • The absolute number of grants-in-aid declined from ₹1.95 lakh crore in 2015-16 to ₹1.65 lakh crore in 2023-24.
  • Consequently, the combined share of statutory financial transfers in the gross tax revenue of the Union government witnessed a substantial decline, declining from 48.2% to 35.32%.

Possible Reasons Behind Declining States’ Share

• Calculation Methodology
  • One of the primary reasons for the diminishing share of States in gross revenue lies in the calculation method.
  • The net tax revenue, from which the States' share is determined, excludes revenue collections under cess and surcharge, revenue from Union Territories, and tax administration expenditure.
• Role of Cess and Surcharge
  • In 2015-16, the revenue collection through cess and surcharge accounted for 5.9% (₹85,638 crore) of the gross tax revenue and by 2023-24 this ratio surged to 10.8% (₹3.63 lakh crore).
  • This substantial increase underscores the Union government's strategic move to channel funds through cess and surcharge, enabling it to implement its own schemes in specific sectors.
• Exclusion of States from Cess and Surcharge Revenues
  • The revenues generated through these additional levies need not be shared with the States.
  • This selective exclusion from sharing underscores a more centralised control over financial resources by the Union government.
  • The increasing reliance on cess and surcharge not only enhances the Union's financial autonomy but also limits the resources available for devolution to the States.

The Centralisation of Public Expenditure and Its Implications

• Union Government’s Routes of Financial Transfer
  • Apart from traditional financial transfers like tax devolution and grants-in-aid, the Union government employs two other routes for direct financial transfers to the States - Centrally Sponsored Schemes (CSS) and Central Sector Schemes (CSec Schemes).
  • These avenues give the Union government a significant role in influencing the priorities of the States.
• Influencing State Priorities Through CSS
  • In the case of CSS, the Union government proposes schemes and provides partial funding, with the States committing the remaining financial resources.
  • This compels States to align their priorities with those proposed by the Union government, and, therefore, the financial commitments by the States mirror the Union's priorities.
  • Between 2015-16 and 2023-24, the allocation for CSS increased substantially from ₹2.04 lakh crore to ₹4.76 lakh crore through 59 CSS.
  • However, the actual financial transfers to States under CSS paint a different picture. In 2023-24, only ₹3.64 lakh crore was transferred to States, retaining nearly ₹1.12 lakh crore of the CSS allocation for other expenses.
• CSec Schemes and Exclusive Control
  • Fully funded by the Union government, these schemes operate in sectors where the Union government holds exclusive legislative or institutional controls.
  • The allocation for CSec Schemes saw a significant increase from ₹5.21 lakh crore in 2015-16 to ₹14.68 lakh crore in 2023-24, encompassing more than 700 schemes.
  • This shift in allocation emphasises the Union government's inclination towards allocating a larger share of finances to CSec Schemes.
• Potential for Bias in Resource Allocation
  • The decentralised nature of implementation in CSec Schemes allows the Union government considerable latitude in allocating financial resources.
  • It raises the question of whether these schemes are used as tools for channelling funds with a motive to benefit specific States or constituencies.
• Challenges for Cooperative Federalism
  • The 15^th FC acknowledged the Union government's arguments for the downward revision of States' share in Union tax revenue from 42% to 41%, citing higher expenditure commitments.The Commission, however, retained the share at 41%.
  • This sets the stage for potential future challenges, as the Union government might repeat such arguments before the 16^thFinance Commission.
  • These developments cast a shadow on the collaborative spirit of cooperative federalism.

Conclusion

• The evolving landscape of financial transfers between the Union government and the States in India demands careful consideration.
• The deviations from Finance Commission recommendations, the increasing reliance on non-statutory transfers, and the potential for anti-federal fiscal policies highlight the need for a comprehensive review of the fiscal architecture.
• It will ensure equitable distribution and uphold the principles of cooperative federalism.

Q1)  How are the recommendations of the Finance Commission implemented?

The recommendations of the Finance Commission are implemented as under:- Those to be implemented by an order of the President: The recommendations relating to distribution of Union Taxes and Duties and Grants-in-aid fall in this category. Those to be implemented by executive orders: Other recommendations to be made by the Finance Commission, as per its Terms of Reference. 

Q2) What are some critical changes since the constitution of 15th FC?

The biggest challenge and change were the pandemic COVID-19 and the subsequent geopolitical challenges i.e China's aggression on LAC. The combined government debt-GDP ratio had shot up close to 90% at the end of 2020-21. Many States are facing large fiscal imbalances.

Source: The Hindu