Vertical Fiscal Imbalance (VFI)

Source- This post on Vertical Fiscal Imbalance (VFI) has been created based on the article “What is vertical fiscal imbalance?”  published in “The Hindu” on 6th September 2024.

Why in News?

The issue of Vertical Fiscal Imbalance (VFI) in India has recently gained attention due to increasing concerns over the financial relationship between the Union government and the States.

Vertical Fiscal Imbalance (VFI)

1. VFI happens when different levels of government (national and state) do not have balanced financial powers.

2. In India, the central government collects most of the taxes, but the state governments handle most of the spending, like providing public services. For example- State governments are responsible for 61% of public spending but only collect 38% of the revenue. This makes states rely heavily on money transfers from the central government, highlighting a challenge in how finances are shared.

Why Reducing VFI is Important

Since the central government controls tax collection but states are responsible for delivering many public services, states need more money to meet their responsibilities efficiently.

Reducing VFI helps ensure states have enough funds to provide better services to the public.

How VFI is Calculated

1. Own-Source Revenue (OSR): The revenue states generate themselves, excluding central government transfers.

2. Total Expenditure: The total spending responsibilities of states.

3. Intergovernmental Transfers: The money states receive from the central government.

Formula: VFI = 1− (Own-Source Revenue/Total Expenditure)

A result below 1 means states’ revenues are not enough to cover their spending, even with central transfers.

Role of the Finance Commission: The Finance Commission helps address VFI by deciding how central taxes are shared with states. This is done through tax devolution and grants.

Eliminating VFI: To fix VFI, the share of taxes given to states needs to be increased. The 14th and 15th Finance Commissions recommended shares of 42% and 41%, but experts suggest 49% is needed.

Recommendations for the 16th Finance Commission

1. Increase Tax Devolution: Raising the share of taxes for states to 49% would help reduce VFI.

2. Excluding Cesses and Surcharges: These should not be part of the tax revenue calculation as they reduce the funds available for states.

3. Promote Fiscal Federalism: Giving states more resources would help them manage their responsibilities better, leading to improved governance and services.

UPSC Syllabus: Indian Economy