Today’s Discussion or Focus Topic: Financial Transfer In India
What is the current status of tax devolution in India?
Introduction
Financial devolution refers to the transfer of financial resources and decision-making powers from the central government to the states.
Why in the discussion?
Many states in India claimed that they are not getting their fair share as per the current scheme of tax devolution. According to them, they contribute more to the national tax pool than the amount they receive.
Constitutional Framework
Article 270 of the Constitution specifies the framework for the distribution of net tax income between the Central Government and the States.
1. The Finance Commission (FC), constituted every five years, recommends the vertical distribution of funds from the pool of divisible taxes {other than cess and surcharge} of the Central Government.
2. Additionally, it provides a formula for the overall allocation of these funds among different states.
3. In addition to the allocation of taxes, grants-in-aid are also provided to the states as per the recommendations of the Finance Commission.
The 16th Finance Commission under the chairmanship of Dr. Arvind Panagariya has been entrusted with the task of making recommendations on related subjects for the period 2026-31.
Criteria for transfers between states
At present, as per the recommendations of the 15th Finance Commission, the share of states in the divisible pool (vertical/asymmetrical transfers) is 41 %.
Concerns regarding tax devolution:
- Exclusion of cesses and surcharges: Concerns have been raised over the exclusion of cesses and surcharges from the divisible pool of tax revenue, thereby reducing the states’ share in tax revenue.
- The cess and surcharge collected by the central government is estimated to be about 23% of its gross tax receipts for the session 2024-25, which is not part of the divisible pool and hence is not shared with the states.
- Inadequate compensation for GST implementation: Some states believe that compensation for revenue loss during GST implementation is inadequate, and are calling for a fair mechanism to overcome the revenue shortfall.
- Lack of flexibility in the use of funds: Some states favor greater flexibility in the use of devolved funds to meet local priorities.
the way forward
- Review of the fiscal federalism framework: There is a need to conduct a comprehensive review of the fiscal federalism framework to identify gaps and inefficiencies in the devolution process.
- This may involve setting up a committee or commission to assess the effectiveness of the existing system and propose reforms.
- Performance-based incentives: Linking additional transfers to performance indicators in areas such as good governance, transparency, and development outcomes can incentivize responsible resource management.
- Strengthening institutions: Strong institutions like the Comptroller and Auditor General of India (CAG) can ensure effective oversight and accountability in the management of returned funds.
Note:
- Income inequality: Refers to the disparity between the income of a state and the state with the highest per capita income.
- To ensure equality among states, states with lower per capita income get a higher share.
- Population: This represents the population count based on the 2011 census. Earlier, till the 14th Finance Commission the population of the year 1971 census was considered, but this practice was stopped in the 15th Finance Commission.
- Forests and Ecology: The proportion of dense forest area in each state compared to the total dense forest area in all states is considered.
- Demographic Performance: Introduced to recognize states’ efforts in population control, with states with lower fertility ratios receiving higher scores.
- Tax Effort: States that demonstrate high efficiency in their tax collection process are rewarded with tax effort.