Challenges of Fiscal Federalism and Central Tax Distribution in India

Fiscal federalism is the cornerstone of India’s diverse federal structure. It embodies the principles of decentralization, where power and resources are devolved from the central government to state governments. This fosters autonomy, allowing states to tailor policies and spending to their specific needs and populations. Most importantly, fiscal federalism enshrines the concept of equitable distribution of resources.

Central tax distribution serves as a crucial mechanism within this framework. It facilitates the flow of revenue collected by the central government to state treasuries. This mechanism plays a critical role in sustaining fiscal autonomy that is predictable central tax inflows empower states to manage their finances independently, pursue their own development priorities, and reduce their dependence on central government largesse. The second is by bridging the fiscal gap between richer and poorer states, central tax distribution helps narrow regional disparities in infrastructure, social services, and economic opportunities. This fosters more socio- economic progress across the country.

However, achieving true equity in central tax distribution remains a challenge. Despite constitutional mandates, significant disparities persist among states in their share of central tax receipts. These variations reflect deeper complexities in Indian governance as variations can expose weaknesses in a state’s administrative capacity, tax collection efficiency, and ability to translate central funds into impactful programs. The current distribution formula balances needs-based allocation (e.g., population density) with efforts to bridge fiscal gaps (equity considerations). Striking the right balance remains a constant debate. Inter-state political dynamics and lobbying efforts can influence central tax distribution decisions, potentially creating unintended consequences.¹

Understanding these governance dimensions is crucial for unpacking the intricate relationship between the central and state governments. By analyzing how central tax distribution interacts with these factors, we can identify areas for improvement and work towards a more effective and equitable system. This, in turn, strengthens India’s federal structure and paves the way for a more balanced and inclusive pattern of development across all states.

Centre-State Relations in India

India’s federal structure thrives on a complex yet vital dance between the central government and state governments. This intricate relationship, particularly concerning finances, finds its foundation in the very bedrock of the nation’s law – the Constitution of India.²

The Constitution acts as a blueprint, meticulously outlining the division of financial powers and responsibilities between the Union (central government) and the states. Tucked away in the Seventh Schedule lies a treasure trove of information – the division of legislative powers. Imagine three lists:

• The Union List (List I): This is the central government’s exclusive domain, encompassing subjects like safeguarding the nation’s borders (defense), navigating international relations (foreign affairs), and controlling the currency.
• The State List (List II): Here, states reign supreme. They are solely responsible for maintaining law and order (police), ensuring public health, and overseeing agriculture, the lifeblood of many communities.
• The Concurrent List (List III): This list fosters collaboration. Both the central and state governments have the authority to legislate on subjects like criminal law, ensuring a cohesive legal framework across the country. Marriage laws and bankruptcy regulations also fall under this shared responsibility.³

Moving beyond legislation, Articles 268 to 293 of the Constitution delve into the nitty-gritty of financial powers. Think of it as a detailed financial agreement:

• Article 268: This article acts as a financial map, specifying how the proceeds from specific taxes and duties will be shared between the Centre and the For instance, taxes collected on railway fares are divided between the two entities.
• Article 269: Here, the focus is on taxes levied on the sale or purchase of While the central government collects these taxes, Article 269 mandates that the revenue be assigned to the states.
• Article 270: This article tackles the distribution of taxes collected by the central government. It outlines the specific share that will be allocated to the states, ensuring they have sufficient resources to fulfill their responsibilities.
• Article 280: Recognizing the need for a fair and dynamic system, the Constitution establishes the Finance Commission. This independent body plays a crucial role in recommending the distribution of financial resources between the Union and the

By understanding these constitutional provisions, we gain a deeper insight into the financial relationship between the central and state governments. It’s a system of checks and balances, ensuring each level of government has the resources it needs to function effectively while fostering collaboration for the nation’s overall progress.⁴

FINANCE COMMISSION

 India’s federal structure thrives on a delicate balance between the central government and the states. A key player in maintaining this equilibrium is the Finance Commission, established by Article 280 of the Constitution.

Composed of Experts, Delivering Fairness:

The Commission, typically a five-member team led by a chairperson with Supreme Court judge-level credentials, is meticulously chosen. Members possess expertise in economics, finance, public administration, and related fields, ensuring well-rounded perspectives on financial matters.

The Commission’s role extends far beyond simply recommending the distribution of tax revenues between the Centre and states. It also:

• Guides Grant Distribution: The Commission lays down guidelines for disbursing grants-in-aid from the Consolidated Fund of India, ensuring crucial financial support reaches states in need.
• Strengthens Local Governance: By suggesting effective utilization of state funds for Panchayats and Municipalities, the Commission empowers local bodies, fostering stronger grassroots development.
• Resolves Financial Disputes: Acting as a quasi-judicial body, the Commission can settle financial disputes arising between the Centre and states, streamlining financial decision-making.

Other than these Article 270 of the Indian Constitution outlines the framework for distributing the central government’s tax collection, known as the net proceeds, between itself and the states. This shared pool of taxes includes income from sources like corporate tax, personal income tax, the central portion of the Goods and Services Tax (GST), and the Centre’s share of the Integrated GST (IGST).

The Finance Commission (FC), established every five years as mandated by Article 280, plays a crucial role in this process. They analyze the financial needs of each state and recommend a fair distribution of this “divisible pool” of taxes. It’s important to note that this pool excludes additional levies imposed by the central government, such as cess and surcharges, which are not shared with the states.

In addition to tax distribution, states also receive grants-in-aid based on the Finance Commission’s recommendations. These grants provide essential financial support, often targeted towards states with specific developmental needs.⁵

BASIS FOR ALLOCATION:

The Finance Commission in India doesn’t use a single, fixed basis for allocating the divisible pool of taxes between the Centre and the states. Instead, they consider a multi-factor formula with weightage assigned to different factors:

Current Considerations:

• Needs (40% weightage): This factor considers aspects like population density (more people signify greater needs) and area (larger states may have higher infrastructure demands). Additionally, weightage might be given to factors like forest cover and ecological fragility.
• Equity (45% weightage): This aims to bridge the fiscal gap between richer and poorer states. Per capita income disparity is a key factor here, ensuring states with lower incomes receive a larger share of the pool.
• Performance (15% weightage): This incentivizes states to improve their own tax collection Higher own tax revenue generation and potentially, lower fertility rates, lead to a larger share from the central pool.

A central function of the Finance Commission is to determine the appropriate share of central tax revenue, known as tax devolution, to be distributed among Indian states. This ensures states have the financial resources needed to deliver essential services.

The 14th Finance Commission (FC) significantly increased the recommended tax devolution rate by 10 percentage points, bringing it to 42% of the central tax pool. However, the 15th FC’s mandate included a new element: assessing the potential impact of such devolution on the central government’s own fiscal health.

This shift in focus reflects a need to balance the financial needs of both the central government and the states. While ensuring adequate resources for states is crucial, the central government requires sufficient funds to fulfill its own national responsibilities. The 15th FC’s assessment aimed to strike a sustainable balance between these competing demands.⁶

Balancing Needs and Priorities: Challenges Faced by the 15th Finance Commission

 The 15th Finance Commission (FC) of India has grappled with several challenges in determining the tax devolution rate for states. Here’s a breakdown of the key issues:

Concerns Over Reduced Devolution:

• Impact on States: The initial focus on assessing the impact of devolution on the central government’s finances raised concerns that the recommended share for states might be
• Balancing Act: Striking a balance between ensuring adequate resources for states and maintaining the central government’s fiscal health is a constant challenge.

Population Data and State Discontent:

• 2011 Census and Southern States: Using the 2011 census data, which reflects population growth, sparked discontent among southern states with lower fertility They felt it could disadvantage them compared to states with higher populations.
• Demographic Performance Criteria: To address these concerns, the 15th FC introduced a new “demographic performance” criterion that rewards states with lower fertility rates.

Fiscal Deficit Targets:

• Unmet Goals: The 14th FC’s ambitious targets for reducing the fiscal deficit of both the central government and states were not achieved.
• Impact of COVID-19: The pandemic’s economic fallout has further complicated fiscal projections, making it difficult for the 15th FC to set realistic deficit targets.

Challenges in Making Projections:

• Uncertainty and External Factors: The 14th FC faced uncertainties due to the implementation of GST, while the 15th FC is grappling with the COVID-19 pandemic’s economic disruptions.
• Adapting to a Changing Landscape: Making accurate projections for five years is inherently challenging, and unforeseen circumstances can quickly render them

The 15th Finance Commission is navigating a complex economic landscape. By acknowledging these challenges and exploring potential solutions, they can strive towards a more sustainable and equitable system of tax devolution for Indian states.

SUGGESTIONS:

Expanding the Divisible Pool:

• Including Cess and Surcharges: Currently, cess and surcharges levied by the central government fall outside the divisible pool of taxes shared with A proposal suggests incorporating a portion of these revenues, potentially leading to a larger pool for distribution.
• Phasing Out Cesses and Rationalizing Tax Slabs: This could simplify the tax system, eliminate redundancies, and ultimately contribute to a fairer resource allocation among

Incentivizing Efficiency in Resource Management:

• Revisit Horizontal Devolution Criteria: The current formula might not sufficiently emphasize efficiency. Increasing the weightage given to metrics like tax collection efficiency, governance effectiveness, and fiscal responsibility could incentivize states to manage resources more productively.

Reflecting GST Contributions: 

• Considering Relative GST Contribution: The Goods and Services Tax (GST) is a significant revenue source for both Centre and states. Factoring in the relative contribution of each state to GST collection could lead to a more balanced distribution of these revenues.

Enhancing State Participation:

• Formalize State Involvement: Drawing inspiration from the collaborative GST council model, a proposal suggests establishing a formal mechanism for state participation in the Finance Commission. This could involve state representation in the decision- making process, fostering greater transparency, inclusivity, and consensus-building.

By implementing these potential reforms, the Finance Commission can be even more effective in fostering fiscal equity, rewarding responsible fiscal management, and promoting India’s overall economic development.

CONCLUSION:

India’s federal structure thrives on a delicate dance between the central government and its states, with fiscal federalism acting as the music that keeps them in step. The fair distribution of central taxes plays a central role in this performance. It not only ensures fiscal autonomy for states, but also fuels a more balanced socio-economic development across the nation.

Bridging the gap between this ideal and reality remains a challenge. Inter-state political dynamics, varying administrative capacities, and ever-evolving financial needs complicate the pursuit of true equity and efficiency in tax distribution. However, the ongoing discourse, particularly the reforms suggested by the Finance Commissions, reflects a commitment to continuous improvement.

As India’s economic and political landscape matures, the mechanisms of fiscal federalism must adapt as well. Measures like including cess and surcharges in the divisible pool, refining tax

devolution criteria based on efficiency and GST contributions, and fostering greater state participation in fiscal decisions all hold promise for a more equitable and efficient system.

These reforms won’t just strengthen the financial relationship between the Centre and states, but also fuel the broader goal of sustainable and inclusive development for all of India. The evolving fiscal landscape demands continued dialogue, innovative policymaking, and a spirit of collaborative governance – all essential ingredients to ensure India’s growth story benefits everyone.

REFERENCES 

• Alex, (April,2020) How do State get Revenue from the Centre? Clear IAS , https://www.clearias.com/states-revenue-center/
• Adrija ( February, 2024) Population, GST lie in the heart of India’s North, South money wars over central funds, Money Control, https://www.moneycontrol.com/news/business/population-gst-lie-in-the-heart-of-indias-north-south-money-wars-over-central-funds-12207041.html
• Monika Yadav (February, 2024) Centre-State tax sharing row, The New Indian Express, https://www.newindianexpress.com/business/2024/Feb/11/centre-state-tax-sharing- row-no-problem-with-formula-say-experts
• Taxation in India, Invest India, https://www.investindia.gov.in/taxation
• GST Collection Analysis: State- wise Breakdown, https://taxguru.in/goods-and service-tax/gst-collection-analysis-state-wise-breakdown-igst-settlement.html#google_vignette
• Financial Relation Between Centre and State, (September,2022) Law Corner, https://lawcorner.in/financial-relations-between-centre-and-state/

Notes

 ¹ Taxation in India, avaible at https://byjus.com/free-ias-prep/taxation-india/ (last visited on 10^th April 2024)

² How do States get revenue from the Center? Available at : https://www.clearias.com/states-revenue-center/ (Last modified on 2^nd April 2020)

³ Seventh Schedule Of Indian Constitution – Lists, Powers & Issues Available at : https://testbook.com/ias- preparation/seventh-schedule-of-Indian-constitution (Last modified on 12^th Sep 2023)

⁴ Centre-state Relations: Financial https://blog.ipleaders.in/centre-state-relations-financial/ (Last modified on 20^th June 2020)

⁵ Finance Commission available at : https://prepp.in/news/e-492-finance-commission-indian-polity-upsc-notes (Last Modified on 19th April 2024)

⁶ GST Collection Analysis: State-wise Breakdown and IGST Settlement available at : https://taxguru.in/goods- and-service-tax/gst-collection-analysis-state-wise-breakdown-igst-settlement.html (Last modified on 19^th Dec 2023)