The Union government is endowed with more tax powers than the States, while the States are assigned more expenditure responsibilities than the Union government. This gives rise to a vertical fiscal imbalance (VFI) between the Union and State governments.

 

Balance tax revenues with states

  • The Union government is endowed with more tax powers than the States, while the States are assigned more expenditure responsibilities than the Union government.
  • This gives rise to a vertical fiscal imbalance (VFI) between the Union and State governments that refers to the mismatch between the revenue-raising capacity and expenditure needs of the Centre and the States.
    • It equals one minus the ratio of the State’s own revenue to expenditure.
    • If this VFI ratio is zero, the States have enough own revenue to meet their own expenditure and there is no need for financial transfers.
    • If VFI ratio becomes more positive, it indicates that states own expenditure is exceeding its revenue owing to shrinking pool of taxes assigned or devolved to them.
  • Hence, Article 280 of the Indian Constitution attempts to correct this VFI by establishing Finance Commission every five years to deal mainly with the asymmetry between expenditure responsibility (of states) and revenue-raising authority (Union or GST Council).
  • However, this task to correct VFI remains unaccomplished by the Finance Commission.

 

What is the trend of VFI in India?

  • Increasing trend in VFI is being observed from the data for all the States over the periods of the last three Finance Commissions (2005-06 to 2020-21).
  • For the latest period of 2015-16 to 2020-21, the ratio was 0.530, which means that only 47% of the States’ own expenditure was financed by their own revenue in that period.
  • This was accompanied by four major changes as follows —
    • Expansion of divisible pool of taxes of the Union from two (income tax, corporation tax) to all (income tax, corporation tax, central GST and excise duties), thus enlarging the revenue base to be shared with the States.
    • Implementation of fiscal responsibility legislation to constrain the fiscal deficits of the States.
    • Dissolution of the Union Planning Commission, leading to the withdrawal of Plan grants.
    • Introduction of Goods and Services Tax (GST) in 2017.
  • These changes hence have considerably altered the States’ revenue structure leaving them with little revenue autonomy and more dependent on the Union government.
    • For instance, the withdrawal of the Union government’s plan grants and loans to the States has affected the States’ combined budget.
    • Only 40% of the State’s expenditure was financed by their own revenue as VFI ratio increased for the same period to 0.594 from 0.530 between FY15 to FY20.

 

What should be done?

  • Bringing revenue from petroleum products under states — The CGST and the excise duty on petroleum products could be assigned to the States. Presently, the Union government has exclusive power to levy excise duty on petroleum products, and the States have exclusive power to levy excise duty and sales tax on liquor.
  • Quash Union control — GST shall continue as a tax determined by the GST Council. However, the veto power of the Union government should be removed by constitutional amendments to Article 279A. This will enable the States to settle tax issues among themselves, with the Union government only facilitating the arrival of consensus among the States.
  • Address horizontal fiscal inequality by equalisation transfers — The tax base of the GST, namely consumption, is not equally distributed among the States. The unequal tax base with unequal expenditure requirement between the States creates horizontal fiscal imbalance among the States. Thus, the Union government should allocate equalisation transfers (like grant-in -aid) to address the State’s fiscal capacity and expenditure needs and mitigating regional differences.
  • Assigning entire commodity tax to the States — Commodity taxation should be moved to State List II of the Seventh Schedule of the Constitution. The collection of commodity tax revenue by each State will then be a function of the size and structure of its economy and its efficiency in tax administration.

 

Conclusion

Reassigning taxing powers to the States is the ideal fiscal federalism in a market-driven economy. It will provide freedom for the States to chart their strategy of economic development, with the Union government playing the essential role of regulation of markets.

 

SourceThe Hindu

 

QUESTION – An overhaul of the GST regime can improve the vertical fiscal imbalances between the Union and the states in India. How? Discuss in brief.