7 PM | An Analysis of Fiscal Transfers to States | 25 March, 2019

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Constitutional provision for fiscal federalism

The fiscal federal arrangements that are provided in the Constitution adopted were largely the logical extensions of the Government of India Act, of 1935. The Indian Constitution lays down the functions as well as taxing powers of the Centre and States. Jurisdictions over tax revenue were assigned according to the following scheme where five categories of taxes were provided

  • Taxes, which are levied, collected and retained by the Central government.
  • Taxes, which are levied and collected by the Central government but wholly, assigned to the States.
  • Taxes which are levied and collected by the Union government but the net proceed is shared with the States. This category of taxes is also known as divisible pool.
  • Taxes, which are levied by the Union but, collected and retained by the States.
  • Those taxes, which are collected, levied and retained by the States.

Note: In a major restructuring of the above scheme the 80th amendment to the Constitution in 2000 all the Central taxes were made shareable.

In India, the Constitution recognises the problem of fiscal imbalances. It provides for the appointment of the Finance Commission by the President of India every five years to resolve them by making recommendations on tax devolution and grants in aid of revenues. The objective of transfers is to ensure minimum standards of public services.

There are, in general, three channels through which federal transfers flow to the States.

  1. Finance Commission: In order to determine the quantum of States’ share from the sharable pool and to determine the principle that should govern the distribution of such share amongst the States. Besides sharing of tax and duty the State also receive grants-in aid of their revenue under Article 275. The Finance Commission also recommends quantum of such grants.
  2. Grants in Aid: Constitution provides for the Grants-in-aid to the State governments in whose case gap between expenditure and revenue is estimated to persist even after the devolution in the form of tax sharing. Planning commission was used to transfer the funds and allocate such resources under article 282, which was outside the preview of finance commission.
  3. Central Ministries: Central Ministries provide finance to their State counterparts in the form of the grants. Such grants are meant for financing the specified projects.

Note: The Planning Commission was replaced by the NITI Aayog in 2014-15, which was simply a think-tank with no powers of resource allocation.

Fiscal distribution current scenario

Finance Commission is empowered by the Constitution to give all transfers –general or specific. After the Fourteenth Finance Commission, the entire architecture of the transfer system has changed. All general-purpose transfers are now recommended by the Finance Commission and all specific purpose transfers are given by the respective Central ministries.

The Fourteenth Finance Commission decided that it will stay away from giving specific purpose transfers which required continuous monitoring. One of its major recommendations has been to increase the share of tax devolution to 42% of the divisible pool. The commission has argued that this does not necessarily affect the overall transfers but only enhances the share of unconditional transfers.

• General purpose transfers (which include both tax devolution and unconditional ‘block grants’) increase the capacity of states to determine their expenditure priorities and allocate budgetary resources accordingly.
• Specific purpose transfers are mostly grants that are tied to particular activities undertaken by sub-national entities.


Issues with fiscal distribution

  1. Determination of total allocation: It is difficult to determine the total transfers that need to be made to state. In recent time share of centre reduced.
  2. Authority to transfer fund: At present tax and grant transfer is being determined by both finance commission and central government. There is need of robust mechanism through which funds are allocated or transfer to states
  3. Discrepancy in Amount: Often, the final grant given is significantly lower than the originally approved amount
  4. Decline in share of centre after transfer: In 2010-11 the share of the Centre was 64.68%. After transfer, the share came down to 40.20%. In the case of the States, their share before transfers was 35.32%. After the receipts of transfers the share of States went up to 59.80%. In 2016-17, the share of the Centre after transfers was 33.37% and that of the States was 66.63%.
  5. Misallocation of grants: Designing the grants not linked to meet the shortfall in services from the prescribed levels results in significant misallocation. It is not necessarily the educationally backward State or the State with poor health indicators that gets more education or health grants
  6. Impact poorer states: The uniform matching ratio across States makes it difficult for the low-income States to utilize the grants allocated to them fully
  7. Overuse of equality criteria: Relatively richer States have their own problems and they feel ‘cheated’ because of the overuse of the equity criterion.

Way Ahead

An appropriate balancing of criteria is needed particularly in the context of the rise in unconditional transfers. Centre and States must take a broader view of fund transfer than what is stipulated in the Constitution. There is a need to fix ratio of fund transfer that should go to the States constitutionally. The shareable tax pool must also include cesses and surcharges as these have sharply increased in recent years. Fixing the ratio at 42% of shareable taxes, including cesses and surcharges, seems appropriate.

The centre may also allow the States to levy tax on personal income (In the United States and Canada, both Federal and State governments have concurrent powers to levy income tax). The freedom given to the States must be limited. As it is important that the levy by the Centre and States together should be reasonable.

Source: https://www.thehindu.com/opinion/lead/another-look-at-fiscal-transfers/article26626986.ece

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