Why in the News?

The financial relationship between the Union and State governments in India is imbalanced, similar to other nations with a federal constitutional structure.

What is Vertical Fiscal Imbalance (VFI)?

Vertical fiscal imbalance (VFI) refers to the mismatch between the revenue-raising powers and expenditure responsibilities of different levels of government (between the Center and state) within a country.

Why should Vertical Fiscal Imbalance (VFI) be reduced?

• Decentralization of Expenditure: States are responsible for 61% of the revenue expenditure, focusing on crucial sectors like health, education, and infrastructure, but they generate only 38% of the revenue.
  • This imbalance creates a dependency on central transfers, limiting the States’ fiscal autonomy.
• Need Efficiency in Spending: Reducing VFI would provide states with more resources, allowing them to respond better to local needs and improve governance efficiency.
• Need to strengthen Fiscal Federalism: A reduction in VFI promotes a healthier system of cooperative federalism, ensuring that states have adequate resources to carry out their constitutional responsibilities and meet the demands of their populations.
• Need Preparedness for crises: VFI becomes more pronounced during crises (e.g., COVID-19), leading to fiscal stress for States. A more balanced fiscal arrangement ensures better crisis management at the sub-national level.

Present Scenario of VFI and Tax Devolution in India

• VFI Extent: The 15th Finance Commission noted that despite States‘ heavy spending responsibilities, their revenue-raising powers are limited.
• Tax Devolution Rates: The 14th and 15th FC recommended devolving 42% and 41%, however, estimates suggest that an average share of 48.94% was necessary between 2015-2023 to eliminate the VFI.
• Exclusion of Cesses and Surcharges: The exclusion of cesses and surcharges from the divisible pool of taxes shortens the net proceeds. States argue this limits the resources available to them to meet their expenditure responsibilities.
• Fiscal Responsibility: Despite the constraints, states have largely adhered to borrowing limits under fiscal responsibility legislation. However, states still struggle to meet their expenditure responsibilities, highlighting the need for greater financial support from the Centre.

What should be the role objective of the 16th FC?

• Increase Tax Devolution: Many States demand that tax devolution from the Union’s net proceeds should be raised to 50%. The 16th Finance Commission must consider raising the devolution rate to around 49% to address the VFI and ensure sufficient untied funds for States.
• Address Cesses and Surcharges: The 16th Finance Commission should evaluate the exclusion of cesses and surcharges from the divisible pool.
• Empower States with Fiscal Autonomy: The Commission’s objective should be to empower States with greater fiscal autonomy by ensuring adequate resources for them to perform their constitutional duties without undue dependence on the Centre.
• Support Local Priorities: The Commission should aim to provide States with untied resources, enabling them to cater to jurisdictional needs and set priorities that align with their specific developmental challenges, ensuring a more responsive governance system.

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