Understanding Vertical Fiscal Imbalance in India’s Federal System

What’s in today’s article?

• Why in News?
• Central Transfers to States
• Vertical Fiscal Imbalance (VFI) in India

Why in News?

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.

This imbalance means that States rely heavily on transfers from the Union government to meet their expenditures. The result is a Vertical Fiscal Imbalance (VFI) in India's fiscal federalism, where the decentralisation of expenditure responsibilities exceeds the States' revenue-raising capacity.

Central Transfers to States

• About
  • The Finance Commissions recommend the States’ share in the net tax revenue of the Union government.
• Under Article 280, the President is required to constitute a Finance Commission (FC) at an interval of five years or earlier.
• 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.
  • 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.
• Composition of transfers
  • The central taxes devolved to states are untied funds, and states can spend them according to their discretion. 
  • Over the years, tax devolved to states has constituted over 80% of the total central transfers to states. 
  • The centre also provides grants to states and local bodies which must be used for specified purposes. 
• These grants have ranged between 12% to 19% of the total transfers.
• Tax devolution to states
  • The 14th FC considerably increased the devolution of taxes from the centre to states from 32% to 42%. 
• In the 15th FC, share of states in the central taxes for the 2021-26 period is recommended to be 41%.
• The adjustment of 1% is to provide for the newly formed union territories of J&K, and Ladakh from the resources of the centre.
  • The Commission had recommended that tax devolution should be the primary source of transfer of funds to states. 
  • This would increase the flow of unconditional transfers and give states more flexibility in their spending.
• Formula used to distribute fund among states

• Population/Demography - Population is an indicator of the expenditure needs of a state.
• Demographic performance - Demographic performance criterion rewards states for their efforts to control population growth.
• The commission considered indicators like fertility rate, infant mortality rate, and sex ratio to assess states' efforts.
  • Income distance – It is the difference between the per capita income of a state with the average per capita income of all states.
• States with lower per capita income may be given a higher share to maintain equity among states.
  • Area is used as a criterion as a state with larger area has to incur additional administrative costs to deliver services.
  • Forest & Ecology - it indicates that states with large forest covers bear the cost of not having area available for other economic activities.
• Therefore, the rationale is that these states may be given a higher share.
  • Tax and fiscal efforts
• Grant in aid
  • Besides the taxes devolved to states, another source of transfers from the centre to states is grants-in-aid. 
  • As per the recommendations of the 15th Finance Commission, the following grants will be provided to states from the centre’s resource: 
    • Revenue deficit grants
    • Sector-specific grants: Sector-specific grants is given to states for eight sectors: health; school education; higher education, etc. 
    • A portion of these grants will be performance-linked.
    • State-specific grants: These will be given in the areas of: social needs; administrative governance and infrastructure; water and sanitation etc.
    • Grants to local bodies
    • Disaster risk management

Vertical Fiscal Imbalance (VFI) in India

• Constitutional Division of Financial Duties
  • In India, the Union and State governments have distinct responsibilities for revenue collection and expenditure.
  • The Union government collects taxes like Personal Income Tax, Corporation Tax, and certain indirect taxes to maximise tax collection efficiency.
  • However, on the expenditure side, local governments are best positioned to efficiently deliver public goods and services to citizens.
• Rising VFI in India
  • India's Vertical Fiscal Imbalance (VFI) is larger and increasing compared to other federal systems, as noted by the 15th Finance Commission.
  • Crises like the COVID-19 pandemic have further deepened the gap between the revenue generated and expenditure responsibilities of State governments.
• The Role of the Finance Commission
  • The Finance Commission is responsible for addressing VFI by determining how to distribute taxes collected by the Union government to the States.
  • This is based on the "Net Proceeds," which include the Union’s Gross Tax Revenue minus surcharges, cesses, and collection costs.
  • The primary challenge of VFI relates to the allocation of these proceeds to the States.
  • In addition to tax devolution, the Finance Commission recommends grants under Article 275 of the Constitution for States needing financial assistance.
• However, these grants are often temporary and for specific purposes.
  • Additionally, the Union government makes tied transfers through centrally sponsored and central sector schemes, which come with conditionalities, under Article 282.
• Unconditional Transfers: A Key Solution
  • Among the various transfers, only the devolution of taxes from net proceeds is untied and unconditional.
  • This makes it crucial for addressing the fiscal needs of the States without additional burdens or restrictions.
• Raising Tax Devolution to Address VFI
  • Many States have demanded that the 16th Finance Commission raise the share of tax devolution from the net proceeds to 50%.
  • 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.
  • Various analysts support this demand, showing that States' actual expenditures align with their borrowing limits.
  • To eliminate VFI, the share of net proceeds devolved to the States should rise to around 49%.
• This would provide States with more untied resources, allowing them to respond better to local needs, enhance spending efficiency, and foster cooperative fiscal federalism.

Q.1. What is Vertical Fiscal Imbalance (VFI) in India?

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.

Q.2. How can increasing tax devolution reduce VFI?

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.

Source: What is vertical fiscal imbalance? | PRS |The Hindu | PRS