What is vertical fiscal imbalance?
The role of the 16th Finance Commission should be to eliminate vertical fiscal imbalance in federal relations. What should it do when revenues are concentrated with the Union government, and the States are burdened with expenditure responsibilities?
(1) Introduction
The concept of Vertical Fiscal Imbalance (VFI) refers to the mismatch between the revenue-raising capacities and expenditure responsibilities of different tiers of government. In India, this imbalance is evident in the fiscal relationship between the Union government and the States, where the Union collects a larger share of the revenues, while the States are responsible for a higher proportion of expenditures. This asymmetry creates a dependency of States on Union transfers, which is addressed by the Finance Commission. As India gears up for the 16th Finance Commission, a critical question arises: how can VFI be reduced to improve the fiscal autonomy and efficiency of States?
(2) What is Vertical Fiscal Imbalance?
Vertical Fiscal Imbalance occurs when there is a disparity between the financial resources and expenditure obligations of various levels of government in a federal system. In India, the Union government collects around 62% of the total revenue, whereas the States collect only 38%, despite being responsible for about 61% of the total public expenditure. This imbalance stems from the constitutional assignment of revenue and expenditure responsibilities, wherein the Union holds a majority of tax collection powers, and the States bear the burden of significant expenditure responsibilities like health, education, and social welfare.
(3) Reasons for VFI in Indian Fiscal Federalism
(i) Revenue Concentration with Union Government: The Union government holds the power to collect major taxes such as Personal Income Tax and Corporation Tax, while the States have limited revenue sources, primarily from GST, property taxes, and vehicle taxes.
(ii) Expenditure Decentralization: States are responsible for the delivery of most public services, such as education, health, agriculture, and social welfare. This creates a heavy expenditure burden on the States, outpacing their revenue capacity.
(iii) Centralized Decision-Making: The Union government’s control over a large share of fiscal resources and the centrally sponsored schemes (CSS) further limits the fiscal autonomy of the States.
(iv) Cesses and Surcharges: The Union government’s growing reliance on cesses and surcharges, which are not shared with the States, exacerbates the VFI. For instance, during 2022-23, cesses and surcharges made up a significant portion of Union revenue collections, but these do not form part of the divisible pool of taxes shared with the States.
(4) Role of Finance Commissions
The Finance Commissions, constituted under Article 280 of the Constitution, play a pivotal role in addressing VFI by recommending the distribution of Union revenues between the Union and the States and among the States. They assess the revenue and expenditure requirements of the Union and State governments and recommend the devolution of taxes, grants-in-aid, and other fiscal transfers.
(i) Tax Devolution: The Finance Commissions recommend the share of the States in the Union’s gross tax revenue. The 14th Finance Commission increased the States’ share to 42% from 32%, while the 15th Finance Commission slightly reduced it to 41%. However, even with this increase, VFI persists due to the exclusion of cesses and surcharges from the divisible pool.
(ii) Grants-in-Aid: Under Article 275, the Finance Commission recommends grants to States in need of assistance. These are specific-purpose grants aimed at addressing deficits or promoting particular sectors. However, these are temporary and tied to specific conditions, limiting the fiscal autonomy of States.
(iii) Centrally Sponsored Schemes (CSS): The Union government transfers funds to States through CSS, which fall outside the purview of the Finance Commission. These schemes often come with strict conditions, further reducing the States’ discretion over expenditure decisions.
(5) Need to Reduce Vertical Fiscal Imbalance
Reducing VFI is crucial for ensuring efficient and responsive governance at the sub-national level. The following reasons highlight the need to address this imbalance:
(i) Efficiency in Expenditure: Decentralized governance allows States to spend more efficiently on public services by being closer to the needs of their citizens. States can better assess the local demands for education, healthcare, and infrastructure and can spend in ways that maximize social welfare.
(ii) Fiscal Autonomy: Excessive dependency on Union transfers curtails the fiscal autonomy of States. States often have to comply with conditions imposed by the Union for receiving funds, which may not align with their priorities. Reducing VFI would give States greater flexibility in planning and executing their expenditure programs.
(iii) Cooperative Federalism: A balanced fiscal relationship between the Union and States is fundamental to cooperative federalism. Addressing VFI would promote more equitable and harmonious relations, fostering collaboration rather than competition between the two levels of government.
(iv) Addressing Crisis Situations: The COVID-19 pandemic exposed the vulnerabilities in India’s fiscal federalism, as the States were unable to generate sufficient revenue to meet the rising expenditure demands in health and social sectors. Reducing VFI would strengthen the fiscal capacity of States to deal with crises and enhance overall governance.
(6) Recommendations for the 16th Finance Commission
The 16th Finance Commission, which will be tasked with making recommendations for the next five-year period, has a critical role to play in reducing VFI. The following measures should be considered:
(i) Increasing the Share of Tax Devolution: The share of States in the Union’s divisible pool of taxes should be increased from the current 41% to at least 48.94%, as recommended by several experts. This would help States meet their own revenue expenditure more effectively.
(ii) Inclusion of Cesses and Surcharges in the Divisible Pool: The Finance Commission should consider including cesses and surcharges in the divisible pool. These are currently retained entirely by the Union, further reducing the States’ share of the gross tax revenue. Including them in the divisible pool would provide States with more untied funds.
(iii) Untied Transfers: The Finance Commission should emphasize increasing untied transfers to States. This would allow States greater freedom in deciding how to allocate resources, enhancing the responsiveness of public spending to local needs.
(iv) Strengthening Fiscal Responsibility Legislation: While enhancing devolution, the 16th Finance Commission should also work on improving the fiscal discipline of States. Strengthening fiscal responsibility laws, with penalties for non-compliance, could ensure that States use devolved funds judiciously.
(v) Equalizing Expenditure Needs: The Finance Commission should also focus on equalizing the expenditure needs of States. Special grants and assistance can be recommended for States with larger populations or those facing unique fiscal challenges.
(7) Conclusion
Vertical Fiscal Imbalance is a structural challenge in India’s fiscal federalism that has persisted despite several reforms. With the upcoming 16th Finance Commission, there is an opportunity to recalibrate the fiscal relationship between the Union and the States. By increasing tax devolution, including cesses and surcharges in the divisible pool, and enhancing untied transfers, India can move towards a more equitable and cooperative fiscal system. Such reforms are essential to empower States, improve the efficiency of public spending, and ensure a stronger and more resilient federal structure.
