Devolution of funds to South Indian States

  • October 12, 2023
  • Posted by: OptimizeIAS Team
  • Category: DPN Topics
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Devolution of funds to South Indian States

Subject: Economy

Section: Fiscal Policy

Why in News?

Tamil Nadu has criticized the central government for its unfair treatment of the state regarding the devolution of funds and highlighted the following points: –

  1. Comparative Contributions shows Step motherly Attitude: Tamil Nadu contributes more to the central government in terms of direct tax compared to some other states, like Uttar Pradesh. However, despite its contributions, Tamil Nadu receives significantly less in the devolution of funds.
  2. Discrepancy in Devolution: Tamil Nadu received only 29 paise for every rupee it contributed as tax, whereas Uttar Pradesh received ₹2.79 for every rupee contributed.
  3. Direct Tax Contributions: Between 2014-15 and 2021-22, Tamil Nadu contributed ₹5.16 lakh crore in direct taxes but received only ₹2.08 lakh crore through devolution. In contrast, Uttar Pradesh contributed ₹2.24 lakh crore and received ₹9.04 lakh crore through devolution.
  4. Finance Commission Recommendations: Tamil Nadu has been adversely affected by the recommendations of the Finance Commission over the past 15 years. The 15th Finance Commission recommended a lower share (4.079%) of the total divisible pool of Central taxes for Tamil Nadu, compared to the 12th Finance Commission (5.305%).
  5. Census and Family Planning: South Indian States have been penalized for effectively implementing family planning measures initiated in 1972.
  6. Disaster Relief Funds: Tamil Nadu receives fewer disaster relief funds compared to states like Uttar Pradesh and Bihar.

The role of the Finance Commission in India’s fiscal federalism is critical, and it is responsible for determining the vertical sharing (between the Centre and States) and horizontal sharing (among the States) of the Centre’s tax revenue among states.

Why there are so many issues raised by the South Indian States?

  • The upcoming Finance Commission (16th FC) in India will face significant challenges as it grapples with reshaping fiscal federalism in the context of the Goods and Services Tax (GST) regime.
  • The shift from a production-based to a consumption-based taxation system necessitates a comprehensive reevaluation to address tax-sharing principles, regional disparities, and the complexities introduced by the GST structure.

However, several issues and challenges have emerged in the process of Horizontal and Vertical Distribution:

  1. States’ Demand for a Higher Share: States often demand a higher proportion of the Centre’s tax pool, which is currently set at 41%. However, there is limited room to increase this further due to the Centre’s own expenditure needs and borrowing constraints.
  2. Change in Population Base Year: The previous Finance Commission (2017) introduced a change in the base year for determining expenditure needs, shifting from 1971 to 2011 population figures. This change favored the States who neglected family planning but faced protests from states with well-controlled population growth.
  3. Conflict Over Revenue Deficit Grants: The allocation of revenue deficit grants to states in deficit on the current account remains a contentious issue. Determining the reasons behind a state’s fiscal deficit is challenging, and Finance Commissions have struggled to find a balance between supporting deficit states and not penalizing responsible ones.
  4. Inefficiencies and Criticisms: The horizontal distribution formulas used have faced criticism for being inefficient or unfair, and the fault lines among states have deepened along political, economic, and fiscal dimensions.
  5. Shift to the GST Regime: The introduction of the GST regime marks a significant shift in India’s taxation system. This transition from a production-based to a consumption-based tax system necessitates a comprehensive reevaluation of fiscal federalism to align with the new tax paradigm.
  6. Impact on Vertical and Horizontal Imbalances: While the GST system can potentially address historical vertical imbalances in tax revenue distribution, it also introduces new horizontal imbalances among states due to varying consumption patterns and economic development levels.
  7. Equitable Resource Allocation: To ensure a fair distribution of resources among states, it is essential to revisit the criteria for resource allocation, considering the principles of fiscal federalism and the specific needs of each state within the GST framework.
  8. Reviewing the Compensation Scheme: The Commission should review the necessity, viability, and desirability of the GST compensation scheme, considering the performance of GST revenues over the past six years.
  9. Adaptation to Changing Economic Realities: India’s economic landscape is dynamic, with evolving challenges and opportunities. A comprehensive reevaluation allows fiscal policies to adapt to these changes, ensuring they remain relevant and effective.
  10. Fiscal Responsibility: A reevaluation should assess the long-term fiscal health of both the central government and state governments, recommending measures for managing fiscal deficits and public debt responsibly.
  11. Institutional Relationships: Establishing formalized institutional relationships between the GST Council and the Finance Commission presents a challenge in the evolving federal financial structure.

Key – Issues to Address by the Finance Commission:

  1. Cesses and Surcharges: The Centre’s increasing use of cesses and surcharges, which are not shared with states, needs to be addressed. A clear set of guidelines should be established for when and how these additional cesses and surcharges are levied. There should be a formula or mechanism to cap the amount raised through cesses and surcharges, preventing excessive or arbitrary impositions.
  2. Government Spending on Freebies: Political parties’ practices of providing freebies should be formalized and restrained. The Finance Commission can play a role in developing a mechanism to prevent excessive populist spending.

In the interest of long-term fiscal sustainability, the upcoming Finance Commission should take a proactive approach and provide guidelines on issues related to cesses, surcharges, and government spending. Balancing the needs of states and fiscal responsibility is crucial for the country’s economic health.

Understanding Fiscal Federalism:

  • Fiscal federalism involves how financial responsibilities and resources are divided among different levels of government in a federal or decentralized system. This encompasses generating, collecting, sharing, and spending revenues at both the national (central) and subnational (state or regional) levels.
  • India’s multi-tiered system of governance operates as a federal republic, making fiscal federalism a crucial component of its governance structure

Finance Commission: –

The Finance Commission is a constitutional body in India that plays a crucial role in fiscal federalism. It is established under Article 280 of the Indian Constitution, and its primary function is to recommend the distribution of financial resources between the central government and the state governments.

Here’s a brief overview of the Finance Commission’s key functions and responsibilities:

  1. Resource Distribution: The primary task of the Finance Commission is to recommend the division of tax revenues and other financial resources between the Union (central government) and the states. This division ensures a fair and equitable distribution of funds to meet the needs of both the central and state governments.
  2. Tax Devolution: The Commission recommends the share of central taxes to be allocated to the states. This allocation is vital for states to finance their various development programs and functions.
  3. Grants-in-Aid: In addition to tax devolution, the Finance Commission also suggests grants-in-aid to states that may have special financial needs or face fiscal challenges. These grants aim to support states in fulfilling their obligations and responsibilities.
  4. Fiscal Transfers: The Commission examines the fiscal situation of both the Union and the states and recommends measures to augment the revenue resources of the states. It also assesses the need for and provides recommendations on revenue-sharing agreements between states.
  5. Other Matters: Apart from resource distribution, the Finance Commission may also be tasked with examining any other financial or fiscal matters referred to it by the President of India.
  6. Five-Year Cycle: The Finance Commission is typically constituted every five years. Each new Commission’s recommendations are applicable for a specific five-year period, ensuring periodic reviews and adjustments in the fiscal relationship between the central and state governments.
  7. Independence: The Commission is expected to make recommendations independently, free from political interference. Its members are typically experts in finance, economics, and related fields.
  8. Parliament’s Approval: The Commission’s recommendations are presented to the President, who, in turn, lays them before Parliament. These recommendations need the approval of both houses of Parliament to become effective.

In summary, the Finance Commission is a crucial institution in India’s fiscal federal structure, playing a vital role in ensuring the equitable distribution of financial resources between the central government and the states, as well as addressing fiscal disparities and promoting cooperative federalism.

Devolution of funds to South Indian States economy