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By Seela Subba Rao

Most of the federal governments are vested with powers to raise tax revenues while the States are responsible for undertaking a large part of the public expenditures. The allocation of taxation powers vis-à-vis responsibilities per se creates an imbalance known as vertical imbalance. Further, the existence of vast regional disparities contributes to horizontal imbalances among States in terms of their resource capacity to expenditure responsibilities.

At present, all taxes of the central government except cesses and surcharges are to be shared with the States in accordance with the recommendation of the Finance Commission. The prime aim of these transfers in the past was to correct the differentials in revenue capacity as well as cost disability factors inherent in the economies of the States. Another reason was to foster fiscal efficiency among the States. The criteria used in the past for distribution of the share of States can be categorised broadly under three groups: Need factors such as population and income measured either as distance from highest income or as inverse; cost disability factors such as area and infrastructure distance; and fiscal efficiency indicators such as tax efforts and fiscal discipline.

Under tenures of the past few Finance Commissions (FC), these distributive criteria had converged. The criteria and weightages assigned for determination of shares of States too underwent many changes. The FCs have been assigned the responsibility of transfer of net tax revenue to States following objective and rational criteria in the best interest of cooperative federalism.

15th Finance Commission

The present 15th Finance Commission has recommended that the States be given 41% of the divisible tax pool of the Centre during the period 2021-26 as against 42% recommended by the 14th FC for 2015-20. The adjustment of 1% is to provide for the newly formed union Territories of Jammu & Kashmir and Ladakh from the resources of the Centre. The criteria for distribution of central taxes among the States for the period 2021-26 is the same as that of 2020-21. However, the reference period for computing income distance and tax efforts has undergone certain changes (for 2020-21, the reference period is 2015-18 and for 2021-26, the reference period is 2016-19). Resultantly, the individual share of States was slightly affected.

The 15th Finance Commission suggested that the Centre bring down the fiscal deficit to 4% of the GDP by 2025-26. For States, it recommended the fiscal deficit limit (as % of GSDP) of: 4% in 2021-22, 3.5% in 2022-23 and 3% during 2023-26. If a State is unable to fully utilise the sanctioned borrowing limit as specified during the first four years (2021-25), it can avail itself of the unutilised borrowing amount in subsequent years (within the 2021-26 period). Extra annual borrowing worth 0.5% of the GSDP will be allowed to States during the first four years (2021-25) upon undertaking certain power sector reforms in their respective States.

It has recommended grants of Rs 4,36,361 crore from the union government to local bodies for the period 2021-26. This is an increase of 52% over the corresponding grant amount of Rs 2,87,436 crore by its predecessor for the period 2015-20. The commission has also recommended grants amounting to Rs 45,000 crore to be tied to agriculture sector reforms in certain areas such as land lease, sustainable and efficient water use, export promotion and self-reliance in the production of oilseeds, pulses and wood-based products.

Views of States

Some States have expressed that the current tax devolution at 41% is not adequate to meet their budgetary provisions since the tax revenue itself had shrunk due to the impact of Covid 19 on tax collection. A few experts also opined that the concern of States with regards to the increase in cess and surcharge by the Centre appears to be genuine. Even though the shareable pool of tax revenue is 41%, the actual share works out to 30% of gross tax revenues. This results in financial stress on the States’ resources. It is observed that the share of cess and surcharge in gross tax revenue has nearly doubled to 19.9% in 2020-21 from 10.4% in 2011-12. This situation has perhaps compelled the 15th Finance Commission to recommend a higher grant-in-aid and lower tax devolution to States.

According to the latest FC award, the share in central taxes has declined for eight States — Andhra Pradesh, Assam, Karnataka, Kerala, Odisha, Tamil Nadu, Telangana and Uttar Pradesh. Karnataka is the biggest loser with a loss of 118 basis points of the share, followed by Kerala with 60 basis points and Telangana losing 40 basis points of share. Over the years, the States have been urging the Centre to either completely do away with cess/surcharge or bring them into the divisible pool. This way the States will get a greater share of devolution from the Centre’s net proceeds to meet their development targets.

Road Ahead

Some States, which are under pressure due to the pandemic, are facing a fiscal crisis that would adversely impact their development and welfare commitments in the coming years. After the outbreak of the pandemic, the average interest burden ratio for all the States, measured by interest payment as a percentage of revenue receipts, increased to 14.8% in 2020-21 from 12.7% in 2019-20. As a result, the average revenue deficit ratio for most of the States has worsened.

It is pertinent to mention that the net tax revenue is obtained by excluding cesses and surcharges, cost of collection of taxes and transfer to National Disaster Response Fund from gross tax revenue. Therefore, a higher pool size of cesses and surcharges diminishes the overall size of the divisible pool of tax cake. Since the States are constrained to generate new resources, it is imperative that the Centre brings in a suitable constitutional amendment to include cesses and surcharges into the divisible pool.

The Finance Commission, in addition to share in central taxes, recommends grants to States. There are other transfers to States too such as Grants through Niti Aayog and non-plan grants (non-statutory) through which the Centre helps the States.

There are certain taxes exclusively assigned to the States which they can handle at their discretion. These include taxes on land and building, professions, duties on liquor, luxury and entertainment, stamp duty, mineral rights and capitation tax. Thus, the size of revenue receipts can only increase marginally.
While determining the share of the States in the divisible pool of central taxes, it is necessary to look at the overall transfer relative to Centre’s gross revenue receipts.

(The author is former Assistant General Manager, Nabard)

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Author: Howard Caldwell