Tax devolution refers to the distribution of tax revenues between the central government and the state governments. It is a constitutional mechanism, under Article 280(3)(a) of the Constitution of India, that mandates the Finance Commission (FC) to make recommendations regarding the division of the net proceeds of taxes between the Union and the states.
The concept of Fiscal Federalism includes the financial relations between units of governments in a federal government system. The Indian government recently released the third installment of tax devolution to state governments amounting to Rs 1,18,280 crore in June 2023.
Allocation and Distribution of this Devolution
From the recent release, Uttar Pradesh received the highest portion of allocation, Rs 21,218 crore, followed by Bihar with Rs 11,897 crore. Other beneficiaries include Madhya Pradesh, West Bengal, and Rajasthan. This allocation is aimed at allowing states to accelerate capital spending, finance their development or welfare related costs, and provide resources for priority projects or schemes.
Key Recommendations of 15th Finance Commission
The 15th Finance Commission recommended several changes in various areas. For Vertical Devolution, the share of states in central taxes for the period 2021-26 was recommended to remain at 41%, identical to the previous period. This is lesser than the 42% share suggested by the 14th Finance Commission for 2015-20. The reduction of 1% was meant to provide resources for the newly formed union territories of Jammu and Kashmir and Ladakh.
For Horizontal Devolution, the Commission advised assigning different weightages to various parameters such as demographic performance, income, population, area, forest and ecology, and tax and fiscal efforts. It also proposed post-devolution revenue deficit grants amounting to about Rs. 3 trillion over the five-year period ending FY26.
Performance-Based Incentives and Grants to States
The Commission recommended grants revolving around four main themes: social sector, rural economy, governance and administrative reforms, and power sector. Each of these was targeted at improving specific aspects of state administration, such as health and education in the social sector, agriculture and maintenance of rural roads in the rural sector, judicial reforms and statistics improvements in governance, and additional borrowing opportunities for the power sector.
Grants to Local Governments and Their Implications
The Commission proposed performance-based grants for incubation of new cities and health grants to local governments. For Urban local bodies with a population of less than a million, basic grants were proposed. For larger cities, performance-linked grants were suggested through the Million-Plus Cities Challenge Fund (MCF), tied to the cities’ performance in air quality improvement and urban drinking water supply, sanitation and solid waste management.
The Role of the FC in Maintaining Fiscal Federalism
The Finance Commission plays a crucial role in maintaining fiscal federalism through its recommendations regarding distribution of tax proceeds and allocation of taxes among states, augmenting resources of local governments, promoting the principle of cooperative federalism, and enhancing public spending and fiscal stability.
About the 15th Finance Commission
The Finance Commission is a constitutional body that defines the method for distributing the tax proceeds between the Centre and states, and among the states as per the constitutional arrangement and present requirements. The 15th Finance Commission was constituted in November 2017, under the chairmanship of NK Singh, and its recommendations will cover a period of five years from the year 2021-22 to 2025-26.
