Concerns in India’s Fiscal Federalism – On irregularities in vertical devolution

Source: The post concerns in India’s Fiscal Federalism has been created, based on the article “On irregularities in vertical devolution” published in “The Hindu” on 29th February 2024.

UPSC Syllabus Topic: GS Paper 2-Indian Polity – Issues and challenges pertaining to the federal structure.

News: The article discusses the issues in India’s fiscal federalism, focusing on the unfair distribution of tax revenue between the central government and states.

What are the Concerns in India’s Fiscal Federalism?

The central government’s increasing retention of tax proceeds, evident in the rising share of cesses and surcharges, is a key concern in India’s fiscal federalism.

This trend contributes to the shrinking of the divisible pool, with these collections growing from 11.3% of the gross tax revenue in 2009-10 to 16.3% in 2022-23. States face the challenge of more tied transfers, restricting their spending freedom.

Furthermore, the government’s non-compliance with Finance Commission recommendations on revenue sharing exacerbates the situation, a point underscored by the Comptroller and Auditor General’s (CAG) reports on mismanagement of funds.

For information on the Issues with Fiscal federalism read here

Why is there shrinking of divisible pool?

Introduction of Cesses and Surcharges: The central government has been introducing new cesses and surcharges, like the Agriculture Infrastructure and Development Cess in 2021-22, and retaining them exclusively.

Exclusion from Divisible Pool: These cesses and surcharges are excluded from the net divisible pool, which is the portion of tax revenue shared with states.

Rising Share of Exclusions: The proportion of tax revenue excluded has increased significantly, from 11.3% of the gross tax revenue in 2009-10 to 16.3% in 2022-23.

What indication has been given by CAG on sharing of resources between the Union and States?

Non-Transfer or Short Transfer of Cesses: The Comptroller and Auditor General (CAG) highlighted instances where cesses collected were either not transferred or inadequately transferred to designated funds.

Specific Examples of Mismanagement: For instance, only 60% of the Health and Education Cess collected in 2021-22 was transferred to its reserve fund. Similarly, a small fraction (9.6%) of the Research and Development Cess collected over two decades was transferred to its respective fund.

Large Scale of Discrepancy: The extent of short transfers is substantial, with billions not reaching the intended funds. This includes shortfalls in the Swachh Bharat Cess and under-transfers in the Road Cess and Clean Energy Cess.

How is the spirit of cooperative fiscal federalism diluting?

Deviation from Finance Commission’s Recommendations: The Union government has not fully adhered to the Finance Commission’s recommended sharing rates. For instance, during the 15th Finance Commission period, the share actually devolved was only 38.1%, below the recommended 41%.

Rise in Tied Transfers: States are receiving more funds tied to specific central schemes, restricting their ability to allocate resources based on local needs.

Credit Usurpation by the Union Government: There’s a tendency of the Union government to take credit for projects, even when states contribute significantly, undermining the partnership principle in fiscal federalism.

Conditionalities on Grants: Several grants to states are contingent on fulfilling certain conditions, including the insistence on specific labelling, which imposes Union government preferences over state priorities.

What reforms are needed to address these issues?

1.The 16th Finance Commission should compensate states for historical wrongs in devolution.

2. Accurate estimates of “net proceeds” should be published in budget documents.
3. Union government should legislate strict limits on the collection of cesses and surcharges.

Question for practice:

Discuss how the principles of cooperative fiscal federalism are being undermined in India.