On financial devolution among States | Explained

Opposition-ruled States in South India demand fair share in tax revenue distribution, highlighting issues in financial devolution scheme.

The story so far: Recently various Opposition-ruled States especially from south India have claimed that they have not been receiving their fair share as per the present scheme of financial devolution. They have raised issues about their less than proportionate share of receipt in tax revenue when compared to their contribution towards tax collection.

Article 270 of the Constitution provides for the scheme of distribution of net tax proceeds collected by the Union government between the Centre and the States. The taxes that are shared between the Centre and the States include corporation tax, personal income tax, Central GST, the Centre’s share of the Integrated Goods and Services Tax (IGST) etc. This division is based on the recommendation of the Finance Commission (FC) that is constituted every five years as per the terms of Article 280. Apart from the share of taxes, States are also provided grants-in-aid as per the recommendation of the FC. The divisible pool, however, does not include cess and surcharge that are levied by the Centre.

The FC is constituted every five years and is a body that is exclusively constituted by the Union Government. It consists of a chairman and four other members who are appointed by the President. The Finance Commission (Miscellaneous Provisions) Act, 1951, has specified the qualifications for chairman and other members of the commission. The Union government has notified the constitution of the 16th Finance Commission under the chairmanship of Dr. Arvind Panagariya for making its recommendations for the period of 2026-31.

The share of States from the divisible pool (vertical devolution) stands at 41% as per the recommendation of the 15th FC. The distribution among the States (horizontal devolution) is based on various criteria. Table 1 lists the criteria for horizontal devolution among the States from the 11th to 15th FC.

The criteria as per the 15th FC can be briefly explained as follows. ‘Income distance’ is the distance of a State’s income from the State with highest per capita income which is Haryana. States with lower per capita income would be given a higher share to maintain equity among States. ‘Population’ is the population as per the 2011 Census. Till the 14th FC, weightage was given for the population as per the 1971 Census but that has been discontinued in the 15th FC. ‘Forest and ecology’ consider the share of dense forest of each State in the aggregate dense forest of all the States. ‘The demographic performance’ criterion has been introduced to reward efforts made by States in controlling their population. States with a lower fertility ratio will be scored higher on this criterion. ‘Tax effort’ as a criterion has been used to reward States with higher tax collection efficiency.

The Constitutional scheme has always favoured a strong centre in legislative, administrative and financial relations. However, federalism is a basic feature and it is important that States don’t feel short-changed when it comes to distribution of resources. While there are always political differences between the Union government and Opposition-ruled States that exacerbate the problem, there are genuine issues that need to be considered.

Firstly, cess and surcharge collected by the Union government is estimated at around 23% of its gross tax receipts for 2024-25, which does not form part of the divisible pool and hence not shared with the States. To provide a perspective, the total tax revenue for the year 2022-23 (actual), 2023-24 (revised estimates) and 2024-25 (Budget estimates) of the Union government is ₹30.5, ₹34.4 and ₹38.8 lakh crore respectively. The State’s share was/is ₹9.5, ₹11.0 and ₹12.2 lakh crore respectively, which constitutes around 32% of the total tax receipts of the Centre which is way less than the 41% recommended by the 15th FC. Cess like the GST compensation cess is for the repayment of loans taken to compensate States for the shortfall in tax collection due to GST implementation for the period 2017-22. Some of these amounts are also used for centrally sponsored schemes that benefit the States. However, the States have no control over these components.