BY NAGESHWAR PATNAIK IN Bhuaneswar, Februaryb 17, 2021: India is not just the largest democracy in the world, but also the largest federal nation with 29 states and 7 Union Territories. The Constitution of India makes a clear demarcation between the functions and finances for each level of Government and assigns responsibilities and powers to each level of Government following the principle of comparative advantage. The federal system of India, however, has not been able to implement the principle—“finances follow functions” successfully and shows an inherent “centripetal” bias in the division of fiscal powers.

Way back in 1990, the then Odisha chief minister Biju Patnaik virtually threw a gauntlet at the centre by demanding ‘fiscal autonomy’. Ever since many states have sought more fiscal freedom and even the present chief minister, Naveen Patnaik has raised his father’s demand saying that the centre is not discharging its constitutional responsibility of enshrining true federal spirit.

The assignment of functions and finances following the principle of comparative advantage has resulted in significant “vertical fiscal imbalances.” In terms of revenue authority, the Constitution vests important powers in fiscal matters with the Centre and also gives it an inherent advantage in raising revenues from the most buoyant, broad-based, mobile, and progressive tax sources (e.g., corporation tax, customs, personal income tax, service tax, excise duty), creating a relatively centralized nation.

The States, on the other hand, are assigned some relatively less buoyant taxes like a tax on agricultural income and wealth, registration fees, excise duty on sale of alcoholic products, stamp duties, tax on purchase and sale of goods, motor vehicle tax, tax on passengers and goods transported through inland waterways and roads, general sales tax and so forth. However, from a revenue productivity viewpoint, only tax on the purchase and sale of goods has proven to be important.

The State Governments fall short of resources to meet their expenditure requirements on their own, leading to deficits at State level and vertical fiscal imbalance at the Centre–State level. The Constitution of India, recognizing the mismatch between revenue capacity of the States and its expenditure needs, has mandated formation of a Finance Commission under Article 280 every 5 years to make recommendations on the assignment of revenues (includes those taxes which are levied by the Centre) to States, share the proceeds of certain centrally levied taxes with the States, and provide the States grants-in-aid (Article 275).

The 80th Amendment to the Constitution in 2000, made a provision to share all the Central taxes with the States, laying the foundation of fiscal decentralization in India’s federal system. These transfers constitute a significant portion of the total revenue receipts of the States and play a significant role in bridging the resource gap between their expenditure commitments and their resources.

The FC report was laid before the Parliament and the finance minister announced the acceptance of its recommendation of retaining the share of states in central taxes at 42 per cent. She also stated that on its recommendation revenue deficit grants of Rs 1.18 lakh crore to the states have been provided for in the budget.
The share of states in the centre’s taxes is recommended to be decreased from 42% during the 2015-20 to 41% for 2020-21. The 1% decrease is to provide for the newly formed union territories of Jammu and Kashmir, and Ladakh from the resources of the central government. Some of the recommendations have far-reaching implications on government finances, both of the Centre and the states.

“We believe that there is a strong case for enhancing this to 1 per cent of the divisible pool in order to meet the security and other special needs of the Union Territories of Jammu and Kashmir and Ladakh. Since this enhancement has to be met from the Union’ Government’s resources, we recommend that aggregate share of States may be reduced by 1 percentage point to 41 per cent of the divisible pool. Therefore, we recommend an aggregate share of 41 per cent of the net proceeds of Union taxes (divisible pool) to be devolved to States in the year 2020-21”, the Commission observed.

The states will forgo Rs 16,000 crore due to slashing of one per cent of the divisible pool, notwithstanding the fact that the first charge on taxes collected is devolution and statutory commitments, not the Centre’s expenditure. This move is in line with the system envisaged in the Constitution, which is clear on the charge of revenues collected. This is first time, a finance commission has carved out resources meant for distributable statutory grants and dipped into the states’ revenue share, as against the tax share, in order to finance the Centre’s exclusive expenditure obligation. What has been done is not in line with the system envisaged in the Constitution. The Constitution is very clear on the charge of revenues collected.

This move of earmarking and financing the Centre’s expenditure from the states’ money heralds a significant departure from the much hyped cooperative federalism. So far, the Centre has been used to pre-empt resources from the kitty to be distributed among the states but only to finance expenditures in areas earmarked for states. This was done through the centrally-sponsored schemes, but at least the states’ money was being used in the states, even if on a discretionary rather than a criteria basis.

The 15th FC also did little on redesigning the “revenue gap-filling” though compensation law provides minimum-guaranteed revenue of 14 per cent to every state. The revenue deficit grants have been carried forward. Consequently, the total grants, statutory and non-statutory, account for almost 55 per cent of the total transfers — up from less than 50 per cent in recent years. The share of tax devolution in aggregate transfers has dropped to 45 per cent, making the system more discretionary.