Centre will share 41% of the pie, but it has shrunk the pie itself

The final report of the Fifteenth Finance Commission (FFC) for 2021-22 to 2025-26 was tabled in Parliament on February 1 along with the Union Budget. This is the first Finance Commission to sit after India switched to a new indirect tax regime, called the Goods and Services Tax, and also the first to make its recommendations in the wake of a pandemic that has wreaked havoc on economies around the globe. Little surprise then that the title of the report itself was changed to ‘Finance Commission in COVID Times’.

Finance Commissions generally submit their reports for a five-year duration. The FFC was given an additional year due to uncertainties in key macro-areas such as new monetary policy framework, GST, bankruptcy code and demonetisation.

Since it was constituted at a time when India was undertaking wide-ranging reforms, the FFC was tasked not only with determining the traditional distribution between the Union and states of the net proceeds of taxes, but also with reviewing and commenting on the design of fiscal principles for various grants that are typically provided alongside revenue shares.

It was, in particular, asked to consider sector-specific and performance-based incentives to support and motivate the efforts of state and local governments in a variety of policy areas such as power, solid waste management and adoption of direct benefit transfers. It was also asked to recommend funding mechanisms for defence and internal security. While the Centre has agreed, in principle, to a non-lapsable defence fund, it has signalled it would not accept the recommendation of sector-specific grants.

In response to the prevailing pandemic and to build resilience to shocks, the FFC, for the first time, took a deep dive into the health sector. Overall, it recommended an enhanced public outlay for the sector and also proposed the creation of an All-India Health Service. It recommended that the spending on health by states should be increased to more than 8% of their budgets by 2022. Recognising the urgency of addressing the pandemic, it also sought to frontload the financial resources assigned for the health sector.

With the pandemic creating new challenges in the education sector, the Commission provided a grant for technological solutions, especially for higher education. Similarly, it has recommended grants for agricultural reforms and strengthening judiciary, and for local governments tied to their performance.

But what it would say on tax devolution, the most critical part of its recommendations, was the most keenly watched aspect because that is the major source of fund for the states. The Commission kept the division of the net proceeds of taxes collected by the Union government between the Centre and the states at 41%, almost the same as recommended by the 14th FC. The14th FC had recommended the divisible pool to be 42%. The adjustment of 1% has been done in view of the change of status of Jammu and Kashmir and Ladakh, funds for which will now be the Centre’s responsibility.

However, while the divisible pool looks the same as in the 14th FC in percentage terms, the actual amount of funds devolved will be much less because the Centre has reduced the divisible pie by building in cesses and surcharges into the levies, which are not shareable with the states, while reducing the shareable tax components. What is sharable is the net proceeds of only the taxes that the Centre levies and collects, such as income tax, corporation tax, central GST and excise duties.

“The divisible pool has been squeezed so much that the actual devolution will be much less than 41%. It will be even lower than the 32% that existed prior to the 14th Finance Commission,” Kerala Finance Minister Thomas Isaac told DH.

Over time, especially since 2014, the Centre has increased the share of cesses and non-shareable special excise duty components on commodities, including diesel and petrol, so much that the sharable taxes have been shrinking. Last year, the Centre amended the Finance Act to raise the limit up to which the government can raise special excise duty on petrol to Rs 18 per litre and diesel to Rs 12, from earlier limits of Rs 10 and Rs 4 respectively. In this year’s Budget, the Finance Act was amended to impose an agriculture infrastructure development cess of Rs 2.50 per litre on petrol and Rs 4 on diesel.

Currently, the Centre levies duties and cesses on diesel to the tune of Rs 31.80 per litre, of which only Rs 1.80 is shared with the states. Prior to 2014, the total central duties on diesel amounted to Rs 3.56 per litre. Similarly, on petrol, the current central levy is Rs 32.90, but the bulk of that is non-shareable excise and cess. Less than Rs 1.50 per litre is shared with the states.

Speaking to DH, former finance secretary Subhash Garg cautioned that after re-adjustment of cess and non-shareable excise, the divisible pool has been effectively reduced to 28-29%. The 41% recommended by the FFC is now a mirage.

The numbers in the Budget for 2021-22 confirm this. The Centre has pegged the tax revenue at Rs 22.17 lakh crore in the Budget. Based on that, it has pegged the share of the states at Rs 6.65 lakh crore. This puts the states’ share at a little more than 29%.

In contrast, the FFC has specifically asked the government to broaden the base for both direct and indirect taxes by reducing exemptions and improving compliance, without imposing a higher burden on the poor. It has implored against the Centre’s temptation to levy new cesses and surcharges that reduces the proportion of Union revenues eligible for transfers to states from the divisible pool. The Commission estimates cesses and surcharges to average 18.4% of gross tax revenue between 2021-22 and 2025-26.

The tax revenue of the Union and the states stood at about 17% of GDP in 2018-19 and has remained broadly constant since the early 1990s. At the same time, cesses and surcharges earmarked by the Centre have grown over time, amounting to about 15% of its gross revenue, reducing the proportion of Union revenues eligible for transfer to states from the divisible pool.

In contrast to India, tax revenue has been rising in other emerging markets and low-income countries as they narrow untapped revenue potential, or the tax gap relative to tax capacity.

The Finance Commission said that given the international trends, there is a compelling case for raising India’s tax ratio from both macroeconomic and redistributive perspectives, especially at the sub-national level. This is essential for building fiscal space, meeting social protection and infrastructure needs, and driving inclusive growth.

The Commission has also recommended a restructuring of GST and rationalisation of rates. However, several experts and chief ministers of states that DH spoke to said it would be better to leave the issue of GST to the GST Council. The Centre, however, has hinted it would take up rate restructuring in the next GST Council meeting.