Are States getting funds they are entitled from the Centre?

Agitations by Kerala and Karnataka governments highlight fiscal federalism issues in India, urging 16th FC to address inequalities.

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.

Within the domain of vertical devolution — that is the sharing of resources between the Union and States — there are two disturbing trends that need urgent redressal. First, the Union government has sought to keep an increasing share of its proceeds out of the divisible pool so that they need not be shared with States. Secondly, it has also not been devolving the shares of net proceeds to the States as mandated by successive FCs.

The net divisible pool, or net proceeds, is that part of the gross tax revenue from which a share would have to be vertically devolved by the Union to all States. Such shares are assigned by each FC for a five-year period. Earlier, all corporation taxes and customs duties were fully absorbed by the Union, and only income taxes and excise duties were shared with the States. However, with changes over the years, culminating in a constitutional amendment in 2000, all taxes of the Union were added to the net proceeds. But there was a catch — cesses and surcharges under Article 270 and Article 271 were kept out of the net proceeds. In the past, such exclusion of cesses and surcharges were based on specific FC recommendations. But the amendment in 2000 provided a constitutional basis for it. Presently, the net proceeds consists of the gross tax revenue after the deduction of cesses, surcharges and the cost of collection of taxes.

Over the past decade or more, several cesses and surcharges were introduced by the Union government. When the Goods and Services Tax (GST) was initiated in 2017, the expectation was that many cesses and surcharges would be discarded and subsumed into the GST system. On the contrary, new cesses and surcharges continued to be introduced, and many old cesses and surcharges remained outside the GST system. For instance, the Agriculture Infrastructure and Development Cess was introduced as recent as in 2021-22. Similarly, when the Health and Education Cess was introduced in 2017-18, it just replaced the Primary Education and Secondary Education cess on direct taxes. The expansion of cesses and surcharges have led to the exclusion of an increasing share of the gross tax revenue from net proceeds. Interestingly, there is conflicting information released by the government on the quantum of cesses and surcharges. In December 2022, responding to a question raised in the Rajya Sabha, the government stated that the share of cesses and surcharges in the gross tax revenue was 18.2% in 2019-20, 25.1% in 2020-21 and 28.1% in 2021-22. But responding to another question in the Lok Sabha in March 2023, the government stated that the corresponding shares were 15.6% in 2019-20, 20.5% in 2020-21 and 18.4% in 2021-22.

To obtain more accurate estimates of cesses and surcharges, this article uses disaggregated data from budget documents between 2009-10 and 2024-25. The collection of each type of cess and surcharge was separately recorded and added up, after giving due consideration to their occasional abolishment and/or merger with other taxes. The total collection of cesses and surcharges rose from ₹70,559 crore in 2009-10 to ₹6.6 lakh crore in 2023-24 (RE) and ₹7 lakh crore in 2024-25 (BE). These collections include the GST compensation cess, which is given to the States as per statutory requirements. If we deduct the GST compensation cess, the collection of cesses and surcharges rose from ₹70,559 crore in 2009-10 to ₹5.1 lakh crore in 2023-24 (RE) and ₹5.5 lakh crore in 2024-25 (BE). Considered as a share of the gross tax revenue, cesses and surcharges fell from 11.3% in 2009-10 to 9.5% in 2014-15, but then rose to 15.3% in 2018-19, a peak of 20.2% in 2020-21 and 16.3% in 2022-23. As per the tentative figures for 2023-24, cesses and surcharges are estimated at 14.8% of the gross tax revenue, which is still higher than the corresponding shares in 2009-10 or 2014-15 (see Chart 1).

Between 2009-10 and 2023-24, a cumulative total of ₹36.6 lakh crore was collected by the Union government as cesses and surcharges. An additional ₹5.5 lakh crore is projected to be collected as cesses and surcharges in 2024-25. This amount was not shared with States and was used solely by the Union government.

The Union government may argue that a part of this amount was used to finance centrally sponsored schemes and central sector schemes, while another part was used to provide non-plan grants or capital transfers to States. The problem, however, is that such transfers are not untied as is the case with the devolution of State’s share in central taxes. In centrally sponsored schemes, about 40% of the cost must be borne by the State governments. Even in central sector schemes, the contribution of the Union government is often meagre, and the State governments are forced to contribute significantly larger amounts to run the schemes meaningfully.