Finance Commission – Issues related to devolution of resources

[op-ed snap] Another look at fiscal transfers

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Mains Paper 2: Polity | Functions & responsibilities of the Union & the States, issues & challenges pertaining to the federal structure

From UPSC perspective, the following things are important:

Prelims level: State Finance Commission (SFC)

Mains level: Role of finance commissions in fiscal federalism and changes proposed


NEWS

CONTEXT

Concept of federalism

  • Federalism is an old concept.
  • It is well known that the efficiency of a government depends on, among other factors, its structure.
  • In large countries, it has been felt that only a federal structure can efficiently meet the requirements of people from different regions.

The reason behind the existence of the present form of federalism

  • In our country during the independence struggle, provincial autonomy was regarded as an integral part of the freedom movement.
  • However, after Independence, several compulsions, which included defence and internal security, led to a scheme of federalism in which the Centre assumed greater importance.
  • Also in the immediate period following Independence, when the Centre and all States were ruled by the same party and when many of the powerful provincial leaders migrated to the Centre, the process of centralisation gathered further momentum.
  • Economic planning at a nation-wide level helped this centralising process.

What is Fiscal Federalism?

  • Fiscal federalism is the economic counterpart to political federalism.
  • Fiscal federalism is concerned with the assignment on the one hand of functions to different levels of government, and with appropriate fiscal instruments for carrying out these functions on the other.
  • The Central government must provide national public goods that render services to the entire population.
  • A typical example cited is defence.
  • Sub-national governments are expected to provide goods and services whose consumption is limited to their own jurisdictions.

Determinations of Raising of Taxes by different units of government

  • An equally important question in fiscal federalism is the determination of the specific fiscal instruments that would enable the different levels of government to carry out their functions.
  • This is the ‘tax-assignment problem’ .
  • In determining the taxes that are best suited for use at different levels of government, one basic consideration is in relation to the mobility of economic agents, goods and resources.
  • It is generally argued that the de-centralised levels of government should avoid non-benefit taxes and taxes on mobile units.
  • This implies that the Central government should have the responsibility to levy non-benefit taxes and taxes on mobile units or resources.

Problems in assigning different  taxing responsibilities  to different levels of government

  • Different Constitutions interpret differently what is mobile and what is purely a benefit tax.
  • For example, in the United States and Canada, both Federal and State governments have concurrent powers to levy income tax.
  • On the contrary, in India, income tax is levied only by the Central government though shared with the States.
  • Recognising the possibility of imbalance between resources and responsibilities, many countries have a system of inter-governmental transfers.

The provision in Indian Constitution regarding the division of taxes

  • The Indian Constitution lays down the functions as well as taxing powers of the Centre and States.
  • It is against this background that the issues relating to the correction of vertical and horizontal imbalances have been addressed by every Finance Commission, taking into account the prevailing set of circumstances.
  • However, Central transfers to States are not confined to the recommendations of the Finance Commissions.
  • There are other channels such as those through the Planning Commission until recently as well the discretionary grants of the Central government.

Recent changes in the division of tax proceeds

  • The Fourteenth Finance Commission has broken new ground in terms of allocation of resources.
  • One of its major recommendations has been to increase the share of tax devolution to 42% of the divisible pool.
  • This is a substantial increase by almost 10 percentage points.
  • The commission has argued that this does not necessarily affect the overall transfers but only enhances the share of unconditional transfers.
  • Over years, the performance of the Central government is judged not only on the basis of actions taken which fall strictly in its jurisdiction but also on initiatives undertaken in the areas which fall in the Concurrent and even State lists.
  • Today, the Central government is held responsible for everything that happens, including, for example, agrarian distress.
  • The Planning Commission was replaced by the NITI Aayog, which was simply a think-tank with no powers of resource allocation.

Way Forward

  • The Constitution should be amended and the proportion of shareable taxes that should go to the States fixed at the desired level.
  • The shareable tax pool must also include cesses and surcharges as these have sharply increased in recent years.
  • Fixing the ratio at 42% of shareable taxes, including cesses and surcharges, seems appropriate.
  • Another possible route is to follow the practice in the U.S. and Canada: of allowing the States to levy tax on personal income, with some limitations.
  • Also once this power is given to the States, the transfers from the Centre need adjustment.
  • There are issues relating to horizontal distribution. An appropriate balancing of criteria is needed particularly in the context of the rise in unconditional transfers.
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