In News:

The debate on fiscal federalism in India has intensified following the Union government’s acceptance of the 41% tax devolution recommended by the Sixteenth Finance Commission. While the recommendation appears to maintain the existing share of tax revenues for States, critics argue that structural changes in the fiscal framework may gradually reshape the balance of financial power between the Centre and the States.

Fiscal Federalism in India

Fiscal federalism refers to the division of financial powers, taxation authority, and expenditure responsibilities between different levels of government in a federal system. In India, the Constitution establishes a structured framework for fiscal relations between the Union and the States.

Key constitutional provisions include:

• Articles 268–281: These articles govern the distribution of taxation powers and revenue sharing between the Union and the States.
• Article 280: Provides for the establishment of the Finance Commission, which recommends the sharing of central taxes and grants to States.
• Seventh Schedule: Divides taxation powers between the Union List and the State List.

Since the Union government collects a major share of taxes, the Finance Commission periodically recommends how the divisible pool of central taxes should be distributed among States.

Evolution of Tax Devolution

The share of States in the divisible pool has increased over time:

• 14th Finance Commission: Increased States’ share to 42%.
• 15th Finance Commission: Reduced it slightly to 41% after the reorganisation of Jammu and Kashmir.
• 16th Finance Commission: Recommended retaining the 41% share.

Although the percentage has remained unchanged, analysts argue that the effective transfer of resources to States may be declining.

The Divisible Pool and the Issue of Cesses and Surcharges

The divisible pool represents the portion of central tax revenues that is shared with States. However, certain revenues such as cesses and surcharges are excluded from this pool and are retained entirely by the Union government.

Over time, the share of the divisible pool in gross tax revenue has declined:

• 13th Finance Commission period: 89.2%
• 14th Finance Commission period: 82.1%
• 15th Finance Commission period: 78.3%

This trend implies that even though the States’ share is fixed at 41%, the base from which this percentage is calculated has shrunk, reducing the overall transfer to States.

Key Recommendations of the Sixteenth Finance Commission

The Union government accepted several major recommendations of the Commission, including:

• Retaining 41% tax devolution to States
• Acceptance of the horizontal distribution formula among States
• Approval of grants to local bodies
• Continuation of the disaster management funding framework

However, several structural reforms proposed by the Commission were deferred. These include:

• Reform of Fiscal Responsibility Legislation (FRL) frameworks
• Regulation of off-budget borrowings by States
• Reforms in the power sector distribution companies (DISCOMs)
• Rationalisation of subsidies

Fiscal Stress in States

The Commission also highlighted rising fiscal stress in several States. For example:

• Punjab: Debt–GSDP ratio of 42.9% and revenue deficit of 3.7% of GSDP (2023–24).
• Rajasthan: Liabilities at 37.9% of GSDP.
• West Bengal: Liabilities at 38.3% of GSDP.
• Andhra Pradesh: Liabilities around 34.6% of GSDP.

In some cases, borrowing is used primarily to finance revenue expenditure such as salaries and interest payments, rather than capital investment. Another concern is off-budget borrowing, where loans are raised through government-controlled entities and serviced using public funds.

Changes in Horizontal Devolution

The Finance Commission also revised the horizontal distribution formula among States. Earlier, a criterion known as tax and fiscal effort rewarded States that improved their tax collection efficiency. This has now been replaced with a “contribution to GDP” indicator with a weight of 10%.

This shift may benefit economically stronger States such as Maharashtra, Gujarat, and Karnataka, which contribute significantly to national GDP. However, poorer States such as Bihar, Jharkhand, and Uttar Pradesh, which depend heavily on central transfers, may gain relatively less, raising concerns about weakening the principle of fiscal equalisation.

Local Body Grants

The Sixteenth Finance Commission also recommended ?7,91,493 crore in grants for rural and urban local bodies. These grants are divided into:

• Basic grants for essential services and administration.
• Performance grants linked to conditions such as timely constitution of State Finance Commissions, audited accounts, and compliance with data reporting systems.

However, implementation challenges persist, as only 62.6% of recommended urban local body grants were released during the previous Finance Commission period.

Conclusion

The retention of 41% tax devolution appears to preserve the formal structure of fiscal federalism. However, the increasing use of cesses and surcharges, changes in allocation criteria, and delays in structural reforms indicate evolving Centre–State fiscal dynamics. These developments may gradually reshape India’s fiscal federal landscape, raising important questions about resource distribution, fiscal autonomy, and cooperative federalism.

Why is it in the News?

The recent agitations by the governments of Kerala and Karnataka, and the support extended by several State governments, have highlighted many disquieting issues in the practice of fiscal federalism in India.

Context:

• The recent protests by the governments of Kerala and Karnataka, supported by several other state governments, have brought to light several concerning issues regarding fiscal federalism in India.
• These protests underscore the pressing need for the newly constituted 16th Finance Commission (FC) to approach the matter with seriousness and innovation to address grievances related to growing vertical and horizontal inequalities in resource allocation.

What is Fiscal Federalism?

• Fiscal federalism refers to the distribution of financial authority and obligations among various tiers of government within a nation.
• It encompasses considerations like determining the roles and responsibilities of the central and state governments in delivering services, devising mechanisms for revenue generation and allocation among these entities, and establishing fair and efficient systems for transfers or grants distribution to promote equity and effectiveness.

Fiscal Federalism in India:

• The framers of the Constitution stipulated that the Central government would share its tax revenues with the states and provide grants from the Consolidated Fund based on a formula determined by the Finance Commission every five years.
• India operates under a three-tier federal tax system, delineating the powers of the Central government, state governments, and local bodies to levy taxes.
• The Central government possesses the authority to impose taxes on individual and corporate incomes, along with indirect taxes like central goods and services tax (CGST), integrated goods and services tax (IGST), and customs duties. Additionally, it collects surcharges and cesses on various taxes.
• State governments are responsible for levying state goods and services tax (SGST), stamp duties, land revenue, state excise duties, and professional taxes.
• Local bodies exercise jurisdiction over taxes such as property or house taxes, tolls, and utility taxes on services like electricity and water.

What are the Constitutional Provisions?

• The Constitution of India outlines the taxation authority of both the Union and States, categorizing them into the Union List and the State List respectively (as outlined in the Seventh Schedule under Article 246).
  • Initially, there was no taxation provision in the Concurrent List.
• However, with the introduction of GST, the need for a concurrent taxation framework arose, leading to the insertion of Article 246A (as the 101st Amendment in August 2016).
• This amendment empowered the Union to legislate for CGST (Central GST) and IGST (Integrated GST), while the States were granted the authority to enact SGST laws.
• Article 270 of the Constitution outlines the mechanism for distributing net tax proceeds collected by the Union government among the Centre and the States.

What are the Concerns with the States?

• Growing Vertical and Horizontal Inequalities: States have raised concerns about increasing disparities both vertically, pertaining to the sharing of resources between the Union and States, and horizontally.
  • The Union government's inclination to retain a larger share of its proceeds outside the divisible pool has exacerbated these inequalities.
• Retention of Proceeds: The Union government's practice of withholding a greater portion of its proceeds from the divisible pool has diminished the share allocated to States, contravening mandates from successive Finance Commissions.
• Proliferation of Cesses and Surcharges: Various cesses and surcharges, such as the Agriculture Infrastructure and Development Cess, have been introduced by the Union government, leading to an expansion of these revenue streams.
  • This expansion has resulted in a larger portion of the gross tax revenue being excluded from net proceeds, thereby depriving States of their rightful share.
• Financial Exclusion of States: Over the period from 2009-10 to 2023-24, the Union government collected a substantial cumulative amount of ?36.6 lakh crore through cesses and surcharges, all of which remained unshared with the States.
  • The imposition of cesses and surcharges has faced criticism from the Comptroller and Auditor General (CAG), further highlighting concerns about their impact on state finances.

Way Forward

• Rectifying disparities in resource sharing and addressing the proliferation of cesses and surcharges are critical imperatives for the 16th Finance Commission (FC).
• The FC should proactively address historical imbalances in vertical devolution by compensating States appropriately and ensuring accurate estimates of "net proceeds" in budgetary documents.
• Moreover, it should consider providing lump sum untied grants to States to offset shortfalls in devolution over the past decade.
• Simultaneously, legislative measures must be enacted by the Union government to impose strict limits on the collection of cesses and surcharges, ensuring their automatic expiration after a defined period and preventing their rebranding under different names.
• Furthermore, States must adhere to the principles of fiscal federalism by allocating sufficient resources to local bodies and promoting dynamic and transparent development initiatives at the grassroots level.

What is the Finance Commission?

• The Finance Commission is constituted by the President under Article 280 of the Constitution, mainly to give its recommendations on the distribution of tax revenues between the Union and the States and amongst the States themselves.
• Two distinctive features of the Commission’s work involve redressing the vertical imbalances between the taxation powers and expenditure responsibilities of the center and the States respectively and equalization of all public services across the States.

Functions of the Finance Commission:

• It is the duty of the Commission to make recommendations to the President as to the distribution between the Union and the States of the net proceeds of taxes which are to be:
  • Divided between them and the allocation between the States of the respective shares of such proceeds;
  • The principles which should govern the grants-in-aid of the revenues of the States out of the Consolidated Fund of India;
  • The measures needed to augment the Consolidated Fund of a State to supplement the resources of the Panchayats in the State based on the recommendations made by the Finance Commission of the State;
  • The measures needed to augment the Consolidated Fund of a State to supplement the resources of the Municipalities in the State based on the recommendations made by the Finance Commission of the State;
  • Any other matter referred to the Commission by the President in the interests of sound finance.
• The Commission determines its procedure and has such powers in the performance of its functions as Parliament may by law confer on them.

Appointment of the Finance Commission and Qualifications for Members:

• The Finance Commission is appointed by the President under Article 280 of the Constitution.
• As per the provisions contained in the Finance Commission Act, 1951 and The Finance Commission (Salaries & Allowances) Rules, 1951, the Chairman of the Commission is selected from among persons who have had experience in public affairs, and the four other members are selected from among persons who:
  • (a) are, or have been, or are qualified to be appointed as Judges of a High Court; or
  • (b) have special knowledge of the finances and accounts of the Government; or
  • (c) have had wide experience in financial matters and administration; or
  • (d) have special knowledge of economics

How are the recommendations of the Finance Commission implemented?

• The recommendations of the Finance Commission are implemented  as under:
  • Those to be implemented by an order of the President:
  • The recommendations relating to the distribution of Union Taxes and Duties and Grants-in-aid fall in this category.
  • Those to be implemented by executive orders:
  • Other recommendations to be made by the Finance Commission, as per its Terms of Reference

When was the first Commission Constituted and how many Commissions have been Constituted so far?

• The First Finance Commission was constituted under the chairmanship of Shri K.C. Neogy on 6th April 1952.
• 15th Finance Commissions have been Constituted so far at intervals of every five years.
• The 16th Finance Commission was constituted on 31 Dec 2023 with Shri Arvind Panagariya, former Vice-Chairman, NITI Aayog as its Chairman.
  • The 16th Finance Commission is required to submit its recommendations by October 31st, 2025.
• However, the recommendations of the 15th FC cover the six years up to 31st March 2026.