Context:
The 16th Finance Commission’s decision to retain the States’ share at 41% of the divisible pool of central taxes has triggered debate on fiscal federalism, with several States arguing that growing reliance on cesses and surcharges by the Union government reduces their effective share of revenues.
Key Highlights:
Finance Commission Recommendation
• The 16th Finance Commission retained the vertical devolution rate at 41%, the same level recommended by the 15th Finance Commission.
• Vertical devolution refers to the division of tax revenue between the Union and the States.
Divisible Pool and Its Limitations
• The divisible pool includes shareable central taxes, which are distributed among states as per the Finance Commission formula.
• However, cesses, surcharges, and collection costs are excluded, meaning these revenues are not shared with States.
Rising Use of Cesses and Surcharges
• The Centre’s reliance on non-shareable taxes has increased significantly:
• Cesses increased from ₹44,688 crore (FY15) to ₹3,52,650 crore (FY22).
• Surcharges increased from ₹15,702 crore to ₹40,758 crore during the same period.
• This trend reduces the effective share of states in total central tax revenue.
Shrinking Share of Divisible Pool in Gross Tax Revenue
• The divisible pool’s share in the Centre’s Gross Tax Revenue (GTR) has remained below 90% for six consecutive years.
• Earlier, between FY13–FY18, it remained above 93%, indicating a declining shareable revenue base.
States’ Demands
• 18 states have demanded an increase in vertical devolution from 41% to 50%.
• States argue that they bear greater responsibilities in sectors like health, education, and welfare, requiring greater fiscal autonomy.
Finance Commission Observations
• The Commission acknowledged increasing reliance on cesses and surcharges by the Union government.
• Suggested the possibility of voluntary transition of such revenues into the divisible pool through mutual agreement between the Centre and States.
Significance / Concerns
• The issue raises concerns regarding cooperative federalism and fiscal balance.
• States worry that reduced fiscal space may hinder welfare spending and development initiatives.
Relevant Prelims Points:
• Finance Commission
• Constitutional body under Article 280 of the Constitution.
• Constituted by the President every five years.
• Functions:
• Recommend distribution of tax revenues between Centre and States.
• Determine principles for grants-in-aid.
• Suggest measures to augment resources of Panchayats and Municipalities.
- Divisible Pool of Taxes
• Portion of central taxes shared with states.
• Includes income tax, corporation tax, GST components, etc.
• Excludes cesses and surcharges. - Cess vs Surcharge
• Cess: Tax imposed for a specific purpose (e.g., Education Cess, Health and Education Cess).
• Surcharge: Additional tax on existing tax liabilities, often applied to higher-income brackets. - Vertical vs Horizontal Devolution
• Vertical Devolution: Centre–State tax sharing.
• Horizontal Devolution: Distribution of states’ share among states based on criteria such as population, income distance, area, and forest cover.
Relevant Mains Points:
Implications for Fiscal Federalism
• Increasing reliance on cesses and surcharges undermines the spirit of cooperative federalism.
• Reduces predictable fiscal transfers to states.
• Limits states’ ability to plan long-term development programs.
Structural Fiscal Imbalance
• India exhibits vertical fiscal imbalance, where:
• Revenue powers are concentrated at the Union level, while
• Expenditure responsibilities are largely borne by states.
Arguments Supporting the Centre
• The Union requires fiscal flexibility to fund national priorities such as defence, infrastructure, and economic stabilization.
• Cesses allow targeted funding for specific schemes.
Arguments Supporting the States
• States deliver major public services including healthcare, education, agriculture, and local governance.
• Reduced revenue sharing can strain state finances and increase borrowing.
Way Forward
• Rationalize the use of cesses and surcharges.
• Improve transparency in tax sharing and fiscal transfers.
• Strengthen cooperative fiscal federalism mechanisms such as the GST Council and Inter-State Council.
• Consider gradual expansion of the divisible pool.
UPSC Relevance:
• Prelims: Finance Commission, divisible pool, cess and surcharge, Article 280.
• Mains: GS Paper II – Fiscal Federalism, Centre-State Financial Relations, Cooperative Federalism.