Context

Financial devolution among States is a crucial aspect of India's federal structure, ensuring equitable distribution of resources and fostering balanced development across regions. At the core of this mechanism lies the role of the Finance Commission (FC), a constitutional body responsible for recommending the distribution of tax proceeds between the Centre and the States. Through its periodic assessments and recommendations, the FC plays a pivotal role in shaping fiscal relations and ensuring that States receive their fair share of resources. However, recent concerns raised by Opposition-ruled States, particularly those in southern India, have underscored disparities in revenue allocation, sparking debates about the efficacy and fairness of the current system.

Role of the Finance Commission

The Finance Commission, constituted every five years, serves as the cornerstone of India's fiscal federalism. Comprising a chairman and members appointed by the President, the Commission operates independently to assess the financial needs of States and make recommendations accordingly. Its mandate encompasses both vertical and horizontal devolution, determining the share of taxes allocated to States from the divisible pool and devising criteria for distribution among States. Additionally, the Commission advises on grants-in-aid, ensuring that States with specific needs receive adequate financial assistance. By providing an objective framework for resource allocation, the Finance Commission facilitates cooperative federalism and fosters balanced development across regions.

Basis for Allocation of Tax Revenue

The allocation of tax revenue to various States is guided by a set of criteria established by the Finance Commission. These criteria, ranging from income distance to demographic performance, are designed to account for disparities in economic development, population size, and environmental factors among States. For instance, income distance measures the gap between a State's income and the State with the highest per capita income, ensuring greater assistance to economically disadvantaged regions. Similarly, population and forest cover are taken into consideration to address demographic and ecological challenges. By incorporating these diverse parameters, the Finance Commission strives to promote equity and inclusivity in revenue distribution, reflecting the principles of cooperative federalism.

Trends in Divisible Pool Allocation

In recent years, concerns have emerged regarding the diminishing percentage share of the divisible pool of taxes allocated to southern States. Analysis spanning several Finance Commission cycles reveals a trend wherein southern States have experienced a gradual decline in their share of tax revenue. This phenomenon can be attributed to the emphasis placed on criteria such as income distance and population size, which tend to favor states with greater economic disparities and larger populations. Consequently, despite their significant contributions to tax collection, southern States find themselves receiving a decreasing proportion of the divisible pool, exacerbating disparities in resource allocation. Addressing this trend is imperative to uphold the principles of fiscal federalism and ensure equitable development across all States.

Challenges and Potential Solutions

The challenges surrounding financial devolution underscore the need for proactive measures to recalibrate the system and address existing disparities. One key issue pertains to the exclusion of cess and surcharge from the divisible pool, depriving States of a significant portion of tax revenue. To mitigate this, there is a compelling argument for enlarging the divisible pool by incorporating certain cesses and surcharges, thereby enhancing States' share of resources. Additionally, there is a pressing need to rebalance the criteria for horizontal devolution, placing greater emphasis on efficiency indicators such as tax effort. By rewarding States for their tax collection efficiency, the system can incentivize fiscal prudence and ensure a more equitable distribution of resources.

The Way Forward

In conclusion, achieving optimal financial devolution among States necessitates a nuanced approach that balances the principles of equity, efficiency, and federalism. While the Finance Commission serves as a critical institution in this regard, its recommendations must evolve to address emerging challenges and rectify existing disparities. Enlarging the divisible pool, reevaluating criteria for allocation, and enhancing State participation in the decision-making process are essential steps toward fostering cooperative federalism and promoting balanced development. By embracing these reforms, India can realize its vision of inclusive growth and equitable prosperity across all regions.

Source – The Hindu