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Cut in states share in tax may become next big flashpoint
October, 27th 2020

The issue of the Goods and Services Tax (GST) compensation controversy may have been laid to rest for now, but the Centre and the states, on opposing sides in that debate, find themselves in a similar position again -- this time over the ongoing discussion on a possible review of the share of states in the divisible pool of revenue.

Both facts are known, but the GST compensation controversy, although resolved, may make the task of the Finance Commission difficult. It is expected to submit its final report on the devolution in the next few days.


At the core of the debate is what was five years ago hailed as a major boost to federalism.

The previous 14th Finance Commission, in a historic step in 2015, sharply increased the states’ share in the divisible pool – the repository where all taxes are collected before being divided between Centre and states – to 42% from 32%, holding that tax devolution should be the primary source of transfer of funds to states.

Chairman of the 15th Finance Commission NK Singh declined to comment on the issue due to reasons of confidentiality.

The Constitution, through Article 280 to 281, provides for finance commissions, set up every five years, a mechanism for division of taxes and revenues vertically i.e. between the Centre and states, and horizontally, i.e. among all states, based on their levels of development, prosperity and regional needs.

The final report for the 2021-26 period is due to be submitted by October 30, 2020.

The Centre, in its terms of reference for the current Finance Commission, included a provision on reduction in states’ share of 42% in total taxes due to the creation of the newly formed Union territories of Jammu & Kashmir and Ladakh. The creation of these new UTs naturally meant the overall share of states had to come down.

In its first report for 2020-21 period, the 15th Finance Commission accordingly reduced states’ share by 1%, i.e. from 42% to 41%. But the larger issue has been unresolved. There have been four meetings with state finance ministers on the issue, the person quoted in the first instance said.

West Bengal finance minister Amit Mitra has been attacking the Centre over what he alleged was an attempt to “control” the terms of reference of the finance commission. On August 1, he accused the Centre of attempting to directly “intervene”.

“The Centre will keep nudging the finance commissions, states will also want more, but the Finance Commission will have to make an objective, fair assessment, and take its own call. If it toes the Centre’s line, then the institution will lose its sanctity,” said M Govinda Rao, a noted economist who was a member of 14th Finance Commission.

According to Rao, the ruling parties at the Centre, over the years, have tended to roll out more central schemes falling in states’ domain to gain political advantage. “The Centre’s spending on programmes in states’ subjects has increased from 13% to 17% in recent years, while that on concurrent subjects has increased from 15% to 19%. This allows the Centre to take ownership of welfare schemes. But it also burdens its finances,” Rao explained.

The last budget estimated the total share of states in taxes at ₹7.84 lakh crore for 2020-21. An individual state’s share is determined by a predetermined formula. Various factors go into the criteria where weights are assigned, including for population, income distance, forest cover and area. Income distance is defined as the difference between the per capita income of a state and the average per capita incomes of all states. States with lower incomes may get a higher share. For instance, according to the 14th Finance Commission’s award, Bihar, a poorer state, had a 9.7% share in taxes, while Haryana, a richer state, had 1.1%. “The Finance Commission is currently looking into the funding patterns of centrally sponsored schemes as a possible solution,” the person quoted in the first instance said.

According to Rao, one of the mandates of the current Finance Commission is to make sectoral grants to states based on measurable performances on various parameters. “If the sectoral grants are more, then tax devolution will have to come down. Besides, revenue projections are falling due to Covid. So, it will be a difficult call.”

One of the key mandates of the 15th Finance Commission is to look at the full implications of GST and issues related to large shortfall in collections and high volatility in GST revenues.

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