Mint Explainer: How the transfer of funds from the Centre to states is decided

Karnataka chief minister Siddaramaiah led a protest in New Delhi on 7 February to press for a more equitable share in central taxes for the state. The following day, Kerala chief minister Pinarayi Vijayan led another protest against the Centre’s fiscal policy towards states. 

The Kerala government has also approached the Supreme Court against the Centre’s decision to reduce its borrowing limits, overstepping the approved recommendations of the Finance Commission.

The Union government, in turn, has blamed these states for mismanaging their finances.

Prime minister Narendra Modi in a cutting retort said the Opposition parties, particularly the Congress, were trying to create a North-South divide. Finance minister Nirmala Sitharaman said the share of taxes and grants transferred to states was based on a formula recommended by the Finance Commission and not on the whims of the Union government. 

Mint explains how central taxes are shared with states and how transfers such as grants-in-aid are decided.

 

Why do states need a share of the Centre’s tax collections?

India has a three-tier federal tax system, with the powers of the Centre, states, and local bodies to collect taxes clearly demarcated. 

The Central government has the power to collect taxes on incomes of individuals and businesses, as well as indirect taxes such as the central goods and services tax, integrated goods and services tax, and customs. The Centre also collects surcharges and cesses on taxes. 

States collect state GST, stamp duty, land revenue, state excise, and professional tax. Local bodies collect property/house tax, tolls, and taxes on utilities such as electricity and water. 

Taxes on petroleum products are among the major sources of revenue for the Centre and states–the Centre levies excise duties while states levy value-added tax.

Taxes on the incomes of individuals and businesses are an important source of revenue, accounting for more than 50% of the Centre’s gross tax revenue. Central excise duty on petrol and diesel accounts for another 10%.

This structure creates a fiscal imbalance because the Central government collects a larger share of taxes, while states are responsible for providing social services such as education and healthcare, as well as for developing infrastructure such as roads, public transportation and utilities such as electricity and water and sewerage networks.

Their tax collections alone are too little for states to pay for all their expenditures.

 To address this imbalance and ensure equitable development across the country, the founding fathers of the Constitution provided that the Centre shall share its tax revenues with the states as well as provide grants from the Consolidated Fund as per a formula decided by the Finance Commission every five years.

Central taxes that are shared with states go into a divisible pool, and cesses and surcharges are excluded. Thus, the Centre gets to keep the entire collection of cesses and surcharges.

How does the Finance Commission decide on transfers to each state?

As required by the Constitution, a new Finance Commission is constituted usually every five years and its terms of reference notified. Its primary role is to determine the ratio in which central taxes in the divisible pool should be shared between the Centre and the states (vertical devolution), and the share of each state (horizontal devolution). 

The commission is also required to recommend principles that should govern the transfer of grants-in-aid of revenues to states.

The Centre may notify various parameters that the Finance Commission should consider when determining the awards. For instance, when the Fifteenth Finance Commission was constituted with N.K. Singh as the chairman in November 2017, it was told to use the Census data of 2011 while making its recommendations. 

The Fourteenth Finance Commission chaired by Y.V. Reddy used the 1971 population (like the previous panels) but gave some weight to the 2011 population to capture demographic changes though it had no such directions in the terms of reference. The Reddy-led panel felt it would have been unfair not to consider the 2011 Census.

Other than population, Finance Commissions consider steps taken by individual states to stabilise population growth and outcomes on education, health and nutrition, income distance, and tax and fiscal measures. 

They also take into account a state’s land area and forest and ecology while determining the horizontal devolution. 

The Fifteenth Finance Commission gave income distance the highest weight (45%) for determining the horizontal devolution, and this ensured poorer states got a greater share in the transfers. Population was given a 15% weight and demographic performance 12.5%.

The commissions have to also consider the impact of implementing the goods and services tax on state finances while determining the devolution formula. Suggestions and demands put forward by all stakeholders–Centre, states, local bodies, government agencies, and domain experts–during multiple consultations over the two-year tenure of the Commission, as well as findings of various studies commissioned, are considered before finalising awards, though not all such demands are accepted. 

The Fourteenth Finance Commission raised the share of states in the Centre’s divisible pool of taxes to 42%, from 32% awarded by the Thirteenth Finance Commission. This ratio was retained by the N.K. Singh panel, with 1% of the pool set aside for Jammu & Kashmir and Ladakh, and 41% for 28 states.

Are there any other fund transfers from the Centre to the states?

Central ministries run various centrally sponsored schemes and central sector schemes that are implemented in the states. While the central government fully funds central sector schemes, states have to foot a part of the bill for many centrally sponsored schemes that they implement. 

Budget documents show that the Centre transferred ₹4,05,918 crore to states for centrally sponsored schemes in 2022-23, and that it intends to raise that to ₹4,39,314 crore in the current fiscal year. 

The transfers under central schemes were ₹12,867 crore in 2022-23, and will rise to ₹64,172 crore this year. Transfers worth ₹1,48,098 crore were made under ‘other categories expenditure’ to states in 2022-23, which for the current year is estimated at ₹1,32,712 crore. Such transfers were also made to union territories.

Centrally sponsored schemes include MGNREGS, PM Awas Yojna, Jal Jeevan Mission, and National Health Mission. Central sector schemes include PM Kisan, Crop Insurance Scheme, Regional Connectivity Scheme, and Production Linked Incentives.

That apart, states get loans from the Centre for externally aided projects and as special assistance for capital expenditure. The budget documents show the sum of all transfers from the Centre to states and union territories at ₹18,64,615 crore for 2022-23, of which ₹9,48,406 crore, or 51%, was devolution of states’ share in central taxes.

What is the grievance of states such as Karnataka and Kerala?

When the N.K. Singh panel drew up the inter se shares of states in the 41% of the divisible pool based on the formula for horizontal devolution, Uttar Pradesh got 17.94% and Bihar 10.06%. Other states that got relatively large shares were Madhya Pradesh (7.85%), West Bengal (7.52%) and Maharashtra (6.32%). 

In contrast, among the southern states, Tamil Nadu got 4.08%, Karnataka got 3.65%, and Kerala 1.92%.

Karnataka and Kerala saw their share in the divisible pool decline from the levels recommended by the Reddy panel when the Fifteenth Finance Commission finalised its awards. Bihar and Maharashtra saw their shares rise from 9.67% and 5.52%, respectively. 

The shares of Karnataka fell from 4.71% and Kerala’s from 2.5%. 

Southern states lament that they are being penalised for the progress they have made on demographic performance–they performed better than many other states on education, literacy, health, and per capita income.

The contraction of the share resulted in an estimated loss of ₹62,098 crore for Karnataka over five years, Karnataka chief minister Siddaramaiah tweeted ahead of his 7 February protest in Delhi. He has also claimed that the state was deprived of drought relief assistance.  

Some states are also aggrieved about being denied a share in the cesses and surcharges collected by the Centre. Collections of cesses and surcharges on direct taxes have increased over the years. However, states do not get any share of it as these are not part of the divisible pool.  

Can transfers from the Centre to states be linked to the tax contribution of individual states? 

Citizens living in Mumbai have long complained that the city was denied adequate funding for infrastructure development even though the metropolis is the largest contributor to tax collections. 

Karnataka’s chief minister has also raised this as an issue. In his tweets, Siddaramaiah has claimed that Karnataka receives only ₹12-13 out of every ₹100 it collects as taxes. The southern state is the second-highest contributor to taxes after Maharashtra.

However, such claims lack legitimacy. 

Maharashtra and Karnataka are the top contributors to the tax kitty because they are home to the head offices of profitable businesses from the old economy and new economy sectors. 

Taxes on corporate income, which is close to 30% of the Centre’s gross tax revenues, are collected in the state in which a company is headquartered even if most of its activities including manufacturing are in other states. 

Of the nearly 1.7 million active companies in the country, 319,000 are in Maharashtra and 238,000 in Delhi. Karnataka has fewer (114,000) but it is home to profitable IT companies.