Financial Relations

Financial Relations (Article 268-293 Part XII)

Financial Relations or Fiscal Federalism refers to the division of responsibilities with regards to public expenditure and taxation between the different levels of the government.

Taxation Power divided between Centre and State: 

• The Parliament has exclusive power to levy taxes on subjects enumerated in the Union List (which are 13 in number)
• The state legislature has exclusive power to levy taxes on subjects enumerated in the State List (which are 18 in number).
• There are no tax entries in the Concurrent List. In other words, the concurrent jurisdiction is not avail- able with respect to tax legislation. But the 101st Amendment Act of 2016 has made an exception by making a special provision with respect to goods and services tax. This Amendment has conferred concurrent power upon Parliament and State Legislatures to make laws governing goods and services tax.

• Residuary power of taxation vest with the Parliament. Ex: Gift Tax, Wealth Tax and Expenditure Tax.

Constitutional Limitations on the State

• A state legislature can impose taxes on professions, trades, callings and employments. But the total amount of such taxes payable by any person should not exceed 2,500 per annum.
• A state legislature is prohibited from imposing a tax on the supply of goods or services or both in the following two cases: (a) where such supply takes place outside the state, and (b) where such supply takes place in the course of import or export. Further, the Parliament is empowered to formulate the principles for determining when a supply of goods or services or both takes place outside the state, or in the course of import or export.
• A state legislature can impose tax on the consumption or sale of electricity. But no tax can be imposed on the consumption or sale of electricity which is (a) consumed by the Centre or sold to the Centre; or (b) consumed in the construction, maintenance or operation of any railway by the Centre or by the concerned railway company or sold to the Centre or the railway company for the same purpose.
• A state legislature can impose a tax in respect of any water or electricity stored, generated, consumed, dis- tributed or sold by any authority established by Parliament for regulating or developing any inter-state river or river valley. But, such a law, to be effective, should be reserved for the president's consideration and receive his assent.

This all has led to:

• The assignment of revenues and expenditures according to the principle of comparative advantage results in the Central governments having access to most broad-based taxes and subnational governments having responsibilities to provide most of economic and social services but inadequate revenue handles to provide them. (Vertical Imbalances)
• There are wide differences among the States in the capacity to raise revenues as the size of the tax base varies widely. The variations in the tax base among the States results variations in the standards of public services delivered even when the States make uniform effort at raising revenues. (Horizontal Imbalances)

These variations violate the principle of “horizontal equity” or “equal treatment of equals”. These vertical and horizontal fiscal imbalances will have to be resolved through a system of intergovernmental transfers from the Centre to the States.

Correction to these Imbalances

Constitutional arrangements of Taxation between centre and State:

1. Taxes Levied by the Centre but Collected and Appropriated by the States (Article 268): This category includes the stamp duties on bills of exchange, cheques, promissory notes, policies of insurance, transfer of shares and others.
   • The proceeds of these duties levied within any state do not form a part of the Consolidated Fund of India but are assigned to that state.

2. Taxes Levied and Collected by the Centre but Assigned to the States (Article 269): The following taxes fall under this category:
   • Taxes on the sale or purchase of goods (other than newspapers) in the course of inter-state trade or commerce,
   • Taxes on the consignment of goods in the course of inter-state trade or commerce.

The net proceeds of these taxes do not form a part of the Consolidated Fund of India. They are assigned to the concerned state.

3. Levy and Collection of Goods and Services Tax in Course of Inter-State Trade or Commerce (Article 269-A): The Goods and Services Tax (GST) on supplies in the course of inter-state trade or commerce are levied and collected by the Centre. But this tax is divided between the Centre and the States in the manner provided by Parliament on the recommendations of the GST Council.
4. Taxes Levied and Collected by the Centre but Distributed between the Centre and the States (Article 270): This category includes all taxes and duties referred to in the Union List except the following:
   • Duties and taxes referred to in Articles 268, 269 and 269-A 
   • Surcharge on taxes and duties referred to in Article 271 
   • Any cess levied for specific purposes. 

The manner of distribution of the net proceeds of these taxes and duties is prescribed by the President on the recommendation of Finance Commission.

5. Surcharge on Certain Taxes and Duties for Purposes of the Centre (Article 271): The Parliament can at any time levy the surcharges on taxes and duties referred to in Articles 269 and 270 (mentioned above). The proceeds of such surcharges go to the Centre exclusively. In other words, the states have no share in these surcharges. However, the Goods and Services Tax (GST) is exempted from this surcharge. In other words, this surcharge cannot be imposed on the GST.

Besides sharing of taxes between the Centre and the states, the Constitution provides for grants-in-aid to the states from the Central resources. There are two types of grants-in aid, viz, statutory grants and discretionary grants:

Statutory Grants:

• Article 275 empowers the Parliament to make grants to the states which are in need of financial assistance and not to every state. Also, different sums may be fixed for different states. These sums are charged on the Consolidated Fund of India every year.
• Apart from this general provision, the Constitution also provides for specific grants for promoting the welfare of the scheduled tribes in a state or for raising the level of administration of the scheduled areas in a state including the State of Assam.
• The statutory grants under Article 275 (both general and specific) are given to the states on the recommendation of the Finance Commission.

Discretionary Grants:

• Article 282 empowers both the Centre and the states to make any grants for any public purpose, even if it is not within their respective legislative competence.
• Under this provision, the Centre makes grants to the states. The Centre is under no obligation to give these grants and the matter lies within its discretion.
• Notably, the discretionary grants constitute the larger part of the Central grants to the states (when compared with that of the statutory grants).

Current scenario of Fiscal management of various States:

• Backward states are generally not able to attract investments due to lack of infrastructure on their own due to lack of investible funds. Backward states have a limited own resource due to a small economy and a weak market structure. Therefore, they rely heavily on funding and tax sharing support from central government. For example, West Bengal and Jharkhand have low tax– Gross State Domestic Product (GSDP) ratio, while Karnataka and Kerala have a higher tax–GSDP ratio as a result of the better tax administration of their state governments.
• In the light of revenue deficit grants provided by the FC14, eight states have shown revenue deficit in their budgets for 2015–16. All these states are high-income or average-income states.
• On the other side, Low-income states have been generating revenue surplus, especially after the Twelfth Finance Commission’s (FC12) recommendation for implementing the Fiscal Resources of Budgetary Management Act (FRBMA), by compromising on their social and economic needs by compromising on their social and economic needs.
• However, they should spend more on better human and economic development outcomes. Further, they should utilise their full debt potential for creation of adequate infrastructure
• Contrary to this, developed states utilise and sometimes cross limit of the FRBM Act (states are allowed to borrow loan till 3.5% GSDP) for more development outcomes. Instead of rewarding them, Finance Commission 14 has penalised the revenue-surplus states for maintaining the fiscal discipline.
• Against this backdrop, it can be seen that the states that have not followed FRBM Act norms are awarded with revenue deficit grants, whereas states that have a high population pressure are being penalised since 1971 for not following the desired development trend.

Finance Commission

• The Finance Commission (FC) is a constitutional body that determines the method and formula for distributing the tax proceeds between the Centre and states, and among the states as per the constitutional arrangement and present requirements.
• Under Article 280 of the Constitution, the President of India is required to constitute a Finance Commission at an interval of five years or earlier.
• The 15th Finance Commission was constituted by the President of India in November 2017, under the chairmanship of NK Singh. Its recommendations will cover a period of five years from the year 2021-22 to 2025-26.

Recommendations of 15th FC

• Vertical Devolution (Devolution of Taxes of the Union to States):
  • It has recommended maintaining the vertical devolution at 41% - the same as in its interim report for 2020-21.
    • It is at the same level of 42% of the divisible pool as recommended by the 14th Finance Commission.
  • It has made the required adjustment of about 1% due to the changed status of the erstwhile State of Jammu and Kashmir into the new Union Territories of Ladakh and Jammu and Kashmir.
• Horizontal Devolution (Allocation Between the States)
  • For horizontal devolution, it has suggested 12.5% weightage to demographic performance, 45% to income, 15% each to population and area, 10% to forest and ecology and 2.5% to tax and fiscal efforts.
• Revenue Deficit Grants to States
  • Revenue deficit grants emanate from the requirement to meet the fiscal needs of the States on their revenue accounts that remain to be met, even after considering their own tax and non-tax resources and tax devolution to them.
  • Revenue Deficit is defined as the difference between revenue or current expenditure and revenue receipts that includes tax and non-tax.
  • It has recommended post-devolution revenue deficit grants amounting to about Rs. 3 trillion over the five-year period ending FY26.
    • The number of states qualifying for the revenue deficit grants decreased from 17 in FY22, the first year of the award period to 6 in FY26, the last year.
• Performance Based Incentives and Grants to States
  • These grants revolve around four main themes.
  • The first is the social sector, where it has focused on health and education.
  • Second is the rural economy, where it has focused on agriculture and the maintenance of rural roads.
    • The rural economy plays a significant role in the country as it encompasses two-thirds of the country's population, 70% of the total workforce and 46% of national income.
  • Third, governance and administrative reforms under which it has recommended grants for judiciary, statistics and aspirational districts and blocks.
  • Fourth, it has developed a performance-based incentive system for the power sector, which is not linked to grants but provides an important, additional borrowing window for States.
• Fiscal Space for Centre
  • Total 15th Finance Commission transfers (devolution + grants) constitutes about 34% of estimated Gross Revenue Receipts to the Union, leaving adequate fiscal space to meet its resource requirements and spending obligations on national development priorities.
• Grants to Local Governments
  • Along with grants for municipal services and local government bodies, it includes performance-based grants for incubation of new cities and health grants to local governments.
  • In grants for urban local bodies, basic grants are proposed only for cities/towns having a population of less than a million. For Million-Plus cities, 100% of the grants are performance-linked through the Million-Plus Cities Challenge Fund (MCF).
    • MCF amount is linked to the performance of these cities in improving their air quality and meeting the service level benchmarks for urban drinking water supply, sanitation and solid waste management.

Criticism

• Performance based incentives disincentivize independent decision-making. Any conditions on the state's ability to borrow will have an adverse effect on the spending by the state, particularly on development thus undermining cooperative fiscal federalism.
• It does not hold the Union government accountable for its own fiscal prudence and dilutes the joint responsibility that the Union and States have.
• The share of southern states out of India’s population has decreased by 4 percentage points (between 1971 to 2011) whereas the share of the northern state at the same time has increased, so southern states are apprehensive of their share because of the use of 2011 census data.

Challenges in Fiscal Federalism in India

• Increasing Central Dominance in Fiscal Policies: A series of steps by the Union government undermined the principles of fiscal federalism. This has been manifested by:
  • Increasing monetary share of the States in Centrally Sponsored Schemes (CSS).
  • Imposition of demonetisation without adequate consultation with the States.
  • Outsourcing of the statutory functions under the Smart Cities Mission
  • As of 2020-21, the Union government’s share in the total contribution of the petroleum sector was 68%, which left only 32% to the States.
    • In 2013-14, the Union: State share was almost 50:50.
• Taxation Related Issues: Enlarging the non-divisible pool of taxes in the form of cess in petrol tax and instituting the Agriculture Infrastructure and Development Cess have resulted in a situation where the Union continues to exclusively benefit from tax collection.
  • The share of non-divisible pool cess and surcharge in total taxes collected by the Union government has increased from 12.67% in 2019-20 to 23.46% in 2020-21.
  • The 2021-22 Budget Estimates indicate that the States’ share of Union tax has reduced to 30% against the mandated 41% devolution prescribed by the 15th Finance Commission.
  • GST Specific Issues: During the pandemic, the Union government repeatedly violated the compensation guarantees to the States under the GST regime.
    • Delay in paying the States their due worsened the impact of the economic slowdown.
    • The GST compensation period expires in 2022, and despite multiple requests from the States, the deadline has not been extended.
• Inadequate Funding: Cash-starved States have been seeking non-tax avenues to generate funds to sustain their programmes.
  • The suspension and transfer of the Member of Parliament Local Area Development (MPLAD) funds to the Consolidated Fund of India led to a major crisis situation for most States.
  • Although the Government has raised the borrowing limit under the Fiscal Responsibility and Budget Management Act (FRBM) from 3% to 5%, it has imposed certain restrictive conditions making it more difficult for the states to borrow.

Positive Change in Fiscal Federalism: 

• Replacement of planning commission by Niti Aayog.
• Removal of Distinction between Plan and Non Plan expenditure. 
• Introduction of GST. 
• Increase in devolution of taxes from 32% to 42% by 14th Finance commission and 41% by 15th FC.
• Outcome Based Budgeting: Introduced in 2017-18 with the formulation of outcome framework for 68 Ministries/Departments along with the Union Budget document.
• Allowing State entities to borrow directly from Official Development Assistance (ODA) Partners after 2017.
• Role of State Governments in improving ‘external relations’: Signing of Sister City Partnership Agreement by many of the Indian cities like – Varanasi, Hyderabad, Bangalore, etc. with major cities of the developed countries. 

Suggestions:

Recommendation by Punchhi commission are as follows-

• The Commission recommends a comprehensive review of all transfers to States with a view to minimizing the component of discretionary transfers, particularly those channelled through Central Sector Schemes.
• Recommend higher Central transfers to backward States to enable them to improve their physical and human infrastructure.
• All future Central legislations involving States’ involvement should provide for cost-sharing as in the case of the RTE Act.
• The royalty rates on major minerals should be revised at least every three years without any delay. States should be properly compensated for any delay in the revision of royalty beyond three years.
• A part of the sale proceeds of the spectrum should be devolved to States for expenditure on infrastructure projects.
• This ‘one-size fits all’ approach to fiscal consolidation has constrained fiscally strong States to raise more resources. Therefore, State-specific targets of fiscal deficit in the FRBM legislation of States.