In India, the financial relationship between the Union and States is asymmetrical, typical of federal constitutional frameworks.
According to the 15th Finance Commission, States account for 61% of revenue expenditure but collect only 38% of revenue receipts, making them dependent on transfers from the Union.
This disparity between expenditure responsibilities and revenue-raising powers leads to a situation of Vertical Fiscal Imbalance in India's fiscal federalism.
The Need to Reduce Vertical Fiscal Imbalance (VFI)
The Union and States have distinct financial duties.
Union collects taxes such as Personal Income Tax and Corporation Tax for efficiency, while the States handle public goods and services for proximity to users.
This imbalance merits focus because expenditure efficiency is improved when decisions are closer to users, highlighting the importance of reducing VFI.
Rising Imbalance and the 15th Finance Commission's Observations
The 15th Finance Commission noted that India has experienced a growing vertical imbalance, larger than most federations.
Periods of crisis, like the COVID-19 pandemic, exacerbated these imbalances, widening the gap between States' revenues and expenditure responsibilities.
Finance Commission's Role in Addressing VFI
The Finance Commission deals with two questons:
How to distribute taxes collected by the Union to all States.
How to distribute those taxes among individual States.
Transfers to States come from the "Net Proceeds" of the Union's taxes (Gross Tax Revenue minus surcharges, cesses, and collection costs).
Article 275 of the Constitution of India allows Parliament to provide grants-in-aid to states in need of assistance
Apart from tax devolution, Finance Commissions recommend short-term and purpose-specific grants to States in need.
Article 282 of the Indian Constitution covers how the Union or a state can use its revenue to make grants for public purposes
There are additional conditional transfers from the Union under Article 282 through centrally sponsored schemes, but only tax devolution is unconditional.
Measuring VFI in India
Global Method: VFI is measured by the ratio of States' Own Revenue Receipts (ORR) plus tax devolution to their Own Revenue Expenditure (ORE).
If the ratio is less than 1, it indicates that States' revenue is insufficient to meet their expenditure, reflecting VFI.
This deficit is used as a proxy for VFI after tax devolution.
Increasing Tax Devolution to Eliminate VFI
The 14th and 15th Finance Commissions recommended tax devolution shares of 42% and 41%, respectively, but eliminating VFI would have required 48.94% for the period 2015-2023.
States are now demanding a fixed 50% share of net proceeds from the 16th Finance Commission, citing the exclusion of cesses and surcharges as reducing the net proceeds.
The study supports the demand for increased devolution, suggesting that 49% of net proceeds should be devolved to States to eliminate VFI.
Benefits:
More untied resources for States to address local needs.
Better responsiveness to jurisdictional priorities.
Enhanced efficiency of public expenditure.
A shift towards cooperative fiscal federalism.
COMMENTS