Ensuring Equitable Tax Distribution Among States

GS2 – Polity

Context:

The upcoming 16th Finance Commission, whose recommendations will apply from April 2026, is facing increasing pressure from States to enhance their share in centrally collected taxes from the current 41% to 50%.

What Is the Divisible Pool of Taxes?

This refers to the shareable portion of the Union government’s gross tax revenues, distributed among States as per Finance Commission recommendations under Article 270 of the Constitution.
Taxes shared include:

• Corporation Tax
• Personal Income Tax
• Central GST (CGST)
• Centre’s share of IGST

In addition to tax devolution, the Finance Commission also recommends grants-in-aid to States.
However, cess and surcharge collected by the Union government are excluded from the divisible pool, reducing the total amount shared with States.

Current Status:

Though the 15th Finance Commission set States’ share at 41%, the actual amount transferred has fallen short due to the rising use of non-shareable cess and surcharges.

Challenges in Financial Devolution

1. Rising Use of Cess and Surcharge:
   The share of these non-divisible tax instruments has increased from 12.8% (2015–2020) to 18.5% (2020–2024) of total central tax revenue.
   This has effectively reduced the actual States’ share to around 31%, undermining the intended 41% allocation.
2. Reduced Revenue Autonomy Post-GST:
   With the GST regime absorbing many State-level taxes, States have lost significant independent tax-raising powers.
   While GST collections have shown growth, States remain heavily dependent on Union transfers for fiscal needs.
3. Horizontal Devolution Imbalance:
   The current formula tends to reward:

• States with larger populations and lower per capita income
• Often to the disadvantage of States with better governance, stable populations, and strong fiscal performance (notably in the South)

Use of 1971 census population and the income distance criterion results in relatively wealthier, demographically stable States receiving a smaller share.

4. Unequal Return on Tax Contributions:
   States receive varying returns for every rupee they contribute to central taxes.

• Economically advanced States often receive less than ₹1 per ₹1 contributed.
• Larger, populous States like Uttar Pradesh receive more than they contribute, partly because many firms pay taxes where they are headquartered.

5. Representation and Mandate Issues:

• Southern States have raised concerns about inadequate representation in the 16th Finance Commission’s composition.
• While the Commission’s Terms of Reference appear specific, there are worries based on previous commissions being burdened with vague directives and possible political bias.

The Road Ahead

1. Moderate Increase in Vertical Sharing:
   A balanced approach—raising States’ share to around 45%—can reinforce the spirit of cooperative federalism.
2. Reform Cess/Surcharge Usage:
   Consider either capping these instruments or including them in the divisible pool to prevent erosion of States’ fiscal autonomy.
3. Update Devolution Criteria:
   Revise the horizontal devolution formula to include performance-based metrics, area-based needs, and governance quality—moving beyond just demographic factors.
4. Broaden Stakeholder Involvement:
   The process of appointing Finance Commission members should involve consultations with States and ensure regional representation, particularly from the South.
5. Towards a New Federal Framework:
   There is an urgent need for a fresh political agreement that acknowledges the growing fiscal and political disparities between States and the Union, and ensures a more balanced distribution of financial and decision-making powers.