Fiscal Federalism in Focus: Debate Over Retaining 41% Tax Devolution to States

Why in the News ?

The Government of India has accepted the Sixteenth Finance Commission of India recommendation to retain 41% tax devolution to States from the divisible pool of central taxes.

While this decision maintains the existing share recommended by the Fifteenth Finance Commission of India, it has triggered debates over the evolving nature of fiscal federalism in India, particularly regarding:

• Shrinking divisible pool due to cesses and surcharges
• Changes in allocation criteria among States
• Rising fiscal stress in several State governments

Fiscal Federalism in India

Fiscal federalism refers to the distribution of financial powers, taxation authority, and expenditure responsibilities between different levels of government in a federal system.

In India, it governs how tax revenues are shared between the Union government and State governments to ensure balanced development and efficient governance.

Constitutional Framework

The Constitution provides a clear framework for fiscal relations through several provisions:

• Articles 268–281 of the Constitution of India: Define taxation powers and revenue-sharing mechanisms between the Union and States.
• Article 280 of the Constitution of India: Provides for the establishment of the Finance Commission to recommend tax devolution and grants.
• Seventh Schedule of the Constitution of India: Divides taxation powers among the Union List, State List, and Concurrent List.

Since the Union government collects a significant portion of taxes, a redistribution mechanism is required to ensure equitable allocation across States. This role is performed by the Finance Commission.

Evolution of Tax Devolution

Over time, the share of central taxes devolved to States has increased.

• The Fourteenth Finance Commission of India raised the States’ share to 42% of the divisible pool.
• After the reorganisation of Jammu and Kashmir, the Fifteenth Finance Commission of India slightly reduced the share to 41%.
• The Sixteenth Finance Commission of India has now recommended continuing the 41% share.

Although the percentage has remained stable, debates have emerged about whether the actual transfers to States have effectively declined.

Understanding the Divisible Pool

The divisible pool refers to the portion of central tax revenues shared between the Union government and the States.

However, not all tax revenues are included in this pool.

Excluded Components

Certain revenues such as cesses and surcharges are not shared with States and are retained entirely by the Centre.

These levies are often imposed for specific purposes, such as:

• Education
• Infrastructure development
• Health initiatives

Declining Share of Divisible Pool

According to Finance Commission data, the divisible pool’s share of gross tax revenues has gradually declined:

• 13th Finance Commission period: about 89.2%
• 14th Finance Commission period: about 82.1%
• 15th Finance Commission period: about 78.3%

This means that even though States receive 41% of the divisible pool, the base itself has become smaller, leading to concerns among States about declining fiscal transfers.

Recommendations of the Sixteenth Finance Commission

The Sixteenth Finance Commission of India evaluated the fiscal position of both the Union and the States and made several recommendations.

Key Recommendations Accepted

The Union government accepted several major proposals:

• Retaining 41% tax devolution to States
• Continuing the horizontal distribution formula among States
• Providing grants to local bodies
• Supporting the disaster management funding framework

Structural Reforms Deferred

However, some important structural reforms were deferred for future consideration, including:

• Reform of Fiscal Responsibility Legislation (FRL) frameworks
• Regulation of off-budget borrowings by States
• Reforms in power distribution companies (DISCOMs)
• Rationalisation of subsidies

The government indicated that these issues would be examined separately in the future.

Structural Issues in State Finances

The Finance Commission’s report highlights growing fiscal stress in several States.

Examples of State Debt Levels

• Punjab – Debt-to-GSDP ratio around 42.9% (2023–24)
• Rajasthan – Liabilities about 37.9% of GSDP
• West Bengal – Liabilities about 38.3% of GSDP
• Andhra Pradesh – Liabilities about 34.6% of GSDP

In many cases, borrowing is used to finance revenue expenditure such as salaries, subsidies, and interest payments rather than productive capital investments.

Concern Over Off-Budget Borrowing

Some States engage in off-budget borrowing, where government-controlled entities borrow funds and repayments are made using public resources.

This practice:

• Keeps liabilities outside official fiscal deficit figures
• Reduces fiscal transparency

The Finance Commission recommended tighter regulation of such borrowing practices.

Changes in the Horizontal Devolution Formula

The Finance Commission also revised the formula used to distribute funds among States.

Previous Criterion

Earlier, the formula included tax and fiscal effort, rewarding States that improved tax collection efficiency relative to their economic capacity.

New Criterion

The new formula introduces a “contribution to GDP” indicator, assigned 10% weight in the allocation formula.

Likely Impact

States with strong economic output such as:

• Maharashtra
• Gujarat
• Karnataka

may benefit from this criterion.

However, poorer States such as:

• Bihar
• Jharkhand
• Uttar Pradesh

may benefit less because they rely more heavily on central transfers.

Critics argue that this change could weaken the principle of fiscal equalisation, which aims to support less-developed States.

Local Body Grants

Finance Commission transfers also include grants to local governments.

The Sixteenth Finance Commission recommended ₹7,91,493 crore in grants for rural and urban local bodies.

Types of Grants

1. Basic Grants

These support essential functions of local governments such as sanitation, water supply, and administration.

2. Performance Grants

These are released only if certain conditions are met, including:

• Timely constitution of State Finance Commissions
• Maintenance of audited financial accounts
• Compliance with national data reporting systems

Implementation Challenges

During the previous Finance Commission period, only about 62.6% of recommended urban local body grants were actually released, highlighting administrative and compliance challenges.

Implications for India’s Fiscal Federalism

Recent developments reflect important trends shaping fiscal federal relations.

1. Growing Centre–State Asymmetry

Increasing reliance on cesses and surcharges allows the Union government to retain a larger share of revenues.

2. Shift in Allocation Principles

Greater weight given to GDP contribution may favour economically stronger States.

3. Delayed Structural Reforms

Key reforms related to fiscal discipline, subsidies, and power sector finances remain unresolved.

4. Fiscal Stress in States

Rising debt levels and off-budget borrowing indicate growing fiscal challenges for State governments.

5. Evolution of Cooperative Federalism

The debate over tax devolution reflects broader discussions about balancing fiscal autonomy with national economic coordination.

Significance

The debate surrounding the 41% tax devolution highlights the evolving dynamics of India’s federal system.

Ensuring a fair distribution of financial resources is essential for:

• Balanced regional development
• Fiscal stability of States
• Effective governance at local levels

The Finance Commission remains a crucial institution in maintaining cooperative fiscal federalism in India.