Introduction

• Recent agitations and concerns raised by state governments highlight critical issues in the practice of fiscal federalism in India.
• Kerala and Karnataka governments, supported by others, have underscored the urgency for the 16th Finance Commission (FC) to address vertical and horizontal inequalities in devolution

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Explained: Financial Devolution among States

Trends in Vertical Devolution

• Shrinking Divisible Pool: Historically, the divisible pool consisted mainly of income taxes and excise duties shared with states. However, recent changes have seen the exclusion of certain taxes, like corporation taxes, from the divisible pool, reducing the share available for states.
• Expansion of Cesses and Surcharges: Despite the GST implementation, new cesses and surcharges continue to be introduced, contributing to the exclusion of an increasing share of gross tax revenue from net proceeds, impacting vertical devolution.
• Conflicting Data: Discrepancies in government-released information on the quantum of cesses and surcharges have raised concerns about transparency and accurate reporting, which are vital for assessing the true extent of vertical devolution challenges.

Financial Implications

• Collection Trends: Disaggregated data analysis reveals a significant rise in the collection of cesses and surcharges over the past decade, with amounts not shared with states but retained solely by the Union government, exacerbating the vertical devolution imbalance.
• Cumulative Collection: Cumulatively, substantial amounts have been collected as cesses and surcharges, depriving states of their rightful share and necessitating corrective measures to address historical wrongs in vertical devolution.

Challenges in Tied Transfers

[A] Nature of Transfers:

• Central Schemes: The requirement for state contributions to centrally sponsored schemes and central sector schemes places a financial burden on states, undermining their fiscal autonomy and perpetuating a patron-client relationship with the Union government.
• Conditionalities: Grants provided to states often come with conditionalities, such as labelling requirements, further limiting states’ flexibility in utilizing funds according to their specific needs.
• Loan Nature: Most capital transfers to states are in the form of loans, adding to states’ debt burdens and constraining their financial freedom.

[B] Impact on Federal Dynamics:

• Centralizing Tendency: Imposed conditionalities and the reliance on centrally sponsored schemes reinforce a centralizing tendency, eroding the principles of cooperative fiscal federalism and undermining states’ autonomy in fiscal matters.
• Substitution of Untied Transfers: The substitution of untied transfers with centrally sponsored schemes introduces rigidity in Union-State relations, hindering effective collaboration and diluting the spirit of cooperative federalism envisioned in the Indian federal structure.

Scrutiny by Comptroller and Auditor General (CAG)

• Non-Transfer of Funds: Instances of non-transfer or short transfer of collected amounts, as highlighted by the Comptroller and Auditor General (CAG), raise concerns about the effective utilization of funds and the transparency of financial management practices.
• Consequences:
  1. Defeat of Collection Logic: The failure to transfer cesses and surcharges to the designated reserve funds undermines the intended purpose of their collection, leading to inefficiencies and potential misappropriation of funds.
  2. Ruse for Fund Diversion: The discrepancies in fund transfers raise suspicions regarding the true intent behind cesses and surcharges, with indications that they may serve as a means to divert funds away from the divisible pool for other government expenditures.

Deviations from Finance Commission (FC) Recommendations

[A] Assessment of Union Government’s Claims:

• Retention of Gross Tax Revenue: While the retention of a portion of gross tax revenue by the Union government has a basis in constitutional provisions, the failure to adhere to FC recommendations on sharing net proceeds raises questions about the government’s commitment to equitable fiscal federalism.
• Failure in Net Proceeds Sharing: Analysis of the share of central taxes devolved to states against FC-stipulated percentages reveals consistent underperformance by the Union government, indicating a significant deviation from FC recommendations.

[B] Quantitative Analysis:

• Shortfalls: Comparisons of actual devolutions with FC-recommended shares highlight substantial shortfalls, amounting to significant cumulative amounts over the years, representing a systemic failure in achieving equitable distribution of resources among states.
• Cumulative Impact: The cumulative amounts not devolved to states underscore the magnitude of the fiscal imbalance and the urgent need for corrective measures to rectify historical injustices in vertical devolution.

Way Forward: Reform Agenda for the 16th Finance Commission

[A] Corrective Measures

• Compensations to States: Addressing historical wrongs in vertical devolution requires compensatory measures to ensure fair resource distribution among states and rectify past imbalances.
• Accurate Reporting: Mandating accurate reporting of “net proceeds” in budget documents is essential for transparency and accountability in fiscal management, enabling stakeholders to assess the true extent of resource allocation.
• Addressing Shortfalls: Providing lump sum untied grants to states to offset past shortfalls in devolution is crucial to restoring states’ fiscal autonomy and promoting cooperative federalism.

[B] Legislative Action:

• Limiting Cesses and Surcharges: Enacting legislation to impose strict limits on the collection of cesses and surcharges, with provisions for automatic expiry and prevention of rechristening, is necessary to prevent misuse and ensure transparency in revenue generation.

Conclusion

• The stance of the 16th Finance Commission on vertical devolution is pivotal for the survival of fiscal federalism in India, requiring decisive action to address existing challenges and uphold the principles of cooperative federalism.

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