What is vertical fiscal imbalance?

The article discusses the Vertical Fiscal Imbalance in Indian fiscal federalism and the need for increased tax devolution.

The financial relationship between the Union government and the States in India is asymmetrical, as in many other countries with a federal constitutional framework. As the 15th Finance Commission noted, States incur 61% of the revenue expenditure but collect only 38% of the revenue receipts. In short, the ability of the States to incur expenditures is dependent on transfers from the Union government. Consequently, there is the problem of Vertical Fiscal Imbalance (VFI) in Indian fiscal federalism where expenditure decentralisation overwhelms the revenue raising powers of the States.

Constitutionally, the financial duties of the Union government and the States are divided. On the revenue front, to maximise the efficiency of tax collection, the Personal Income Tax, the Corporation Tax and a part of indirect taxes are best collected by the Union government. But on the expenditure front, to maximise the efficiency of spending, publicly provided goods and services are best supplied by the tier of the government closest to its users. It is in this context that the extent of VFI merits attention.

The 15th Finance Commission had noted that India has had a larger, and rising, vertical imbalance than most other federations. These imbalances were further magnified during periods of crises, such as the COVID-19 pandemic, which drove a large wedge between one’s own revenues and expenditure responsibilities at the sub-national level.

The problem of VFI falls under the purview of the Finance Commission, and it deals with broadly two questions. The first question is how to distribute the taxes collected by the Union government to the States as a whole. These transfers are made as a prescribed share of the “Net Proceeds” (Gross Tax Revenue of the Union less surcharges, cesses and costs of collection). The second question is how to distribute taxes across States. The matter of VFI arises as part of the first question.

Apart from devolving taxes, the Finance Commissions also recommend grants to States in need of assistance under Article 275 of the Constitution. But these are generally for short periods and for specific purposes. There are also transfers to the States that fall outside the Finance Commission’s ambit. For example, the Union government spends substantial amounts — under Article 282 of the Constitution — on subjects falling in the State and Concurrent lists through centrally sponsored schemes and central sector schemes. But such grants are tied transfers that include conditionalities. In sum, the devolution of taxes from the net proceeds is the only transfer to the States that is untied or unconditional.

Here we try to estimate the VFI in India after the devolution of taxes to the States. We measure VFI at the level of “all States”, and not separately for each State. For this, we use a globally accepted method. We first estimate a ratio where the numerator is the sum of the Own Revenue Receipts (ORR) and the tax devolution from the Union government for all States. The denominator is the Own Revenue Expenditure (ORE) for all States. If this ratio is less than 1, it implies that the sum of own revenue receipts and tax devolution of the States is inadequate to meet the ORE of the States. If we subtract this ratio from 1, we get the deficit in receipts. It is this deficit that we use as a proxy for VFI after devolution.

We can then ask the simple question: how much should tax devolution rise over and above that recommended by the past Finance Commissions to equalise the ratio to 1? Equating the ratio to 1 would eliminate VFI. In the attached table, we show that the average share of net proceeds devolved to the States between 2015-16 and 2022-23 should have been 48.94% to eliminate the VFI. But the shares of tax devolution recommended by the 14th and 15th Finance Commissions were only 42% and 41%, respectively, of the net proceeds.