Irregularities in Vertical Devolution

GS Paper II:

News Excerpt:

The recent agitations by the governments of Kerala and Karnataka, and the support extended by several State governments, have highlighted many disquieting issues in the practice of fiscal federalism in India.

  • These agitations show that the newly constituted 16th Finance Commission (FC) would have to proceed seriously and innovatively to justly address complaints of increasing vertical and horizontal inequalities in devolution.

Why is there a shrinking of the divisible pool? 

  • Declining Divisible Pool:
    • Over the past decade, a concerning trend has emerged with the divisible pool shrinking, impacting equitable resource allocation between the Union and the States.
    • The Union government's practice of retaining a larger portion of its earnings outside the divisible pool has led to reduced resources available for distribution among the States.
  • Proliferation of Cesses and Surcharges:
    • This has further complicated the financial landscape, despite initial expectations that the Goods and Services Tax (GST) would streamline taxation.
    • Continued development of additional cesses and surcharges has exacerbated the problem, contributing to the opaqueness surrounding fiscal operations.
    • Disaggregated data reveals a substantial increase in the collection of cesses and surcharges between 2009–10 and 2024–25, rising from ₹70,559 crore to ₹7 lakh crore.
    • States continue to face challenges in accessing their rightful share of the collected funds, exacerbating the issue of fiscal imbalance.
  • Lack of Transparency and Accountability:
    • Conflicting government data regarding the collection and allocation of cesses and surcharges has created transparency issues, hindering accountability in fiscal management.
    • Despite the legal mandate for States to receive a share of the GST compensation cess, a significant portion of the collected funds remains unavailable.

How does the rise in tied transfers impact fiscal autonomy?

  • Rise in Tied Transfers: Tied transfers are increasing alongside the diminishing divisible pool, burdening States with stringent requirements and impeding their fiscal management.
  • Financial Pressure from Central Programs: Central programs demand substantial financial contributions from State governments, exacerbating their financial burdens.
  • Constraints of Grant Conditionalities: Conditionalities attached to grants further restrict States' ability to address local priorities, perpetuating a patron-client relationship between the Union and States.
  • Transformation of Capital Transfers into Loans: Even seemingly beneficial capital transfers can transform into loans, adding to States' repayment obligations and financial strain.

What are the CAG's key indictments regarding the transfer and utilization of collected cess amounts in India?

  • Failure to Transfer Collected Amounts: 
    • The CAG reports highlight instances where collected amounts from various cesses, such as the Health and Education Cess, Research and Development Cess, and Swachh Bharat Cess, were either not transferred or transferred incompletely to the respective reserve funds as required by law.
  • Significant Shortfalls in Fund Transfers: 
    • The CAG found significant shortfalls in fund transfers, such as only 60% of the Health and Education Cess and a mere 9.6% of the Research and Development Cess being transferred to the designated reserve funds.
  • Impact on Fund Utilization: 
    • Non-transfers and short-transfers of cesses undermine the purpose of their collection, hindering the effective utilization of funds for their intended purposes, such as education, health, research, and clean energy.
  • Concerns of Fund Diversion: 
    • The findings raise concerns that cesses and surcharges may serve as a means to divert funds away from the divisible pool, potentially to meet other financial requirements of the central government, rather than being used for their specified purposes.

Deviations from FC Recommendations:

  • Continued Departures from FC Provisions
    • Despite claims of adherence to Finance Commission (FC) recommendations, empirical evidence suggests persistent deviations from the FC provisions regarding the allocation of net proceeds to States, indicating a serious constitutional irregularity.
  • Union Government's Failure to Meet FC Percentages:
    • Analysis reveals that the Union government consistently falls short of the percentages mandated by the FC, exacerbating vertical inequality and undermining fiscal federalism objectives.
  • States' Underpayment of Central Taxes: 
    • A comparative study demonstrates that States consistently fail to pay their share of central taxes, with cumulative shortfalls amounting to ₹5.61 lakh crore between 2009–10 and 2024–25 (BE), indicating a blatant violation of the constitution.
  • Pressing Need for Reform: 
    • The substantial deficit over multiple fiscal cycles underscores the urgent necessity for reform and realignment, signalling a departure from entrenched trends of fiscal centralization.

Way Forward:

  • Prioritize Fiscal Integrity: 
    • In order to overcome anomalies in vertical devolution, the 16th FC should concentrate on re-establishing fiscal integrity, transparency, and equity in the distribution of resources.
  • Adopt Comprehensive Measures: 
    • Provide precise net proceeds estimation, give States compensatory funds, and pass laws to prevent the spread of cesses and surcharges.
  • Promote Real Cooperative Federalism: 
    • Release funds from onerous conditions on the States so that they can independently handle regional concerns and promote real cooperative federalism.
  • Demonstrated Commitment to Reform: 
    • Stakeholders must show a resolute commitment to correcting systemic inequalities and preserving the values of fairness and openness in the distribution of resources.
  • Seize the Reform Opportunity: 
    • Through coordinated action and reform initiatives, the 16th FC has the opportunity to redefine fiscal federalism and usher in a period of inclusivity, accountability, and resilience.

Finance Commission:

The Union Cabinet chaired by Prime Minister Narendra Modi has approved the creation of three posts at the level of joint secretary for the 16th Finance Commission, chaired by Arvind Panagariya.

 What is the Finance Commission?

  • The Finance Commission is constituted by the President under Article 280 of the Constitution, mainly to give its recommendations on the distribution of tax revenues between the Union and the States and amongst the States themselves. 
  • Two distinctive features of the Commission’s work involve: 
    • Redressing the vertical imbalances between the taxation powers and expenditure responsibilities of the centre and the States respectively. 
    • Equalization of all public services across the States.

What are the functions of the Finance Commission?

 The Commission must make recommendations to the President as to— 

  • The distribution between the Union and the States of the net proceeds of taxes which are to be, or maybe, divided between them and the allocation between the States of the respective shares of such proceeds; 
  • The principles which should govern the grants-in-aid of the revenues of the States out of the Consolidated Fund of India;
  • The measures needed to augment the Consolidated Fund of a State to supplement the resources of the Panchayats in the State based on the recommendations made by the Finance Commission of the State;
  • The measures needed to augment the Consolidated Fund of a State to supplement the resources of the Municipalities in the State based on the recommendations made by the Finance Commission of the State;
  • Any other matter referred to the Commission by the President in the interests of sound finance.
  • The Commission determines its procedure and has such powers in the performance of its functions as Parliament may by law confer on them.

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