7.4] Center-State Finance Relations

Vertical and horizontal imbalances are common features of most federations and India is no exception to this. The Constitution assigned taxes with a nation-wide base to the Union to make the country one common economic space. However, states being closer to people and more sensitive to the local needs have been assigned functional responsibilities. This naturally involves state expenditure disproportionate to their assigned sources of revenue resulting in vertical imbalances. Horizontal imbalances across States are on account of factors, which include historical backgrounds, differential endowment of resources, and capacity to raise resources.

Unlike in most other federations, differences in the developmental levels in Indian States are very sharp. In an explicit recognition of vertical and horizontal imbalances, the Indian Constitution embodies the following enabling and mandatory provisions to address them through the transfer of resources from the Centre to the States

1. Levy of duties by the Centre but collected and retained by the States (Article 268)
2. Taxes and duties levied and collected by the Centre but assigned in whole to the States (Article 269).
3. Sharing of the proceeds of all Union taxes between the Centre and the States under Article 270. (Effective from April 1, 1996, following the eightieth amendment to the Constitution replacing the earlier provisions relating to mandatory sharing of income tax under Article 270 and permissive sharing of Union excise duties under Article 272).
4. Statutory grants-in-aid of the revenues of States (Article 275)
5. Grants for any public purpose (Article 282).
6. Loans for any public purpose (Article 293).

In addition to provisions enabling transfer of resources from the Centre to the States, a distinguishing feature of the Indian Constitution is that it provides for an institutional mechanism to facilitate such transfers. The institution assigned with such a task under Article 280 of the Constitution is the Finance Commission, which is to be appointed at the expiration of every five years or earlier. Under the Constitution, the main responsibilities of a Finance Commission are the following.

1. The distribution between the Union and the States of the net proceeds of taxes which are to be divided between them and the allocation between the States of the respective shares of such proceeds.
2. Determination of principles and quantum of grants-in-aid to States which are in need of such assistance.
3. Measures needed to augment the Consolidated Fund of a State to supplement the resources of the Panchayats and Municipalities in the State on the basis of the recommendations made by the Finance Commission of the State.

[Finance commission have been already discussed under 6.3] Finance Commission of India]

1. Dominant Role of Center in Tax Collection

1. To address regional imbalance created because of colonial policies. All resources generated in a state, cannot be kept entirely under the state, it will create more imbalance. Thus, centre collects taxes and carries out redistribution.
2. The dominant role of state in collection of taxes also helps in centralized planning to achieve faster economic growth.
3. This also helps in creation of uniform tax structure across country, helping ease of doing business.

2. Analysis of the distribution of taxes

1. The high yielding and more elastic taxes have been kept under Union. However, Union’s revenues are not just for the use of Union. It is to be distributed among states as per prescribed formula. This will address vertical as well as horizontal imbalance.
2. States also have power to impose taxes, however taxes kept under the state are not high yielding, rigid and thus not sufficient. Hence states are made dependent on center.

2.1 Ways in which states get resources.

Borrowings.

While the state government are allowed to borrow the funds to meet the developmental needs, the power of borrowing of state governments is limited. 

1. They cannot borrow from outside the country. 
2. In the domestic market also, there are limitations:
   • In case they have borrowed from Union government, and the loan remains outstanding, they cannot borrow from the market without the permission of the Union government.
   • In case they have borrowed from the market. And in such case the counter-guarantee is given by the union, they cannot get fresh loans without the approval of the union.

Grants in Aids

There is a provision for Grants in aid of revenue. There are two types of grants.

1) Statutory Grants

Grants under Art 275, provided to needy states.

2) Discretionary Grants.

These are called discretionary because both Union and state governments can give these grants for any public purpose even when it does not come within their legislative competence. It comes under Art 282.

There is also a dispute with respect to discretionary grants between union and states. It also created conflict between finance commission and planning commission.

Distribution of taxes

The constitutional scheme of the distribution of taxes is continuously evolving. The recent amendment is 101 Amendment Act.

3. Goods and Services Tax (GST)

The 101st Amendment Act of the Indian Constitution, enacted in 2016, introduced the Goods and Services Tax (GST) in India. This amendment brought about significant changes to the country’s tax structure.

1. The amendment introduced a comprehensive Goods and Services Tax (GST) to replace multiple indirect taxes levied by the Central and State Governments, including excise duty, service tax, VAT, and others.
2. It provided both the Centre and the States with concurrent powers to levy GST on the supply of goods and services. This led to the creation of Central GST (CGST) and State GST (SGST) for intra-state transactions, and Integrated GST (IGST) for inter-state transactions.
3. The amendment established the GST Council, a constitutional body responsible for making recommendations on key GST issues, including tax rates, exemptions, etc. The Council consists of the union finance minister (as the chairperson), the union minister of state for finance, and each state can nominate a minister in-charge of finance or taxation or any other minister as a member.
4. The amendment included provision to compensate states for any revenue loss states might incur due to the implementation of GST for a period of five years (terminated in June 2022).

3.1 Revenue Distribution under GST

Under the Goods and Services Tax (GST), the distribution of taxes is designed to ensure that both the Central and State governments receive their share of revenue. GST is divided into three types:

1. Central Goods and Services Tax (CGST): This tax is levied by the central government on intra-state supply of goods and services. The revenue goes to the Central Government.
2. State Goods and Services Tax (SGST): This is levied by the state government on intra-state supply of goods and services. The revenue goes to the respective State Government.
3. Integrated Goods and Services Tax (IGST): This is levied by the Central Government on inter-state supply of goods and services, including imports. Revenue from IGST is shared between the Central and State Governments as per the provisions of the GST law.

3.2 Distribution Mechanism:

Intra-State Supplies

When a transaction occurs within a state, both CGST and SGST are levied. For example, if the GST rate is 18%, then 9% will go to the Central Government (CGST) and 9% to the State Government (SGST).

Inter-State Supplies

When a transaction occurs between states, IGST is levied. The IGST collected by the Central Government is distributed between the Centre and the destination state where the goods or services are consumed.

Example

Intra-State Sale: A product sold within Maharashtra at 18% GST will see 9% CGST going to the Central Government and 9% SGST going to the Maharashtra State Government.

Inter-State Sale: A product sold from Maharashtra to Gujarat at 18% GST will be subject to 18% IGST, which is collected by the Central Government. The Central Government then distributes a portion of this IGST to the Gujarat State Government.

Currently, the GST rate list comprises four slabs, namely 5%, 12%, 18%, and 28%. The GST council has assigned each good and service to one of these five tax slabs. Essential commodities such as food grains, milk, fresh fruits and vegetables, healthcare services, education, and transportation services are exempted from GST.

3.3 GST Council

Voting pattern – The vote of the central government has a weightage of one-third of the total votes cast, and the votes of all the state governments taken together have a weightage of two-thirds of the total votes cast in that meeting.

To pass any decision, 3/4th of the votes is required.

It makes GST 3-legged race. States have to cooperate with states, Union and states have to cooperate with each other.

3.3 Various Issues

1] Implication of GST on federalism.

Whether GST strengthens federalism or weakens federalism will depend on our perception of federalism. If we define federalism in terms of strengthening of states, GST weakens the states. If we define federalism in terms of cooperative federalism, GST forces the units of federalism to cooperate.

Those who consider GST as anti-federal give following arguments.

1| Federalism is a political contrivance where units desire unity without uniformity. Hence introduction of one tax goes against the spirit of federalism. We can take the example of USA, despite being the most advanced market economy, USA has not gone for introduction of GST.

2| Sales tax has been the most important source of revenue for the state governments. Now they do not have complete freedom to determine the rate of the tax.

Sales tax had been one of the most contested issues in the constituent assembly. Ambedkar, who always favored strong center, had the view that state governments should be given complete autonomy in determining the rate of sales tax. Constitution should not prescribe any limit.

3| Sales tax has been a major method for the states to pursue the public policy of their choice. If we go by principle of federalism, it should be the choice of the state to decide. e.g. If Government of Bihar believes in banning of liquor, even when it amounts to the loss of revenue, it is their choice. Similarly, if state of Gujarat wants to promote manufacturing, state of Tamil Nadu aims to invest in health and education, it should be their choice.

4| There are concerns of manufacturing states because GST is a destination-based tax.

On the other hand, those who believe in the spirit of cooperative federalism, they believe that

1| GST compels all the units to cooperate. They believe that GST will convert tangles of the relations to tango.

2| If states have monopoly over determining rates of sales tax, they also get power to levy service tax.

3| It is believed that in the long term, the revenues of the states will increase, will give them more resources.

2] Concerns with Planning Commission

1) Planning commission was extra-constitutional, non-statutory body. 

2) Planning commission impacted the cabinet system

It became super cabinet. Planning commission not only made policies but also had powers to determine the outlays. Thus, it reduced ministries to the level of implementing agencies. The members of planning commission were hand-picked by the prime minister, they were not elected by the people yet became the major power in the system.

3) Planning commission reduced the scope of finance commission.

There was no constitutional limitation on finance commission in determining grants. Finance commission could have determined the criteria for both type of grants. However, because of Planning Commission, the system developed, where finance commission used to decide the revenue grants, and Planning Commission to decide the grants for development. Hence Planning Commission had to decide over huge outlays in comparison to finance commission. Hence Planning Commission became more powerful.

3.4 Comparison between Planning Commission and NITI Aayog

Planning commission had become anachronistic. Planning is a feature of socialist economy rather than market economy. Market economy is based on demand and supply. Socialist economy is supply driven. Socialist economy is directed by the state.

In 1990s India shifted from state-directed economy, towards market-driven economy. Hence the nature of planning also changed from centralized to indicative planning. Unlike centralized planning, where Government will not only determine the priorities but also the allocation of resources, indicative planning means Government will only give indications to the market or private player about government’s priorities. For example, if the priority of government is promotion of cement industry, it will make such policies, incentives which will attract private players to invest in that industry. However, it appears that the present government has ended even indicative planning.

Present government has abolished Planning Commission and introduced NITI Aayog on 1st Jan 2015. NITI Aayog is a policy making institution rather than planning institution.

3.5 Approach of NITI Aayog

According to Prime Minister, NITI Aayog is based on cooperative federalism. Cooperative federalism in true sense. States will be involved in the formulation of policies since inception. State will determine their priorities. The modality in the NITI Aayog is working groups of the interested states.

NITI Aayog is also based on the vision of ‘team India’. It means it also includes private sector in the formulation of policies. According to the Prime Minister, it is a ‘bottom up’ approach. NITI Aayog has transferred the power to make allocations to finance ministry. Instead of planned document, it has produced 3 years agenda for reforms. According to Balveer Arora, NITI Aayog is the imperfect clone of the institution which it aimed to abolish.

3.6 Finance Commission.

It is entirely a Union body. Neither in the selection of the members nor in deciding terms of reference, state governments have any say.

[Refer 6.3] Finance Commission for more details]