India has a federal setup where the Union and states have a constitutional arrangement to share the financial resources among themselves. There are tax resources which form a divisible pool that can be shared between the Union and the states.
Under Article 280 of the Constitution of India, the finance commission is set up to recommend among other things the share of states in this central tax pool. The recommendations of the finance commission are implemented by the government of the day.
States in India have many development obligations and this gives rise to a requirement for more resources. In addition to other sources, states’ share in the central tax pool is one of the most significant ways to fund their development plans. The advantage of this share is that it is untied, or comes without conditions. States can utilise this money at their discretion with more flexibility.
NDA I – Making the Pool Larger
Until the Vajpayee government, the states were getting their share from income tax collections (mostly), basic excise duties and special excise duties, etc.
After the finance act of 1959, the corporation tax (a major source of revenue) didn’t form the part of the divisible pool. States had submitted to the third finance commission that they were deprived of expanding source of revenue to which they were constitutionally entitled. The central governments, one after the other, mostly led by Congress party, never paid much heed to demand of the states of raising their resources by restoring the pre-1959 arrangement.
The share of states in income tax was raised from 55% in the 1950s to 85% in 1990s. The share in incomes tax collection was not enough for states to fund their welfare plans. The states kept demanding for inclusion of corporation tax in the pool along with the income tax so that their share in absolute terms become big. This was never fulfilled until NDA I government came to picture.
It was the Atal Bihari Vajpayee government which on the recommendation of 10th finance commission introduced the 80th constitutional amendment act in 2000 to bring all central taxes and duties including corporation tax and service tax, barring some in the pool. The share of states was also fixed at 29%. This came to be known as ‘alternative scheme of devolution’.
Let’s understand this with the help of a hypothetical example, before the Vajpayee government’s move, if the divisible pool (a large chunk of which was formed by income tax) had Rs. 100, states with 85% share will get Rs. 85. But, after the alternative scheme of devolution, if the widened divisible pool had Rs. 500, states with 29% share will get Rs. 145. Thus, the share of the states increased in terms of absolute value. Moreover, states had the chance of benefitting from the buoyancy of the number of taxes added to the pool.
NDA II – Increasing the Devolution by Significant Percentage
The eleventh and twelfth commissions had recommended that the share of states be fixed at 29.5% and 30.5% respectively in the central tax revenue. This devolution to the states increased to 32% after the recommendation of the 13th finance commission. Thus, by the time the UPA government left in 2014, states only had 32% share in the net proceeds of shareable central taxes.
Giving more autonomy and devolution to states, NDA II government led by PM Modi, on the recommendation of the 14th finance commission, had increased the share of states in the central taxes to 42%, a significant jump of 10 percentage points.
However, one can argue that it is the finance commission which recommends the measures to the government from time to time. But it should be noted that the final call is taken by the government.
We have seen how a change brought by the Nehru government in 1959 affected the revenue of states adversely, given his philosophy of centralising more power and resources. The continuation of this idea by successive governments showed their willingness to continue with the centralisation of resources. In contrast, a decision to have all union taxes (except some) in the divisible pool or a decision to raise the states’ share by significant 10 percentage points by NDA governments suggest their approach of decentralising and empowering states more.
(This article is only limited to vertical distribution of net proceeds from central tax collections between union and states.)