Understanding Vertical Fiscal Imbalance and its Implications on Indian Federalism
- September 6, 2024
- Posted by: OptimizeIAS Team
- Category: DPN Topics
Understanding Vertical Fiscal Imbalance and its Implications on Indian Federalism
Sub: Polity
Sec: federalism
Why this is in News
The 16th Finance Commission is expected to play a pivotal role in addressing the Vertical Fiscal Imbalance (VFI) in India’s federal structure. With increasing financial pressures on state governments, discussions on fiscal relations between the Union and states are gaining prominence.
What is Vertical Fiscal Imbalance?
Vertical Fiscal Imbalance refers to a situation where the distribution of revenue collection powers and expenditure responsibilities is skewed between different levels of government.
In India, the Union government collects a majority of the revenues, while the states bear a significant portion of the expenditure responsibilities. This leads to fiscal strain at the state level, dependent on central transfers for efficient functioning.
Calculation Method:
VFI is measured using a ratio of Own Revenue Receipts (ORR) and tax devolution against the states’ Own Revenue Expenditure (ORE). If this ratio is below 1, it signifies that the states’ resources are insufficient to cover their expenditures, indicating the extent of VFI.
Implications of Vertical Fiscal Imbalance (VFI)
State Dependence: Increases reliance on Union transfers for revenue.
Reduced Fiscal Autonomy: Limits states’ ability to allocate resources independently.
Spending Inefficiency: Reduces effective allocation of resources.
Crisis Exacerbation: Worsens fiscal gaps during economic crises.
Addressing the Imbalance: To eliminate VFI, tax devolution to the states would need to be increased significantly. Analysis shows that between 2015-16 and 2022-23, the devolution share should have been 48.94%, whereas the 14th and 15th Finance Commissions recommended only 42% and 41%, respectively.
16th Finance Commission: It was constituted on December 31, 2023, with Dr. Arvind Panagariya as its Chairman.
Objective: It recommends the distribution of taxes between the Union and states, and provides guidance on grants-in-aid to the states.
Key Functions:
Tax Devolution: The Finance Commissions play a crucial role in addressing VFI by recommending the distribution of tax revenues from the Union to the states. These transfers are based on the “Net Proceeds” of taxes, i.e., the Gross Tax Revenue minus surcharges, cesses, and collection costs.
Grants and Assistance: It recommend grants to states under Article 275 of the Constitution, though these are limited to specific needs and short durations.
Other Transfers: The Union also transfers funds to states through centrally sponsored schemes under Article 282, though these come with specific conditions.
FINANCE COMMISSION
Aspect | Details |
Type | Quasi-judicial, Constitutional Body |
Constitution | By President of India under Article 280 |
Duration | Constituted every five years or earlier if necessary |
Primary Function | Recommends distribution of financial resources between Union and States |
Composition | Chairman + 4 members appointed by the President |
Eligibility for Reappointment | Chairman and members eligible for reappointment |
Qualifications (Chairman) | Experience in Public Affairs |
Qualifications (Members) | Expertise in Judiciary, Finance, Administration, or Economics |
Functions | Tax distribution, Grants-in-aid, Augmenting funds for Panchayats & Municipalities, Other financial matters referred by the President |
What is Horizontal Fiscal Imbalance (HFI)? Financial disparity between states due to differences in revenue capacity and expenditure needs. Causes: Variations in economic development, resource availability, and population. |
Addressing the issue of Vertical Fiscal Imbalance is crucial for the smooth functioning of India’s fiscal federalism. By increasing the share of tax devolution, the 16th Finance Commission can enhance state autonomy, improve spending efficiency, and foster cooperative federalism, ensuring balanced economic governance across the country.