Allocation of Funds between The Centre and States- On financial devolution among States

Source: The post allocation of funds between the Centre and states has been created, based on the article “On financial devolution among States” published in “The Hindu” on 22nd February 2024.

UPSC Syllabus Topic: GS Paper 2-polity-issues and challenges pertaining to the federal structure, devolution of powers and finances up to local levels and challenges therein.

News: The article discusses the financial arrangement in India where taxes collected by the central government are shared with states. On financial devolution among States

What is the basis for the allocation of funds between the Centre and states?

Under Article 270 of the Indian Constitution, a scheme is established for distributing net tax proceeds, collected by the central government, between the Centre and the States.

The divisible pool, which includes taxes like corporation tax, income tax, GST, and the Centre’s share of IGST, is shared with the states but excludes cess and surcharges.

The Finance Commission, formed every five years, recommends how these funds are allocated. The 15th Finance Commission has advised a 41% share from this pool for the states.

For information on Finance Commission read here

Now, the basis for allocation includes:

Income Distance: States with lower per capita incomes receive more to promote equity. The benchmark is the state with the highest per capita income, which is Haryana.

Population: The 2011 Census data is used for population considerations, moving away from the 1971 Census data used earlier.

Forest and Ecology: States with larger forest cover get a bigger share, recognizing their ecological contribution.

Demographic Performance: States that have better controlled their population growth receive more funds.

Tax Effort: States with higher tax collection efficiency are rewarded with a greater share.

What are the issues with the allocation of funds between the Centre and states?

Exclusion of Cess and Surcharge: About 23% of the central government’s gross tax receipts come from cess and surcharge, which are not part of the divisible pool. For instance, in the 2024-25 budget, the total tax revenue of the Union government is ₹38.8 lakh crore, but states only receive around 32%, less than the recommended 41%.

Variation in Returns to States: There is a noticeable disparity in what states get back for every rupee contributed. For example, industrially developed states receive less than a rupee for every rupee contributed, compared to states like Uttar Pradesh and Bihar.

Decreasing Share for Southern States: Over the last six Finance Commissions, the share in the divisible pool for southern states has been reducing due to the criteria focusing more on equity and needs than on efficiency.

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What should be done?

Include Cess and Surcharge in Divisible Pool: Currently, cess and surcharge are not shared with states. Including them in the divisible pool would increase the funds available for states.

Reconsider Efficiency Criteria in Fund Allocation: Give more importance to the efficiency of tax collection by states in the allocation process, which would encourage states to improve their tax collection systems.

Enhanced State Participation in Finance Commission: Similar to the GST Council, states could have a more formal role in both forming and working with the Finance Commission, leading to a more collaborative and transparent fiscal federalism.

For more information read here.    

Question for practice:

Discuss the key challenges in the current allocation of funds between the Centre and states in India, and suggest potential reforms to address these challenges.