India adopted asymmetrical political federalism where Centre was more powerful compared to States, which translated into asymmetric fiscal federalism as well.
Fiscal union and its functioning has become an important issue after the Eurozone crisis. Fiscal union implies having a Federal government/Central agency which could transfer funds to needy states in the union. One of the key reasons for escalation of Eurozone crisis is lack of fiscal union in the zone. The periphery economies of Greece, Ireland etc. faced a shock and could not get funds from any such central agency. They could also not devalue their currency as monetary policy role remained with European Central Bank. As a result they had to go for internal devaluation and impose fiscal austerity on their public leading to wide outcry. A fiscal union would have alleviated these financing concerns. Comparisons have been made with United States where needy States like California and Florida have got share of funds from the Federal government.
Role of Finance Commission
- Article 280 of the Constitution mandates formation of Finance Commission (FC) every five years. At present, we have 14th FC being setup(Chaired by Dr. Y V Reddy - Ex RBI Governor), which has to give its recommendation by 31st Oct, 2014. Its recommendations will cover the five year period commencing from 1st April, 2015.
- The Commission provides the basis for sharing Central taxes with States and also provides for certain Grants-in-Aid to States for special purposes. The Commission is appointed by the President and it has a Chairperson and four members.
- In India, while the Central govt has greater access to most of the important and buoyant revenue sources, the state govts have to face major expenditure responsibilities in the social and economic sectors. The distribution of taxation powers is intended to minimise tax problems in a federal set-up, such as double taxation, tax rivalry among States, duplication of tax administration and tax evasion. So to avoid such conflicts b/w states, majority of tax rights have been assigned to central govt. from the beginning. So while state govt. collects only 1/3rd of the total tax revenue accruing to the govt sector, its expenditure obligations are disproportionately high. This creates an imbalance where centre collects more revenues while states have to spend the money. This imbalance is called "vertical imbalance".
- Apart from this, the existence of vast regional disparities contributes to horizontal imbalances among States in terms of their resource capacity relative to their expenditure responsibilities. e.g. Comparing resource mobilization capacity of any NE states with that of Gujarat?
- This is where Central Finance Commission plays an important role, to ascertain the precise estimation of the quantum of resource transfers to address the vertical and horizontal imbalances.
- The Commission reviews both the Centre and State finances and places its recommendations before the Parliament.
- Broadly the role of Finance Commission is:
- Distribution of taxes between the Union and the States
- Distribution within states
- Distribution to Urban local Bodies and Rural Panchayats
- Any other matter referred to the Commission by the President in the interests of sound finance. E.g. 13th FC was asked to provide a roadmap for fiscal consolidation. 14th FC has been asked to look at pricing of public utility services like drinking water, irrigation, water, power, etc. and ways to make PSUs competitive and markets oriented.
- Finance Commission - Share of Taxes
- Vertical Transfers - From Centre to State
|Recommended Share of States in Major Divisible Taxes|
As we can see from above table that till 10th FC, only income tax and basic excise duties were shared with States. Even within excise duties, the number of items/commodities covered has increased from 3 commodities in 1st FC to All commodities from 4th FC period onwards. Its only from 11th FC onwards (2000-05), that all the taxable resources (income tax, corporate tax, customs etc. – post 80th Constitutional Amendment) are shared except for cesses and surcharges levied by the Centre. As per the Constitution, the cesses and surcharges are levied for specific purposes and are not to be shares with States. However, 13th FC reported that share of cesses and surcharges in total Centre’s taxes have increased considerably from 3.5% in 2001-02 to 13.6% in 2009-10. States had requested 13th FC to include cesses and surcharges in the divisible pool. Hence, the 13th FC recommended that the Centre reduce share of cess and surcharges in the gross tax revenues. However, this would require Constitutional amendment.
Another issue is sharing of non-tax resources of the Centre with States. 13th FC noted that Non-tax revenues as a percentage of GDP was expected to rise on account of auction of 3-G spectrum, offshore oil and gas reserves etc. However, for sharing non-tax revenues of the Centre will require a Constitutional amendment.
- Horizontal Transfers – Division of centre’s share of tax between states
Once, FC determines the vertical transfer from Centre to States it also needs to arrive at Horizontal transfer which is distribution of States’ share of central tax revenues within different States. FC has looked at different sharing formulas over the years.
1. Population - The larger population States would get higher share of the tax resource pool. So UP will get more weight in this criteria than say Punjab. Census 1971 is taken for population figures.
2. Area of State – Logic used was that, state with larger area has to incur additional administrative costs to deliver a comparable standard of service to its citizens. However one thing to be noted here is that the costs of providing services would increase only at a diminishing rate, and beyond a point, incremental costs may become negligible. Hence FC accordingly made adjustments for it.
3. Income Distance - Taxation capacities of States differ highly, specially between Special Category States (SCS) and Non Special Category States (NSCS).
4. Fiscal Discipline - Incentive to States managing their finances prudently. So a Gujarat would get more weight age than say West Bengal on this criteria
- Finance Commission - Share of Grants-in-Aid
- Under Article 275 (1) of the Constitution, certain Grants-in-Aid could be given to different States for special purposes like Grants for development areas like education, improvement in justice delivery, Incentive for issuing UIDs, disaster relief etc. If GST is implemented (whenever), Centre would transfer compensation (for revenue loss of state) through this cost centre.
- Unlike transfer of Central taxes, in case of Grants-in Aid calculations differ as nature of Grants are different. In the Union Budget these Grants-in-Aid are categorized in Non-Plan Expenditure and further classified as Revenue expenditure.
- Role of Planning Commission in State Finances
- Apart from Finance Commission, Centre transfers funds to States, via other mechanisms as well. Planning Commission plays a central role in this transfer of funds. Basically Centre provides Plan funds for two purposes. In both, the Planning Commission plays a critical role:
1. Assistance to States’ Plan: Centre contributes to financing Plan expenditure of States. Earlier, this assistance used to be provided mainly via loans from Centre. However, 12th FC asked Centre to provide most funds in form of Grants and encouraged States to borrow directly from markets. Since then share of loans from Centre has declined and most of plan transfers happens in form of grants. This move also helped in development of State Development Loan market.
2. Centrally Sponsored Schemes (CSS): It is designed by Centre in consultation with Planning Commission (ICDS, NREGA, NRHM, PMGSY, SSA etc). There is no fix formula for sharing funds and it differs across schemes (50:50, 75:25 etc). Earlier most of CSS were fully Centre sponsored and now States also have to share the financing of these schemes. This has added to further burden on the States. (Recently Narendra Modi was talking about this with the press after his meeting with PC).
- Centre channelizes funds for both State Plan and CSS via various Ministries.
- In Finance Commission recommended transfers, one has clarity on the nature of devolvement to States. In Planning Commission recommended transfers the clarity is relatively less as these are finalized before the Union Budget with Centre and States in the annual National Development Council meeting.
- Just as seen in the case of Finance Commission, there is a need to look at horizontal transfers in these Planning Commission funds as well. Planning Commission follows Gadgil-Mukherjee formula to divide these funds across the twenty-eight States.
Special Category Status
The concept of a special category state was first introduced in 1969 when the 5th Finance Commission sought to provide certain disadvantaged states with preferential treatment in the form of central assistance and tax breaks.
Initially three states Assam, Nagaland and Jammu & Kashmir were granted special status but since then eight more have been included (Arunachal Pradesh, Himachal Pradesh, Manipur, Meghalaya, Mizoram, Sikkim, Tripura and Uttarakhand).
The rationale for special status is that certain states, because of inherent features, have a low resource base and cannot mobilize resources for development.
Some of the features required for special status are:
- hilly and difficult terrain;
- low population density or sizeable share of tribal population;
- strategic location along borders with neighbouring countries;
- economic and infrastructural backwardness;
- non-viable nature of state finances.
The decision to grant special category status lies with the National Development Council, composed of the Prime Minster, Union Ministers, Chief Ministers and members of the Planning Commission.
Why different state CMs are clamouring for “Special Category Status(SCS)” for their states?
- The main assistance from centre to state plan comes through Normal Central Assistance (NCA), which 30% of the share goes to 11 special category states and the remaining 70% to remaining 17 states. Moreover special category states get 90% of the NCA as grants and remaining 10% as loans.
- For SCS states share of Central govt. in CSS is also more. So if for NSCS state CSS share becomes 75:25, couple of years after its intro, for SCS states, it remains 90:10 for a long time.
- SCS states also get special central assistance(SCA) as shown in figure above.
- Grants from FC also gets distributed in separately for 11 SCS states 30% and all other NSCS states 70%.
- Special category states also receive special assistance addressing features like hill areas, tribal sub-plans and border areas.
- Beyond additional plan resources, special category states can enjoy concessions in excise and customs duties, income tax rates and corporate tax rates as determined by the government.
Check this excel sheet where I have shown the % of central assistance to Annual State Planned outlay. Special category statuses clearly get lots of benefits from centre. Access Excel Sheet here