Financial Devolution of Taxes Among States

Devolution of taxes is crucial for fostering a cooperative federal structure. Read this article to know about the Divisible Pool of Taxes, Allocation Basis of Devolution and related challenges.

Table of Contents

Context: Southern Indian states have raised concerns about the unequal distribution of funds under the current financial devolution system. Recently, Tamil Nadu’s Chief Minister, M.K. Stalin, highlighted concerns about the Union government withholding funds for state projects.

Divisible Pool of Taxes

Defined by Article 270 of the Constitution, it includes taxes shared between the Union and States, like corporation tax, personal income tax, and central GST.
Distribution is based on Finance Commission (FC) recommendations, currently at 41% of the pool going to States.
Cess and surcharge levied by the Centre are excluded.

What is Tax Devolution?

Tax Devolution is the process of allocating tax net proceeds between the Union and the states.
Tax devolution is one of the core tasks of the Finance Commission constituted under Article 280 (3) of the Constitution.

Finance Commission

It is a constitutional body, constituted every 5 years by the Union Government as per Article 280.
Comprises a chairman and four members appointed by the President.
The qualifications for the chairman and members are specified in the Finance Commission (Miscellaneous Provisions) Act, 1951.
Recommends allocation of divisible pool and grants-in-aid to States.
Article 280(3)(a): Assigns the Finance Commission (FC) the duty to recommend how the net proceeds of taxes should be divided between the Union and the states.

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Allocation Basis of Financial Devolution Among States

Vertical Devolution: The 15th FC recommended a share of 41% of the divisible pool for states.
- This marked a slight decrease from the 42% recommended by the 14th Finance Commission.
Horizontal Devolution: Distributes the divisible pool among States using various criteria:
- Income distance: States with lower per capita income receive a higher share to promote equity.
- Population: Based on 2011 Census data, except in the 15th FC.
- Forest and ecology: Considers the proportion of dense forest in each State.
- Demographic performance: Rewards States with lower fertility rates.
- Tax effort: Encourages States with higher tax collection efficiency.

15th Finance Commission and Tax Devolution

Finance commission makes recommendations regarding the distribution of net proceeds of taxes between the Union and the States.
Share of states in central taxes: The share of states in the central taxes for the 2021-26 period is recommended to be 41%, same as that for 2020-21.
It is less than the 42% share recommended by the 14th Finance Commission for 2015-20 period.
The adjustment of 1% is to provide for the newly formed union territories of Jammu and Kashmir, and Ladakh from the resources of the centre.

Challenges

Cess and surcharge exclusion: Excluding these, estimated at 23% of Union tax receipts, reduces States’ share significantly.
Unequal returns: Some States get less than ₹1 for every rupee they contribute to Central taxes, highlighting disparity.
- For instance, industrially developed states like Maharashtra and Tamil Nadu often receive less than a rupee for every rupee contributed, while states like Uttar Pradesh and Bihar receive more, reflecting the principles of equity over efficiency.
Declining share for Southern States: Their percentage share in the divisible pool has been decreasing over the last few FCs.
Varying grants: Grants-in-aid recommended by the FC differ among States, leading to potential imbalance.

Way Forward

Expand divisible pool: Include a portion of cess and surcharge, with gradual phase-out of some levies.
Increase efficiency weightage: Consider State GST contribution as a criterion for horizontal devolution.
Formal State participation: Establish a more structured arrangement for States’ involvement in the FC.