Fiscal Space and Finance Commission Impact on States

The fiscal space of state of Indias has seen notable changes in recent years. The 14th Finance Commission (FC) increased states’ share in central taxes from 32 to 42 per cent. This shift reversed the relative shares of revenue between the Centre and states. The 15th FC period, however, witnessed a slight decline in states’ fiscal space. The 16th Finance Commission’s recent report is expected to address these emerging concerns.

Changes in States’ Share of Central Taxes

The 14th FC raised states’ share in the divisible pool of central taxes from 32 to 42 per cent. This increased states’ share relative to combined revenue receipts from 15 per cent in the 13th FC period to 19.2 per cent in the 14th FC period. Consequently, states’ post-transfer revenue share rose from 63.85 to 68.08 per cent. This marked a reversal where states gained a larger fiscal share than the Centre.

Trends During the 15th Finance Commission Period

The 15th FC period saw a marginal fall in states’ total revenue receipts. Their fiscal space declined from 68.08 to 67.39 per cent of combined revenue receipts. Tax devolution share dropped by 1.05 percentage points to 18.2 per cent. This was partly offset by increased FC and non-FC grants. States’ own revenue receipts also fell slightly from 37.72 to 37.35 per cent. The number of states was reduced to 28, and the Centre raised non-sharable cesses and surcharges, which impacted states’ revenues.

Impact on High-Income States

Five high-income states—Haryana, Karnataka, Kerala, Maharashtra and Tamil Nadu—experienced no change in fiscal space between the 13th and 14th FC periods. The increase in central transfers was neutralised by a fall in their own revenues. However, comparing the 15th with the 14th FC periods, these states faced a decline in fiscal space by 0.38 percentage points. This was due to decreases in both own revenues and central transfers. The rise in non-sharable cesses and surcharges and the devolution formula contributed to this fall.

Challenges Ahead for States’ Revenues

States’ Goods and Services Tax (GST) revenues may face further pressure due to recent rate reductions under GST 2.0 and the discontinuation of the GST compensation cess. The Centre’s increase in non-sharable cesses and surcharges reduces the divisible pool. Both Centre and states need to boost their tax revenues to meet growing fiscal demands. A balanced system of transfers must ensure equity and reward contribution fairly.

Expectations from the 16th Finance Commission

The 16th FC is expected to revisit the weight given to criteria like distance in horizontal distribution. It may address concerns about shrinking fiscal space for states, especially high-income ones. The Centre should avoid raising non-sharable cesses and surcharges to protect states’ revenues. Both levels of government require enhanced resources to tackle multiple developmental challenges effectively.

Questions for UPSC:

1. Taking example of India’s Finance Commissions, discuss the role of fiscal federalism in balancing Centre-state financial relations.
2. Examine the impact of Goods and Services Tax reforms on the fiscal autonomy of state of Indias.
3. Analyse the challenges faced by high-income states in maintaining fiscal space when central transfers decline, and suggest measures to address this issue.
4. With suitable examples, discuss the importance of equitable resource distribution in a federal system and critically discuss how criteria like distance and population affect this distribution in India.

Answer Hints:

1. Taking example of India’s Finance Commissions, discuss the role of fiscal federalism in balancing Centre-state financial relations.

1. Finance Commissions recommend tax devolution and grants to ensure equitable resource sharing between Centre and states.
2. 14th FC increased states’ share in divisible central taxes from 32% to 42%, enhancing states’ fiscal space .
3. Grants (FC and non-FC) complement tax devolution to address vertical and horizontal imbalances.
4. Fiscal federalism balances autonomy and unity by allowing states financial independence while maintaining national cohesion.
5. Periodic FC reviews adjust transfers based on changing economic conditions and developmental needs.
6. Non-FC grants at Centre’s discretion can affect states’ fiscal autonomy, denoting need for transparent fiscal federalism.

2. Examine the impact of Goods and Services Tax reforms on the fiscal autonomy of state of Indias.

1. GST subsumed many state taxes, centralizing indirect tax collection but states get fixed compensation initially.
2. Recent GST 2.0 reforms reduced GST rates extensively, lowering states’ GST revenue collections.
3. Discontinuation of GST compensation cess removes a key revenue support for states, reducing fiscal space.
4. States’ dependence on Centre for grants may increase due to reduced own tax revenues under GST regime.
5. GST reforms have constrained states’ ability to independently raise revenues from indirect taxes.
6. States need to diversify revenue sources and improve tax administration to regain fiscal autonomy.

3. Analyse the challenges faced by high-income states in maintaining fiscal space when central transfers decline, and suggest measures to address this issue.

1. High-income states like Maharashtra, Karnataka faced decline in fiscal space due to fall in own revenues and central transfers.
2. Increase in non-sharable cesses and surcharges by Centre reduces divisible pool, disproportionately affecting these states.
3. Devolution formula may not adequately reflect contribution or needs of high-income states, causing revenue shortfalls.
4. Dependence on central transfers makes states vulnerable to policy changes at Centre.
5. Measures – Revise devolution formula to balance equity and contribution; reduce non-sharable cesses; enhance states’ own tax bases.
6. Encourage states to improve tax compliance and diversify revenue streams beyond central transfers.

4. With suitable examples, discuss the importance of equitable resource distribution in a federal system and critically discuss how criteria like distance and population affect this distribution in India.

1. Equitable resource distribution ensures balanced regional development and fiscal capacity across states.
2. Finance Commissions use criteria like population, income distance to allocate funds fairly among states.
3. Distance criterion favors geographically remote or difficult states needing more funds for infrastructure.
4. Population criterion ensures states with larger populations get adequate resources for public services.
5. Excessive weight to distance may reduce funds for populous or economically larger states, causing tensions.
6. Example – 16th FC expected to revisit distance weight to address concerns of high-income states losing fiscal space.